The other day, I received a comment on the blog regarding the fact that gold is running up while oil is breaking down.  So, I decided to do a little research.

One way to make money in the markets over the long run is to find correlations and take advantage of them when they breakdown.  Pretend you’re looking at a braid.  One’s up, the other one seems to catch up.  The other one falls and soon the first one follows.  They may vibrate differently but they end up going in the same direction and at the same destination.  Typically, you buy the cheap one and sell the expensive one.  So, should we be selling gold and buying oil?  That may be what the blog reader was really asking.

From 2000 until mid 2008, gold and oil moved in tandem.  In fact, they were about 80% positively correlated.  Gold was always generally about 10 times the price of oil.  But, 2008 changed all that.  The correlation broke down and it’s been very sporadic ever since.  There have been times they’ve moved almost opposite of each other.  Why is this?  The simple answer is that the global economy slowed taking oil with it.  On the other hand, all the easy money and stimulus around the world has lead investors to buy gold as a reserve currency.  Also, gold has been a “safe” place to put your money.  AKA, part of the fear trade.   (I don’t always agree with that but it’s definitely in a long-term bull market that doesn’t look over yet.)  In fact, I remain long precious metals.

Above is the picture of the ratio from 2000 to the present.  I’ve drawn a red vertical line when everything changed (mid 2008).    Y0u can see oil plummeted while gold continued to push higher.  In fact, the ratio went from averaging 10 to a high of over 25 (gold is 25 times the price of oil).  This was after reaching a low of around 7 earlier in 2008.  The recovery in 2009 caused the ratio to revert closer to the mean but the recent European troubles have caused another spike.  That’s the ratio.  Now for the correlation.  In other words, how tight is that braid?

You can see the drop off that started in 2008 (red vertical line) and now the correlation is zero.  That means gold & oil aren’t correlated at all.  For now, that pairs trade of buying the cheap one and selling the expensive one won’t work.  The correlation has broken down.

But, we can’t just look at the last decade.  So, I decided to go back prior to 2000.  I looked at the data from 1986-2000 to see what the average ratio was between gold & oil.  Remember, in the 2000s (last decade), the ratio averaged about 10.  From 1986-2000, the ratio was 20!  Below is a picture of that ratio.

The current ratio is 17 in 2010.  So, perhaps we’re just going back to the normal ratio of 20.  How about the correlation back in the 1980s and 1990s?  You can see from the picture below (mislabeled – should read Gold vs. Oil Correlation).  There was no correlation.  It ebbed and flowed back and forth with no real reliability.

What’s the conclusion from all of this?  It tells me just like the dollar and gold, that these correlations aren’t consistent enough for us to trade around.  Treat gold & oil independently and trade them based on other variables besides watching what the other one is doing.

As the economy recovered in 2009, Australia was the first country to start tapping on the brakes to prevent further inflation by raising interest rates.  They haven’t stopped.  Now, we see China is tapping on the brakes as well.  For the last several years, all we heard was if you’re going to invest, it better be in “global growth”.  While this is certainly true in the long run, what about now?

The argument has been our country is driving dollars offshore.  There are billions of people industrializing.  The U.S. dollar is going to zero.  Interest rates are going to the moon and inflation is right around the corner.  But, let’s review the last few months.  Earlier this year, I discussed on a podcast that perhaps we should maybe prepare for lower interest rates in the near term, not higher.  I thought of this because literally every person I talked to then (and even now) believes inflation is here and we better prepare.  So, I first examined the contrarian view.  Since then, the numbers have proved me correct.  Inflation could be a problem down the road but even though the monetary base has exploded, the multiplier effect has been going down.  Money isn’t circulating as fast as people would have imagined.  So, we’re still in a flat to deflationary environment.  Thus, the Fed hasn’t raised rates and long-term rates have actually come down.

In the last few weeks, the Greece situation has been the hot topic and money has come out of the Euro and into U.S. dollars.  Yes, the dollar has risen.  Now, we all know the government doesn’t want this to happen.  They need a weaker dollar so we can inflate our way out of this.  But, the dollar is going up, interest rates are coming down, and the place to be is the United States of America.  Put on your global hat for a minute.  Let’s say for a minute you’re a billionaire with money and assets that have to be allocated anywhere in the world.  You look at the most exciting places to invest:  China, Latin America, India, etc.  Exciting but risky and they’re growing so fast that their government has started to put the brakes on to slow it down.  That’s typically not the best investing environment.  On top of that, some of the brightest investment minds we have are saying China is another bubble about to burst.  So, that’s out (for now).  Then, you look across the pond to invest your money.  Good ‘ole Europe.  The grandfather (or mother) of the world.  But, they’re falling apart, behind the curve, their currency is falling, and it’s just a mess.  What’s left, the United States of America.  Money is flowing into U.S. treasuries, the U.S. dollar, and stocks with limited international exposure.  Small caps, mid caps, etc. are the place to be.

