A ‘Golden Ruler’ for Investing in the New Year

New Year’s resolutions abound, and many are probably adopting some version of the “Golden Rule” for their life, but what their investing? The Golden Rule sets the standard for our interactions with others, but did you know there is a similar standard for investing? I realize I’m asking a lot of questions. However, I’m about to give you some answers that may help you throughout the coming year and beyond.

Over the many years that I’ve have taught trading and investing, I’ve discussed the role of gold. Typically, I introduce the topic with this question, “is gold a commodity or a currency?” While I don’t have you in a live class, I do want you to think about that for a second.

The most popular response is that it’s a commodity. Some will say both and very few will say currency. It makes sense since we don’t exchange gold to buy things and there is little understanding of what money is. The “Golden Ruler” is the approach as using gold to price things and is based on gold as a currency.

Let’s dig a little deeper.

Golden Ruler: Gold as a Currency

What economic use does gold have in society? It’s soft, heavy and is used in very few processes. In fact, virtually all the gold ever mined is in stored in some vault somewhere. What I’m advocating here is that gold has very little economic value as a commodity.

However, gold is rare, it doesn’t rust or corrode, maintaining its integrity indefinitely. It’s divisible and it’s also rare. These are all great qualities of money. It’s these properties that make it a potential store of value, medium of exchange and unit of account. This is what defines money!

If you are still skeptical of gold as money, consider that it is in high demand among banks, particularly central banks. Also, consider that the countries that have the most gold in store are have the most robust financial markets and economies.

Understanding gold as money allows you to understand that it therefore has no value except as money. That makes its value constant! Understanding that can give you great power as an instrument of valuation.

Golden Ruler: Gold as a Measuring Stick

 If gold has constant value, that means that we can price things in gold instead of U.S. dollars or another foreign currency. This is helpful because the dollar is always fluctuating in value and gold isn’t. If you can strip out the variable impact of the dollar, you can now begin to assess the value of an investment.

For example, the S&P 500 is a gauge of the strength of the U.S. stock market and economy. However, if the dollar is losing value, the S&P 500 will have the mirage of moving higher, all things being equal. That means that following the price of the S&P 500 doesn’t indicate what the value is doing.

By taking a relative strength line of the S&P 500 to gold you strip out the impact of the dollar. This is because gold and the S&P 500 are priced in U.S. dollars. Now you can see what the value of the market is doing rather than just the price.

The chart below is just such an indicator. It is the SPX divided by the SPDR Gold Trust (NYSEARCA: GLD). You’ll notice that the ratio recently peaked on November 30 and has been trending down ever since. This means that the S&P 500 has been declining in value but is slightly higher in its dollar price. This erosion of value can’t be seen without this kind of comparison, but it is often times felt by traders and investors.

The next chart is a long-term chart of the same ratio. You’ll notice that the market peaked in value in July of 2005 and hasn’t returned to that value since. This makes intuitive sense given the massive liquidity injections that were made during the financial crisis, again in 2012 and over the past year. The dollar’s value has eroded, giving the appearance of the economy being better off than it really is. Again, for many, this makes intuitive sense.

Conclusion

Is gold and the Golden Ruler perfect? No, but the use of gold as a measuring stick provides you with the best approximation of value as there is. We’re seeing right now that the value is eroding in the stock market headed into 2021. If this trend continues with rising gold prices and a relatively strong dollar against other currencies, it could give a significant signal that a major correction may be coming soon.

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