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Jes Black

Jes Black, hedge fund manager at Black Flag Capital Partners, specializes in foreign exchange and global macro trends. Prior to organizing the fund he helped…

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Long Term Look at Dow to Gold Ratio

What to Expect from the Second Bush Administration

Last week we showed a chart of the dollar to show that President Bush is exactly the opposite of former President Reagan. This week we would like to update our comparison of Bush and the Presidents he most closely resembles from an economic history standpoint.

Readers may recall that we drew a parallel between the Bush and Nixon eras by showing a chart of the Dow to gold ratio in the January 2 issue. We said, "This bear market rally looks awfully similar to that of the liquidity induced rebounds from the late 1960s and early 1970s." Here we have updated the Dow to gold ratio and made some interesting comparisons.

First look at the bottom graph of the Dow to gold ratio from 1991 to 2005 in log form. Note that the ratio broke below its rising trendline in January 2003 and never recovered despite the liquidity-induced rally of 2003. Some rally!

Second, look at the top chart from 1929 to 2005. Note that the all time high of 42 in 2000 met the trendline from the previous peaks of 1929 and 1965.

Third, the market's sideways movement over the past two years is basing along parallel trendline support from the 1940s. When this gives way and the Dow to gold ratio is trading below the 2003 low of 21 a major recession should occur in the US.

Understand that the Dow to gold ratio has a perfect forecasting record. Whenever the ratio is trending higher, the economy and the nation prospers. When it is trending lower the nation becomes split. And when it breaks down there are riots in the streets.

In times past the government has always taken actions that unintentionally accelerate the downtrend and thus the negative forces affecting the society as a whole. Looking at this chart, a student of market history would conclude that Bush is the antithesis of Reagan in nearly every respect, but a perfect amalgamation of Wilson and Nixon with a dash of Hoover for good measure.

We are not being flippant or political here. Hoover and Nixon are today considered terrible presidents but were probably disliked more because the economy was in a tailspin than anything else.

Wilson is admired for his role in expanding government and taking America from isolationism to the international stage. The price we paid for this priviledge are the Federal Reserve (thus inflation), the income tax (to pay for World War I), Treaty of Versailles (which all historians agree made World War II a cinch) and daylight savings time (which makes it dark by 5).

More importantly, all three share the ignomious distinction of presiding over a year on year loss in the market in excess of 20%. You can view the stats here: http://www.activetradermag.com/coverstory0904.pdf

The only other presidents to see a total year on year decline in excess of 20% are McKinley, shot shortly after the stock market slump, and President Bush.

Finally, observe how Nixon was first elected in 1968 near a peak in the Dow to gold ratio. His decision to escalate the War in SE Asia and to not tighten the fiscal belt to pay for it was the primary reason the Dow to gold ratio declined so rapidly during his time in office.

President Bush was also elected shortly after the all time high in the Dow to gold ratio and it has been going down ever since. This is mainly due to the soaring budget deficits that cannot be financed by savings-short US citizens.

Expanding the War on Terror to Tyranny

We are now convinced the Dow to gold ratio will collapse in the immeidate future after hearing the word "tyranny" five times in President Bush's inauguration speech. In this respect President Bush and Wilson are nearly identical. Recall that Wilson's religious views were the single driving force in his political career, shaping his quest for world peace and taking America from isolationism to an Empire.

The US consumes 80% of the world's savings to support the cost overruns of its Empire and the expense of spreading peace in the Middle East will most likely bankrupt us. Recall that the last time the Dow to gold ratio was declining there was a successful oil embargo and a series of wars between these nations. When the Dow to gold ratio began to turn up again in the 1980s and 1990s we had reconciliation process. But that was aborted after the Dow to gold ratio turned back down. Since then we have had the intifada, a new version of the Berlin Wall and assassinations in Isreal. The US has decided to go it alone in Iraq which has directly led to this quagmire and we have let Ossama bin Laden escape while his minons exploite the chaos in Mesopotania. Perhaps most astonishing is that a good economist with a penchant to trading could have pointed this out to the White House. But then not many economists trade or understand cycles, or anything else of real value to prediciting the economy.

At the least, should President bush expand the War on Terrorism/Tyranny like Nixon expanded the war in Vietnam into Cambodia the end result will most likely be a global recession preceded by a Dow to gold crash. That may sound bearish. But it is backed up by tangible facts, not wishful thinking or blind faith.

Perhaps the easiest reason to explain why the Dow to gold ratio will decline is not the "real value of gold" as so many like to point out. To us the reason the Dow gold ratio will decline over the coming year is that finance now makes as big a percentage of the S&P 500 as oil stocks did back in the 1970s. We feel confident that gold may not rise this year but the Dow to gold ratio will decline as interest rates ries. Therefore, the chart above argues for a cyclical decline in fnancial stocks relative to hard assets. As this happens and costs rise in the US bond prices should decline. We see this in the rise in the price of oil in terms of gold.

Note: You can read our strategy report on US bonds in this month's issue of Futures magazine here: http://www.fxmoneytrends.com/futuresmagjan2005techtalk.pdf

Moreover, our latest research shows that the ratio of shorts to longs held by commercial hedgers, aka smart money insiders, in the 30-year bond reached an all time high, eclipsing the high seen in 1998 before bond prices collapsed.

Note that the short ratio reached a record high in 2004 even though bond prices have not reached new highs. Moreover, the magnitude of the rise in short interest is also a very compelling argument against a further rise in bond prices. Finally, the rise in short percentage coincided with a record net long position by speculators five weeks ago, indicative of a major top in prices.

As such we feel that bond yields should rise which will drain liquidity from the market and weigh on stocks, bonds and the precious metals during the first half of this year. For the gold bugs out there still not convinced we show you the chart of gold priced in euros which is now breaking down despite the sharp decline in the euro recently.

Recall that we have been bearish on gold and the euro since we first predicted a major top back in October. You can read that here at: http://www.fxmoneytrends.com/insights/10.28.04.EuroGold.pdf

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