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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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In light of the mixed results obtained so far, we have checked the relationship between gold and oil price levels for stability. We have calculated R-squared values for gold and oil prices in a one-year window for each day in the 1987-2012 period (subject to data availability). The results are presented on the chart below.



The red line shows the R-squared values calculated in a one-year window ending on the day for which the value is shown. The changes in the R-squared can be perceived as the stability of the gold-oil relationship. High values indicate that for a one-year period prior to the day for which the value is reported the link between gold and oil was relatively strong and they traded in the same directions. Low values indicate that for one year the relationship was questionable and gold and oil traded independently. We can see that the stability of the relation has been fluctuating dramatically for the last 25 years.

It is considerably difficult to find any apparent relationship between the behavior of R-squared values and the price of gold. To check for any such link, we have applied two thresholds to the R-squared values. The first threshold would be one that was broken when R-squared went up. The other one was one that was broken when R-squared was declining. We have checked for different values of the thresholds, values that would coincide with highest or lowest past returns of gold. Altogether, we have answered four questions:
  • If the R-squared was going down, what threshold would have coincided with highest returns?
  • If the R-squared was going down, what threshold would have coincided with lowest returns?
  • If the R-squared was going up, what threshold would have coincided with highest returns?
  • If the R-squared was going up, what threshold would have coincided with lowest returns?
The answers:
  • For R-squared going down, a threshold of 63.8% would have coincided with monthly returns of 5.4%.
  • For R-squared going down, a threshold of 80.8% would have coincided with monthly returns of -7.2%.
  • For R-squared going up, a threshold of 81.1% would have coincided with monthly returns of 10.8%.
  • For R-squared going up, a threshold of 86.2% would have coincided with monthly returns of -11.0%.
Even if the above might seem slightly complicated, they imply two straightforward points:
  • When the relationship between gold and oil was strong but deteriorating, gold returns tended to be considerably low.
  • When such a relationship was significant and strengthening, gold returns tended to be extreme – either considerably high or considerably low.
The above results do not imply that such relationships were tradable. But they point out that the degree to which gold and oil traded in the same direction could have had influence on gold returns.

To sum up: There seems to be a relatively strong relationship between gold and oil prices, but not between gold and oil returns. The strength of the relationship between gold and oil coincides with high or low gold returns. This relationship may not be useful for speculation over the long term but it's possible that patterns emerge locally, in short time spans. Results of our analysis of the relationship between gold and oil show that if you are considering entering the gold market and the relationship between gold and oil is strong but deteriorating, you may want to double check the current situation on the market. Additionally, if you are to enter the market and the above-mentioned relationship is strengthening, this could coincide with considerable movements in gold to either side. You might want to check additional factors to confirm which side it might be.

For the full version of this essay and more, visit Sunshine Profits' website.

Twitter: @SunshineProfits
No positions in stocks mentioned.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

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