By contrast, when the Dow/gold ratio is low and below 5, stocks are cheap and gold is overvalued. The low period occurred, for example, in the early 1980s to about 1995.
The average for the Dow/gold ratio was about 12.6 over the past 80 years. It hit an all-time high of 42 in 2000, but has dropped to about 13 as of this writing. During this period, gold has outperformed stocks by a wide margin.
On the downside, the ratio hit close to 1 in 1980. Afterward, gold prices performed poorly, while the stock market soared starting in midyear 1982. So where do we stand today as the ratio drops amid falling stock prices and rising gold prices?
Based on today's Dow/gold ratio, gold could be considered overvalued at $900 per ounce. But like many others, Mike Martin, the chief investment officer of Financial Advantage Inc. in Columbia, Md., says gold prices may rise because of the concerns about big government, deficits and future inflation. And since short-term Treasury securities pay almost no interest, the opportunity cost of holding gold is negligible.
At this writing, Martin had 9% of his client assets in a gold exchange-traded fund as a low-cost way to own bullion. "Clearly, there is a lot of room for the price of gold to rise and the value of the Dow components to fall, or both, based on the historic range of their relationship to each other," says Martin, the former director of research at T. Rowe Price. "The current price is way below the $2,000 inflation-adjusted level it reached the last time the world was dealing with very high dollar inflation in the late 1970s, early 1980s. So there is a lot of potential upside."
Martin, however, cautions that owning gold bullion traditionally has had disadvantages. Among those: It is a sterile asset in that it pays no interest or dividends; it can be expensive to store in a safe place, so there's a carrying cost; and the price has been highly volatile over the years.