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Thinking of Entering the Gold Market? First Check the Relationship Between Gold and Oil Prices

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There seems to be a relatively strong relationship between gold and oil prices, but not between gold and oil returns. Here's how this relationship can help investors.

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With such results on the table, it would be tempting to proclaim that you can trade this relationship. But to see if this is really the case, we'll turn to a different chart.



This chart is similar to the previous one but it differs from it in two ways: we plot weekly gold and oil returns instead of prices and we shorten the analyzed period to start with the year 2002. The results here are completely different than before. The cloud of points does not seem to reveal any coincidence or relationship – it does not follow any visible trend and the points look like plotted randomly in the middle of the chart, around 0% returns for both gold and oil. R-squared suggests that 7.2% of the changes in gold returns can be explained by changes in oil returns. The conclusion might be that higher weekly oil returns don't necessarily imply anything meaningful for weekly returns of gold as far as long-term analysis is concerned. We have obtained similar results for daily, monthly and quarterly returns.

The main point is that, even though the general price level of gold evolves in a similar direction to oil, the relationship may not be tradable based on data for the long term. Over longer periods of time and on average, opening long speculative positions in gold based on expected appreciation of oil may simply not be profitable.

Having said that, it's still possible for short-term patterns to emerge occasionally. So, even though there seems to be no relationship between gold and oil returns over the long term, it may happen that a relationship unveils itself in a short period of time offering trading opportunities.

A popular way to analyze gold in terms of crude oil is the gold:oil ratio in which the price of gold is divided by the price of oil. We present historical levels of the ratio along with prices of gold on the chart below.



Peaks in the ratio signalize periods when gold was expensive relative to oil. Troughs point out periods when gold was relatively cheap compared with oil. The ratio does not reveal any striking patterns or relationships. As is with charts, it can be interpreted differently by different persons. Quick calculations yield an R-squared of 3.4%, which suggests that the ratio on its own may not have any particular impact on gold prices at the same point in time.
No positions in stocks mentioned.
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