January 21, 2015

Gold-Oil Ratio at Extreme Level

One of the most reliable of financial indicators has just reached a crucial level, indicating a likely turn in the markets. I speak of the gold/oil ratio, an idea first introduced to me back in the 1980s in a book by John Dessauer (the title of which escapes me). The long term gold-oil ratio is something like fifteen. As the following chart indicates, it has reached a level just shy of 28. Over the last twenty years, it reached this level three separate times, and on each occasion fell promptly back to earth.

Those inclined to immediately rush out and buy oil and sell gold may duly be warned that the gold-oil ratio did reach nearly 33 on two occasions in the 1980s (though in neither case was it there for very long). However, it is rather impressive that in late 1993, in early 1999, and in early 2009, it reached the precise level at which it now sits, and that in each case the 28 level constituted the turning point  in the price action. This must surely count as an extremely strong line of resistance.

But there is another anomaly that makes the picture even more interesting from a financial standpoint. Though gold is extremely expensive in relation to oil, gold stocks are still very cheap in relation to oil stocks. Consider the following chart looking at the ratio of the $HUI, a gold stock index, with the $XOI, an oil stock index. The data here go back to 1996:

Given what has happened to the gold-oil ratio, one would think that the gold stock-oil stock ratio should be closer to the top of the chart than to the bottom. For gold miners, oil is a very considerable cost of doing business, so a decrease in oil prices increases their profit margins (at least, what there is of them). As the chart shows, there has been a very considerable rally in the gold stock-oil stock ratio, from .10 to .16 over the last six months, but these were from very depressed levels. Given the gold-oil ratio in the first chart above, this suggests that the gold stock-oil stock ratio has much further to run, that is, that gold stocks will do much better than oil stocks over the next year or so.

The conclusion suggested by these two charts is that one should go long oil and short gold, and long the gold stocks and short the oil stocks.

Just to round out our look at these various ratios, here's two other charts that reinforce the conclusion that oil is a lot cheaper than the oil stocks, and that gold stocks are a lot cheaper than gold.


One note of caution. Going long oil is tricky because the oil market is in contango. That is, the contracts further away from the immediate month are more expensive. The most widely traded oil fund (USO), an etf that tracks the daily movement of the oil price, will not keep pace with the futures contract when the futures curve is in contango. A way around this is another etf, USL, that buys contracts in equal amounts over the next twelve months, but the gold-oil ratio is not as extreme in the outer months, so it is not clear whether that is the better strategy.

One final chart that puts together these various relationships. Let's call it The Grand Anomaly, a testament to the inefficiency of markets.

I cannot depart the subject without recalling Adam Smith's observation in The Money Game, a popular market book from many years ago. Anyone who has a desire to speculate in the commodities markets should take a nap until the feeling goes away.

No comments: