Secular trends in Western equities and gold

In our previous missives, we have discussed the different kinds of market trends and how to identify them. Our second article introduced "moving averages" as an effective technique for identifying primary and secondary trends, but we observed the use of other techniques for identifying secular trends.

This article, the ultimate in our series of investigations, outlines the method we use to do this, primarily as it relates to the secular trends in Western equities and gold.

Markets exhibit trends that last for extended lengths of time – significantly longer than a business cycle (four to five years). The underlying drivers of these trends, while embedded in fundamentals, can be tracked using simple technical methods, of which the Dow Gold Ratio is one.

We believe that gold entered in a secular uptrend in 2000, the same time that Western markets descended into a secular downtrend. The Dow Gold Ratio, which is essentially the relative strength of US equities (using the Dow Jones Industrial Average index) to gold bullion prices (measured in US dollars), demonstrates this.

Simply put, when the ratio is rising, US equities are outperforming gold, and the converse also holds true (another way of interpreting the ratio is "how many units of gold does it take to buy a unit of the Dow?"). The ratio peaked in 2000, at a time when US equities were outperforming gold on a relative basis.

When plotted since 1920, we observe this ratio to move in clear cycles which demarcate these secular trends. These cycles represent the alternation between investor "greed" and "fear" over secular timeframes that exist because the macroeconomic environment conducive to the extended performance of one asset class is rarely conducive to the performance of the other.

When investors believe the environment is conducive to equities and earnings growth (organic growth rather than via inflation), "greed" (a rush into Western equities) overwhelms "fear" (a rush into gold), leading to a rise in the Dow Gold Ratio over prolonged periods, as Western equities outperform gold on a passive investment basis.

Such was the case over 1920 to 1929, 1950 to 1966 and 1980 to 2000 and marks the secular uptrend in Western equities and a simultaneous secular downtrend in gold.

When investors believe the converse to be true – often the case when economic growth slows significantly, inflation worries dominate or fiscal deficits drag on growth – investors view capital preservation as more important and pile into real assets (gold).

Over these periods, the Dow Gold Ratio falls, as gold outperforms Western equities on a passive investment basis. This was the case over the periods of 1929 to 1940, 1966 to 1982 and more recently since 2000.

The trend in the Dow Gold Ratio that began in 2000 does not appear exhausted when viewed in the context of history. Typically, the ratio has reached two to five units of Dow for every unit of gold before reversing.

This is one of the few metrics that allows us to value gold objectively, and which leads us to believe that gold, while overvalued, has a further upside. A conservative target for gold, calculated using this ratio, is somewhere in the region of $2500 troy/oz. When this ratio bottoms out, Western equities will be an all-time buy.

Finally, it is worth highlighting that while Western equities are mired in a secular downtrend, investors can still make money by holding them over these periods, but only if they use an active (as opposed to passive) investment strategy. Trading the business cycle, or stockpicking, are the ways to invest over these periods.

Alternatively, constructing a balanced portfolio with a healthy weighting in alternatives – including gold, hedge funds and other real assets – is another way to proceed and the method we have employed in the funds we manage.

Rashpal Sohan is asset allocation analyst at Rathbone Unit Trust Management. The views expressed here are his own.