Phewww…I think we’re all breathing a collective sigh of relief – 2008 is officially over!
Don’t get me wrong, I wish the markets would go up forever and we all could be rich and never have to worry about a thing. Realistically, that just isn’t going to happen. Those of us prepared for what is ahead, however, realize its times like these when genuine opportunity is created.
In that spirit, I’d like to reveal the Trade of Year. It’s not too often a trade like this comes along. It’s only created by a truly chaotic market. This trade will capitalize on a small market sector which is completely out of whack. To top it off, the rare blend of limited downside and unlimited upside will have any investor or trader salivating. In a few moments you’ll see why this truly is the trade of the year.
The Trade of the Year is on gold. But it’s not what you think. As far as I’m concerned, gold is still at a midpoint. The bond market is predicting deflation. Deflation pushes down the value of everything. It can destroy an economy. Every major bust has ended in deflation – every bust.
The Fed is doing everything within its ever-broadening powers to prevent deflation. It wants inflation. Americans won’t start consuming again until their debts are paid off. The sooner the Fed can inflate them away, the earlier the U.S. economy can get back to some sense of normalcy.
Right now, no one knows if the Fed can win this battle. They’ve never won the battle against deflation before, but they’ve never really been this aggressive before. Only time will tell. But here’s the thing, with the Trade of the Year, it doesn’t matter.
If you look at what the historical gold ratios (which have been fantastic predictors of very profitable trend changes in gold prices) tell us, they tell us to buy and sell gold.
Buy and sell? That’s right. At the Prosperity Dispatch, we believe we’re at a midpoint for gold where it could easily take off and set new highs. Or gold could get caught up in a deflationary storm that drives down the price of everything. But with the Trade of the Year, you can take advantage of it all. Of course, that is without having to use any volatile options or other trading strategies where the odds are stacked against you.
First, let’s see what the historical gold indicators are telling us to do.
Dow/Gold Ratio: Buy Gold
For the past century, the Dow/Gold Ratio has been a leading predictor of the starts and ends of bubbles. The Dow/Gold ratio is calculated by figuring out how many ounces of gold it would take to buy the Dow Jones Industrial Average. On Tuesday, the Dow closed at about 8,600. An ounce of gold was changing hands for about $880 an ounce. Thus, the Dow/Gold ratio was about 9.8 (8,600/880).
If you take a look at the chart below (courtesy of U.S. Gold – AMEX:UXG) it’s easy to see the Dow/Gold Ratio has peaked just before the two major bear markets of the past century.
The Dow/Gold ratio has always peaked near a point of maximum pessimism. Following severe recessions or depressions, the Dow/Gold ratio bottomed out at 1 or 2. During peak periods of fear, gold became such a dear safe haven, one or two ounces of gold could buy the entire Dow.
Are we headed there? There’s certainly an outside chance, but it’s certainly not a sure thing either.
If we look at this ratio completely objectively, the Dow/Gold ratio is telling us to sell stocks and buy gold. Either gold is going to $4,300 (half the Dow), the Dow is going down to 1,760, or somewhere in between.
Gold/Oil Ratio says: Sell Gold
The Dow/Gold ratio isn’t the only key gold-to-something-else ratio trotted out every few weeks to build a case for gold. The gold/oil ratio is also a closely watched indicator used to anticipate whether to buy or sell gold. The long run gold/oil ratio is about 14. This means an ounce of gold will buy about 14 barrels of oil. There have been plenty of ups and downs over the years, but the long run gold/oil ratio (or in this case, technically the oil/gold ratio) usually reverts to its mean of about 14.
If you take a look at the chart below (as featured in John Lee’s Revisit the Tight Bond Relationship Between Gold and Oil) you can see the gold/oil ratio has been climbing steadily over the past few months.
As oil prices collapsed, an ounce of gold has been able to purchase more and more oil. Over the summer, when gold was around $800 and oil was $150 a barrel, the ratio hit a low of just above 5. It was the second lowest point for the ratio in 20 years! When the ratio was that low, it was time to sell oil and buy gold.
Now, that has all changed. With oil around $40 a barrel and gold recently touching $880 an ounce, an ounce of gold can buy 22 barrels of oil. That’s well above the historical mean. The ratio, if we expect it to revert to its historic mean, is telling us to sell gold and buy oil.
Buy, Sell, or Hold?
Huh? Two of the key gold ratios are telling us to do different things. The Dow/Gold ratio is telling us to buy gold. The Gold/Oil ratio is telling us to sell gold.
What are we supposed to do? Well, if we look at one more chart, we can see what the Trade of the Year is telling us to do with gold.
A Ratio at an Extreme
The markets have gone absolutely crazy over the past few months. The combination of forced liquidations of hedge funds, mutual fund investors pulling out all the cards, and a refusal of investor to take any type of risk has thrown a lot of historical correlations out of whack. None of which is more out of whack than the Gold/XAU ratio.
The Gold/XAU ratio is a measure of index of leading gold mining companies (XAU – Philly Gold and Silver Sector Index) relative to gold price. Over the past 25 years, the Gold/XAU ratio has been about 4. That means an ounce of gold was worth 4 times more than the XAU Index.
Earlier this week, when gold hit $880 an ounce, the XAU index was sitting at 121. This put the Gold/XAU ratio at 7.27 – almost double its 25-year average.
With the chart below (taken from Troy Schwensen of the Global Speculator) it’s easy to see how crazy the Gold/XAU ratio has gotten lately.
The Gold/XAU ratio peaked around 11 a few months ago. Now, it’s back close to 7 and closing back in on 4. The ratio is telling us to sell gold and buy gold stocks.
When you look at all three ratios, there’s only one worth acting on. The Gold/Oil ratio is returning to previous highs. The Dow/Gold ratio is at a midpoint. The Gold/XAU ratio is truly at an extreme. It hasn’t been this far out of whack in decades. Now that the Gold/XAU ratio is working its way back to its historical norm, I’d say it’s time to jump in with both feet.
The Trade of the Year
This is why, I believe the Trade of the Year is to short SPDR Gold Shares (NYSE:GLD) and buy Market Vectors Gold Miners (NYSE:GDX) on an even $1 for $1 basis. This way you profit as the Gold/XAU returns to its historical norm of 4.
Gold could go to $1,000 or $2,000 which would cost a lot on the short position, but would certainly be made up on the valuation of the gold mining stocks (imagine the cash flow they’d be raking in with low energy costs and sky-high gold prices). Or if gold prices collapse the mining shares will fall too, but gold should fall a lot faster than the mining stocks.
It’s the best of both worlds. If gold goes up, we’ll make a killing. If gold drops, we’ll probably break even.
Don’t get me wrong, there will be plenty of trading opportunities this year. For instance, high-flying Panera Bread (NASDAQ:PNRA) shares will surely go the way of other “hot” restaurant stocks like Chipotle’s (NYSE:CMG) and over-valued darlings like Salesforce.com (NYSE:CRM).
Also, U.S. Treasuries are likely to experience some weakness this year, but it probably won’t be hard and fast like most are expecting. After all, bubbles fueled by greed (i.e. uranium, oil, and agriculture) fall hard. But bubbles built on fear are less likely to fall apart too quickly.
There are plenty of ways to take advantage of a coming rally in gold, but I consider the short gold/long gold stocks the trade of the year. It’s a “win/don’t lose” type of trade which only comes along every once in a while. If you keep an eye on risk/reward, there won’t be too many better trades you can make this year.