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In my previous article, I wrote about how, over the last four decades, for reasons related to something like Gibson's Paradox, the oil/gold ratio appeared to dictate the Dow/gold ratio.

(click to enlarge)Oil/gold ratio vs Dow/gold ratio 1968-2012

(source: Dow and gold, Wren Investment Advisers; WTI, St Louis Fed)

When the oil/gold ratio rose to 0.12 or above, the Dow/gold ratio began to slide until the oil/gold ratio fell to 0.05 or below, after which the Dow/gold ratio would rise again.

Setting aside the specific ratio levels, the reason for this relationship is, as I argued, that real commodity prices are tied to equity yields rather than to real interest rates, as postulated by Lawrence Summers and Robert Barsky 25 years ago.

(click to enlarge)Real commodity prices vs earnings yields

(source: commodities, UNCTAD; earnings yields, Shiller)

It is not that Barsky and Summers were wholly wrong, however, when they tied real gold and copper prices to real interest rates. It is just that it is the ratio between these two commodities that is tied to real interest rates, which tend to lag by about 16 months.

(click to enlarge)gold/copper ratio vs real interest rates

(source: commodities, UNCTAD; interest rates and cpi, St Louis Fed)

Speaking of lags, if you look back up at the chart of commodity prices relative to earnings yields, you can see that most of the spikes in yields were preceded by rather powerful run-ups in commodity prices.

Below, I compared year-on-year changes in real commodity prices (average of copper, silver, gold, and oil) with year-on-year changes in earnings yields.

(click to enlarge)Annual changes in earning yields vs changes in real commodity prices 1971-2012

(source: earnings yield, Shiller; commodities, UNCTAD)

Nothing especially relevant stood out from this angle. Generally speaking, periods with exaggerated moves in commodities appeared to also be marked by exaggerated changes in earnings yields. The 1970s commodity run seems to have been marked by one-off explosions in commodity prices, while the 2000s were marked by steadier rates of increase. I was also interested to see that the only change in earnings yields bigger than the 2008-2009 one was the 1974-1975 spike.

(click to enlarge)year-on-year changes in real commodity prices vs changes in earning yields 1971-2012

(source: commodities, UNCTAD; earnings yield, Shiller)

In the chart above, I compare changes in individual commodities with changes in the earnings yield.

The best indicator of spikes in earnings yields appears to be spikes in crude oil. A 50% jump in UNCTAD's crude oil index tends to be followed by a 19% or greater spike in yields within sixteen months. The only instances of oil spikes of the former magnitude not being followed by a yield spike of the latter were in 1981-1982, when earnings yields did not jump up until something like twenty months later, and in our current circumstances. The oil spike in the winter of 2009-2010 has not been followed by a comparable jump in earnings yields. From the other side, the only jumps in yields that were not preceded by these oil spikes within the prior sixteen month periods were the winter of 1977-1978 and the aforementioned 1981-1982 episode. All in all, we have eight oil spikes by my count and eight yield spikes, and it would appear that we have six, possibly seven, pairings.

For those sympathetic to Stephen Leeb's "Oil Indicator", these types of correlations will probably come as little shock. For those unfamiliar with Leeb's observation, simply stated, he wrote that year-on-year 80% spikes in end of month spot WTI crude oil prices typically mark tops of stock markets while increases of 20% tend to mark bottoms.

(click to enlarge)Leeb

(source: WTI, St Louis Fed; Dow, Wren Investment Advisers)

The chart above gives some impression of that relationship. It should perhaps be noted here that the Fed's oil price data produces slightly different results from the data in Leeb's book. According to the Fed's data, a "Leeb shock" occurred in September 1979, while in Leeb's book it occurred in February 1980. I am not sure what source Leeb used, so it is difficult to double check. It might make some difference with respect to my argument, since Leeb's numbers would appear to be more favorable, but I do not think my numbers will be fatal.

One thing that you might notice is that during the 1970s and 2000s, Leeb's Indicator was not always especially effective at identifying tops and bottoms in the Dow. It usually identified tops late and bottoms early.

(click to enlarge)Leeb

(source: Dow, Wren Investment Advisers; WTI, Fed)

(click to enlarge)Leeb

(source: WTI, St Louis Fed; Dow, Wren Investment Advisers)

Following the Indicator, if you sold the Dow in 1999, it had you buying back in at almost the same price a year later, only for the stock market to drop 3000 points by the end of 2002. And by the time the Indicator had you selling again, in 2008, you were selling at almost the same price you had bought in at nearly a decade prior.

