Why Gold Will Outperform Stocks This Year

| About: SPDR Gold (GLD)

There are many ways to trade gold (NYSEARCA:GLD) in today's market. Gone are the days when investors were left with only physical gold or futures as today's market offers myriad choices for exposure to gold. I prefer using pairs trades on gold as anything that has no earnings, dividends, or other traditional valuation metrics can be difficult to assign a value to. In this article, we'll take a look at gold in the context of the S&P 500 (NYSEARCA:SPY) in order to determine if gold is overvalued or undervalued in relation to stocks.

To start, here is the ratio of the S&P 500, as represented by the SPY ETF, to gold, as represented by the GLD ETF, for the past three years.

You can see that during 2011 gold vastly outperformed the S&P 500, sending the ratio down to 0.60 in the summer. However, since that time, SPY has been destroying GLD after a quick snapback to the ~0.85 area during 2012. Last year saw the ratio of the SPY to GLD double from 0.80 to 1.60 at the end of 2013. As we all know, stocks rose something like 30% last year while gold languished and crushed those who were long. The beauty of the ratio trade is that one can take advantage of relative overvaluation in one market and undervaluation in another, juicing potential returns. In this case, someone who was long stocks and short gold made almost 100% in 2013 versus ~30% long stocks only and a loser long only gold. Of course, those returns work both ways and someone that got it wrong was severely punished.

So what do we do now, given this information? As you can see, recent history suggests that this ratio is very stretched, to say the least. It appears as though the overvaluation of stocks relative to gold has gotten to the point where there is more of a margin of safety on this trade. Before we get into the specifics, keep in mind this is a riskier way to trade these two instruments and you must be disciplined enough to get out if the trade moves against you. Otherwise, you could experience large losses like what would have happened if you'd performed this trade the wrong way in 2013. Just make sure you know what you're doing before you attempt a ratio trade.

Now, after breaking out of the .80 to .90 range of 2012, the SPY:GLD ratio spiked, as discussed earlier. We'll examine this in more detail in order to find out what could come next and how one could profit from it.

This chart shows the ratio from the beginning of 2013 until today and what it depicts is quite telling. First, stocks have become far more overvalued in relation to gold over the past 14 months but I think we all knew that. Second, I believe the ratio offers traders a way to profit from the ratio and we'll take a look at a couple of ways right now.

You can use this ratio to make longer term bets or you can use it to trade in and out of positions. The longer term bets can be made by examining the trend of the ratio and placing your bets accordingly. Of course, the trade for the past year or so has been to be long stocks and short gold but it appears that has begun to turn. If you look at the uptrend line I drew on the chart, it appears the uptrend has been at least disrupted and possibly broken. While this alone is not enough information to trade on, you could certainly make a case that the uptrend has stalled and that a reversal could be in the offing shortly.

However, I think using longer term trends in the context of shorter term ones is also a useful way to put the odds in your favor in terms of timing. There are a couple of ways to do that but I like using the RSI and MACD to do that with gold. You can see on this chart that the 14 day RSI has been a great indicator of when to get long gold and short the SPY over the past year. If you notice, each time the RSI gets over 80, it has been a terrific signal to put this trade on and very profitably at that. Using the RSI is a good way to capture a quick, short move as a snap back to the mean; this is not the trend, it is a short term move. However, using short term moves can help you either trade in and out of the instruments or get a better entry point for a longer term trade. Similarly, the MACD shows that extremes have been good places to make bets one way or the other on this ratio. Using these in conjunction would have produced some very profitable trades in 2013 and I think we can still use this information in 2014 but on the other side of the trade.

I don't think anyone expects stocks to go up another 30% this year and with gold beaten down, the other side of this trade looks intriguing. However, as you can see on the chart, the MACD shows the long gold/short SPY trade has gotten a bit extended as the uptrend we saw before has apparently broken. We saw something similar in September of 2013 and the result was a quick reversal of gold underperforming the SPY. I suggest waiting for this to occur once more before attempting to put on the long gold/short SPY trade as the market could move against you very quickly and very soon, possibly even this week. I would wait for the oversold reading on this ratio to abate before getting in and in fact, those less risk averse among us could get long stocks and short gold here in anticipation of the move.

This ratio of stocks to gold can provide important clues about which trading instruments may be more overvalued versus others and can also provide information you can trade on, as we've seen here. However, this is not for the faint of heart and large losses are very possible when putting on this trade. As we saw in 2013, the ratio of SPY to GLD doubled, leaving those that got it right with enormous gains while those that were on the other side of the trade were crushed. I suggest eschewing the longer term trades and making quick in-and-out trades based upon shorter term indicators in the context of the longer term trend. With the longer term trend of stocks outperforming gold appearing to have been broken, I think the favorable trade here is to look for opportunities to get long GLD and short the SPY in 2014, but wait for favorable short term indicators to do so.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. I may initiate a pairs trade in either direction in GLD/SPY at any time.