The Gold/Oil Ratio Shows A Crisis Is Inevitable

Market developments over the past six months have created an environment where a “crisis” seems all but inevitable. The world’s reserve currency, USD, is now 17% stronger than it was in June on a trade-weighted basis. Europe and Japan, the world’s largest and fourth largest economies, are in recession, while China, the third largest economy, is getting ready to lower growth forecasts. Indicative of weak demand, the CRB Commodity Index is down 41% since its 2011 peak.

The world’s most important commodity, crude oil, has fallen more than 60% since June. Economists are still divided about whether or not cheaper oil is good for the economy. The bullish camp argues that lower prices at the pump are the equivalent of a tax cut. Gasoline prices have fallen a record 112 consecutive days, and motorists in 18 states can find gasoline cheaper than $2.00/gallon. AAA estimates US drivers saved $14 billion on fuel in 2014 thanks to lower prices.

Alternatively, the bearish camp will point out that such a dramatic decline in gasoline prices is an extremely deflationary force on an already vulnerable economy. Deflation is dangerous because it slows the supply of money and credit flowing through the economy, and reduces consumer demand in a self-reinforcing cycle. The latest reading from December showed US Core CPI, which excludes food and energy, growing at 1.6% Y/Y – down from 2.0% in June. Bruce Kasman, Head of Economic Research for JP Morgan, noted recently that global consumer inflation is set to fall below 1%, record lows for a non-recessionary period.

As usual, the correct answer lies somewhere in the middle. While the impact on the broader economy is debatable, historically, extreme fluctuations in oil have wreaked havoc on financial markets. Several metrics indicate we’re headed for major volatility. For instance, since 1990, every time 1oz. of gold bought more than 20 barrels of crude oil, there was some form of “crisis.” Since November, the gold/crude ratio has been surging higher and recently broke through 24. On average, the ratio has historically traded around 15.

This doesn’t necessarily mean US stocks will get dragged into the turmoil. The European sovereign debt crisis in 2011 triggered an -18% correction, but the S&P 500 finished +15% higher on the year. The same thing happened in 1998 when the Asian currency crisis led to a significant decline, but the US market finished the year +27% higher.

Does this mean that gold is overvalued or that crude is cheap? It’s too soon to tell, but the last two 50%+ declines in crude oil, during 1986 and 2008, predated 25% gains in gold in the following year. Perhaps both are poised to appreciate. Oil’s fundamentals still look weak, but most of the global supply comes from the Middle East and Russia – far and away the world’s most hostile regions. Gold may look expensive relative to oil, but it too has been stuck in a bear market.

While the gold / oil ratio above 20 may be an arbitrary indicator, it has accurately predicted 4 “crises” over the past 25 years.  It’s also a clear signal that investors are nervous, preferring safety over growth. The global economy is sailing through unchartered waters, and gold/crude could be pink skies in the morning. Sailors, take warning.

Forbes