Revisiting the Gold/Oil Ratio

"Who cares what you say," a friend asked/declared last night. "Market cycles, super cycles, unicycles, quadricycles...you throw all those words around to avoid the real subject."

"There's no such thing as a quadracycle," we replied.

"It's a car you moron, and you're ignoring the point."

"Which is,"?

"You blew it. You got the single biggest investment story of 2009 wrong. And now you won't hardly mention it or bring it up. You pretend like it didn't happen. But it did. Real people lost real money because you were wrong. What do you say to that, smartypants?" Our response is below.

First though, the controlled burn by the world's central bankers is clearly underway. At least they hope it's controlled. The Bank of England cut its key policy rate one full percentage point to 2%. It's the lowest level since 1939.

While the BOE goes on financial war footing, the precocious ten-year old European Central Bank snapped to attention and slashed its key rate by 75 basis points to 2.5%. The ECB, like the rest of the global banksters, fears rising unemployment, falling consumer spending and business investment. So do the markets, apparently.

The Dow was down over 200 points and the S&P 500 was down nearly three percent in New York. But the big shocker on the day was oil. It fell nearly seven percent to under US$44, its lowest level since 2005. Oil is down 70% from its highs. But a Merrill Lynch analyst says that if the economy is as bad as everyone expects in 2009, a barrel of crude may go as low as US$25.

Let's take a closer look at oil. But let's do it terms of gold, revisiting the gold/oil ratio.

If you're wondering what the inter-market relationship is between gold and oil, hold the thought. It's a good question. And the brief answer is that oil and gold both tell you things about what's going on in the economy (oil goes up with rising GDP, gold up when the USD is weak). The long answer would take longer than either of us has today.

So what is the chart telling us now? Well just to update it, the gold futures price is $765.50 and the oil futures price is $43.67. That leaves the current gold/crude ratio at 17.5. That means it would take you 17.5 barrels of crude to buy an ounce of gold.

You can see the chart is all over the shop. But 15 turns out to be the historic average for the ratio. So if the ratio is rising, what does it mean? It means either oil is oversold or gold is overbought. For the ratio to return toward its historic average, oil prices would have to rise, or gold prices to fall.

What do you reckon will happen? We reckon the ratio will increase, with the oil price falling more and the gold price holding steady or rising. There's no law of physics that says the ratio must return to 15, only that 15 is the average level.

But 2009 is going to be a strange one. Oil prices should fall to reflect a dismal world economy. Gold prices, we reckon, should rise, to reflect the inflationary fires being stoked all over the globe. There's no guarantee it will happen that way, of course. We erred in believing commodity prices and resource stocks would hold up (both absolutely and relatively) better than financial prices. But we badly underestimated the pyramid of leverage upon which all stock prices were built.

Gold could suffer from the further deleveraging of planet earth (both household and corporate balance sheets). But we like the way our friend Dr. Marc Faber put it in his latest Gloom, Boom, and Doom report, "I remain of the view that successful reflation of the asset markets will likely manifest in precious metals strengthening against all paper currencies and other assets. Consequently, I continue to recommend that investors accumulate physical gold and silver."

Does Dr. Faber think that the reflation of the asset markets will be successful? And what happens to gold if it isn't? More on that next week.

Some Friday fun.

Hi,

I love your work, and the entertaining way you write about the financial scene.

I've learned more from you than I did in my economics classes at Uni all those years ago.

Now that you're all buttered up and compliant, please take a look at this:

http://www.youtube.com/watch?v=28I0JK0byLU

It's a parody of the old song "Monster Mash", updated for the current financial situation. It's very well done. Did you guys write it?

Cheers,

Eric G.

Thanks Eric. We didn't write it. But it was a hoot. And now for the rest of our testy conversation over what went wrong in 2008 and how to make it right in 2009.

"See, you don't have anything to say," our sceptical friend continued last night. "Face it mate, you're a spruiker like the rest of them and you have no clue. You have no idea what to tell people to do in 2009. You should retire and go back to Uni and read books or become a secretary. At least you type well."

"Gee, with friends like you...but look, of course I see your point. I wear glasses, but I'm not deaf. We've been working around the office to figure out what we got wrong in 2008 and how we can make it right in 2009. It's about survival bias."

"Blah blah blah. More words. Deeds man. Not words. Deeds."

"Hear me out. Our fundamental thesis (resource scarcity, the Money Migration, collapse of the dollar) was all correct. But I believed resource equities, backed by tangible assets, would both relatively and absolutely outperform as the financial sector collapsed. And I thought the transition away from the American model toward whatever comes next would be more gradual."

