The Dow-Gold Ratio Renders Its Verdict

As those of you who have read my book know, I’m a firm believer in the power of looking at the daily closes of the Dow Jones Industrial Average and comparing it to the price of an ounce of gold. For those of you who don’t know, the Dow Jones started as a simple average of the share price of all of the companies that comprise it; for example, if there were three companies on the comprised the Dow average that had share prices of $5, $10, and $15, then the average would simply be $10.

Over the years, the number of Dow companies that comprise the Dow has risen from the original twelve to now include thirty different industrial companies. Since it’s simply an average of the number of companies, expanding the number didn’t have much impact. it’d be similar to looking at the average test score for classes of different sizes: more or fewer students don’t matter as we’re looking at an average. The reason the Dow Jones Industrial Average (DJIA) is such a large number in comparison to the stocks that comprise it is that those stocks have had numerous splits throughout the years while the Dow has not. Rather the Dow simply corrects for splits so as to maintain a continuous average throughout time. Just as the price of a single share of Microsoft stock would be $8928 at the close of 2007 if it had never split, the DJIA is a average of companies with such share prices.

While the DJIA may correct for stock splits, it does not correct for inflation. It’s a purely nominal index. That it fell to 41 during the Great Depression and then rose to over 14,000 in 2007 gives a false sense of its performance over that timeframe because the $41 average price would buy a lot more goods than $41 today. Yes, the 14,000 close shows an increase in purchasing power for holders of those stocks compared to the 1933 level, but it’s not nearly as dramatic as the raw numbers indicate. So in order to compare the closes of the Dow over time, we need to correct for inflation. My preferred way of doing that is simply by dividing the DJIA by the price of an ounce of gold. 

The result is what I term the Dow-Gold ratio. Here’s a graph I borrowed from Fred’s Intelligent Bear Site to show you what it looks like:


Dow-Gold Ratio from 1900 to Present
Dow-Gold Ratio from 1900 to Present

The graph nicely shows in real terms the rise and fall of the DJIA over the 20th century. You can easily pick out from the graph where the Dow-Gold peaked at 18.4 in 1929: that means that the dollar price of a “share” of the Dow could have bought over eighteen ounces of gold. But, as the collapse of the stock market wore on, the Dow would have bought you only two ounces of gold at the bottom in 1932 when the Dow closed at 41 and gold was $20 an ounce. 

I found the Dow-Gold ratio fascinating, so I got more data that allowed me to look further back. The Dow was established in 1897, but the companies that comprised it had been around for far longer. We can use the share price of these companies as a sort of “proxy” index to see the Dow-Gold over a much longer timeframe. I put the data in Excel and generated the graph below.



A Logarithm of the Dow-Gold Ratio
A Logarithm of the Dow-Gold Ratio

I then tried to fit a line to a logarithm of the data, and that’s when I made an interesting discovery: a single line could not be fit to the graph. The Dow grew at a far greater rate during the 1800s than during the 1900s. Any line that closely fit the graphs ascent during the 1800s would soon outpace the 1900s. So I had to break the line into two separate line segments. Where the line breaks is quite telling. It breaks right around the the mid-1920s.

After the mid 1920s, the performance of the Dow becomes very erratic. It sores to ridiculous highs and then crashes down to comparatively unbelievable lows. It also rises at a much slower rate. When I took the slope of the best fit line and compared them, the Dow (and by extension the American economy) showed a compound growth of 2.57% whereas, in the 20th century, it only shows a compound growth of 1.24%. That means that the American economy is growing at half the rate it did back in the 1800s and with dramatically more volatility.

What could have happened around that timeframe of the early 1920s that would have caused this?
Astute Libertarians will already know this answer: the Federal Reserve. The Federal Reserve Act was passed on Dec. 23rd 1913 and, as we can see from the graph, the American economy was soon thrown into turmoil and grew at a much slower rate. In addition, you can see that as we abandon the Gold standard and went towards a pure fiat money system, that the stock market gyrations simply got wilder. This is the world we live in today.

As we can see from the graph, we started a new decline in 1999. So far we’ve seen the Dow-Gold ratio fall from a almost 44 down to less than 10 today. As we can also see from the graph, it has a lot further to fall. The Obama Administration and Ben Bernanke are trying to sell America on how they are going to save the economy, but the graph clearly shows the result of central banker and government meddling. Our economy today is far worse off than if we had stuck to the simple, common sense, economic strategies of the 1800s. Unfortunately, this is a reality that few are willing to accept.

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