Here’s Why It’s Too Early For A Gold Bottom

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It’s that time of year when I start combing through the agenda for the upcoming Inside ETFs conference to figure out which panels and presentations I want to make sure I don’t miss. Today I noticed a dedicated panel on gold and silver investing, and I scratched my head a bit.

Gold? Seriously?

If there’s one asset class that’s been hammered by the Trump election, it’s gold. As I write this, gold has declined 10.5% nearly in a straight line. On the surface, this is just simple risk-on selling—the S&P 500 is up over 6% in the same period, and all that equity-chasing money had to come from somewhere.

But what about gold’s traditional roles as inflation hedge, reserve currency, safety asset and counter-correlated diversifier?

I’m fascinated by gold because it’s the only important financial asset in the world that’s basically fictitious. It’s a pure commodity of psychology. It has worth because everyone says it does, and its relative value versus other things is only based on belief.

In that way, it’s much like technical analysis. There’s no more magic to a line on a chart than there is to an ounce of the yellow metal, and yet both are important and meaningful precisely because enough people believe they’re meaningful.

The Correlation Factor

There are a few ways I generally look at how investors are feeling about gold beyond just the simple “they sold it so it’s down” analysis. The first is correlations. For many investors, including a small slug of gold in a portfolio is a way to have a hedge for bad times. But that’s only helpful if in fact gold moves the opposite direction of other major asset classes. So how’s that working out?

The top line here is the price of the SPDR Gold Trust (GLD); the bottom line is the 40-day rolling correlation to the S&P 500. The good news for the correlation story is that other than a little blip this fall, for the most part, gold has remained a counter-correlated asset, more so in the past few years than during the big bull-run on gold since the financial crisis. So that’s one positive for the gold investment case.

The Inflation Hedge Factor

What about the much-vaunted use of gold as an inflation hedge? Reasonable people can disagree, but in my opinion, we’re more likely to have an increased inflationary environment over the next few years than a flat one. Of course, inflation is a rather “lumpy” statistic to plot gold against in the short term, so let’s see how gold has been faring versus a proxy: the iShares TIPS bond ETF (TIP).

Again, this looks like at least decent news (as it has been for years, frankly). While the correlations between the two classic strategies to match inflation aren’t strongly correlated, they are at least positively correlated. So that’s two check marks.

Gold Vs. Oil

The last thing that’s always struck me as interesting to look at is how people value gold versus the granddaddy of commodities: oil. The traditional way of looking at this relationship is with a simple ratio:

The ratio between gold and oil is plotted on the bottom here, and you can read this as saying, “Right now, an ounce of gold buys you 23 barrels of oil.” Why look at this ratio? Well, historically, this is a pretty mean-reverting ratio, hovering around 15 (depending on when you measure, of course).

Both oil and gold investors often look to the ratio to find outlier periods. Back in 2008, when you could barely buy seven barrels of oil with an ounce of gold, believers would have said, “Either oil has to crash, or gold has to run.” In fact, both things happened, until by early 2009 you could have said the opposite: “Either gold has to crash, or oil has to run.”

In that case, gold grew slowly, but oil ran, getting the ratio back to some version of “normal.”

So what’s that line tell us now? Well, in hindsight it most assuredly tells us that at the beginning of 2016, we were deep in anomaly territory, with an ounce of gold buying more than 40 barrels of oil. The implication was, again, that either gold had to come way, way down, or oil was going to have to get more expensive.

What has in fact happened is about half of what we’d expect to truly mean-revert: Oil has climbed back up from an astounding $26 low in February earlier this year, but until the election, gold wasn’t cooperating. Since the election, however, the gold/oil ratio has come down from about 22 to just over 20.

Break Out The Voodoo Doll

I’m not in the business of making market predictions, but by this particular brand of witchcraft and fortune telling, “normalizing” to a more historic gold/oil ratio of 15 would have gold either falling precipitously from its current level around $1,165 to something like $765—a further decline of 35%. Alternatively, oil could rally from $51 a barrel to $77, an increase of 50%.

Of course, you could see both happen, but with less dramatic moves, or you could see neither happen, and we could remain at these historically high levels for the foreseeable future.

But here’s the thing: I can’t create much of a case for a 50% rally in oil right now. The incoming administration is likely to be very friendly to the oil and gas industry, meaning more exploration and production, and I agree with ETF.com Analyst Sumit Roy that recent OPEC actions will be fruitless.

On top of that, we’re seeing pretty classic “risk-on” behavior from the market, and I don’t particularly see why that won’t continue to be the case. So that points to at least a psychological downward force on gold. And gold, as I’ve suggested, is mostly a psychological commodity.

Could I be wrong? Of course. In 2015, the gold/oil ratio was at 23 and ran up to 41 before returning, and of course, we could see something similar.

I suspect this set of cards will still be on the table in six weeks in Florida, and I can’t wait to hear the discussion.

Dave Nadig is CEO of ETF.com. You can reach him at [email protected], or on Twitter @DaveNadig. At the time of writing, he held no positions in the securities mentioned. Join Dave and the rest of the ETF.com team at Inside ETFs, January 22-25, 2017, by registering here. Use the code “ETF.com” to get $100 off your registration.