Wednesday, February 18, 2009

The Dow Jones Industrial Average / Gold Ratio: Expansion & Contraction Cycles

This is Part 2 of a series on the Dow Jones Industrial Average / Gold Ratio. In the first part, a basic review was presented on the ratio and it's potential meaning.

The chart below annotates the ratio with expansion and contraction cycles. Expansion cycles exhibit steeply ascending trends while the contractions exhibit abrupt and steep declines. When the ratio is increasing, historically, it aligns with expansion cycles in business and the associated stock markets. Contractions, in contrast, exhibit abrupt downturns. Typically, for some unforeseen reason, these "changes in trend" come as a surprise to the masses.

Both "tops" and "bottoms" exhibit "V-shaped" patterns. The change from contraction to expansion appears abrupt while the same occurs when trending from expansion to contraction. I use the term "inflection point" to define these abrupt "points in time". Subsequently and most interestingly, many other variables change in alignment with this ratio.

While this ratio exhibits sharp inflection points, the associated stock market indices typically do not always present the same obvious "change in trend". The chart below of the DJIA illustrates this in the time frames from 1963-1981 and 2000 to present. Both timeframes exhibit a flat "zig-zag" pattern in the DJIA. In contrast, many variables such as unemployment, inflation, and money supply changed drastically during these periods. From this, one could conclude that the DJIA/Gold Ratio presents a more accurate depiction and timing of economic cycles. It also appears to present very obvious inflection points that could be utilized to make changes in one's investment strategy and choice of asset classes (e.g. Gold purchase versus stock).

I believe that the most significant conclusion from the ratio in the most recent cycle is that the contraction began in the 1999-2000 timeframe. The U.S. public and the media were oblivious to this significant inflection point and they have just awoken to the consequences of the "already in progress" contraction. All are fixated on blaming the recent mortgage crisis and the politicians in Washington. The mortgage crisis was just one more "falling domino" with many more to come.

These data and the "invisible hand" of the economic cycle do not care what CNN or Fox report to the public. It also does not care who is in power in Washington. The cycle will carry on despite the political games being played out in the Senate, Congress, and on "bubblevision".

This analysis and the associated data illustrate the significance of understanding the historical cycles and the associated changes that align with them. Time would be best spent trying to understand history and how it might portend future events that could ultimately effect us all personally. As they say, "a good offense is the best defense". I once again state that the ratio appears to indicate that we are still quite far from "the bottom". The cycle began in 1981-82 and we rode the "expansion wave" for many years. We now want "the pain" to be very short. As they say "good luck with that".

PDF's of these charts can be downloaded at:

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