Gold/Oil ratio against equities

In my September 1st piece, I argued the importance of valuing gold relative to silver via the gold/silver ratio, concluding that gold will UNDERperfom silver despite its status in the limelight. Indeed, the G/S ratio has fallen 7% since the article, hitting a new 13-month low of 59.0. My case for "faster" gains in silver remain in place.

So how about Gold/Oil ratio? Readers of my book and previous articles on the topic recall that the G/O index bears a highly negative correlation with risk appetite/stocks/market sentiment. The rationale being that when G/O ratio ceases to rise and begins to pull lower, it is a case of re-emerging energy prices relative to metals, usually reflecting improved appetite/higher growth/weak-US-based gains in energy prices. The converse case applies.

The G/O ratio is especially valuable during the early stages of a rebound as it predicts deteriorating risk appetite and falling equities (2008 example) while a peak followed by an early stage decline, usually suggests rising stocks, led by higher energy prices (April example) and May example .

With the above evidence continuing to prove effective since 2007, let us integrate it into the G/O relationship of today. The chart below shows the G/O ratio in the upper panel and the S&P500 in the lower panel. The latest correlation between S&P 500 and G/O ratio on a 2-month rolling basis stands at -0.63. The red lines indicate the inverse correlation of the overall trend. Note how G/O ratio began drifting lower (due to faster oil appreciation relative to gold last week), which has been accompanied with a clear increase in the S&P 500 (and other stocks). The break out of the S&P 500 above 1,150, could mean further decline in G/O ratio potentially towards the 6-month trend line support of 15.20.

And if the above dynamics continue i.e. further declines in G/O ratio and higher S&P 500, this could well take the form of rising oil prices revisiting the $86-87 level.

Diamond in the Energy Rough

The weekly US crude oil chart below shows a rare "diamond formation", which in technical analysis is a rare pattern. Diamonds could be either continuation patterns (bullish) or reversal patterns (bearish). In this case, the weekly chart broke above the $80.50 trend line resistance last week (falling trendline line), showing a continuation out of the multi-month pattern, whose 1st half held up during Oct 2009-May 2010. The importance of last week's break out and this week's follow-through is highlighted by the break of the all-important 200-week MA. The next test emerges through a required break above $83, which is the high from Aug. 2010 (small red circle). Tuesday's closing price was at $82.82 was not enough. A Friday close above $83 would be necessary, while a close above $75-76 is required to maintain the uptrend.

In the event that $83 is broken with a weekly close (preferably), this stands the chance of extending S&P 500 towards its next resistance of 1,190 (200-week MA, which was broken in June 2008) and 11,200 on the Dow Jones Industrials Index. Is this plausible? An "upbeat" US earnings season and rising confidence that US markets will be "liquefied" by Fed asset purchases could well do the trick for now. The implications for the USD index suggest a possible decline below the 76 trendline and into a prelim target of 74.

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