May 25th, 2011
by Albertarocks, Guest Author. See information at end of article.
One of the areas of study that is very helpful is putting together meaningful relationships in the form of ratios. After all, as the old saying goes, “Everything is relative”. There are few places where that wisdom is truer than in the world of market analyses. Just make sure you compare apples to apples, right? Follow up:
If there were no such thing as currency depreciation this exercise would be a waste of time since both groups, equities and commodities, would remain relatively constant, shifting in value only to the extent necessary to satisfy the general economic pressures of supply and demand. But unfortunately, not one single currency in the world has been immune from devaluation. Again, the key word in any ratio analysis is “meaningful” because the number of potential cross studies is almost unlimited. For example, it’s entirely possible to compare the price of cotton to shares of Google to see if that particular ratio displays any patterns that make sense in any way. Obviously, a study of the cotton:Google ratio is not something I’m going to waste my time on because there’s just not a whole lot of logic to it. I suppose an argument could be made that there might be a good reason to do a study on the relationship between the Baltic Dry Index and Chipotle Mexican Grill. After all, if the CMG burritos are really as tasty as I’m being told, then when the rest of the world finds out about it and CMG starts delivering all over the planet, the BDI just might get a much needed booster shot in the old stern.
But there are dozens of relationships which are much more logical and that do indeed provide very valuable guidance. We’ll investigate several of these in future articles, but I’ll just mention a couple more great examples for your consideration. One spectacular method of measuring the appetite for risk is the Aussie:Yen cross which correlates so closely with the S&P that it’s almost spooky. However, the price action in the Yen since the catastrophe struck Japan has been unusually volatile. On the grand scale of things though, I don’t think there’s any reason to expect that the value of the Aussie:Yen cross as a great indicator has been diminished in any way. Another fascinating study is that of the S&P 500 priced in gold. Now that’s an eye opener if I’ve ever seen one. What it shows is that since year 2000 the value of equities as priced in gold has actually been in a massively deflationary phase. In other words, while investors who have their life’s saving tied up in a successful mutual fund are quite satisfied with what appear to be stellar returns, in real terms the results have been nothing short of dismal. It’s really an illusion thanks only to the FED’s liquidity driven stock market bonanza.
The stark reality is that when priced in gold or commodities, those investors have actually been losing their collective arses. In fact, since March of 2000 the S&P 500 has lost a whopping 83% of its value when priced in gold. Unfortunately, too many people just can’t see the horrible reality of it all and tend to only think in ‘dollar’ terms. Their perception is something akin to “I don’t care where the S&P stands in terms of gold. My account is up 92% in the past two years and if you don’t think I’m happy about that think again.” In all due respect to those people, they need to have their eyes opened… and quick. How about this? How would their thinking change if they just open their minds and considered what the S&P looks like when priced in terms of something they can really relate to, the price of gasoline at the pump? Well that’s exactly what we’re going to do in the following paragraphs. What follows is a clear picture of what ‘really’ happened to the S&P 500 over the past dozen years.
We really have to start with the view from 30,000 feet in order to get a good grasp on the big picture. Before we begin, I’d like to make it clear that this particular study is not geared toward helping you make an investment decision later this week. It’s a general overview that will provide us with some valuable timing guidance. The goal is to identify evidence of either a continuation of a trend or a major reversal. But at the very least, the chart below already discloses a massive secular change that started in 2000 and that we’d darned well all better be aware of. This monthly view is the most stunning chart of the 3 we’re going to look at. I urge you not to interpret the chart at first glance as being ‘too busy and confusing’. It really shows only three things, the S&P, the price of oil, and the ratio between the two. The information it displays in a single picture is considerable and the annotations will help guide you through the evidence:
Follow up:Not at all! In fact, unless we compare apples to oranges the entire exercise just isn’t… fruitful. We’re going to look at the S&P 500 relative to the price of oil going back a dozen years and see what the equities markets have been doing in ‘real’ terms. The idea here is that if we can, at least for the sake of discussion, accept the price of oil as being somewhat representative of all commodities… then there might be some valuable information to be found. Besides, it isn’t much of a stretch at all to accept the price of oil as a proxy for all commodities.
[Click on graph to enlarge]
The first thing you’ll notice is that there are two basic and readily definable ‘eras’. The 1990’s when equities were rising much faster than oil (or gold, or cotton, or burritos or any other commodity) and the period from 2000 to present. The difference is simply stunning. And folks… I can’t emphasize enough how important this is. The most alarming take-away from this monthly chart is that since the beginning of 1999, the S&P 500, as priced in oil, has fallen 87.3%. Yes, you read that right! Even after a non-stop two year rally in equities, the value of equities today is only 1/8th of what they were worth 12 years ago. That little nugget lets a bit of air out the old party balloon, doesn’t it?
