When making recommendations in my weekly newsletter EPIC Insights , I have always been wary of the risk profile. The portfolio has done extremely well during sell-offs and rallies and I have no interest in surrendering gains by blindly diving into untested ideas. For that reason, one of my favorite approaches is to construct a pair trade. By being long of one instrument and short of another, we eliminate market direction and trade the basis between the items.
With pair trades, you look for two items that should trade in the same direction yet have experienced a temporary dislocation. By betting on an eventual return to normality, pair traders will make money regardless of the direction the market takes.
As commodities, gold and oil share many similarities. Both are negatively correlated to the U.S. dollar, offer a hedge against inflation, and perform well when investors seek hard assets. Over the last three years, the two items show daily price movements that are highly correlated to one another. All the similarities point to an expectation that as prices move up and down, the relationship between gold and oil should remain relatively static.
However, there are a few key differences that cause the prices of oil and gold to diverge. Gold has little industrial use and is seen as both an inflation hedge and a store of wealth. Oil is an industrial commodity that sees its price fluctuate based on economic expectations. These differences take what should be a static long-term relationship and offer tremendous short-term volatility. Within the shorter movements is where I seek opportunity.
The easiest way to examine the price of these items is through the gold/oil ratio. Over long periods, the ratio is very steady. Since 1983, the ratio has averaged 15.7 (15.7 barrels of oil were needed to buy one ounce of gold). Over 1-, 5-, and 10- year periods the average has been 12.4, 10.4, and 10.6, respectively. Currently the ratio stands at 19.4—above both the averages seen in the last decade and those seen over the last 25 years.
Over the coming months, I expect the economy to show signs of recovery as the massive monetary and fiscal stimulus takes effect. While I do not believe government intervention will solve our problems, I do believe it will drive oil higher on demand factors and take gold lower as fear subsides. Such action will drive the ratio toward its 10-year average of 10.6.
For retail investors, this trade would have been impossible to do a few years ago. However, the advent of ETFs now allows us to position for the move. As a proxy for oil, use the United States Oil Fund (USO). For gold, use the SPDR Gold Trust (GLD). Expecting the gold/oil ratio to decline, I recommend a long position in USO and a short position in GLD as this week's fundamental trade .
Sean Hannon, CFA, CFP
Epic Advisors, LLC