Determining the fair value of an asset can be difficult, even in the most transparent markets. One approach that investors can follow is to analyze the price relationship between two asset classes. The Dow Jones to gold ratio is one such popular metric that maps how a broad measure of the U.S. stock market -- the Dow Jones Industrial Average -- is performing relative to the price of gold bullion.
Dow Jones Industrial Average
One of the most closely watched stock market indexes is the Dow Jones Industrial Average. The DJIA is a price-weighted index of 30 large corporations that are representative of different sectors of the U.S. economy, such as financial services, manufacturing and information technology. Examples of DJIA components include American Express, Boeing and Intel. The index's price is updated in real time and is the stock market indicator most quoted by the media.
Gold offers investors diversification beyond traditional asset classes, such as stocks and bonds. When speaking of gold for investment purposes, rather than for applications such as coins or jewelry, the appropriate terminology is "gold bullion" -- or gold valued for its weight. Today, investors can buy gold bullion in a number of ways, including the old-fashioned way -- as bars of gold -- or as tradable instruments, such as mutual funds, futures contracts and exchange-traded funds such as SPDR Gold Shares. Gold is sometimes regarded as a hedge against declines in the U.S. dollar and the stock market.
Dow Jones Gold Ratio
The Dow Jones gold ratio expresses the price of the DJIA as a multiple of the price of one ounce of gold. For example, if the DJIA is trading at 15,000 points and the price of gold is $1,300 per ounce, the Dow Jones gold ratio is 11.5, or 15,000 divided by 1,300. The ratio has fluctuated widely over history, trading as low as 1.0 during the stock market crash of 1980 to above 40 during the dot-com bubble of 2000.
Interpreting the Ratio
The Dow Jones gold ratio can provide investors with valuable insights. First, it tracks how the precious metal has performed relative to a representative swath of corporate America. Second, it can be used to help determine whether the stock market or gold bullion is underprice or overpriced, as when the ratio is out of kilter. However, there is no guarantee that the past relationship between these two assets will persist in the future.
Giulio Rocca's background is in investment banking and management consulting, including advising Fortune 500 companies on mergers and acquisitions and corporate strategy. He also founded GradSchoolHeaven.com, an online resource for graduate school applicants. He holds a Bachelor of Science in economics from the University of Pennsylvania, a Master of Arts in English from the University of Hawaii at Manoa, and a Master of Business Administration from Harvard University.