The Oil/Gold Ratio: You Wouldn’t Believe Me If I Told You

The economic commentary I dabbled in in previous posts became rather boring, because my analysis of markets is based on a trading system I developed a couple of years ago. Although it is fun trying to anticipate what my trading system will say in the future, for the most part, my analysis of markets as they stand at any given moment is just the product of application of that system.

(Note: there is a link to some clumsily constructed charts below).

Moreover, I am not an economist and I cannot explain precisely why my system has worked for the last 40 years. I feel quite confident that it can only exist in the kind of monetary regime we have today, a system based on fiat money rooted in an ideological disposition that believes markets are fundamentally flawed. But, why a specific level of a certain ratio should be so decisive is utterly beyond my comprehension.

If I had some notion of where to turn to for answers, I would probably have made a more sincere effort to get to the bottom of these questions, but my initial impression of the state of modern economics is so dismal that I cannot justify to myself wading through endless papers and books and statistics with a peculiar and perhaps unnecessarily elaborate nomenclature to find out. I do not have an economist’s mind, which is probably why I stumbled across this trading system in the first place.

I want to offer a note about Austrian economics as well. I would, with very little hesitation, place myself in that camp, but as I have tried to get feedback about my trading system, I have found that most Austrians tend to be extremely averse to listening to markets. Part of my trading system is based on Stephen Leeb’s “Oil Indicator”, which I will get into later. Leeb has shown that a year-on-year rise in oil prices in excess of 80% is a clear sell signal for the stock market, while a year-on-year rise of 20% is bullish. I have tried to show with my system that the situation is slightly more complex than this, but Leeb’s is nevertheless quite solid on its own. It has worked for 40 years. No Austrian (from what I can gather) has taken an interest in this question or attempted to explain it.

If the price of oil were to steadily drop from $100 to $1 over the course of the next six months, this would obviously be bullish. And yet, if Leeb’s rule were to hold true, if oil were to remain at $1 for a year and then jump to $2 one day, the stock market would crash. Now, Leeb does not use this hypothetical example, and I don’t know if he would go so far as to argue that this would happen, but something similar has happened before. In the mid-1980s, oil prices dropped and then recovered their former levels and this triggered the 1987 crash. From the standpoint of historical prices, there was nothing special about 1987 oil price levels, but because it was an 80% increase over a 12 month period, this somehow became critical.

Moreover, there is no evidence than anybody was paying attention to this 80% level at the time. The 1987 market crash is still a “mystery”.

This 80-20 rule of Leeb’s is so consistent (although I believe I have perfected it) that no economist in their right mind should not have some sort of explanation for why it works. Scour the internet as you will, send imploring e-mails to economists or hedge fund managers or economic commentators as you will, no answer is forthcoming. Only warnings to leave this kind of business to the professionals.

If what I have found is true, then the situation is even worse than I have described, because although it is not difficult to imagine why a sudden boost in oil prices is a negative for the stock market and the economy–even apart from why 80% should be such a magic number–there nevertheless remains the question of why a sudden boost in oil prices should have a similar effect on gold prices.

What I have found is that Leeb’s Oil Indicator, this 80-20 rule, works alternatively on the Dow and on gold, depending on the trend in the Dow/gold ratio. Where Leeb’s rule has been least successful in the stock market, during the 1970s and 2000s, it has worked exquisitely in the gold market. And, where Leeb’s rule has performed best in the stock market, during the 1980s and 1990s, it was useless when applied to gold.

My interpretation of this phenomenon is based on George Cooper’s observation about the feedback loops that capital markets are prone to, in which the normal market rules of supply and demand take on a different character than they do in the market for commodities. In the ‘real world’, all things being equal, a price rise will constrain demand, but in capital markets, there is the opposite effect. When prices rise, there is an incentive for demand for a given market instrument to increase, and many of the buyers will already being experiencing a wealth effect from the previous increase in asset prices. Bank balance sheets will be flush with successful loans and the credit markets will be happy to finance greater investment.

This creates a highly unstable situation where asset markets veer between boom and bust. I recommend Cooper’s book if my explanation is not very clear. He does a masterful job of explaining this special characteristic of asset markets.

In any case, this is the only plausible explanation I can find for why the gold markets and the Dow should alternate between being susceptible to Leeb’s 80-20 Oil Indicator. To reiterate, this doesn’t explain the magic behind the particular ratios, but it offers a certain logic to the general phenomenon.

***

Okay. So, I have suggested that Leeb’s indicator can be applied to the equity or gold markets depending upon the trend in the Dow/gold ratio. Leeb’s indicator works best on whichever asset is dominant. That is, if the Dow/gold ratio should be rising–and I should note that this ratio moves in great 20-30 year sweeps–then Leeb’s indicator works on the Dow. When the Dow/gold ratio is falling, i.e., gold is bullish and the Dow is weak, then Leeb’s indicator works on the gold market.

For those who are already familiar with the wonder of the Dow/gold ratio, you may know that this ratio largely mirrors the Dow’s P/E ratio. So, there is good reason to view the Dow/gold ratio as more than a mere curiosity. It is saying something.

This is only the beginning of the argument, however, because just as Leeb’s 80-20 Oil Indicator can tell us when to buy and sell stocks (or, as I argue, gold), there is a way to predict the trend in the Dow/gold ratio. I find this even more bizarre than Leeb’s Oil Indicator, because I have difficulty imagining what the connection between the Dow/gold ratio is with the Indicator I have identified. Or, at least why the particular levels should be so decisive.

Since the establishment of the Federal Reserve, the Dow/gold ratio has been moving to higher highs and lower lows. In 2000, it hit an historic high. Prior to that, the mid-1960s had reached a new high which was followed by the 1980 low, a 1:1 ratio between the Dow and gold that had not been reached since Reconstruction.

Since Nixon took the world off the gold standard, it has been possible to mark these turning points in the Dow/gold ratio by observing the oil/gold ratio. When the oil/gold ratio exceeds 0.12, then the Dow/gold ratio will fall (gold will outperform the Dow) until the oil/gold ratio falls below 0.05, at which point the Dow/gold ratio will rise.

In other words, whether one should apply Leeb’s Oil Indicator to the gold or equity markets can be best determined by reference to the extremes in the oil/gold ratio.

Now, it is not hard to imagine that the Dow should be relatively bullish when oil is relatively low. But, what is so unusual about this situation is that the oil/gold ratio can move around quite violently without effecting the overall trend; it is only when these 0.05/0.12 lines are crossed that things seem to change. I cannot even begin to imagine why these levels should be so critical, except to note that the 0.05 level was roughly the ratio of oil to gold before the abandonment of the gold standard.

There are two occasions when this combination of Leeb’s Oil Indicator and my Oil/Gold Indicator did not seem to work quite as smoothly as I have suggested. This was especially true in the mid-1970s, but I have devised a third rule which accounts for these two situations:

In both instances, the indicated direction of the Dow/gold ratio (indicated by my Oil/Gold Indicator, that is) suddenly switched from ‘falling’ to ‘rising’ while Leeb’s Oil Indicator was in ‘buy’ mode. In both instances, but especially in the mid-1970s, the Dow failed to rally against gold. In fact, the Dow/gold ratio plummeted. But, in both instances (in the 1970s and 2009), the oil price exploded within a 12 month period.

As soon as this occurred and Leeb’s Oil Indicator switched to ‘sell’ and then back to ‘buy’, the Dow/gold ratio began to rise immediately. This continued until 1976, when the oil/gold ratio rose again to 0.12, and the Dow/gold ratio plummeted until 1980. Since May 2010, the Dow has barely held its own against gold, so it is possible that the relationships I have tried to describe here have already broken down. According to my system, the Dow should be outperforming gold, but gold has just broke $1600 and the Dow has been stuck between 12000 and 13000. It will be interesting to see how this plays out.

***

As I have pointed out and everybody can see, I am not an economist. But, unless my data are wrong, these phenomena exist. If you can accept that Leeb’s Oil Indicator has worked quite well for the last 40 years on the stock market, then I think it is easy to accept that it should be applied to the stock and gold markets alternatively, depending on the trend in the Dow/gold ratio. And, if one can accept that, then it is hard to ignore the signal provided by the oil/gold ratio.