"Blah blah blah. You blew it. Admit it."

"I just did. The idea that resource stocks would hold their value better than financials during a crash turned out to be hugely mistaken. I underestimated the amount of leverage in the system that supported resource prices and stocks. A lot of that leverage was hidden. But that's no excuse and doesn't change the fact that the resources were hit much harder than even some of the financials."

"Blah blah blah. So what? I don't care about any of that. Where do we go from here?"

"Well I think there are two parts to the story now. The first you're not going to like to hear. But I'm going to tell you anyway. A lot of these resource stocks are better value now than when I first recommended them. It could be the best time you'll ever have to buy them."

"Heard that one before. Admit it. It was all just a bubble like the dot.coms. BHP is a giant iron sock puppet. The only thing worse than the tech bubble was the resource bubble. You're a jerk if you don't admit it."

"Then I'm a jerk. The main difference between the commodities wipe out and the tech wipe out is that while there never was a big market to justify the earnings multiples for on-line grocery stores, there Is a real and big global market for nickel, lead, zinc, and other commodities. People use this stuff."

"And think about what didn't happen with this bubble. You did not see a huge increase in the productive capacity for minerals, oil, or energy. You got a big ethanol boom. Go corn! But did you get billions of new barrels of oil on-stream or trillions of cubic feet of natural gas or more coal, uranium, or rare earths? I don't think so. The housing bubble produced too many houses. Did the commodity bubble produce too much oil?"

"Less blah. But so what?"

"So you've had a whole boom and bust in the commodities sector without a significant increase in the world's productive capacity for raw materials. If and when BRICs demand replaces American demand-and I admit that could be longer than I first expected-the structural deficit in commodities still exists. Prices have probably finished falling and will certainly go higher. I just don't know when exactly. So you look at individual commodities and the supply/demand picture. Some things may be in oversupply next year because the economy is growing slower. But I don't think chronic resource over supply is our biggest problem of the next twenty years."

"But what should I do now?"

"Using your own brain would be a good start. Think about where we are in history and where we're going. What happened in 2008 was the blow up of a world-wide credit bubble. It caused huge collateral damage. What's going to happen in 2009 is an attempt to reflate that bubble. And it's not going to work, at least not in the way people expect."

"Why not?"

"You cannot step twice into the same river, for other waters are continually flowing on. That's Heraclitus."

"What?"

"What's done is done. The world is changed and changing. What you have now is a whole financial systembacked by the Wall Street Treasury Axisfighting for its very survival. They're going to fight hard and play dirty."

"But their system is irretrievably doomed. I reckon, at least for myself, the first big task for next year is to save yourself from going down with the ship. You can do this by owing physical metals, getting out of most but the very best shares, and increasing your cash percentage of your asset allocation. You may also want to duck and cover for a few months."

"But look, frankly, a lot of people-even you, as dumb as you are-knew the current system was unstable. But it's collapsing faster than any of expected. But we know from history is that markets move in cycles. History moves in cycles."

"Wash, rinse, spin, repeat?"

"Uh, no. Look, what you need to do now is prepare for the next cycle. That cycle is a world economy where American consumption is just a pile of used credit cards on the scrap heap of history. The events of the last six months have fast forwards us toward a world where America's economy is in far worse shape for longer than most people think currently think possible."

"Investors will NOT be able to preserve capital and profit if they think every thing's gonna be all right. The only way you can come out of this better off than you are now is to put some serious thought into what companies are going to be important in that changed world."

"You gonna try and sell me another newsletter now?"

"Not yet. I'm just saying, pay attention to the survivors and the destroyers. Why the survivors?

Because they survived! That's the great thing about survivor bias. It automatically focuses your attention on the competitive winners. THAT's where your focus needs to be today. It all comes back to the Austrians."

"Beer and lederhosen?"

"No. The Australian school of economics and entrepreneurship. For the neo-classicists and monetarists and Keynesians, it's always about models, statistics, and money supply. For the Austrians, economic growth and the business cycle don't naturally begin with credit. They naturally begin with human action. Every fortune begins in the human head and heart, you might say."

"I thought every fortune began with a great crime."

"False. Or maybe true, if you're a rich criminal. But irrelevant if you want to make your fortune ethically. You should focus on entrepreneurs. They are the ones that make it happen. It's not the invisible hand or the free market. Those are just words for motive and opportunity. If you don't take action, it doesn't matter."

"I'm taking action. I'm getting out of here. You're boring me to death. Besides, the free market is dead. It's all about the public interest and the general welfare now. Markets have failed. You had your chance. Now would you please shut up and buy me another round?"

Dan Denning
for The Daily Reckoning Australia

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