Gold and Crude Oil. Should You Be Afraid?

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Published : July 19th, 2008
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Category : Market Analysis





Gold did not follow oil’s steps recently – does this mean that the bull market in gold is coming to an end? Taking into account gold’s latest underperformance, should you expect gold to plunge, as oil corrects/falls? Not quite.


One of the best ways to view current events or price patterns is to take a look at the big picture to see whether or not the situation is indeed extraordinary and should make you alert. Day to day volatile price swings, short term trades, hundreds of 'important' headlines in the mainstream press – they all make us perceive markets emotionally, rather than approach them by means of cold logic. The latter usually leads us to better investment decisions than the former. This is why we always focus on the broad view first. If one can look at the big picture from a different perspective or angle then it’s even better. Keeping that in mind, we decided to check if something similar has happened in the past and if so, what was the final outcome. That outcome could give us indication of what to expect in the near future.


We have prepared two charts with gold and crude oil in two different scales: logarithmic and linear. Since we are talking about rather long term trends and relations, we will first present chart in the logarithmic scale, as it emphasizes growth in percentage terms. This makes it very useful if prices increase substantially. That has certainly been the case with both gold and oil in the previous 8 years.




First things first – there is a massive long-term uptrend in both gold and oil, which has not been violated up to date. Next, gold and oil tend to rise at the same time in the long term. The linear trend line with a positive slope and the R-square coefficient of 89% suggest that this is relatively stable type of correlation. Please note that we have highlighted the phrase 'in the long term'. We have done so, because there were short periods, when oil surged independently from gold, and there were times when profits achieved on gold were superior to those that could have been achieved on crude oil. We are not taking any leverage into account here, just the spot prices.


Generally, one can distinguish two general trend lines – borders of the rising trend channel. Price of gold relative to crude oil used to touch both of these trend lines in the past. These times could have been described as 'critical underperformance'. Should gold fall substantially below the lower trend line, we would start to worry about the healthiness of the precious metals bull market; however this has not materialized yet. According to the trend lines, gold is undervalued relative to crude oil, but it is still way above the level of 'critical underperformance'.


This suggests that gold's rather sluggish performance relative to oil in recent weeks is nothing extraordinary. However we make our final conclusions, we have a second chart to show you. It was created using the same data but this time, we used the linear scale.




This time the chart does not give us a clear picture when it comes to drawing a trend channel, but it tells us more about the shape of the correlation. As you may see, there have been many days, where price of gold was trading between $400 and $500 level, while the price of oil traded between $30 and $70 level. Taking into account these levels and days they materialized, gold increased by a solid 25%, while oil increased more than 100%. That is what we previously referred to as the 'critical underperformance'. But what has happened then? Has the gold bull ended? No, it has not. On the contrary, as the commodities and precious metals bull market continued, gold has managed to rebound and jumped back above the trend line. Should that take place with current trend line and the price of oil of $150, gold would have to go above $1170.


What if that was to take place along with an increase in the price of oil? That is not out of the question, especially given escalating international tensions and increased perceived probability of the war with Iran.


In summary, no matter how you slice it, gold’s recent price action relative to oil or lack thereof, is nothing extraordinary. In fact, history shows that there were cases of more dramatic underperformance, followed by more fair valuation, even leading to overvaluation – taking into account the trend equation as seen on the charts above. Therefore, in our view, there is no need to panic because of the recent performance of gold relative to crude oil.


We use the methodology described in this essay as well as many other techniques to forecast market’s moves and discover unique opportunities for profit, while taking into account the big picture. Register today and you will gain access to all our Tools and much more. When you register, we will send you occasional, brief market alerts, based on our research, whenever situation requires it. Registration is FREE of charge and you may unregister anytime.



Przemyslaw Radomski

Editor, www.sunshineprofits.com




 




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Przemyslaw Radomski is the founder, owner and the main editor of www.SunshineProfits.com. Being passionately curious about the market’s behavior he uses his statistical and financial background to question the common views and profit on the misconceptions. “Don’t fight the emotionality on the market – take advantage of it!” is one of his favorite mottos. His time is divided mainly to analyzing various markets with emphasis on the precious metals, managing his own portfolio, writing commentaries, essays and developing financial software. Most of the time he’s got left is spent on reading everything he can about the markets, psychology, philosophy and statistics. Mr. Radomski has started investigating the markets for his private use well before starting his professional career. He used to work as an informatics consultant, but this time-consuming profession left him little time for his true passion – the interdisciplinary market analysis. Establishing www.SunshineProfits.com gave him the opportunity to put his thoughts, ideas, and experience into form available to other investors.
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