Thinking of buying gold?

Why do people buy stocks? Fundamentally, it is because they believe in the underlying future value of the business being run. Why do people buy gold? This is a much more difficult question to answer since gold is not a business but a commodity and a small portion of its price can be attributed to economic performance of the commodity (unlike copper which has a myriad of industrial applications).

With all the market uncertainty about sovereign debt, a lot of average investors have begun to invest in gold. Since buying gold is not a purchase of an underlying business, it is difficult to determine when a good time to buy the commodity. In a business, you may buy its stock because it had a good quarter, increased the dividend, is a growing business etc. But how can you tell when it is a good time to buy gold?

From a quantitative analysis, it may be useful to look at the Dow/Gold ratio. Quite simply, the Dow/Gold ratio measure how many ounces of gold it would cost to purchase one share in the Dow Jones Industrial Average (which is a proxy of large companies based in the U.S.). If the Dow traded at 10,000 and an ounce of gold cost $1,000, the Dow/Gold ratio would be 10. The higher the ratio, the more capital is in stocks. The lower the ratio, the more capital is in hard assets (gold being the proxy for hard assets). The Dow/Gold ratio currently hovers at approximately 9.

To give some historical context, the Dow/Gold Ratio hit 1 twice (which means an ounce of gold was worth exactly a share in the Dow) in 1932 and 1980. It peaked at approximately 45 during the Dot Com boom.

Here is the interesting thing: the Dow/Gold Ratio has been declining (money moving into hard assets) since the early 2000’s (see Figure 1 graphing the Dow/Gold Ratio). In other words, moving into gold now may means one could be buying towards the end of the appreciation curve for gold. Traders far smarter than you and I may be promoting gold to take profit as the latest trendy investment to buy.

More to the point, why would any average investor want gold to continue to raise? Cheering for gold to appreciate means one is cheering for: (i) higher than tolerable inflation; (ii) massive government debt; (iii) instability in their own economic lives; or (iv) the end of days. I am not sure how taking gains in gold stock would be considered a win if one lost their job or had to pay higher taxes at the same time.

Written by Thicken My Wallet - 5/26/10