Between 1971 and 1974, the gold price rose from $35 an ounce to $190.
That’s not unlike the rise from $250 an ounce in 2001, to $1,920 in 2011.
In late 1974, gold then began a 20-month bear market. This ended in late August 1976 with gold almost 50% lower, flirting with the $100 mark.
That’s not unlike the bear market gold is in now. In the past 21 months, gold has fallen by 40% from its high.
In 1976 another gold bull market began. It ended in 1980 with gold more than eight times higher, at $850 an ounce.
So if history repeats, the stage is now set for an eightfold rise in the gold price, just as we saw in the 1970s.
Quick, quick – buy gold?
Gold looks similar to the 1970s – but don’t ignore the differences
The chart below shows the price of gold since 1971. It is a log chart, ie one that shows percentage gains. (So the distance on the chart between $50 and $100 – a 100% gain – is the same as the distance between $1,000 and $2,000).
I have circled the two corrections – the one from 1974 to 1976, and today’s.
There are similarities between the two periods, unquestionably. And yes, $8,000 gold would be very nice. Indeed, it would be so very nice that it’s rather easy to persuade yourself into thinking that it’s an open and shut case.
But we need to pay attention to the many differences between now and then too.
That $35 an ounce mark from which the ‘70s bull market began, was an artificial low. It was the unsustainable price at which the US set its gold standard over a generation earlier. And it took three years to get from there to $190, not ten as it took from 2001 to 2011.
The $850 high of 1980, too, was a momentary aberration, the price at the morning fix at the height of the Iranian hostage crisis. Just a few days before, it had been $620. A few days later it would be back there again.
There was no computer trading in those days. Anyone who got out at the top did very well – and got very lucky. These and the many other differences are too easily ignored in the desire to believe $8,000 plus gold is coming.
That’s not to say we won’t see $8,000 gold. We could easily. But I just wouldn’t invest on the basis of this pattern alone.
"The only financial publication I could not be without."
John Lang, Director, Tower Hill Associates Ltd
The Dow-gold ratio suggests gold could be about to outperform stocks
However, there is another pattern that I think is worth watching. Looking at ratios between markets, rather than simply measured in the flawed unit of account that is the US dollar, can be useful.
One I like to look at is the ratio between gold and the Dow Jones stock market. For a long time, one of my long-term targets for selling my gold has been when the Dow-gold ratio hits two to one. In other words, when you can buy the Dow Jones index for two ounces of gold.
That might be the Dow at 10,000 and gold at $5,000. Or it could be the Dow at 20,000 and gold at $10,000. It might even be the Dow at 2,000 and gold at $1,000 (although it would take a severely deflationary series of events to make that target).
Below is the Dow-gold ratio since 1800, courtesy of Nick Laird of sharelynx.com.
You can see how the range was much tighter during the 19th century when the world was on a gold standard. (This is indicated by the blue tramlines, leading up to the red vertical line, which marks when the Federal Reserve was created). During the 19th century, the ratio ranged from about 0.2 to 1.
In the 20th century, the range increased. Between about 1900 and 1925, it took anything from two to six ounces of gold to buy the Dow. The Dow rose to being worth 20 ounces of gold in the mania of 1929. It fell back to two in the aftermath, then spent the ‘30s and ‘40s in the two-to-five ounce range.
In the post-war boom the ratio soared again, rising to around 30 by the mid ‘60s. Then came the ‘70s and the ratio fell. In 1980 it hit one again.
The boom of the ‘80s and ‘90s saw the ratio rise to 45 by 1999. Then came another down-cycle. In 2011 – at gold’s peak – it was back at 5. It currently sits just above 11. With the Dow at 15,100 and gold at $1,360 – it takes about 11.1 ounces of gold to buy the Dow.
Looking at it another way, since 2011, the Dow has outperformed gold by roughly two times.
The Dow-gold ratio could be heading lower again
Let’s zoom in and look at the same ratio over the last 100 years.
The 1930s and the 1970s are, in terms of economic performance, perhaps the two decades of the 20th century most similar to what we have now.
Both decades saw a sudden rally in the Dow to gold ratio (in other words, stocks performed better than gold), just as we have recently seen.
I have circled the periods in question on the chart below.
Nick has drawn a green trendline, with a pale green band around it. The ratio stays within this band 75% of the time, and only leaves it during periods of extremity.
Note how in both the 1930s and the 1970s, the ratio ‘reverted to the mean’ (so stocks rose relative to gold). But it then went back to retest the outer reaches of the band – and in the case of the 1970s, went right through it.
The Dow-gold ratio is doing just that now, reverting to the mean and heading towards that green trend line, which lies at a ratio of about 16.
I’m of the mind that our economic problems have not been dealt with. The inflation figures are understated, the employment data ignores many unemployed or underemployed, and quantitative easing has been propping up asset prices across the world.
So I suspect that, just as in the ‘30s and ‘70s, the Dow-gold ratio will reverse. In the coming years, I expect we will come back and re-test the outer reaches of the band. The reversal may even have begun (the high in the ratio was 12) with gold’s recent rally. Or we may have to wait a while longer.
The other possibility, of course, is that our economic woes are on their way to being sorted. The ratio, by fair means or foul, will move on up, just as it has in previous boom times.
So if the ratio rises above that green trend line, it would suggest that I am wrong. Or that I need to review the situation at the very least.
With perfect hindsight, I should have shifted out of gold and into stocks when the Dow-gold ratio hit 5.5 back in September 2011. But I didn’t.
And looking at the current ratio and the broader economic situation, I don’t believe now is the time to be making that shift. If anything, we’re getting nearer the time to be shifting the other way around, from stocks back into gold.
We’ll soon see if I’m right.
Our recommended articles for today
German house prices have finally started to rise, and housebuilders and furniture makers are set to benefit. Matthew Partridge tips six of the best shares to buy now.
When it comes to selling shares, special tax rules apply that can trip up an unwary investor. Tim Bennett introduces HMRC’s share matching rules in this final video in his series on capital gains tax.
New to MoneyWeek?
Welcome, and thank you for visiting us.
Here at MoneyWeek, our aim is simple. To give you intelligent and enjoyable commentary on the most important financial stories of the week, and tell you how to profit from them.
If you've enjoyed what you've read so far, I've got something you'll definitely be interested in.
Every working day the MoneyWeek team sends out a hard-hitting email, 'Money Morning', giving you a rundown of the latest financial events, and revealing what you should do to maximise profits and head off losses…
And with your permission, I'd like to send you Money Morning for FREE.
To sign-up enter your email address below.
We hope you enjoy your stay on the site. Good luck with your investments!
Digital Managing Editor, MoneyWeek