If you put a gun to my head and said you can only invest in two areas for the rest of your life and you have to stick with it, what’s it going to be?  Emerging markets and materials would be my choice.  But, fortunately, we have a little more freedom than that.  So, we look for rotations and try to track where is the money flowing.  In the last month, Chinese stocks are down over 10%, the S&P is down about 2%, and the Russell 2000 (small cap American stocks) is up slightly.  The dollar is up 4.5% and 10-year treasury rates have fallen from 4% to 3.5% meaning money is coming into U.S. bonds.

I perceive this rotation as America being the hide out and the safe place to be for the short-term.  Again, this isn’t a long-term trend but it could last a while.  The global growth story is out there and has been for some time.  Now that the retail investor is catching on to this, I think we have to put our contrarian hat on for a minute.  The place everybody likes to bash is the place attracting the capital.  The U.S. of A.

Even though natural gas prices have risen in the past few days.  The prices in 2010 continue to fall overall.  In fact, just in 2010, natural gas prices are down about 25%.  Since they peaked in July 2008, prices are down 69%!  On the other hand, oil prices have stabilized since their peak and have actually risen 8% in 2010.  This has many concerned that any economic recovery will be muted by rising oil & gasoline prices.  But, what about the investment side of this?  Surely, natural gas has to find a floor.

Looking at the picture below, you can see that oil is 20 times the price of natural gas.  Over the past 20 years, oil has averaged about 10 times the price of natural gas.  So, we are double that right now.  Besides the peak in 2009, this is the highest level since 1990 on this ratio.

There are all kinds of reasons why this ratio could stay high.  But, over the years, I’ve learned several things about markets and investments.  One of them is that when you see a ratio like this get way out of whack, it generally comes back into line at some point.  If you look at P/E ratios for example.  You know I’m not a big proponent of using P/E ratios to make money.  But, overall, investors were rationalizing for years why P/E ratios didn’t matter in the 1990s and early 2000s.  They did matter and stocks were simply too expensive.  That ratio came down and corrected.  I think the oil to gas ratio will come down at some point as well and the long-term play will be to short oil and go long natural gas.  I’ve also learned that sometimes these things take a while.  The safer play right now is going long pipeline companies and natural gas stocks, not the commodity.  But, we’ll certainly continue to watch this ratio.

Click here to listen to Through A Trader’s Eyes Podcast #11 – February 23, 2010

This post published at www.karleggerss.com

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A few weeks ago, I wrote an article regarding a technical pattern that would soon reveal a breakout for gold.  Either it would break down or take off like sugar did recently.  Today may have been that break out to the upside.  After touching $1050 a few days ago, gold has broken the downtrend its been in since early December and looks as if it wants to move higher.

The focus is on the stock market right now as it should be.  The underlying strength in stocks the last few days has been impressive.  There are still plenty of doubters which only adds fuel to the bullish fire.   Stocks I believe will have great moments and bad moments in 2010.  I think this year will be an average of the past two years.  That’s an opportunity for us but also a reason to pay close attention.  The market was deeply oversold as I had stated on my podcast several days ago and we are experiencing the bounce.  But, stocks always steal the spotlight and right now gold is quitely breaking out to the upside.  Based on the chart above, if gold can break the $1150 area (3% above the current level), it has a real shot of testing the all-time highs.

In the past few days, the news headlines have been dominated by financials and technology.  First, there are new taxes being proposed on financial firms.  We bailed them out and now it’s payback time.  At least, that seems to be the attitude in Washington.  No more too big to fail.  Then, we have earnings.  Several financial firms are reporting their earnings in the next few days.  JP Morgan kicked it off this morning.  As a group, financials have performed pretty well this year.  But, besides financials, technology have also been the talk of the town.  Smartphones were extremely popular for Christmas gifts and with Windows 7 causing a technology upgrade, these stocks have done very well also. Then, we get word that Google wants to pull out of China because they are concerned about the Chinese government hacking into their systems.  Other American companies admit the same but have been too scared to say anything in fear of losing business in China.  All of this news in the financial & tech industries has caused investors to forget about some of the sectors that dominated the front page in 2009.

