One Slick Reason To Buy Gold

| About: The United (USO)

Summary

Gold and oil tend to move in the same directin over the long run, but now the relationship has broken down.

Low oil prices could cause the market to panic, benefiting gold.

When oil hit new lows in February, credit spreads spiked and gold soared.

Gold can serve other purposes in your portfolio even if the hedge fails.

If you've read my past articles on gold, you know that I believe gold can be used opportunistically. Today, I'll talk about such an opportunity.

Gold (NYSEARCA:GLD) and oil (NYSEARCA:USO) are both defined as commodities. For example, the Dow Jones Commodity Index (NYSEARCA:DJCI) includes both gold and oil. While commodities have their own risk characteristics (i.e. a shortage of cattle won't impact supply of crude oil), they all have exposure to inflation, which is why they tend to move together over the long run. However, an anomaly has developed between gold and crude oil.

Gold and oil do not have a strong correlation over the short term, but due to their exposure to the common factor (i.e. inflation), they move in tandem over the long run. The ratio isn't one-to-one (i.e. 10% decline in gold does not equate to a 10% decline in crude), but they do move in the same direction nevertheless.

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However, the trend has broken down recently.

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Why is gold moving in the opposite direction of oil? Of course, this could be a coincidence, but this occurred back in February as well, when oil reached historic lows.

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The market did not just suddenly decide to switch it up for fun, there is a good reason. In my other article, I talked about oil's effect on the economy and oil's effect on capital markets (read Oil Anomaly). Theoretically, lower oil prices would be beneficial for the economy. However, we also witnessed its devastating effects on risk appetite. When oil sank to new lows in February, credit spreads spiked to new highs, indicating fear.

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Sounds familiar? As Buffett says: buying gold is going long on fear. Previously, I mentioned that fear is gone (read Sell Gold, Fear Is Gone), but as luck would have it, the market may be entering another episode of unreasonable panic depending on where oil will go (I'm bearish). If the market is perfectly rational, I do not think that credit spreads should spike again even if oil tanks. Unfortunately, market participants aren't perfectly rational, so there is a good chance of repeating that episode in February if oil continues its downward spiral.

This is where gold comes in. Even though the two commodities (gold and crude) are positively correlated over the long term, I believe that current market conditions have created a window of opportunity for investors to use gold as a hedge for oil. A big advantage of using gold to cross hedge rather than using a direct hedge such as futures is that gold can serve other purposes in your portfolio as well (e.g. as a substitute for cash). So even if you "lose," you won't end up with an undesirable financial instrument that does nothing but accumulate losses. For example, if you directly hedge your oil position with futures, if oil jumps to $100/bbl, you'll end up with a losing position that you will liquidate eventually (and recognize the loss).

Conclusion

Over the long run, gold and oil move in the same direction. However, recently their movements started to diverge. I believe that this is an opportunity for investors to buy gold as a hedge for oil, as lower oil could cause the market to suffer from another panic attack, creating fear and benefiting gold. Note that this relies in the irrationality of the market, which may or may not persist should oil slide further. We are already seeing credit spreads rise a bit from two weeks ago, let's see if oil will send the market into another tailspin.

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Disclosure: I/we 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.