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  • Gold has underperformed stocks enormously over the past three years.
  • I believe a bottom in the ratio of gold to stocks has formed.
  • Upside is huge with very limited downside, suggesting the time to get long gold in relation to stocks is now.

A few months ago, I wrote an article detailing why I thought gold (NYSEARCA:GLD) would outperform stocks, as measured by the S&P 500 ETF (NYSEARCA:SPY), in 2014. So far, not much has happened since my call but in this article, we'll take an updated look at my thesis to see if there is something in this trade for the balance of the year.

To begin, the chart below (from StockCharts) represents the ratio of the GLD to the SPY for the past three years. This is the inverse of the chart I used in the previous article, which charted the SPY in relation to the GLD. I used that chart to illustrate the enormous run stocks had experienced relative to gold but in this chart, I wanted to show the vast underperformance of gold in relation to stocks.

(click to enlarge)

And that underperformance has been vast indeed. If we look at the ratio it begins up around the 1.2 range and spikes to 1.6 before consolidating back in the 1.2 area throughout 2012. However, subsequent to that, we see stocks absolutely crush gold and the ratio has since been cut in half to the .65 level we see today. This means that stocks have outperformed gold on a relative basis enormously over the past three years.

If we take a look at the more recent time period of just 2014, we can see a double bottom that is potentially forming around the .6 area. We have bounced slightly off of that since the beginning of June and the ratio has gained five basis points. We also saw a bounce right at the beginning of 2014 from the same level, ultimately reaching .7 before the gold rally was rebuffed and stocks took over again. However, I think the double bottom formation is compelling.

The ratio stands right where it did when I wrote my February article so nothing has really changed for me fundamentally. What has changed, however, is that when I wrote my previous article I was suggesting catching the proverbial falling knife. Now, with the double bottom forming, I think the evidence is much stronger this time around that we are indeed setting up for gold to outperform stocks. Anything could happen but the odds appear to be in the favor of gold to outperform for the foreseeable future.

In particular, if the ratio consolidates in the current area and we see the 50 week moving average stabilize and turn up, it could be off to the races for the GLD to outperform the SPY. The years of underperformance appear to be coming to an end and when the blue line on the chart turns up, we could see enormous outperformance of gold.

One more point from the chart; the RSI line printed some oversold values below 30 at the beginning of 2014. However, with the ratio at the same level as that time period, we see the RSI isn't in oversold territory anymore. I think this is an indication that the selling is much less pronounced this time around, giving some credence to the idea that the double bottom is indeed forming and that we will see the ratio move up more strongly in the coming months.

So assuming I've convinced you, how do you take advantage of this move? There are many ways to do it but for most investors, I'm going to assume that futures and options are out, although those methods would do the trick for gaining exposure to both assets. For our purposes, we'll assume that investors can only go long or short the actual ETFs, keeping the example applicable to most retail investors.

The more enterprising among us could put on a pairs trade that shorts the SPY and gets long an equal amount of GLD. This would essentially buy you the ratio we've been looking at and your trade would move the same way the ratio moves. This is problematic for those investors that can't or simply don't short as shorting requires margin and more risk than simply buying an ETF. This, however, is the purest way to play this ratio.

But, if that is not for you, you could take some funds you've got invested in stocks and move them into the GLD. This is essentially getting most of the move you'd expect from the ratio as selling your stocks would provide you with capital that could then be used to buy GLD. You'd only get one side of the ratio but by selling your stocks, you'd be foregoing the relative losses you'd otherwise experience, if I turn out to be right. Selling stocks to buy GLD is the lowest risk way to put this trade on and is probably right for most investors interested in trading this ratio.

Overall, I think the evidence is reasonably strong in suggesting that gold is set to outperform stocks in the next few quarters. Anything could happen but as investors, all we can do is try and put the odds in our favor. With the ratio not only arresting its decline but forming a double bottom, I think a bounce is coming. Even if I'm wrong, the ratio needs to fall through .6 convincingly before I would change my thesis, indicating strong upside, virtually unlimited upside with limited downside.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article. I may put on the long GLD/short SPY trade at any time.

Source: Strong Evidence Of Gold Outperforming Stocks This Year