Buy gold to hedge US dollar downside risk (page 2 of 2)

The Dow/Gold ratio has fluctuated over time between 1 and almost 45. When the Dow/Gold ratio was under five, gold was expensive and equities were cheap. Conversely, when the Dow/Gold ratio was over 20, stocks were expensive and gold relatively cheap.

Now, it is interesting to observe what has happened since 2000. At the peak of the stock market in March 2000 the Dow/Gold ratio stood at close to 45. In other words, it was for a 'gold money' holder very expensive to buy one Dow Jones Industrial Average since it took 45 ounces of gold to buy the Dow. Thereafter, stocks collapsed into October 2002 and, therefore, the Dow/Gold ratio also declined.

Dow/Gold ratio declines

What is, however, interesting is that despite the stock market's rebound since October 2002, the Dow/Gold ratio has continued to decline. Simply put for the holder of gold - the world's only honest currency, since it cannot be printed by some dishonest central banker - the Dow, although it increased in value in dollar terms, has continued to decline in gold terms with the result that, today, it 'only' takes 20 ounces of gold to buy one Dow Jones Industrial Average.

Simply put, since 2000, gold has risen at a much faster clip than the Dow Jones and I would expect this out-performance to continue for the next few years until 'gold currency' holders will be able to buy one Dow Jones with just one ounce of gold.

So, if Mr. Bernanke does what he believes in - namely that asset deflation has to be avoided at all cost and, therefore, massively prints money, no matter where the Dow will be in future, at 36,000, 40,000, or at 100,000, as some pundits predicted in their in 1999 published books (of course shortly before the market tumbled), you will be able to buy the Dow with ounce of gold worth either $36,000, $40,000 or $100,000.

Now, you may think that I have become insane. That is partially true because I am convinced that the US Fed's monetary policies will lead to exponentially widening wealth inequity and impoverish the majority of US households, which will then lead to social strife, protectionism, war, and the breakdown of the capitalistic system.

However, if one considers that in 1932 and in 1980 one could indeed buy one Dow Jones Industrial Average with just one ounce of gold, then maybe my views are rather conservative. Possibly one will be able to buy, sometime in future, one Dow Jones with just half an ounce of gold!

Therefore, rather than to buy US stocks, I suggest to invest in gold, whereby right now, both the Dow and gold, as well as most other investment markets are significantly over-bought and could easily correct by about 5% to 10% on the downside.

Banking crisis scenario

There are some more issues we need to address. What about if the 'deflationists' such as my friend Robert Prechter, whose arguments I highly respect, are correct and deflation brings down the Dow Jones, home prices, and all other assets by 50% or 90% in value?

In such a scenario, I would expect that there would be serious debt defaults, a collapse of the derivatives market, and an imaginable banking crisis leading investors to rush into an asset that is not a liability of somebody else. Therefore, I believe that if the Dow Jones declined to say 5,000, gold might actually rally further.

What about the US dollar's value against other currencies? This year the US dollar has been strong, but I would expect other currencies to strengthen against the US dollar once the market realizes that the Fed will print again money. At the end of 2004, investors bet heavily against the US dollar and sentiment about the dollar was extremely negative.

Today, however, we have the opposite situation with speculators being extremely positive about the dollar and negative about non-US dollar currencies. In fact, the speculative positions on the dollar stand at a record high. So, I would gradually move some funds out of dollar assets into the Euro, Swiss franc and Yen and even better continue to accumulate gold, silver and platinum.