Gold/Oil Ratio and Pairs Trade Examples

As part of a further evaluation of the context of gold prices (and hence monetary inflation concerns and outlook for the US dollar) I decided to look a bit into how gold prices were relating to other inflation sensitive issues. Oil was the one that I thought would offer the most interesting comparison. The idea I wanted to explore was whether the ratio of gold prices to oil prices was informative on the future price action of either of the two.

After doing some charting I looked for some historical data on the ratio and found the useful chart below. It is not a truly long-term chart, but does go back several decades and shows probably a good sampling of the range that the ratio swings back and forth in.

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The chart above shows the gold/oil ratio in standard units oz/barrel. The chart goes back to about 1973. The basic range for the ratio is between about 8 and 30. The long term average from what I've read on it is about 15.

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In the chart above I used stock charts to create the ratio for the last 3 years of prices. Notice that at the top of the commodity bull last year, with energy related commodities leading the way, the ratio fell very low, below 7. So gold was cheap relative to oil on a historical basis. The first chart shows a point where the ratio got down to about 6.2 in 2005, but the reading last year was the second lowest. The difference was that in 2005 gold shot up about 60% or so over the next year after the ratio got very low. Last year gold dropped about 30% in the months after the low and then got back to around even by this year.

From what I've looked at as far as ratio extremes, I don't see much predictability as far as gold moving up or down on an absolute basis after extremes in the ratio to oil. However, the ratio does seem to help determine points at which gold or oil is likely to out or under perform the other. Like much of the data and analysis I post on the blog, this is best looked at as a ratio that will undergo mean reversion on a long term basis. This means that the average of the ratio is pretty stable not trending over a long period of time. So when the ratio gets far away from the average, it is best to look for it to return back toward the long term average than to get further away. This sets up the opportunity to play the expected performance or relative strength of one versus the other via a pairs trade when the ratio reaches extremes.

A pairs trade is going long one stock and short another in the same sector. So you are market neutral but will benefit if your long position goes down less or up more on a percentage basis than the short position. So you benefit by accurately determining the relative strength of two related issues. As an example, when the market has come way down and starts to turn up you may buy Apple stock and short and equal dollar amount of Dell because you believe that Apple will display superior relative strength to Dell in a rising market.

So back to gold and oil, you could create a pairs trade by buying gold futures or ETFs and shorting oil futures ETFs if you believe that gold will outperform on a relative basis. So in the example of July 2008, the gold/oil ratio reached a historically low extreme indicating that gold was cheap relative to oil. Even though gold dropped about 30% over the next 4 months, oil dropped 60%. So if you had a long gold-short oil pairs trade you would be up 30% between the two and 15% return on total dollars invested at that point.

On the chart above I made some brief notes showing a simple possible strategy of using a close above/below the 50 day moving average to initiate and close a pairs trade after the ratio reached an extreme point. So when the ratio is in a very low historical position you would look to buy gold and short oil. If the ratio gets very high, you would buy oil and short gold. The last year shows a couple nice trades, one in each direction, using that simple method.

Now in a statistical sense the long term mean of the ratio is about 15. The +1 +2 +3 standard deviations are around 20, 25 and 30 respectively. The point is that you probably should not look to pairs trade something when the ratio is right around the average. You want to wait for it to get extreme to give a higher success rate. Currently the ratio is about 15 which is right around the long term average so is probably not a time to try to create a pairs trade.

Now unfortunately from anything I've looked at so far, I have not really found anything that gives me much insight into whether gold will go up or down from here on this basis. But the more you know how markets relate, the better investment decisions you should be able to make with more confidence, and the more opportunities you may recognize and know how to take advantage of.

Some Charts to Help Gauge Sentiment

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This chart I often show which is the equity put/call ratio with 21 and 34 day averages. It is used as a contrarian indicator. When the ratio reaches extreme highs or lows, that can be helpful in timing market turns. But looking at the intermediate averages helps to see the longer ebb and flow of fear in the options market. Despite the senior indexes being only marginally off highs, the averages have started to trend up for the last month indicating a shift in sentiment that often accompanies a market downtrend.

