Wanna trade? I’ll swap you 18 barrels of my crude oil for one of your one-ounce gold bars. Yes, that’s right. Eighteen. Oh, I know you once commanded as much as 39 barrels for your gold, but that was then. This is now.
You see, for the first time in three years, the gold/oil ratio is below 20-to-1. You can see the ratio’s recent track record in the chart below.
Historically—at least since the price of gold was allowed to float—the ratio averaged 15-to-1. That’s an average, mind you. There’s been plenty of variance on either side of the dashed line, mostly as the result of changes in the economic climate.
The ratio’s recognized as a sort of canary in a coal mine, giving advance warning of turbulence ahead. At 15-to-1, both oil and gold are priced to perfection. Oh, there’s some wiggle room that will be tolerated before pundits start writing screeds decrying the market environment but go above 20-to-1, making gold too expensive or oil too cheap, and we’re in crisis mode. Or so it has seemed for a quarter century. Spikes in the ratio preceded a number of financial calamities, including the Asian currency crisis of the late 90s, the Great Recession and, most recently, the Euromarket predicament.
The ratio peaked near 47-to-1 in February 2016 when West Texas Intermediate crude dipped below the $27-a-barrel level. Since then, the ratio lurched lower as oil prices have risen. And, with WTI now topping $70, the ratio has punched through the 20-to-1 floor.
At face value, the gold/oil ratio’s decline could easily be taken as a sign that some sense of normalcy is returning to the markets. Normalcy, of course, isn’t authoritatively defined. Maybe it’s better to say that that the decline heralds a return to normal volatility. That notion seems reasonable given the ratio’s correlation to the CBOE Volatility Index (VIX).
In this sense, the gold/oil ratio is an indicator of market sentiment. Still, one can’t ignore the fundamentals at work in the underlying markets: global oil prices are being levered upward by OPEC production cuts and the Middle East flare-ups, while gold is weighed down by growing prospects of interest rate hikes and a stronger dollar.
I’m betting that there’s a link between the optimism conveyed by the falling gold/oil ratio and the bread-and-circuses fervor expressed in a ratio we examined last week.
Is such optimism really warranted or are investors too exuberant? Time will tell. We can look to the VIX and the gold/oil ratio to gauge investors’ appetites after all the stock buybacks engendered by the recent tax legislation are digested. Let’s hope the result isn’t dyspepsia.
Brad Zigler is WealthManagement’s Alternative Investments Editor. Previously, he was the head of Marketing, Research and Education for the Pacific Exchange’s (now NYSE Arca) option market and the iShares complex of exchange traded funds.