Malinvestments and the Dow/Gold Ratio

In theory, prices measured in gold should end up lower than their starting point after a complete credit cycle. Credit expansion spawns malinvestments which have to be liquidated during the subsequent credit contraction. With a surplus of products and capital goods produced through the cycle, prices end up lower than they started.

With credit cycles being enhanced and made bigger through central banking, the progressive period that we are currently living through should see larger swings than the liberal period that preceded it. There should be evidence of a marked change in price fluctuation, starting late 1913 when the Federal Reserve was established.

As it happens, this is exactly what we see. By studying a 200 year chart of the Dow/Gold ratio, we see a dramatic difference in market behavior between the liberal era and the progressive era. Less than 20 years after the introduction of central banking, there is a huge overshoot to the upside in the value of the Dow. In the late 1960s there is another overshoot, almost as bad as the one in 1929. Finally, there is a pronounced but less severe overshoot in 1999.

Just as predicted by theory, the overshoots are each followed by undershoots. Prices ended up lower than where they started. It also appears that the upward trend channel has been damaged. While the upward price trend is steady and confined during the liberal era, the progressive era has seen such large price fluctuation that no clear trend can be discerned. While it is possible to simply continue the trend channel upwards from the liberal era, a more horizontal line would fit just as well.

Keeping in mind what we know about credit cycles and malinvestments we can reasonably predict that the current price ratio is likely to be a top. Massive monetary easing and credit expansion that dwarfs anything we have seen before has taken us from a low of about 7 in 2009 to a little over 21 in 2018. This looks and feels much more like the bounce during the decline in the 1970s than the start of a new push towards another all time high.

With 2009 marking the start of a massive credit expansion, we can predict that prices will fall below this level over the next decade or so. Adding to this that the entire progressive era can be seen as a gigantic credit expansion, we can be fairly confident that the coming price drop will go beyond the 1980 low of 1. It is not unreasonable to call for a 0.5 bottom. This means that we have no reason to invest in the stock market as long as the Dow/Gold ratio is above 7, and that we should be cautious even at that level. There is no reason to be excited about low prices before we are well below 3.

By Brad Miller Millertime83 - Own work, CC BY-SA 3.0, Link