The trickiest part is the interplay between Leeb’s Oil Indicator and my Oil/Gold Indicator during the mid-1970s and then again in 2009. I suppose that for some people this is an arbitrary collection of coincidences forced together into a ‘system’. But, for me, I see an improbable but orderly dance between oil, gold, and the stock market that has existed ever since the ‘Nixon shock’ (and, I don’t mean Watergate). Perhaps it will only be me, but I think that once you accept Leeb’s Oil Indicator for what it is–an historical fact–and you follow the money, so to speak, you will inevitably stumble across the Dow/gold ratio and the predictive power of the oil/gold ratio. And, from that point, it is a matter of explaining the apparent inconsistency of the mid-1970s, which in my mind becomes much less daunting when the action of oil in that period and then again in 2009 becomes clear.

In fact, the remarkable thing about 2009 is that this ‘third rule’ worked so beautifully and in such a short amount of time. This is the Brian Greene standard I am applying to market phenomena, but what is the alternative?

We have a Dow/gold ratio (and P/E ratio) that has been moving to ever greater extremes. We have an economic system cannibalizing itself–the underlying causes of which no one can really provide a clear explanation. Again, the Austrians can give us a very plausible theoretical account of why things have gone the way they have, but you wouldn’t ask an Austrian to demonstrate this using market data, would you? Austrian reverence for markets only goes so far. As much as I truly admire Austrians for insisting on first principles, I wonder if they are not somewhat deserving of their exile from the mainstream because of their refusal to apply those principles in real time.

https://i1.wp.com/www.targexcapital.com/wp-content/uploads/2010/01/Untitled.jpg

Ratio increasingly volatile?

***

I don’t know if I mentioned it, but I am not an economist, and I don’t really care about economics as such. I have never really cared about money and have only felt the allure of material goods as I have gotten older. For my own reasons, I have always been drawn to religion, philosophy, politics, history, and art. I strive to be a humanist in the tradition of the Greeks and the Renaissance. My interest in mathematics, science, and economics extends only so far as they touch upon my humanistic interests. In my opinion–and I am not the first one to say this, of course–our age is completely dominated by these mechanistic concerns. Putting it in this way, the judgement is harsher than I intend. I love the fact that I can type this harangue on a cheap laptop in an air-conditioned room in the tropics. It is truly a wonder. However, if we have fouled up on first principles, then there are important cultural and civilizational values at stake.

If our economic system is veering or, rather, has veered out of control, it is taking everything else down with it. The humanists will have to pay attention to the role modern society has given to economics and technology, but the economists and scientists must also pay attention to the potential threat their meddling poses to civilization. In the environmental movement, this is a rather commonplace observation, I take it. In terms of economics and society, however, it is amazing how much economic orthodoxy is taken for granted. Talking about the gold standard is like talking about creationism.

This situation is completely twisted, however. There is nothing primitive or barbaric about sound money, and I believe my market system strongly suggests that gold has never actually ceded full authority to the dollar and central banks. To me–and if I recall correctly, Alan Greenspan has made a similar point–there is a strong correlation between our debasement of money and the destruction we have wrought on the environment. I believe that in our attempt to constantly boost economic production, we have managed to distort both the natural world and civilization.

I have recently submitted an essay along similar lines to the Libertarian Papers entitled “Moneychangers in the Temple”. If the correlation of economic phenomena over the last 40 years strikes one as bizarre, the correlation of economic and political/cultural phenomena is at least equally so. This is harder to demonstrate, of course, but we already accept the profound role the Depression had on the rise of fascism and on the welfare state. It should hardly be radical to suggest that economic conditions are shaping the political and social environment, but if this influence is as pervasive as I am trying to argue then we would have to contemplate a stack of market/economic, political, and cultural correlations that would frankly be ridiculous, right?

I guess I am suggesting a conspiracy of absolutely enormous proportions but entirely without the conspiracy. I am rather arguing simply (too simply as some have told me) that our attempt to fix the world of exchange–the economy, the market, catallaxy–in order to form a more perfect world is having a civilizationally disastrous effect and that its particular effects can be measured in the market, described in politics, and intuited in the world of art and music.

