In Saturday’s weekly summary of Smart Investing Daily articles from last week, I promised you an article on gold prices… particularly as the price of gold has spiked higher than $1,486.
Now, I want to remind you of an article we wrote at the end of February called the Gold-to-Oil Ratio, or Gold-Oil Ratio.
The Gold-Oil Ratio asks how many barrels of crude oil one ounce of gold can buy. Historically, this ratio has been at 15.4, meaning one ounce of gold buys 15.4 barrels of crude oil.
If we compare this historic Gold-Oil Ratio to the current ratio, the relationship can tell us if one commodity is overvalued, or undervalued.
Here’s what this means in real terms.
When the current Gold-Oil Ratio is below 15.4, gold is either too cheap, or crude oil is too expensive. When the ratio is greater than 15.4, oil is either too cheap or gold is too expensive.
Right now, the Gold-Oil Ratio is just under 13.7.
So what we have to ask is if gold is too cheap, or if crude oil is too expensive. Let’s take a look at a chart comparing the two:
The green line on the chart represents gold, and the black line represents crude oil, trading over the past six months. Based on this chart, you might make the assumption that oil prices are too low in comparison to gold.
In looking back at the November and December trading, you can see that gold prices did a lot of fluctuating while oil prices caught up. Back then, early December, the Gold-Oil Ratio was about 15.6, very close to the historical average, so it makes sense that oil prices climbed slowly as gold prices fluctuated.
But now, we have a bigger difference in the historic and current ratio, and that means we’re going to see a bigger or more drastic move in either gold or crude oil.
The external pressures on gold prices have been pretty obvious. The underlying fundamentals of our economy are still pointing toward an inflationary climate, and that exerts a whole lot of upward pressure on gold prices.
So long as the Federal Reserve keeps interest rates low, inflation fears will stoke gold prices higher.
But oil prices themselves can be a secondary factor keeping gold prices higher. If the relationship between gold and oil historically trends at a ratio of 15.4, then higher oil prices (sustained by geopolitical upheavals in critical oil producing regions) can act kind of like a helium balloon, bringing gold prices up too.
So let’s take a look at gold on its own and see what we can learn.
The incredible surge in gold prices started in late January after a slight pullback in prices. The end of 2010 saw gold prices climb swiftly, too, so lots of folks were taking gains. But since that bottom, prices nearly seemed to be on a mission to make continuous pushes higher.
In March, gold came up against resistance from the previous highs in 2010. The swinging between that resistance and the new uptrend caused a pennant pattern. This chart formation always has a “flag pole” which is a sharp price increase leading up to the actual pattern.
That’s the swift rise starting from late January.
The consolidation that happens between the resistance line (marked in red) and the uptrend (marked in green) acts like a coiling spring.
When a breakout occurs, pennant formations often break to the upside… as we’ve seen in this chart. Pennants also have a high chance of pullbacks, as we’ve also seen in mid-April. The pullback we’ve seen in gold prices also coincided with a touch on the green trend line.
This is a bullish signal — and we’ve seen the bounce start already.
Now, the pattern of gold prices climbing in waves along that uptrend could continue. This means we could see gold prices pull back in the short term, touch that green trend line, and head higher from there.
Finding an upside price target is a bit harder. We’re in uncharted territory here.
Based on the research in the Encyclopedia of Chart Patterns, pennant formations that break out to the upside climb an average of 25% from the breakout point, which puts gold prices at $1,800.
That seems like an overreach right now, even though the fundamentals behind gold’s climb are still strong and relevant. Gold could perhaps climb as high as $1,550, based on the wide-angle look at gold prices over the past year:
It’s quite possible we’ll see gold prices at $1,550 in the next six to eight weeks.
This theory is busted if gold prices slip below $1,450… This is about the level of the previous resistance line. If this level fails to support gold prices, they might fall as far at $1,400 before finding another level of support.
Some Related Gold ETFs: SPDR Gold ETF (NYSE:GLD), Market Vectors Gold Miners ETF (NYSE:GDX), Market Vectors Junior Gold Miners ETF (NYSE:GDXJ), ETFS Physical Swiss Gold Shares (NYSE:SGOL), Ultra Gold ProShares (NYSE:UGL), PowerShares DB Gold (NYSE:DGL), PowerShares DB Gold Double Long ETN (NYSE:DGP), iShares COMEX Gold Trust (NYSE:IAU), PowerShares DB Gold Double Short ETN (NYSE:DZZ), UltraShort Gold ProShares (NYSE:GLL), UBS E-TRACS CMCI Gold TR ETN (NYSE:UBG), PowerShares DB Gold Short ETN (NYSE:DGZ).
Jared Levy is Co-Editor of Smart Investing Daily, a free e-letter dedicated to guiding investors through the world of finance in order to make smart investing decisions. His passion is teaching the public how to successfully trade and invest while keeping risk low. Jared has spent the past 15 years of his career in the finance and options industry, working as a retail money manager, a floor specialist for Fortune 1000 companies, and most recently a senior derivatives strategist. He was one of the Philadelphia Stock Exchange’s youngest-ever members to become a market maker on three major U.S. exchanges.
Article brought to you by Taipan Publishing Group, www.taipanpublishinggroup.com.