Gold Is Crashing: Catch The Falling Knife

Includes: GLD, IAU, USO, XLE
by: Jeffrey Dow Jones

I sincerely wish my views on gold weren't so nuanced. In the last few years, more people have asked me about it than anything.

For what it's worth, I've been bearish on the yellow metal for what seems like forever but is really only about 2 years. But I believe that everybody should own it. Always. It should be between 5-10% of every diversified investment portfolio (and closer to 5%, these days).

The reason has nothing to do with all the usual bunk and hooey you hear about gold - that it's an inflation hedge, that it's a "safe haven," or that we're inevitably headed back to the gold standard. None of those things are true, anyway.

You own gold because it's different. It doesn't correlate. Things that are different and don't correlate with your other investments add value. It's how you step up The Efficient Frontier.

Look, gold is religion. You believe or you don't. The gold "thought sphere" is broken into three basic camps.

  1. Those who believe. They are passionate in their beliefs and they also believe that those who don't are wrong and destined to spend all eternity in a hyper-inflationary hell. They will call you names and judge you behind your back.
  2. Those who don't believe. Whether it's because they have faith in Ben Bernanke and the modern fiat system or because they're fundamentally skeptical of something that doesn't pay a dividend, generate earnings, or grow equity, they avoid gold. It's just a price, and the price is always higher than it should be.
  3. Those who don't care. These agnostics tend to avoid the debate altogether. They either don't understand or are uncomfortable taking the leap of faith that something like gold requires. So they stay away, periodically stopping by The Church of Gold to gaze in wonder, stupor, or admiration.

When it comes to analyzing gold - technically, the gold price - we have to be extra careful to shut off these pre-existing ideological biases.

There are lots of ways to do this, ways that I've written extensively on in the last few years here at Seeking Alpha and on my weekly newsletter. One that I'm particularly intrigued by is pricing it in terms of another asset.

In this case, crude oil. Consider:

That, my friends, is how many barrels of oil 1oz of gold will have bought you during various points in history.

This chart carries some heavy duty caveats, which I explained in detail back in this old Seeking Alpha piece. (Ironically, it was written in August 2011, exactly when gold touched an all-time high price of $1913/oz. Talk about dumb luck for timing for an article like that!) It represented the last local spike in that chart, 21 barrels per ounce of gold.

As it happened, getting short gold at $1900/oz and long crude at $86/barrel wound up being a pretty good trade. In just six months, the ratio had corrected to around 15 and whether you simply sold gold, bought crude or put on a relative value trade, you did OK.

Again, timing that was total luck. Timing is never my thing. At that point I could have easily imagined that ratio rising towards 23 or 24. The world was awash in gold enthusiasm and I felt very insecure in my bearishness.

Generally speaking, when that chart reaches extreme levels, it's kicked out some really interesting signals.

  • 1985 - It had you shorting crude and buying gold before the "oil glut." In 1986 oil crashed 50% on oversupply and the trade wound up a home run.
  • June 2008 - It had you shorting crude (at $147/barrel) and buying gold (at $900/oz). The financial crisis hit, and that was it for oil prices.
  • February 2009 - In less than a year, the ratio had you buying crude again (at $39, wow) and shorting gold (at $950), which was another relative value home run.

So What About TODAY?

As of this writing, an ounce of gold will get you 17 barrels of crude. It's high, but that indicator is not in extreme territory.

Another thing about this indicator is that it doesn't tell you what's going to happen. Hang on, let me say that again.


What it does tell you is which one of these assets is more expensive, relative to historical norms.

Yes, the gold and crude oil markets have totally different sets of supply/demand inputs. This is why that chart has trended down since the late 70s, as oil has become progressively more expensive to pull out of the ground. Gold isn't really "used" for many things the way that oil is. But gold and crude oil are each commodities, each denominated in dollars, and each subject to the same long-term inflationary forces. In 11 out of 12 months, this ratio doesn't tell you anything of interest. But every once in a while it lets you know when something crazy is going on.

I don't discriminate when it comes to macro trades. The assets in question make no difference. I just look for something that's ridiculously out of line and think hard about whether it makes sense to push back.

Unfortunately, despite the hoopla and concern and newfound-panic in gold right now, this indicator is not at an extreme. If anything, you'd be short gold from the $1,725 extreme last November and long crude from $86.

Here, let me redraw this chart to make it a bit more useful:

It's important to note that gold still probably is a bit expensive relative to crude, but not dramatically so.

If anything, I'd be inclined to catch a falling knife in gold, on the basis that it very well may bounce off strong support around $1,500-1,550. And if you want to short crude oil, today at around $93, I'm totally on board with that idea. This ratio could tick back up towards 20 in a matter of months, at which point I'd probably want to re-establish a short gold / long crude position.

The easiest way to do that is buy a gold ETF (NYSEARCA:GLD) or (NYSEARCA:IAU).

I know this takes some cojones. That is a really difficult chart to buy. I'll understand if you think I'm crazy for trying.

So keep a tight stop. If it falls through $1,525, you're wrong. Pull the ripcord and jump out. Leave whatever ideological beliefs you have about gold back in the airplane.

Other ways to play it

As for oil, it might be a little on the expensive side, but not egregiously so. If you want to get short crude or, depending on your time horizon, use an ETF like (NYSEARCA:USO), you have my blessing. Hopefully you haven't done anything to anger the Oil Gods.

Really, though, keep your eye on this ratio and the bigger picture. If gold prices do bounce significantly, think about using that as an opportunity to re-establish what I think could be a very strong, low-risk relative value trade.

Should gold bounce back up in line with that previous trend, somewhere close to $1,700, I love the idea of dumping or shorting gold and loading up on an ETF like the (NYSEARCA:XLE).

At that point (or now, if your horizon spans several years), it also wouldn't be a bad idea to swap some of your gold shares in GoldCorp (NYSE:GG), Barrick (NYSE:ABX), or Newmont (NYSE:NEM) for major oil companies like Exxon Mobil (NYSE:XOM), Chevron (NYSE:CVX), and Royal Dutch Shell (NYSE:RDS.A). Feel free to use their international counterparts too like Petrobras (NYSE:PBR), PetroChina (NYSE:PTR), and TOTAL (NYSE:TOT).

The reason why I use the big boys for a trade like this is because the integrated majors tend to trade more around the macro environment than the smaller names. You can avoid a lot of idiosyncratic risk by sticking with them. If you're going to use a company like Anadarko (NYSE:APC) with more of a focus on exploration, or a company like Exelon (NYSE:EXC) engaged in alternatives, or even a company like Suncor (NYSE:SU), which occupies a unique space in the industry, you'll want to use more caution and more diversification.

If you are going to go the specific-stock route, make sure you do a little bottom-up analysis to complement today's discussion. Don't make specific-stock investments in a macro vacuum.

In my portfolios I recently sold XLE in late January and cut GLD out of the Aggressive portfolio completely in early February. Those are longer term portfolios, however. If you sweet-talked me into the confessional, I'd rather have oil than gold for the next few years, and indeed am looking to reload on the XLE should the market pull back. This ratio is one of several reasons why.

Anyway, keep your eye on this interesting commodity indicator, along with your other favorite technical signals. They'll rarely time the markets perfectly, but they do a fairly effective job at telling you which way the risk is skewed at any given point in time.

Disclosure: I am long XOM. 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.