If bureaucrats, academics, politicians, and do-gooders manipulate the medium of exchange–and this is no abstraction, but something each of us uses day in and day out and consciously and subconsciously plans our lives around (children, marriage, careers, ideology, religion, etc)–it will have an effect. This was the promise of central banking, wasn’t it? Ending economic dislocation.

The irony is that the Depression and the Second World War were such powerful examples of what a disastrous policy this has been, but they are both used routinely to argue for the necessity of central banking! And, I take it that the people who defend central banking point to the absence of a Great Depression or a world war since then as proof of what a wonderful job that has been done since then.

I am not convinced.

*************************************

I was asked to express my argument in charts, and I have reluctantly agreed to do so. The limited feedback I have received has been that they are not helpful. I am the last person who should be constructing charts, and if somebody would like to construct nicer charts than I have, please let me know, and I would be happy to link to your site. At the end of the day, I am hoping somebody more competent than me will take up this whole argument.

Overstreet charts

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2 comments so far

  1. Tim on

    Thank you for thinking of this and writing it down. It is important to be able to forcast these issues so as to not have any worries seeing what happens in the world when these changes take place, just knowing a little about “why” really helps. I believe Big Finance has played these systems for hundreds or thousands of years. With the internet and all of this information at our fingertips, people like you can make these analysis’ and show the rest of us this part of reality.

    • Alcibiades on

      Thanks for the compliments, Tim.

      In my opinion, “Big Finance” is, if anything, along for the ride rather than in the driver’s seat. Finance is always going to have an important role to play in government and society, and it will always be ‘disproportionately’ large, just as intellectuals, artists, the brave, the strong, the beautiful, the humorous, the cunning, the spiritual and so on, will.

      The critical question is how and why the gold standard came not only to be abandoned in practice but in theory. It is now widely regarded as a crackpot position. The rise of the state and the notion that nature and reality could not only be ‘cultivated’ but ‘manufactured’ and quantified, I believe, at least made the abolition of the gold standard possible. But, there are, I suspect, as yet poorly understood historical forces at work. After all, it is very strange that the conclusion of the ancient evolutionary process that resulted in a global gold standard in the 19th century was almost immediately replaced by fiat currency. One could hold that fiat currency was the next logical step, I suppose, except that fiat currency just isn’t money, except to the extent that it is an almost universally accepted medium of exchange at the moment (and in the vastness of history, it is only a moment, so far).

      One of my criticisms of the Austrians is that although they have a great deal of analytic insight into banking and so forth, they often are too narrowly rationalistic to grasp historical process. They are often too scientistic. They know that gold is money, but beyond that they cannot explain why societies would willfully abandon it or, more to the point, why the entire planet would abandon gold almost at the instant that it had accepted gold. The reason, I think, is that there is a socio-historical impetus beneath the economic one and the Austrians, in their abstract individualism (so powerful a tool in the economic realm), are unable or unwilling to discover it. In other words, as much as I hate it, I might have to accept that there was some kind of historical ‘necessity’ in abandoning the gold standard and going through the turmoil of the last century.

      I suspect that in the assimilation of such radically separate and diverse civilizations to each other and in such rapid fashion that the need for a more accommodative monetary system forced itself on to world history. Although I believe that this monetary system has brought us to war and apocalyptic genocide and totalitarianism more than once, it has also resulted in a world that has probably never been so uniform and egalitarian on a relative basis. At some point, history, I suppose, will recoil from this egalitarian demand and perhaps we are much closer to that point than was once conceivable. I think there are hints of it now in the hand-wringing about what to do with the ‘Club Med’ countries in the euro or what to do with the welfare state guarantees throughout the Western world.

      The choices before the EU at the moment appear, at any rate, exceptionally stark. The southern half of Europe must place itself effectively under German economic oversight, or Germany must simply allow the rest of the eurozone to yoke it and pull the continent along with it, or North and South must part ways. And, of course, none of these sound promising. I don’t think that anybody is confused about the economic steps that need to be taken. The questions are entirely political and historical. The EU is paradoxically founded on the fact that nobody trusts one another, especially the Germans. And nothing was accomplished over the multiple decades of economic integration to fundamentally alter that fact. If I were the Germans, I wouldn’t have any clue what to do, except pray before I go to bed that I will wake up British.

      Anyway, thanks again for your comment. It is an endlessly fascinating subject.


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