The Dow to Gold ratio measures the relative value of the Dow Jones Industrial Average (Dow) compared to gold. It indicates the number of ounces of gold it takes to buy the shares in the Dow Jones Industrial Average index. The Dow Jones is a stock index that includes 30 large publicly traded companies based in the United States. It is one of the oldest and most-watched indices in the world. Gold, on the other hand, is a precious metal that has been used as a store of value and medium of exchange for centuries. It is often seen as a safe haven investment during times of economic uncertainty and is considered an alternative to traditional fiat currencies.
The Dow to Gold Ratio provides insight into the relative performance of stocks (represented by the Dow) compared to gold. When the ratio is high, it suggests that stocks are performing well compared to gold, indicating a strong stock market. Conversely, a low ratio indicates that gold is outperforming stocks, which could be a sign of market weakness or economic instability. Turning points in the Dow to Gold ratio have coincided with turning points in market history: The stock market reached historic highs in 1929, 1966 and 1999 as the ratio did the same. Likewise, the market sat near historic lows in 1932 and 1980 as the ratio hit bottom.
The chart below shows the same data on a linear scale.
The chart above displays the 1-year rolling correlation coefficient between the Dow Jones Industrial Average and the price of gold. A correlation coefficient of +1 indicates a perfect positive correlation, meaning that the Dow Jones and gold moved in the same direction during the specified time window. Conversely, a correlation coefficient of -1 indicates that the Dow Jones and gold moved in opposite directions. The chart shows that the correlation between equities and gold is not stable and can vary, even during economic recessions. There are periods during which the price on gold did not change, which results in a standard deviation of zero and a correlation plus or minus infinity. These periods are removed from the data set and appear as gaps in the rolling correlation series. The correlation coefficient is important for diversification because it helps investors assess the potential benefits of including both equities and gold in their investment portfolios.
Diversification is the practice of spreading investments across different asset classes to reduce risk. In his book Principles, Ray Dalio called diversification the “Holy Grail of Investing”. He realized that with fifteen to twenty uncorrelated return streams, he could dramatically reduce the risks without reducing the expected returns.
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