Sunday, June 24, 2007

Using Intermarket Ratios

Today's chart may look hard to understand, but I think once you read the following explanation, it will make a lot of sense. The premise behind this chart is that the price of gold should move more or less in line with other related markets. When gold is moving in tandem with other related markets, we would say that is natural, and would not pay any attention to it. However, when gold, and other related markets start going in the opposite directions, then we know that one of the markets is out of sync and must correct.

The chart below shows the price of gold in the centre, and has 2 ratio lines on the top, and 2 ratio lines on the bottom. Each ratio line represents a different market. I have Asian Stocks, a Dollar Bear fund, Crude Oil, and Bond Yields, all represented here. These ratio lines are derived from taking the price of a related market, say crude oil, and dividing it by the price of gold, and then taking a 12 day rate of change measurement of the result.

When gold and the related market in question are moving together the ratio lines are flat, and no buy or sell signal is given. If the related market starts doing much better than gold, the ratio line will start moving higher. So when the ratio line is rising, it means that gold is either falling faster, or the related market is rising faster. The opposite is true when the ratio lines are falling. In other words, when the ratio lines reach extremely high or low levels, it signals that there is a large divergence going on, and that there could be a move for gold in the cards.

One way to remember how to use the ratios is that when they are low, it is time to go, and that when they are high, it is time to buy. Anyway, if you look at the above chart, notice that at the May 2006 peak, the Crude Oil ratio line, which is the one right below the chart, dipped down to an extreme low level. This was a sell signal.

Now, if you look at the ratio line immediately above the gold chart, it is a ratio between gold, and a US Dollar bear mutual fund that gives you 2 times the negative return of the performance of the US Dollar. Since gold and the US Dollar are negatively correlated, this fund should follow the gold market. Notice how this ratio line peaked right on the June 12, 2006, bottom. This was a buy signal. Another good signal using this ratio occurred in the middle of July, when the line reached an extreme low. This was a sell signal.

This chart only gives a few clear cut signals each year, but when the signals are given, they tend to be fairly accurate and profitable.

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