The Gold/Oil Ratio is Telling Us Something Again

The Daily Reckoning Australia 

--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."