Gold, which was up about 25% last year, is off to a good start in 2010 as well but isn’t getting the headlines and I believe it’s on the verge of a big move.  The dollar, which had a nice run late in the year has given back almost half of its gains but it’s not newsworthy anymore apparently.  I think it’s still very relevant as are interest rates and gold will certainly be a mover in 2010.

You can see from the picture above that gold has been making higher lows for some time but has just recently been making lower highs as well.  Something will give and I think it will be soon, just like sugar late last year.  With the stock market overbought in the short-term, investors may look to re-allocate to another asset class and gold could be it.  I’m bullish on lots of different metals but I wanted to highlight gold since I get so many questions about gold generally.

With the dollar falling in 2010, the bulls have jumped back on the metals bandwagon.  Longer-term I’m still bullish on the metals as well.  A generally weaker dollar will continue to drive capital into commodity rich nations, commodities, and various metals.  The Powershares DB Base Metals (DBB) ETF still looks as if it has more room to run.  But, if we drill down into some of the companies that operate in the metals space, the story may be a little different.

Last night Alcoa (AA) announced earnings with a big fat miss.  They blamed most of their loss on some restructuring and various charges.  But, given that the stock is at the top of its 1-year range, I think investors will find any reason at all to sell Alcoa.  Longer-term, I think the company is ok but for now, I’m staying away.

The chart above shows Alcoa going back almost a year.  Based on the weak earnings report and the stock market being overbought, I think Alcoa could fall to the $15 dollar range.  There are other companies to short like the video game makers, but if you’re into shorting individual companies, the stop will go at $17.

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Airlines do much better when oil prices fall.  This is a common theory that makes sense on the surface.  After, airlines buy a ton of fuel to run those planes all over the country and world.  When oil prices are high, consumers don’t travel that much.  This all sounds logical.  The problem is you can’t buy or sell airline stocks based on these facts.  In 2009, oil is up over 66%.  If some of these theories were correct, the airline index would be down.  But, it’s not.  Airlines are up over 32% as a basket.

In fact, the chart below is comparing oil and the airlines and their respective correlation.  For most of 2009, there has been a pretty significant POSITIVE correlation, not negative.

Even gold and the dollar which have been moving completely opposite of each other this year don’t always do this.  Before you make an investment decision based on theories, go test them to make sure they hold up over time.

The pullback that the bears were hoping for and the bulls were dreading has happened in gold.  In five days, gold fell approximately 9% from its recent high of $1,227.  The great debate right now though is whether it’s simply taking a breather or was that the peak in gold.

I believe gold is still in the early innings of a long-term run.  The recent move did get ahead of itself.  I commented recently on my radio show that you simply can’t buy a chart that is heading straight as gold was in late November.  Now is the time to re-evaluate since we’ve had the correction.  Below is a picture of gold through the ETF streetTRACKS Gold Trust Shares (GLD).

The uptrend since the summer time is clearly defined here with the blue line.  Based on this, gold could continue seeing more selling pressure to roughly the 1090 area (equivalent to roughly $107.50 on GLD).  That would also be around the 50-day moving average as well.

The numerous reasons investors are buying gold from a fundamental standpoint haven’t changed.  In fact, the reasons are growing as we speak.  Therefore, I believe gold can move much higher over the next several months with pullbacks very similar to what we’ve seen so far.  Eventually, it will become a bubble.  But, we’re not there yet.

Lately, all the talk has been about the dollar.  It’s almost 100% inversely correlated with just about everything else.  When the dollar is down, gold’s up, oil’s up, stocks are up, emerging markets are up, etc.  So, perhaps we really can’t get a huge sell off unless the dollar spikes.  It’s had a few days where it appeared as though the trend was changing.  But, then down it went to new lows.

To me, it’s all about the 50-day moving average.  Until we break above the 50-day moving average, the downtrend is still intact.  Take a look at the picture below.  The green line is that 50-day moving average.  Keep an eye on this green line and that may give you a better idea on the direction of the stock market.

Television

I’ll be on CNBC Asia this evening at 5:10 p.m. CST & Fox Business tomorrow morning at 8:10 & 8:30 a.m. CST.  Make sure you tune in.