Ian McAvity is a GOM. A GOM is a Grand Old Man. When you’re a young hot-shot, you don’t plan on becoming a GOM. You plan on remaining a youthful hot shot. With a few exceptions, such as Warren Buffett, youthful hot shots become whiz kids emeriti. The problem is, the ones who eventually do become GOMs are not recognized as hot shots until they are middle-aged, decades after people should have bought their holding companies’ stocks and held onto them, no matter what.
McAvity is a Canadian investment newsletter publisher. His specialty is charts — not just the usual lines-all-over-the-page charts, but clear, insightful charts. He publishes Deliberations, which doesn’t have a website, doesn’t accept credit cards, and (as far as I can remember) doesn’t send out “subscribe now” mailing packages. How it survives, I don’t know. It’s a mystery.
He is not always bullish on gold, which is good for his subscribers, but he has followed gold for a long time. I have known him for over 25 years.
In the 2007 forecast issue of Deliberations, he presented a chart. If there were a link on-line, I would provide it. The chart traced the ratio of the Dow Jones Industrial Average to the price of gold, beginning in 1900.
McAvity describes the history of the Dow/gold ratio.
In August 1929, your grandfather sold one unit of the Dow and bought 18 ounces of gold. Three years later, when the Dow/gold ratio bottomed at 2:1, he sold 18 ounces and bought 9 units of the Dow.
Those 9 units reached another peak in 1966 when the ratio hit 28:1. Now your father exchanged those 9 Dow units for 252 ounces of gold.
In January 1980, the ratio got to an almost unprecedented 1:1 ratio, so he converted those 252 ounces of gold into 252 units of the Dow.
Come 1999 with the ratio at an unprecedented 43.85 to 1 level, the prudent family converted those 252 units of the Dow into 11,050 ounces of gold!
No trades were based on the price of gold or the level of the Dow . . . it’s just a simple question of how many ounces is the Dow trading for in the market.
This little fictional fable started with 1 unit of the Dow at a peak in 1929. Two tops, two bottoms, and 5 trades later it’s 11,050 ounces of gold, in 70 years.
Consider what took place from 1900 to 1999. There was a world war, a post-war boom, a decade-long depression, price deflation, another world war, the international post-war boom, multiple smaller regional wars, price inflation, the Cold War, and all of the technological wonders that have transformed our lives. Starting with under two ounces of gold in 1900, a family winds up with over 11,000 ounces in 1999 — if the family’s asset manager had perfect timing and there had been no income taxes.
Today, a unit of the Dow costs about 20 ounces. This is down from 44 ounces in early 2000. McAvity offers his analysis as to what we should expect in the future regarding the Dow/gold ratio.
Lower peaks and a lower low in the past six years confirms a major trend reversal and suggests we are headed towards the other extreme in the years to come.
There are some forecasters who think the ratio will return to 1:1, with the number at 3,000. Richard Russell, another GOM, has suggested this possibility. McAvity says he expects a less catastrophic ratio, something in the range of 5:1.
Recessions push down the price of gold and the price of stocks. So, there are times when it is better to be in CD’s or bonds than to be in stocks or gold. There is more to profits than trading gold against the Dow. But McAvity’s point is well taken. Extremes in the Dow/gold ratio offer profit opportunities. It would seem to be wiser to be in gold than in stocks today, especially when dividends are barely sufficient to pay for index mutual fund management fees.
Gold’s price is gyrating wildly. It hit $725 on May 12. It fell back to $640 by May 26. It went below $570 in June. It rebounded to $660 on July 14. It was back to $575 on September 15. It was at $650 on December 1. It is now below $610.
Meanwhile, the stock market has been rising. The bulls are everywhere. While 1999’s talk of “Dow 36,000” is long gone, there is a great deal of optimism.
You can make a better return on your money by investing in low-risk 90-day Treasury bills than in inflation-threatened 30-year T-bonds. Why are bond investors, who usually have far more money than stock investors, convinced that they should compete against each other, bidding the price of T-bonds above T-bills? (Price and interest rate are inverse in the credit markets.)
