By Michael A. Gayed at Marketwatch
I know, I know. Gold is a controversial metal. Some people hate it as an investment because it provides no income, and is a "relic of the past.” Some people love it, arguing it is the safest form of currency in the world with historical relevance. Others simply like how shiny it is.
For market participants, it is important to be dispassionate about any one asset class or strategy and look at how one area of the market may impact another. This is at the core of inter-market analysis — try to see if there is a signal in the price movement of non-broad market investments that is initially ignored by bulls and bears, allowing for an exploitable opportunity as information diffuses with a lag to equity traders.
"I like facts and data because they help me think clearly, beyond the cultural messages that I ingest unwittingly, and sometimes find myself regurgitating almost unconsciously."
So let us look at gold not from an emotional side, but rather from a signaling one. In the 2015 NAAIM Wagner award-winning paper I co-authored titled "Lumber: Worth Its Weight in Gold" (click here to download), we document the signal that gold relative to lumber has on equity and bond markets. Why do we compare gold's relative performance to lumber? Because Lumber is the commodity most sensitive housing, and as such, most reactive to changing growth and inflation expectations.
Gold, on the other hand, is completely non-cyclical and uncorrelated to growth, inflation and most macroeconomic variables. The precious metal tends to move off of stock-market implied volatility, consistent with the notion that in times of market stress, money buys into the commodity.
Generally, when gold is outperforming lumber, stock-market volatility tends to rise and drawdown risk increases.
Take a look below at the price ratio of the SPDR Gold Trust ETF GLD, -0.14% relative to lumber. As a reminder, a rising price ratio means the numerator/GLD is outperforming (up more/down less) the denominator/lumber. In this case, you can think of an upward trending gold/lumber ratio as a signal that we are entering a potential "risk-off" period for equities. I say potential very purposely because, as with any signal, there are false positives. The key is that when the signal is right, the magnitude of it being right swells the frequency of it being wrong.
Note that the ratio has been in an uptrend since early July, and for now the trend remains intact. This provides yet another loud warning signal to stock market bulls in a purely unemotional and factual way as shown in our paper that the odds continue to favor a summer correction which we may be at the start of. This is confirmed by other indicators we use in our investment strategies run for individual and institutional asset allocators, as we ourselves across the board remain in a defensive position.
Focus not on gold as an investment, and not on gold as a trade. Focus on gold as a messenger of information. Right now, the message for the stock market isn't positive. The question is simply when the market will begin to act on it. Will you?