It’s really important to fully understand what is happening when the candles on these charts are rising or falling. In order for the candles (the ratio) to rise, the S&P would simply have to outperform oil. Equities could shoot higher while oil either falls, holds steady or rises, as long as it rises at a lesser rate than equities. Or perhaps the S&P will hold steady, in which case, if the ratio is to turn higher the price of oil would have to drop. Whatever the reason, it’s important to note that the ratio could rise in an up market, a down market or a situation where one is up and the other is down. The only thing that’s important in this type of analysis is the direction of the ratio itself… and of course, either a resumption of the current trend or more importantly, a change in direction of that trend. The reason it’s so important is that when this ratio breaks one way or the other… sometimes the earth shakes.
In the second chart below, we zero in on the weekly scale and immediately notice something quite apparent. The value of the S&P relative to oil (as shown by the candlesticks) has been heading east for nearly a year now. That is one seriously long and very unusual consolidation.
[Click on graph to enlarge]
What it really indicates is that regardless of direction, over the past year equities and oil have been moving at approximately the same rate. However, at the beginning of March we see what appears to be a very important change… when this ratio suddenly breaks to the ‘downside’. This implies something completely different. It implies that if the ratio does indeed continue to drop, the pattern of oil rising faster than equities is going to continue. Wow! This is a rather scary conclusion, but that’s the implication… as long as this ratio continues to drop, the world will endure even more raging inflation. Equities will continue to rise and holders of those equities will just continue to lose money. An astounding revelation, is it not?
The question we now have to ask is “is it possible that rising oil prices reach a certain level when they begin to suck the lifeblood right out of the global economy?” The experience of early 2008 as shown on these charts says “YOU’D BETTER BELIEVE IT!” Therefore, if this ratio is to continue lower, recognizing the next low is going to be of crucial importance. For if past history provides any guidance, once that point has been reached this ratio will respond almost instantly by putting in a bottom. It will mark the day when equities begin to collapse in real terms. It will mark the day when deflation begins with vigor. As an interesting side story, past experience also indicates that perhaps we could expect that a low might occur July 1st, give or take a week or so. This is more an issue related to the seasonality of oil. However, those seasonal lows in oil only provide ‘hints’ about when we might see a bottom in this ratio and should not necessarily inspire us ‘expect’ the next low to occur on any given date.
And finally, for a more defined picture of what is occurring in the present, we dive in for a closer look at the daily chart. Here we’ll be looking for signals that might indicate when a low in the ratio approaches. For all we know it could be in place already, or perhaps a month from now or a year from now. But as long as we can identify a bottom, whether it occur in a July or much later, we’ll be that much better informed about when this ratio might begin to rise with passion, signifying a return of deflationary forces.
[Click on graph to enlarge]
Lo and behold… we see a mighty bounce has occurred already, much sooner than we’d normally expect. Early or not, this is significant. More than likely the bounce off the recent April low is nothing more than a re-test of the lengthy consolidation zone. But we need to keep our eye on this because if the bottom in this ratio is indeed in place, and the ratio is about to soar up right through the consolidation area on its way to a new uptrend, then we are in for a serious bout of deflation. But what caused this recent volatile action? What caused the ratio to suddenly start plunging in the latter half of February and then to suddenly and unexpectedly reverse and shoot right back up again? Here’s what happened:
In late February, the S&P 500 may have put in a very important top… not in dollar terms, but in terms of the price of oil. Not only did we see a Feb. 18th interim peak for equities, but it was accompanied by a massive and unexplained Feb. 16th launch in the price of oil. An explosion that took oil from $86.50 to $114.75 by the first of May. Folks, that’s an astounding 32% in 10 weeks. No wonder equities fell… an oil shock like that is a full blown economy crushing disaster. But following on the heels of that massive spike in oil, we suddenly saw oil plunge almost as quickly starting at the beginning of May. And of course the impact of such a deflationary event was immediately reflected in the chart as evidenced by the sudden re-surge in the candlesticks.
So now we find ourselves at another key make-or-break decision. From here onward, we’ll be watching this ratio to see what it reveals about the likelihood that the world will be enduring ever more inflation or if we’re about to embark on a journey through the deflation grinder first. In theory though, it’s possible that this chart may ‘never’ find a bottom. Specifically, in the unlikely event that the decision has already been made to allow the dollar to fall toward zero, then equities will theoretically rise to infinity, investors will lose even more wealth by holding equities that appear to be rising, and oil will rise to about 50 infinities. That’s a lot… even more than the total of all the money I have in ‘all’ my pants pockets combined.
IN CONCLUSION, we now recognize that we are at a potential inflection point in the history of inflation and deflation.
OUR TASK is to recognize the day when the course becomes clear, because when we find a bottom in this ratio, it will surely mark the most important turning point in the global economic history. And the earth will shake.
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Albertarocks is the pseudonym for a talented chart analyst whose work is published at Elliott Wave Trends and Charts. Most of his work is available only in the paid subscription portion of that website, but the author and publisher have both graciously agreed to allow GEI to post this exceptional work here which has also been displayed in the public section of EWT&C.