This chart is from Sentimentrader.com and is a very interesting look at some of the Rydex fund data that they track. This particular study looks for times when the level of buying or selling in Rydex funds is disproportional to the price movement in the market. When there is lots of buying/inflow while the market does not really makes substantial gains (or even declines) that shows that the Rydex traders are buying the dips or are overly enthusiastic about further gains. During the rally since March when several readings like that show up in a cluster or narrow price range, it has often been at short term tops. We are seeing this again over the last 2 weeks.

This chart is also from Sentimentrader.com. It is what they call the Options Speculation Index and is a broad measure of bullish and bearish bets in the option market. It is used as a contrary indicator and excessive call activity often happens near market highs (and vice versa). This ratio looks at the ratio of calls bought to open and puts sold to open divided by puts bought to open and calls sold to open. The ratio jumped to multi year highs last week, which indicates that the options market is leveraged excessively toward the call side.

This chart is the OEX put/call ratio for 2009 so far. Unlike most put/call ratios I mention this one is a smart money indicator typically as smart traders buy puts as hedges when the market has gotten ahead of itself. In the past there have tended to be several spikes up in this ratio as a significant top approaches. The ratio spiked up on Friday again to 2.04. The intermediate averages of this ratio are also showing this group to be maintaining consistently high put exposure (on a relative basis) consistent with expectations of significant downside risk in the markets.

Another thing of note on the sentiment front is that one of the lowest bearish % readings in the Investors Intelligence survey occurred this week. This is a contrary indicator typically but is best used to time the market with the larger trend. So the question is whether we are still in a longer term bear market in which case I would find this very significant. The 200 day moving average (which is a simple way to gauge long term trend) is pointed up now though. But with several other signs of longer term excess bullish equity speculation, I think it is notable. Also the survey showed a relatively high percentage of advisers expecting a correction. Despite the contrary use of this survey, this particular aspect of the survey has in the past functioned more as a confirming indicator and there often is some pullback when there is a high percentage expecting a correction.

Most of the above measures are more significant over the time frame of a few months rather than a few days. On a short-term time frame there is some mixed data. The VIX spiked up Friday and may be slightly bullish short-term. Also there was a very low cumulative TICK reading on the Nasdaq Friday, which should be bullish as well. But most other short-term sentiment gauges are neutral.

From a charting perspective, the close below 1100 on the S&P made a third failed breakout attempt above the Oct highs. This tends to be a good reversal price pattern. But any move above the recent highs is likely to succeed in a breakout. I maintain the view that the market is in a topping process which may be complete with this most recent failed breakout on the S&P. Tops tend to be slow in the forming and take persistence to establish a successful low risk-high reward position anticipating a new downtrend.

A Look at Market Psychology of the Recent Past and Present

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I have been thinking a good bit about the action in gold the last couple months and trying to look at it from different angles. The chart above shows the CRB commodity index at bottom with wheat, oil, and gold prices above as well as some notes of what I believe the general crowd psychology was at some points in the past.

I can clearly recall news stories about third world starvation and global warming in relation to the soaring grain prices last year near the commodity peak. There was some backlash against use of food based fuels like ethanol from corn and sugar, etc. While all these things may be sensible or even true, it only helped to explain price behavior in the past. What most people do is to assume that the same trends will continue into the future. As a contrarian trader or investor, it is important to learn to recognize consensus opinion and behaviors and willingly act against them. For anybody who pays attention to this type of thing at all, I'm sure you can think back on what the buzz was near the high points of certain commodities over the last year.

Well despite the commodity index now being well off the peak, there is a resurgence of inflation fears with primary concern over monetary inflation and the death of the dollar. This has focused the commodity world's attention on gold. My take is that this could very well be just another successive inflationary peak in a longer process of fundamental deflation.

