“Going Tangible”

As long-term readers of this site know, my long-term forecast is for the Dow to Gold ratio to reach a level of 2, but more likely 1.

As far out as that forecast may seem presently, when one looks at this level from a historical perspective, it’s not that far out.  Since markets often move from one extreme to another over long periods of time, and since the last extreme saw the Dow to Gold ratio exceeding 40, I am of the belief that the next extreme will be at the low end of the spectrum.

Given the direction that Fed policy seems to be taking, I expect that gold will continue to move higher over time as will other tangible assets.

I would be remiss if I didn’t point out that gold, silver and other tangible assets will move higher nominally but probably not much higher in real terms.

If you are planning your financial future or are planning for retirement, this is one of the most important concepts to understand.  And, incorporating strategies that will allow you to potentially capitalize on this concept could be the most important thing that you do to have a bright financial future.

I’ll give you an example and then discuss some strategies.

In nominal terms, stocks are much higher today than they were 20 years ago at the turn of the century.

The Dow Jones Industrial Average stands at about 28,800.  With the price of gold at about $1,560 per ounce, the Dow to Gold ratio stands at about 18.4.  This ratio is calculated by taking the price of the Dow Jones Industrial Average in dollars and dividing it by the price of gold in US Dollars.

Why use this Dow to Gold ratio?

Historically speaking gold has always been money.

Going back to ancient Egypt over 5000 years ago, gold and other precious metals were used in commerce.

An ounce of gold 5000 years ago had exactly the same intrinsic or tangible value as an ounce of gold today.

The same statement could be made about an ounce of gold 20 years ago and an ounce of gold today.  An ounce of gold has not changed.

Yet, when pricing that ounce of gold in US Dollars, one gets a different picture.  20 years ago, an ounce of gold sold for about $250 in US Dollars.  Today, that same ounce of gold sells for more than 6 times as much.

Does that mean an ounce of gold is worth more than it was 20 years ago?

Obviously not.  It’s the same ounce of gold.

Gold has not gained tangible value; the US Dollar has lost purchasing power.  That’s why I like to use the Dow to Gold ratio to determine the real value of stocks.

Let’s go back to calendar year 2000.  The Dow was at about 11,700 in January of that year which was, at the time, a record high.  At that same time, gold was selling for about 270.  That’s a Dow to Gold ratio of about 43.

In other words, it took about 43 ounces of gold to buy the Dow.  Today, it takes about 18.

So, looking at it from that perspective, what might one conclude about the price of stocks?

They are higher in nominal terms, but they are lower in real terms.

I am of the opinion this is almost totally due to the monetary policies of the Federal Reserve.

The Federal Reserve’s balance sheet was about ½ a trillion in 2000.  Today, it’s more than $4 trillion.

How does the balance sheet of the Fed expand?

The Fed creates money to buy assets from member banks.

More recently, the Fed has been ‘injecting liquidity’ into the repo market which is the overnight lending market between banks.

What does this mean?

Simply put, for whatever reason, some banks are not willing to loan money to other banks on an overnight basis.

While no one knows exactly why, one does not have to be a financial genius to conclude that the only reason one would not loan a person or entity money on a short-term basis is because you perceived that there was too much risk to do so.

That’s what we believe is happening presently; money is being created to stabilize this overnight lending market.

But, looking ahead, there are other reasons that I believe the Fed will continue this loose money policy.

The biggest reason is the state of the nation’s finances and debt levels.  This is a topic that we have often discussed, but the problem continues to get larger.

John Mauldin, in his excellent newsletter “Thoughts from the Frontline”, had this to say on the topic this past week (emphasis added):

To think that we have somehow eliminated recessions and risk, or that central banks and the government have somehow become adept at managing the business cycle, is simply foolish. Yet we keep doing it, every single time.

Debt seems harmless enough at first. You have reliable cash flow, repayment is no problem, and you’re going to spend the borrowed money wisely. But human nature tends to make us overdo otherwise good things. And, with debt, you may also have lenders actively urging you to borrow even more. Everything is fine… until it’s not.

Personal debt, while sometimes excessive, isn’t the main problem. Government and corporate debt are the bigger challenges and the reason we will spend the 2020s living dangerously. All that debt is ultimately personal debt, too, since most of us are either taxpayers, shareholders, or both.

In Part 1 of this forecast, I described my relatively benign outlook for the next 12 months. The calm may last into 2021 and even beyond. But beneath the surface, pressure will still be increasing. It will grow slowly, almost imperceptibly, but eventually explode.

Or, to use another metaphor: We are frogs in the kettle and someone just turned on the heat. By the time we notice, our good options will be gone.

To be clear, money creation is NOT a good option, but given the size of the debt, it is the only option that the politicians will consider to be viable.

The only other two choices are to raise taxes or cut spending both of which are not very viable politically.

Any budget can be balanced by cutting spending but the level of cuts that would be required to solve the deficit problem would create a deflationary environment that would be so severe, politicians would be voted out of office in droves.

You simply cannot raise taxes to a level that would be high enough to solve the deficit problem.  There is not enough money in existence.

The only other option is money creation.

In my view, that’s what will continue to happen.

As more money is created, moving more toward tangible assets in your portfolio may be the best way to preserve purchasing power.