Last Update: August 2021

Passive players in the money game often project an attitude of indifference. When it comes to stock picking, they take the high road and simply buy everything. The seduction of diversification is that it allows a bit of an I don’t know and I don’t care attitude regarding stock, or really any asset class and its performance. Which asset is going to kill it next year? Stocks or bonds? Commodities or real estate? U.S. or Foreign? The passive peacocks care little for such queries. What’s it matter if gold soars while stocks sour? …or if bonds boom while oil busts? They own a piece of them all, guaranteeing participation in whatever is hot.

Those walking the active path, on the other hand, are continually confronted with choice. They’ve divorced diversification and the inherent mediocrity that goes along with it in search of fame and fortune. Well, at least the fortune part.

One of my favorite tools for comparing asset classes and determining what is leading and what is lagging is the ratio chart. Its construction is simple really. Step one: pick two asset classes. Step two: divide the price of the first by the price of the second. Step three: recalculate each day and plot the value as a line chart. Allow me to provide an example, and yes, there will be some math. Don’t be scared. It’s good for you, plus it’ll test my division skills.

Let’s say asset A, hereafter referred to as AA, and asset B, hereafter referred to as AB, start out both trading for $1.00

If we put AA in the numerator and AB in the denominator the ratio would start at 1 on day one.

Now, let’s say on day two AA rises to $1.50 while AB only rises to $1.25. The ratio will rise to 1.2 ($1.50/$1.25). The rise in the ratio reveals that the stock in the numerator (AA) outperformed or was relatively stronger than the stock in the denominator (AB). If AA continued to rally more than AB the ratio line would keep rising

Now, suppose on day three AA falls to $1.25 while AB jumps to $1.50. In that case, the ratio would fall to 0.83 ($1.25/$1.50). The drop in the ratio reveals that the stock in the denominator (AB) outperformed or was relatively stronger than the stock in the numerator.

Got it? If not, go back and re-read. Repetition is the mother of mastery.

If we plot the ratio over time, we can get a sense of which asset class if doing better than the other. One of the most famous metrics in the world of asset class comparison is the Dow/Gold ratio. Check it out below:

Ain’t she a beaut? During the 90s the ratio was rising aggressively revealing that the Dow (stocks, essentially) was beating the pants off of gold. Then a regime shift occurred. The year 2000 marked a top in stocks not just on an absolute basis, but also on a relative basis to gold. The reign of gold lasted from 2001 to 2011. A golden decade for precious metals lovers. Then the gold bugs were finally squashed for their undying love of the shiny stuff. The Dow/Gold ratio turned higher in 2011, eventually reversing the major trend and signaling the end of gold’s dominance and the return of stock outperformance.

Consider adding the Dow/Gold ratio to your bag of tricks. If, or more likely when, gold returns to its former glory, the Dow/Gold ratio will reverse lower yet again. Until then, stocks hold the upper hand.

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