There is a major conflict of views going on today. On one side are creditors. On the other side are stock investors.
Bond investors are convinced that it makes economic sense to buy T-bonds that pay less interest than 90-day T-bills. They presumably expect the short-term rate to fall below the long-term rate. They are locking in their rate of return by purchasing T-bonds rather than T-bills, which must be rolled over at a new rate every 90 days. This interest-rate differential is a traditional indicator of a looming recession. Creditors have concluded that an economic slowdown or even a recession will reduce the demand for short-term debt. This will lower the interest rate for T-bills.
Stock investors disagree with bond investors. They see no recession on the horizon. Recessions are bad for stocks. Corporate profits fall, red ink flows, and the future value of shares looks grim.
When recession looms, it is safer to sell shares and buy T-bills or T-bonds. Then wait for share prices to fall. In tax-deferred retirement funds, this is clearly the safest plan, since the investor defers all taxes on portfolio profits. The investors are not penalized by the government for selling shares and buying bonds.
Shares remain high today. This tells me that stock market optimism remains high.
In 2000, the typical stock market investor believed that 15% per annum gains are normal. They aren’t normal. They are wildly abnormal. That optimism remains, though at a muted level, given the fact that the Standard & Poor’s 500 index is below its peak in 2000. The S&P 500, which was at 1550 in early 2000, would be at 4100 today if the market had sustained a 15% return. Yet the hopelessly naïve investors of 2000 have not yet figured out that their hopes and dreams have been nullified by seven lean years of 0% return. What was naïve faith in getting rich back in 2000 has been replaced by naïve faith in getting even over the next seven years.
It isn’t going to happen.
The bond market is screaming this, but stock market investors refuse to listen. “This time, it’s different,” they tell themselves. “We can make up the losses of 2000—2006 by staying in stocks.”
No, they can’t. They won’t. The early boomers reach retirement age next year: age 62. While most of the boomers who actually own stocks are unlikely to retire at 62, or even 65 — they can’t afford to — they are not being replaced by a generation of dedicated savers. Eventually, they will be forced by old age to retire. They will have to sell their shares. To whom? At what price?
The boomers with stocks in their retirement portfolio will hang onto their jobs as long as they can. They are in professions that let them stay on the job. They are not like Joe Lunchbucket, who believed from day one that Social Security and his company’s pension plan would protect his post-retirement lifestyle. Joe is tired. He has few alternative career opportunities. He will retire whenever he can. But he will not sell his shares. He has none to sell.
JOE CAN STILL VOTE
When Joe retires, he will demand an ever-increasing flow of government subsidies. We now have a Democrat-controlled Congress. The pressure to pass laws that help the poor, especially retirees, will be constant. The President will find it difficult to veto such spending. He has vetoed only one piece of legislation in six years: the stem cell research bill. There will surely be no bills rolling back retirement subsidies.
Year by year, the ranks of retirees will swell. Year by year, there will be new political pressure to increase payments and benefits.
This will have to be paid for. With what? Higher taxes on the rich? That will reduce investment and slow the economy. The deficit will get larger.
Eventually, the Federal Reserve will be forced to buy up the debt that foreign central banks will no longer purchase and that American investors cannot afford. That means long-run price inflation. This will push up the built-in cost of living adjustment in Social Security.
Long-run price inflation means a rising price of gold. This probably will not happen in 2007, unless Israel attacks Iran’s nuclear facilities, and Iran then retaliates by cutting oil production and by selling its oil for euros rather than only dollars, as is the case today.
We are in pre-recession mode today. Bond investors understand this. Stock market investors don’t. Neither do gold and silver investors.
The threat of recession to equities — ownership shares — is universal. There is much less threat to credit instruments: CD’s and bonds.
This time it may be different. But the inverted yield curve reveals that the smartest investors think it won’t be different.
Copyright © 2007 LewRockwell.com