Forecasting Major Economic Business Cycles
Watching the Dow/Gold Ratio to Signal the Next Market Cycle
Mar 17, 2009
There are two basic methods of predicting prices in financial markets. The first is that prices ultimately reflect fundamental values in the economy. Prices are determined by actual and expected developments concerning these values; therefore, forecasting prices amount to forecasting fundamentals.
The second approach argues that most fundamental values are already discounted by the market and forecasting prices becomes an issue of deciding what the market is “saying” about itself. It's a matter of technically analyzing prices.
This article looks at a possible chart indicator to forecast crowd sentiment, find trends and pinpoint reversals of the major business cycle. Historically, the ratio of the Dow Jones index and Gold prices has been shown to be one such indicator.
Technical Analysis of Price
In technical analysis of a market, no account is taken of fundamental values because it is assumed investors' expectations are already reflected in prices. The market is trying to anticipate the future, with changes in prices preceding changes in fundamental conditions.
The rationale behind technical analysis is that people indulge in group behavior. Price movements and indices of investor activity, such as the Dow, gold and crude oil, respond to information shocks and their prices oscillate rhythmically in response to cyclic crowd sentiment. These market rhythms have been modeled as fixed, periodic cycles or as dynamic systems with aperiodic cycles.
Using the Dow/Gold Ratio
The Dow/Gold ratio has been found a useful measurement of price changes to reflect crowd activity in the business cycle. It can be interpreted as the number of ounces of gold that buys one share of the Dow.
Example:
- With the Dow at 10,000 and gold at 500, it requires 20 ounces of gold to buy one share of the Dow, so the ratio is 20.
Why settle for the Dow/Gold ratio? The reason is that it shows the cyclical nature of the battle between paper assets and hard assets. When the equity growth phase ends, and preservation of wealth becomes paramount, gold tends to excel. A simple technical analysis of the chart data can reveal when changes are likely to occur.
Dow/Gold Ratio Reveals the Business Cycle
The Dow/Gold ratio chart in figure 1 shows a time period since the 1930s. It can be seen that there are two main peaks and troughs varying from a ratio as low as 1 to as high as 42. When the ratio is on the rise, it is time to buy equities but when the ratio peaks, one needs to switch to selling equities and buying gold.
The peak in the year 2000 indicates the previous signal to start buying gold. Since then, the ratio has been in a downtrend and a bottom is in sight. By extrapolating the graph, a forecasted region of the ratio in the range of 1 - 5 would correspond to pairs of Dow and Gold values. For illustration, one could guess that a ratio of 2.5 may define Dow 5000 and gold $2000. Of course, exact values would dependent on actual market conditions.
Therefore, we could be witnessing an approaching new era for equities. Time will tell but one thing is for sure, it would be wise to consult the Dow/Gold ratio to check if a bottom of the business cycle has been formed.
 |