It is not clear cut to me though because when commodities break out to all time highs, they enter a very strong technical position with no overhead resistance to speak of. So maybe this is the early stages of a long and large move up in gold. But from a crowd psychology standpoint and look at measures of real money sentiment, I tend to think that it is more likely just another domino in the line.

Stocks and commodities tend to advance together over the long term in general. However, there is a key difference in psychology at extreme points between the two. When stocks advance to bubble levels the crowd is euphoric and happy about the high valuations. However, as commodity price reach bubble levels, fear takes hold. Fear of famine, shortage, etc manifest at commodity peaks while it is utter complacency at stock peaks. So the difference in psychology may be why we see stocks top out before commodities often. They are both advancing, but then as commodity prices get so high, the general climate shifts towards fear. Then stocks come down on the fear while commodities blow off to higher highs on the fear.

For those familiar with Elliott wave theory, you know it is a result of crowd psychology. So while prices may exhibit identifiable patterns, larger degree patterns will have identifiable psychological/social trends that happen with them. A correction of a larger trend in its simplest form is said to be a 3 phase move (i.e. down up down, ABC). In looking at the crowd psychology of the recent bear market and the advance since, I would say there have been 2 distinct phases thus far: a progressive fear of and recognition of deflation, and now a directed social effort to combat that and re-emerging fears of inflation. I personally expect there to be at least another reversal of the psychology back toward the deflationary side before any great buying opportunity comes in stocks. Maybe that will take the stock market to new lows, maybe not, but I expect it to take stocks down quite a bit lower than they are now.

Heads Up Post For Friday - New SPXU Trade

Place a day only buy stop order at 39.75 on SPXU tomorrow. Use 37.00 as a GTC sell stop after entry if filled. Use money management guidelines here if guidance is needed.

For those who haven't used a buy stop here's what to do......choose "buy" and then choose "stop" from the order type (limit, market, stop, etc) choices. Then you will put 39.75 for the stop price. The trade won't be filled unless the S&P 500 drops about 2.2% tomorrow.

This post is just a heads up for tomorrow. The stock futures are down about 2% right now, and the US dollar index futures had a huge gap up to open near Wednesday's open. This is looking like a false breakdown in the dollar and corresponding failed breakout in stocks as I've talked about for the last 2 weeks or so.

So the main reason for this post is that there may be a large gap down in the stock indexes tomorrow, but with the market in the current position, it is not going to deter me from recommending a new inverse ETF trade. Granted the position size will have to be smaller because the stop loss will be wide due to the gap.

For those that didn't keep up with the news on Dubai, this is the type of thing that I think will be coming to the front more and more in coming months with Dubai just the Poster Child of excess and linked to what was one of the very biggest commodity bubbles/bull markets in history. The implosion of oil prices has obviously now months later lowered income and profits so that all the debt they took on can no longer be covered. Debt service (interest payments) is drowning them. Ditto with housing. Ditto with government spending in my opinion.

I have never fear mongered on this blog (I have no reason to) and certainly am conscious not to do that after major declines because that is when people will "fall for it" and make bad investment decisions. But after a nearly 70% rally in stocks, I don't consider it fear mongering. It is a reality check on a world awash in debt from "money" that came out of the ether and, if left to substantial free market forces, will surely largely return to the ether. And yes I know the Fed is "printing" money. But if you think that the amount of printing/monetization (say a few trillion $) counter or overbalances the amount of credit (say a couple hundred trillion $) that would disappear under free market conditions via housing/real estate, financial derivatives, etc, then I think you owe it to yourself to better understand the system of our money.

So, while it may be a sucker play to sell on a large gap down, after living through the market the last several months, I have become increasingly convinced that it would/will take a major news event to really shift the psychology out of the weakening uptrend to a legit downtrend. I don't know if this is it, but I expect it to be something with regards to credit/solvency issues.

