Either Stocks Will Fall 37% Or Gold Will Rally 60%

By Graham Summers
June 2009

How’s this for a bubble?

In 1965 one in ten Americans owned stocks. In 1990, one in five Americans owned stocks. Put another way, it took 25 years for stock ownership to double in the US. And most of that growth came between 1983 and 1990 with the introduction of 401(k)s, IRAs and other stock-based retirement plans: suddenly anyone with a large scale employer could invest in stocks without having to open a brokerage account.

Thanks to the Internet and low fee online brokerage accounts, it only took seven more years for stock ownership to double AGAIN. Put another way, the rate at which new participants entered the stock market accelerated four fold between 1990 and 1999. By the end of the 20th century, 48% of US households owned stocks.

This is the one bubble no one talks about.

I’m talking about the bubble in “investing in stocks.” Never before have so many Americans done this. It gave us one of the biggest bull markets in stock history: a mega-18 years run from 1982 to 2000. But it also means that stocks have got a long ways to fall to get back in line with their historic relationships to other asset classes.

Particularly gold.

A lot of commentators talk about how gold is near an all-time high and that stocks have fallen 50%, making them cheap again. However from a long-term perspective, gold and stocks are nowhere near their normal relationship.

According to Dr Marc Faber, editor of the Gloom Boom Doom Report, gold and stocks move in distinctive long-term trends. Over the last 110 years, these trends has staged six major phases:

• 1900-1929: stocks outperform gold
• 1929-1932: gold outperforms stocks
• 1932-1966: stocks outperform gold
• 1966-1980: gold outperforms stocks
• 1980-2000: stocks outperform gold
• 2000-???: gold outperforms stocks

Overall, the median stock to gold ratio for the last 106 years is 5.4. In other words, throughout the 20th century, on average 5.4 ounces of gold would buy one unit of the DJIA.

Today, gold trades at $980. The DJIA trades at 8,500. This puts the ratio of gold to stocks at 8.6. Thus, the DJIA needs to fall to 5,292 (a 37% drop from today’s level), gold needs to rally to $1,574 (a 60% rally from today’s level), or some combination of the two, in order for gold to be appropriately priced relative to stocks again.

When exactly this will happen is anyone’s guess. The gold vs. stocks trends over the last 106 years have ranged in length from three years to 29 years. However, judging from the Fed’s money printing and the recent action in gold, it’s quite possible we’ll see a mammoth run in the precious metal sometime in the next 18 months.

During the last bull market in gold, the precious metal rose 2,329% from a low of $35 in 1970 to a high of $850 in 1980. However, during that time, there was a period of 18 months in which gold fell nearly 50%.

From mid-1971 to December 1974, gold rose 471%. It then fell 50%, from December ’74 to August ’76. After that, it began its next leg up, exploding 750% higher from August ’76 to January 1980.

Now, in its current bull market (2001 to March 2008), gold rose over 300% from $250 to a little over $1,000. And just like in the mid-70s, it began showing signs of weakness after its first big rally up to $1,014 in March ’08. At one point, it even fell to $700, a 30% retraction. Granted, it wasn’t a full 50% retraction like the one that occurred from 1974-76. But we are experiencing a financial crisis. And gold is the most common catastrophe insurance.

If we were to go by the historic pattern of the gold market in the ‘70s, gold should experience upwards resistance for 19 months after its first peak today. Gold’s recent peak was $1,014 in March ’08 (roughly 14 months before the writing of this report). If this bull market parallels the last one, then gold should renew its upward momentum in a very serious way starting in October 2009. And this next leg up should be a major one (the biggest gains came during the second rally in gold’s bull market in the ‘70s).

In fact, it’s already happening…

According to Capital Gold, a precious metals dealer, the demand for gold from self-directed IRAs has more than doubled since January 1, 2009. The World Gold Council notices similar spikes in demand for the gold ETF, writing “Inflows into gold ETFs continued to grow throughout the quarter, with investors buying a record 469 tonnes of gold, dwarfing the previous quarterly record of 145 tonnes, set in the third quarter of last year.”

Globally, entire gold markets that didn’t exist in 1980 are now beginning to buy the precious metal. Vietnam started trading gold futures in June 2007. Already the exchange trades around $100 million in gold futures a day. China’s Shanghai Futures Index started trading gold futures just a few months ago. The latter country has already surpassed the U.S. as the second largest consumer of gold behind India.

Prepare in advance.

Bottomline: don’t let the talking heads fool you. Stocks are not cheap, especially compared to gold. And the bull market is gold is nowhere near over. Over the last 35 years, more Americans began investing than at ANY other period in history. As collapse later this year, they’ll either pull out their money pushing the DJIA lower OR they’ll shift their money into alternate investment classes like gold. When they do, the DJIA will fall further and gold will erupt higher.

Good Investing,

Graham Summers
http://www.gainspainscapital.com/