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The tale of the ounce of gold, the Dow Jones and real wealth

Will gold be a better investment than the stock market, asks this advisory? And what will resources and the loonie be worth tomorrow?

After a spell of craziness in the market and a fantastical rise in the price of gold, it’s time to settle down to a fable. We opt for the one about Grandpa, the Dow Jones

Industrial Average and the ounce of gold.

Haven’t heard it? Well. Grimm’s Fairy Tales it’s not, although it may be a bit like Jack trading the cow for a handful of beans and a shot at the golden harp (no giants, however, were harmed in the telling of our tale).

This tale is about trading Dow Jones units for gold. It comes to us from Ian McAvity’s Deliberations on World Markets and it is told to illustrate where real value lies in the market, and how much those markets have changed over the years.

Mr. McAvity also has some pertinent observations on Canada and Australia and where commodities might be going in the months ahead, a dramatic story in itself.

Toward a much happier ending

Assume, says Mr. McAvity, that the Dow Jones Industrial Average is an exchange traded fund. Here is how its value has stacked up against the price of gold over the years.

In August 1929 (before the October crash, when the market was flying high), Grandpa sold one unit of the Dow and bought 18 1/2 ounces of gold. Three years later (at the height of the Depression) when the Dow/Gold ratio had dropped from 18:1 to 2:1, he sold those 18 ounces and bought 9 units of the Dow.

Those units stayed in the family for the next 34 years. By then, the ratio had climbed back up to 28:1. Your father, now in control of the family finances, sells those 9 units of the Dow for 252 ounces of gold.

In 1980, an amazing thing happened. Gold, after an enormous run-up during the Soviet invasion of Afghanistan, came down hard. The ratio reached an unprecedented 1:1, so Pop converted 252 ounces of gold into 252 units of the Dow. But there was a much happier ending in store.

A powerful lesson in long-term value

In 1999, the Dow/Gold ratio had reached a new high: 43.85 to 1. The time had come to make the family’s fortune by converting the 252 Dow units into 11,050 ounces of gold! If you’d care to convert those ounces into cash at this morning’s price, it comes in at just over $10 million. (The price of gold this morning was $905.80 an ounce. At the end of August 1929 it was $20.59 an ounce.)

None of the trades in the tale, says Mr. McAvity, were based on the price of gold or the level of the Dow, but simply on how many ounces the Dow traded for in the market.

“This little fictional tale started with 1 unit of the Dow at a peak in 1929,” says the editor. “Two tops, two bottoms and 5 trades later it’s 11,050 ounces of gold, in 70 years.”

He uses this tale, he explains, to illustrate one approach to long-term preservation and accumulation of capital over a span of two or three generations. “Nobody could ever catch such extremes in five simple trades,” he acknowledges, “but there is a powerful lesson in long-term relative value thinking in it.”

In this lesson, tangible assets appear to have outpaced financial assets, and by a considerable margin.

This data spans the extremes of war, inflation, deflation and depression. Equally important, it reflects the changing composition of the Dow as the U.S. economy has gone through a metamorphosis. It began life as a producer of goods. It now resembles a heavily indebted consumer, relying on service industries.

Explain it to Charles Dow

“Imagine trying to explain to Charles Dow 100 years ago the inclusion of Disney and McDonalds, Wal-Mart and Home Depot, AIG Index, Citigroup and JP Morgan as representative of American industry for his index of ‘industrial’ giants,” says Mr. McAvity.

“I suspect he might have asked: ‘What do they produce?’ without even realizing he may be thinking along the lines of the Austrian school of economics that holds: wealth must be produced, it cannot be borrowed or printed.”

You probably figured that one out without the aid of any Austrian professors, but the point is made.

“An ounce of gold has been an ounce of gold with tradable value throughout the history of man,” proclaims the editor, “irrespective of a long list of ‘major’ nations and currencies that came and died over time.”