With the technical set-up such that a close below 1100 on the S&P triggers a sell due to a thrice failed breakout, and the potential for a gap down below that level tomorrow, I am not assuming this gap will be bought and the market will move quickly to new highs like has happened so often the last few months.

EUO Trade Stopped Out and New Trade Set-Up

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The chart above is the daily chart of the S&P 500. I have made notes showing a trade set-up that will be triggered if price closes back below 1100 without significant further upside. It is a similar set-up to the one during the June high. Check the chart for the notes. In sum though, I do feel it is worth it to get back in on the short/inverse side of this market if there is another close below 1100 in the next few days. Then the stop will be the most recent high in the market.

The EUO trade was stopped out at 16.95 (down from 17.43 at entry) on the open today as the dollar index gapped down. Thus far all my attempts to catch a significant reversal on this index have failed. However, there is an identical (but upside down) set up on this index as in the S&P, so this puke gap down in the dollar index today may be the last one before a legit advance. I don't know if a lot of detail is necessary on this, but the dollar and stock indexes have had a strong inverse correlation recently. It has not always been so historically, and major turns over the last year or so have tended to see some breakdown of the correlation between the two. So that is something I have been anticipating may happen, and is my justification for making trades both long the dollar and inverse stocks. However, there really has been no point in retrospect - the correlation has been extremely high and not broken yet. So, until I see more definite signs of a reversal, I will probably only be playing one or the other.

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This is an hourly chart of SPY showing a continuing bearish divergence on the MACD on the recent new high. The ADX system is showing no trend, but bulls in control right now. These are still the indicators I am watching, but basically another close back below 1100 on the S&P will be the sign to get back in an inverse ETF.

2x Inverse ETF Volume Update

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The chart above is an indicator I made based off of the sum of the Dow, S&P, and Nasdaq 2x inverse ETF funds. I have posted this before, but for those that haven't seen it the idea is that volume will spike at bottoms of corrections as traders buy these as short term hedges or speculative plays. The reverse logic of that is that volume may fall to low levels at market tops when collectively there is not much fear of downside.

Now one thing that is evident from the chart is that the volume of these funds has dropped in seasonal fashion around the Christmas holiday. That makes sense because total market volume does as well. In fact, a better way to look at this may be to divide the volume above by total exchange volume to filter out the general market influence.

Anyway, the volume has dropped as of yesterday to levels lower than any except the past 2 Christmas periods. Also, Thanksgiving last year showed a low reading which again would be expected on an absolute level. The Nov-Dec January time period tends to show greater than random gains throughout history with the days surrounding the Thanksgiving and Christmas holidays being some of the most consistently positive.

So that may account for some or all of the low reading currently, but volume also dropped to quite low levels in late Oct before a sharp pullback, so it is something to keep an eye on from a sentiment perspective.

I'll try to recreate this chart as a percentage of NYSE volume and post that chart sometime relatively soon as well.

SPXU Stopped Out

The SPXU trade was stopped out today at 37.36 down from 39.25.

I don't have any charts to post right now, but there are some very important ones to look at. I would like to get a video up but really don't know if I will. If not, then I'll post or recap some notables.

It would have been justifiable to re-enter a bearish trade prior to close today, but I held off. There was a classic reversal candlestick (shooting star/doji) in SPY today. It also filled the open gap down off the recent high. However there was a large gap up at the open today, and so there was not really a major breadth reversal in the market as all indexes closed with basically solid gains despite being well off the highs.

With the holiday week which tends to be lighter volume and more bullish than normal, I will just wait to see if there is any downside follow through to today's reversal. Basically if the market moves below last week's low, then I will suggest returning to an inverse ETF trade. That will make the stop wider and thus a smaller position size, but will decrease the likelihood of being stopped out and increase the likelihood that there will be further retracement of the recent advance.