Monday, July 30, 2007

DJIA vs. Gold: The virtue of a long term view

One of the themes I noted while perusing investment boards this weekend was the following: the Dow will collapse, Oil will collapse and Gold will collapse, it's all going to crash.

Ah, the perils of extrapolating a few days worth of data.

I wonder who made the rule that Gold always rallies when the Dow falls? In a world of undefined or elastic worth money, everything is correlated because all prices tend to rise. The issue of concern is by how much.

More to the point for Gold's investors, a strong correlation between Gold's price and those of US equity indices does not necessarily mean that Gold will fall if the Dow collapses. Let's look to financial history for an example.

As the above graph shows, there were times during Gold's last big advance period in the 70s that Gold and the Dow were correlated and times when they were not.

One lesson I draw from that period is that over time, during correlated periods, Gold's beta relative to the Dow rose during periods of equity market rallies and fell during periods of equity market declines. Over time, liquidity aimed at supporting the markets and general business conditions tended, more and more, to flow into Gold.

Additionally, and perhaps quite relevant to the current situation, the '74 decline, coincident with Nixon's ouster from office, was a period when an initially positive correlation between the Dow and Gold turned negative as the Dow decline extended.

How closely the future follows this past remains to be seen, but at least I hope to have shown that leaping to conclusions based on a few days worth of data can be hazardous to your trading profits.


Ruby said...

We know that GATA has laid out why AU will rise. That's all the facts I need to know!

Ruby and the Romantics sang "Our day will come, if we just wait awhile. No tears for us......"

It's just sad that everything is going down the tubes, and when that Special Day comes, I'll be with all my treasure in a barren desert of despair.

OOOoooo, too much doom before bed isn't good for my dreams! Good nite!