There is an epilogue to this fable. At the end of 2007, the Dow/Gold ratio stood at 15.9 to 1, down from the peak of 44 ounces at the height of the stock market bubble of 2000. Where does it go from here?

A vote for gold

Many of his friends, Mr. McAvity says, think the markets and gold will come together again, and even reach a 1:1 ratio. He doesn’t agree. He expects higher ratios as the baby boomers head into retirement and start looking for their entitlements to be honoured, putting a good deal of pressure on financial resources in general and the markets in particular.

In the gold vs. the markets argument, here’s what the editor hears from the market supporters. “[Former Fed chairman Alan] Greenspan wouldn’t let the market fall, [new chairman Ben] Bernanke is going to make sure we don’t have another 1930s depression, and Bush doesn’t care about the dollar anyway. The Dow may hit an inflated 30,000 if Bernanke gets the helicopters out.”

Replies Mr. McAvity: “I hear those arguments, but I suspect gold may prove to have been the better investment irrespective of what happens, when we look back with 20/20 vision from 2020!”

He offers no data on how much gold a handful of beans fetches these days, but you might check with the commodities traders at the Chicago Board of Trade.

The time to buy is behind us

If the outlook for gold may be better than many expect, the commodity story is not a happy one in Mr. McAvity’s book. He is looking at the problem from the point of view of U.S. investors seeking riches in the commodity stocks of Canada and Australia.

“When the theme is popular because the dollar is weak, too few look to see what’s already happened. For U.S. investors, Canada and Australia have been spectacular resource plays for the last 8 to 10 years. The currencies made huge runs, and hot commodity prices elevated their markets,” says the editor. But the future is not so bright.

“The time to buy is well behind us. With an evolving economic slump likely to cool commodity prices, and have a leveraged impact on Canadian exports, it’s time to be taking money off this table.”

Studying his charts, Mr. McAvity is in something of a quandary, however, because it is not clear that the top in oil prices has yet arrived. And natural gas may display a better than expected price recovery. But that’s a small drop in a bucket that is not liable to get much fuller.

The myth of decoupling

A great deal of money has flowed into commodities in various forms over the past three years. What happens to it now?

“The evolving U.S. slump and evaporation of a myth that Chinese growth ‘decouples’ the global economy from a U.S. downturn will take its toll on the money that flowed in as commodity prices chill out, to digest the spectacular gains of recent years.”

The commodity cycle is staring at a first-half slump in 2008. “The huge metals and minerals surge was magnified by takeovers,” adds Mr. McAvity, “a trend clearly unsustainable because Teck Cominco (TSX-TCK) with its two class voting share structure, is the only Canadian major left!”

Finally, there is the loonie effect.

Some northern diversification

The rush of the loonie in 2007 was not just a response to the wavering U.S. dollar. “It resulted from the combined attractors of governmental fiscal discipline (painful surpluses that impressed credit market flows), a rush of foreign takeovers of major resource companies, and the global rush for energy and minerals resources,” says Mr. McAvity.

The takeover game is just about done, since the big miners are mostly gone, and the subprime mess has muddied the availability of leveraged credit. The editor is not buying the claim that Canada now has a “Petro Currency” based on the long life of the oil sands, either.

“Currency revaluation takes time to flow through an economy, and if that coincides with a U.S. recession crimping demand for employment heavy exports, while also softening commodity price pressures, the U.S. downturn impact on Canada will be magnified,” states the editor. “I expect the Canadian dollar to probe the 90¢ level in 2008.”

There is a small bright glow on the horizon, however. “Canada’s longer-term outlook is definitely relatively more attractive than the U.S., and it makes sense for U.S. investors to have some northern diversification.”

Sorry to add that somber forecast on commodities to a nice little fable about gold. But we have to take the bad with the good in the search for wealth. Speaking of which, it might be a good day to head over to the greenhouse and see what they’ve got in the way of beanstalks. Never know where your next golden opportunity might come from.