Golden Ratios

Historically we have seen bubbles occurring in most investment asset classes such as shares, property and even gold bullion. The bubbles occur as the hysteria builds during the period of appreciation and investors flock to the fast appreciating asset class. The bubble belief is based on the premise that the good times will continue forever and the asset will continue to rise forever.

Throughout time we have witnessed some of the most amazing price appreciations in each one of the key asset classes. Whether it be property boom in Japan whereby the land around the Emperial palace was valued more than the state of California, to the tech boom of the late 90’s when a company with no assets or income could be valued at hundreds of millions of dollars, or even the gold boom of the mid 70’s when prices went from $100 to $870 over a very short space in time. The savvy investors always seem to know when to get out, well before the bubble pops and asset prices depreciate suddenly but not everyone is that lucky.

As such, to help us all know when to get out of these bubbles, there are basic ratios which one might utilise to determine if the asset classes which they are considering might be over or undervalued. For example, if we were looking at a residential property in Australia where the rental yield was only 1% you might say the asset class is overvalued, yet if it is 4% it may be fair value, and 6% undervalued. For shares you may look at the price earnings ratio and compare this to the index. If it is 30 times you may think the shares are expensive, if it is 11 times you may think it is fair value and 6 times undervalue.

Gold too has its own ratios, but more importantly it can also be used as a benchmark to value a range of other asset classes to determine if they are also over or under valued. To do this you will need to look at the spot gold price valued in US dollars which is presently trading at around $950 per ounce. Broadly speaking, if you multiply this by 6 to 7 times equating to 6,650, and the if Dow Jones index is trading at around this level, then it would be fair to say the Dow Jones Index is fair value. If you multiply the per ounce figure by 10 times equating to 9,500 and the Dow Jones Index is above this level, you would say that the share market index is overvalued. Lastly if you multiply the per ounce figure again by 4 times to 3,800 you would state the Dow Jones Index is undervalue.

So to demonstrate how this ratio works all the time, let’s compare this ratio in points of time. At the peak of the market in November 2008 the Dow Jones was sitting over 14,000 whilst gold was only $740 per ounce, equating to more than 19 times the price of gold. In 1929 the Dow Jones stood at 381.2 and gold was 19.06 ounces again this was 20 times the price of gold. In both these instances it would be fair to say the share market was overvalued. At the low of 1932 when the Dow was 41.20, gold was sitting at $20 per ounce equating to a 2 times multiple. In 1987, we saw the Dow Jones crash to 1,739 and gold was priced at $499 which is a multiple of 3.4. In both these instances you would say the Dow Jones was undervalued.

By using these basic ratios it can help you determine whether or not the share market or gold are overvalued or undervalued. In reality, you will notice that the market won’t stop once it becomes fundamentally overpriced or underpriced. In the above examples the market kept roaring past 10 times to levels as extreme as 20 times. The same is true on the downside whereby markets crashed well below the 4 times criteria to as low as 2 and 1 times. Well renowned US financial planner Peter Schiff who forecasted this global melt down we are now experiencing, has also predicted that the Dow Jones will go 1 to 1 with the price of gold meaning that next year the Dow will be 4,000 and the price of gold will be 4,000. Only time will tell, but fundamentally the price of gold is still very cheap and the future growth in this asset class is very exciting making it an opportune time to buy and include this asset class in your investment portfolio.