Therefore, I propose the following: that by combining the oil/gold ratio as an indicator of secular turns in the Dow/gold ratio with Leeb's Oil Indicator, we can go some ways to proving each one's validity.

For example, with reference to the previous chart, the oil/gold ratio still indicated that the Dow was dominant when Leeb's Indicator flashed a 'sell' signal in December 1999. By the time Leeb's Indicator had flashed buy, however, in April 2001, the oil/gold ratio had been indicating that gold was now dominant (as of September 2000).

(click to enlarge)Leeb

(source: WTI, St Louis Fed; gold, Wren Investment Advisers)

In effect, by combining the oil/gold ratio and Leeb's Oil Indicator, we would be selling the Dow in 1999 at its all-time inflation-adjusted top and buying gold at the lowest price it has been at in the last 35 years. We would then have sold gold just off its highs in 2008.

Looking at gold since the demise of Bretton Woods versus Leeb's Oil Indicator, one can see that Leeb's Indicator only appears to work on gold when gold is in the ascendant over the Dow.

(click to enlarge)Leeb

(source: WTI, St Louis Fed; gold, Wren Investment Advisers)

Unfortunately, that still leaves us with the problems of 1973-1974 and today, as I mentioned above and in my previous article. In February 1973, the oil/gold ratio fell below 0.05, marking what I have argued "should" have been a shift to a rise in the Dow/gold ratio. But, that rise did not begin until January 1975. Similarly, in January 2009, the oil/gold ratio slipped below 0.05, but the Dow/gold ratio briefly rallied, only to return to its old decline, which possibly ended late last year.

These two instances were also a little unusual in that they are the only two cases when the oil/gold ratio signaled a switch to stocks and out of gold while Leeb's Oil Indicator was in 'buy' mode.

My first article on Seeking Alpha was about how spikes in the gold/oil ratio (i.e., plunges in the oil/gold ratio) tend to result in Leeb oil shocks, and this phenomenon is even more distinct in these two cases.

In February 1973, the oil/gold ratio broke below the 0.05 level. By February 1974, oil was up 184%. In January 2009, oil/gold broke below the 0.05 level, and by January 2010, it was up 87%.

On January 1975, Leeb's Oil Indicator reverted to a 'buy' signal; December 1974 marked the bottom of the Dow/gold ratio, which went from 3.2 to 9.3 in less than two years. The Dow had its best run of the 1970s; gold had a now forgotten collapse of something like 40% of its value.

The Dow/gold ratio continued to rise until September 1976, a month after the oil/gold ratio went back over the 0.12 line. This marked the end of the stock rally and the beginning of the epic '70s gold rally to $800.

This time has been a bit different, however. After the 2009 oil run, the Dow/gold ratio did not revert to form. In June 2010, when the Leeb Indicator slipped back into 'buy' mode, the Dow/gold ratio rallied fairly strongly, but soon faltered and continued to fall into the summer of last year.

This also marked another sharp move below the 0.05 level for the oil/gold ratio, which served as part of the basis for my warning of a possible Leeb shock this summer (although this was not confirmed by the behavior of the yield curve).

Was This Time Different?

One could argue that the Dow/gold ratio never had a chance to recover because of the series of financial tsunamis crashing into the world economy. Indeed, the 20% sell-off in stocks last year was only the third time that stocks had ever fallen so much in bullish (under the definitions of the system I am employing here) stock conditions. The other two instances were associated with the 1981-1982 Latin American banking crisis and the Asian crisis in 1998. The Dow/gold ratio appeared to stumble during those periods, but nothing on the order of our current circumstances.

Here are charts of these three crises. In each, the Dow/gold ratio tended to sag until the oil/gold ratio bottomed.

(click to enlarge)Dow & Latin American crisis 1982

(click to enlarge)oil/gold & Latin American crisis 1982

(click to enlarge)Asian Contagion A

(click to enlarge)Asian Contagion B

(click to enlarge)Eurozone A

(click to enlarge)Eurozone B

(source: WTI, St Louis Fed; Dow and gold, Wren Investment Advisers)

There are no simple take-aways, but the bottom in the oil/gold ratio last year may mean that gold's (GLD) goose was cooked as of August 2011. The 1970s tell us, however, that this may only be the calm before the onset of a yet greater storm a few years down the road.

