Gold: A Fate Worse Than the Cover of Time Magazine

Anyone familiar with contrarian investing knows about the Time Magazine cover-story curse: If a company (or its CEO) or other investment appears on the cover of Time, it means that every last retail target buyer has been tapped, and so it's "time" for the smart money to sell. A newer twist on this kind of sociological indicator is the idea of "Jumping the Shark". The premise is that when a product (be it a TV show, story stock, or any other saleable asset) has run its course, the producers (or suppliers, in the case of stock and many other financial assets) resort to, or are taken in by, embarassingly stupid new "plots". Fonzie has to ski-jump over a shark, wearing his leather jacket and T-shirt over his swim trunks--only this time, The Fonz is gold.

Friday's "5 Dumbest Things on Wall Street” column on, in the version picked up by Yahoo Finance, introduces Number 3 with the subhead, “Gold Jumps the Shark”, bringing attention to the increasing likelihood that there's a bubble in gold, as I warned in a post on Condor Options a few weeks ago. Intercontinental Exchange is accepting gold bullion as collateral for positions in energy (yes, this is actually true):

This week, London-based Intercontinental Exchange (NYSE:ICE) announced that it would begin accepting gold bullion as collateral for energy and credit trades. Take a step back and think about that for a minute: traders will use a highly volatile commodity to back trades—or increase margin—on other highly volatile commodities and derivatives.

So, let's just take a peek at a chart of gold overlaid with the prices of light crude and the US Dollar Index (click to enlarge):

Two things jump out, which, it seems, the geniuses at ICE can't, or pretend not to, see (either their heads are up their backsides, or they're trying to fuel speculation in both commodities, to their own advantage). With the exception of the bubblicious parabolic climax in gold since last spring, oil and gold are highly correlated in direction. The dollar (US Dollar Index), on the other hand, exhibits an inverse correlation, which makes much more sense for an asset used as collateral.

That inverse correlation is no secret to anyone who know anything about oil prices, but it's important to note that the relationship is non-linear--therefore, the two are not 100% correlated, which leaves room for arbitrage. That's pretty much the premise for all the traders who buy (or short) oil futures with US dollars...but apparently, the network (ICE) thinks the audience is willing to pay for more excitement, no matter how absurd.

A closer look at the numbers

I ran a statistical correlation analysis on the assets in question, and the results support the conclusions I drew from the chart above. I'm not equipped to apply the most cutting-edge correlation algorithms, but the basic correlation function provides pretty clear evidence that gold and oil are highly correlated (78.6% over the past two years); whereas the US dollar and oil are not (-56.8%).

The greatest correlation I found, in fact, was between gold and the S&P 500 Index. For the period from November 13, 2008 to November 12, 2010, the correlation between gold (continuous contract) and SPX was about 83%.

The broken record (or broken clock)

Gold is hugely overbought in the weekly and monthly timeframes; the concept of “hard currency” is long dead, and the decoupling of gold and oil adds to the evidence that gold is in a speculative bubble. No doubt, some readers will criticize this analysis as beating a drum long enough that I'll eventually be right, like a broken clock (apologies for the mixed metaphor). My response is that this ridiculous move by ICE is exactly the kind of nonsense that contrarian investors use to identify a buying climax.

Bottom line: It would be wise to be cautious about buying gold right now, and anyone who's sitting on a big paper profit might want to lock in a portion of that gain.

And, finally, it might be smarter for ICE just to accept the good old US dollar (well, not quite as good as it used to be), and stay away from gold as margin for energy positions. Otherwise, ICE might become the next AIG for the shorts to get rich off.

Author's Disclosure: Delta-neutral positions in SPX, SPY, RUT and OEX options. No position in gold, oil or currencies.