In my previous articles, I have argued that, although I am expecting a general sell-off in nearly every asset class this year, especially treasuries (IEF), stocks (DIA) were likely to be the least affected, with the possible exception of crude oil (USO). This would point to a similar scenario of relative equity strength.

If the stock market remains weak (on an absolute basis), under the "rules" of the post-Bretton Woods order as I have hypothesized, it would nevertheless seem highly unlikely to have a 20-25% sell-off without a Leeb shock occurring first. If such a sell-off should occur without a Leeb shock, it would be an indication of just how bad things are, and it might suggest that a new post-post-Bretton Woods order is emerging. A third Leeb shock in five years would hardly be a promising development, either, however.

Some Sophistical Stances

I am sure that some readers will be kind enough to quickly scan this article for objectionable claims and leave some routine remarks about coin tosses, tea leaves, goat entrails, and the like. But it hardly does the problem justice.

The existence of such a system that "operates" on such silly "rules" as the ones I have outlined above is, quite frankly, so improbable as to be virtually unimaginable, and not only "should" it not exist but there should not even be a hint of such an order. The mind revolts at its simplistic idiosyncrasies and magical ratios.

To think that the post-Bretton Woods economy has been in some sense governed by a series of relationships for so long and with such consistency, at least until last year, without anybody being especially aware of it makes one question one's sanity.

How could a boundless system (i.e., the economy) - itself a paradox - at the mercy of scientific, technological, geographical, religious, political, and cultural factors, never mind good ol' supply and demand, possibly behave in such extreme and yet routine ways?

The chances of such an order existing seem astronomical. And, yet, I think this is precisely how systems with fundamental flaws operate. Although I highly doubt that the likes of a George Cooper or Richard Duncan would pay much mind to the system I have described above, if our financial system is as basically misaligned as they argue, then these kinds of extreme imbalances would manifest themselves somewhere, and they would be increasingly susceptible to measurement as the system warred with its own systemic nature in an ultimate bout of reflexivity.

How badly is our monetary system designed? Keynes wrote of Gibson's Paradox that it was "one of the most completely established empirical facts in the whole field of quantitative economics". And yet we have no conclusive explanation for it or why it vanished as the Bretton Woods system disintegrated. A quarter century on, it is now quite evident that the Barsky-Summers explanation simply does not fit the facts, however much we must acknowledge our indebtedness to it.

And Gibson's Paradox is hardly a peripheral concern or merely academic curiosity. It speaks to two fundamentals: interest rates and the general price level. Although not referring to Gibson's Paradox, so far as I can tell, Cooper, as I recall, writes of the difference between capital goods and consumer goods and the radically different pricing laws they obey, and yet we regard all of them as subject to the simple supply-and-demand Econ 101 rules that can, strictly speaking, only be applied to consumer goods.

Our monetary system is, moreover, founded on the existence of a central bank whose chief power and purpose is to manipulate interest rates. It does so, to repeat, without any verifiable notion of how this might impact the price level. And, yet, the rate of price changes (i.e., "inflation") and its stability is considered the raison d'etre of central banking and the "cult of the conservative central banker".

The Warren Buffetts of the world are flabbergasted that an inanimate, virtually functionless hunk of rock could, for decades at a time, produce more value than conglomerates of highly skilled and motivated workers enhanced with the latest technological breakthroughs. Gold bugs and doomsayers can't believe that the system has been able to last as long as it has. And virtually all of us talk about the clean rationality of supply and demand one moment and black swans the next, without even blinking at the growling contradiction staring at us in the face.

So when it comes to comparing the unbelievable lunacy of the gold-oil-dow trinity and the lunacy of an economic science that cannot even explain what it itself acknowledges is its most basic 'empirical facts', but without hesitation goes about correcting those facts (e.g. setting the price of risk), I am inclined to regard, first, these uncanny correlations as closer to the fundamental economic facts, and second, the conditions created by our remarkably strained economic system as an opportunity to establish plausible explanations for some of these oldest conundrums. Even if the patterns that have held up for the last forty years should collapse tomorrow, I would still regard them as the economic phenomena in greatest need of explanation, and an indicator that an economic or ideological revolution is underway.

If, on the other hand, I am completely wrong in my estimation of economics and the economy, and we are already on the path to long-term financial stability and growth, that will make me more than happy. I can go back to concocting half-baked solutions to philosophical quandaries and wondering about things like how Greco-Buddhist civilization collapsed so many centuries ago in Afghanistan.

Source: Setting Invisible Hands On Black Swans: Leeb's 'Oil Indicator' And The Dow/Gold Ratio