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"Crude Cheap, Gold Fair, Stocks Rich"

Tyler Durden's picture




 

Via Nick Colas of ConvergEx,

Today we update our long run historical analysis of the relative value of gold, crude oil and U.S. equities

 

All three are dollar denominated, are notional inflation hedges, and have reliable long term price records (we use 30 year histories as well as shorter time periods here). 

 

Two anomalies pop out from our work.

  • The most notable is that gold is very expensive relative to crude.  The current gold/oil ratio is 22x (that is, 22 barrels at spot prices = 1 ounce of gold).  The 30 year average is 16.7x, and the 10 year average is 13.1x.  Oil would trade at $72 or gold at just $902 to reestablish long run equilibrium.
  • The second aberration is the ratio of the S&P 500 to crude oil prices.  Currently, U.S. stocks trade for 39x spot oil; the 30 year average is 28.2x, and the 10 year average is 17.5x.  To put oil prices back on a “Normal” footing with stocks based on the last three decades of price history would mean crude prices at $74/barrel.
  • Bottom line: crude looks cheapest, gold looks fairly valued, and stocks (no surprise) look expensive based on this analysis.

Why does a barrel of oil contain 42 gallons?  Here’s the story:

The answer goes back to August 1866, when a group of early oil producers in Pennsylvania settled on that measurement. As their model, they used the actual wooden barrels already in local production to hold everything from fish to butter to the region’s whiskey. 

 

One of these barrels, once full of oil, weighed 300 pounds – about as much as one man could roll and stand upright.  And before there were pipelines or heavy duty tankers, producers used barrels to ship their product.  That is how a barrel became the standard unit of measure for oil around the world, even long after modern transport methods made them obsolete.

 

A (more) fun fact: one firm that produced barrels in late 19th century Pennsylvania was Oberly & Heisman. The latter gave his son John an afterschool job at the shop, which provided some spending money when he went off to college and play football.  The rest, as they say, is history.

This constancy of measurement has its uses beyond the energy sector, because we can take the price of a barrel of crude oil as a comparison point to other assets such as gold and U.S. stocks.  After all, all three are priced in dollars, trade freely in the capital markets, and are to varying degrees inflation hedges. Add to this the fact that long term price records exist for each, and you get a useful dataset for assessing the value of each relative to the others.

For example, let’s look at crude oil prices in relation to gold and stocks.  There are some long run charts that highlight these relationships above, but here are the highlights:

With West Texas Intermediate Crude at $54/barrel and gold at $1,200/ounce, the ratio between the two is 22x.  In other words, it takes 22 barrels of oil to buy one ounce of gold.  Given the recent declines for crude, it should be no surprise that the current ratio is very high relative to historical norms.  Over the last 10 years, for example, the average has been 13.1x with a standard deviation of 3.8.  We are well outside the 95% confidence interval, in other words.  Over a longer time frame such as 30 years, the ratio is 16.7x with a standard deviation of 6.0.  By that measure, gold is certainly higher than usual relative to crude, but not as dramatically so as over the 10 year horizon.

 

Bottom line: Oil is certainly cheap relative to gold.  If you wanted to put a fundamental framework around this statistical analysis, you might consider how gold’s inflation hedging qualities might lose some of their luster when oil is so inexpensive.

 

It currently takes 39 barrels of crude to buy one unit of the S&P 500.  By this simple calculation oil looks cheap to U.S. equities, although not as much as the prior comparison to gold.  The long term 30 year average is 28.2 barrels per S&P 500 unit, with a standard deviation of 18.8.  We’re over those levels, to be sure, but not statistically aberrant.  Over the last 10 years, the ratio is 17.5x with a standard deviation of 5.6.  By that shorter term comparison, therefore, we are certainly trading at lofty levels for stocks relative to crude.

 

Bottom line: Crude oil is cheap when compared to stocks.  Can it get cheaper?  Sure.  But it is now noticeably cheaper than historical norms, especially the last 30 years.

Now, let’s try the same math for U.S. stocks and gold and make a few closing remarks:

You need 1.7 ounces of gold to buy one unit of the S&P 500.  That’s not too far off the 30 year average of 1.88 and a standard deviation of 1.3.  Against the 10 year track record, the average gold-to-stocks ratio falls to 1.45 and a standard deviation of 0.62.  Again, pretty much the same as now.

 

Bottom line: gold is fairly priced relative to its historical relationship to U.S. equities.  We like gold for its low price correlation to financial assets, but it seems “Fairly valued” relative to stocks at the moment.

 

You can also use this analysis to come up with a notional “Fair value” for each asset.  Given that gold and U.S. stocks seem pretty balanced versus their historical norms, the question of the hour seems to be: “Where should crude oil trade?”  Recall that the 30 year ratio of stocks-to-gold is 28.2, and that history encompasses a wide swath of time when each asset had its quite dramatic ups and downs.  Divide today’s close of 2,092 on the S&P 500 by that number and you get a target price of $74 for a barrel of WTI.  Do the same with the 30-year gold-to-oil ratio of 16.7x and you get $72 (based on $1,200/ounce for gold).

Those are remarkably close - $72 or $74, based on relative value to gold or stocks – and points to two final observations.

The first is that markets can stay out of balance for a long period of time, even when they seem to agree that oil should be +70/barrel.  The gold/crude ratio got down to 6.8x in 2008, and as high as 51 in the mid-1970s.  So for all of you that think oil has bottomed, you might be right.  Or not…  The historical record is on your side, but it may take some time.

 

The second point is a bit direr: perhaps it is oil that has the “Right” signal here.  By that measure, it is stocks and gold that are overpriced, not crude that is cheap. The 30 year average math here: based on a $54 price for a barrel of crude oil, the correct price for the S&P 500 is actually 1,525.  For gold to sit at its 30 year average ratio to oil, it would price at $902.

In closing, that final point reveals the most important truth about these ratios: they are dynamic.  That means that when one gets out of sync with the others, you can expect volatile price movements as they seek their long term equilibrium.  If oil prices do continue their decline, expect the price of gold and equities to see incremental volatility.  Nature abhors a vacuum, even if it is contained by a neat 42 gallon barrel.

 

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Wed, 04/15/2015 - 11:10 | 5994585 NoDebt
NoDebt's picture

OK, I'm missing something or I'm having a senior moment a little early in life.  Shouldn't those 3 charts on the right just be the inverse of their corresponding chart on the left?  

Wed, 04/15/2015 - 11:16 | 5994627 ZoroAustrian
ZoroAustrian's picture

Indeed, and the ratios in the table should simply be inverted too, and there is something wrong with the math in some cases - i.e. 30-year gold / s&p at 0.79 is not 1/1.88 which is the 30-year s&p / gold.

Seems it's Tylers having a senior moment (or just publishing too damn much too quickly), not you.

In any case, point taken, real commodities cheap, bogus paper promises stupidly expensive.

Wed, 04/15/2015 - 11:43 | 5994811 LawsofPhysics
LawsofPhysics's picture

"real commodities cheap, bogus paper promises stupidly expensive" --  Bingo, especially considering those paper promises can be called into existence with the click of a button...

So many paper claims, so few real assets...   ...how that saying go again...  ...when fraud is the status quo, possession is the law.

Wed, 04/15/2015 - 11:47 | 5994829 Captain Debtcrash
Captain Debtcrash's picture

I work in the oil industry so am already long oil through my job. Besides retirement accounts I'm out of stocks, but I am still acquiring PM's. I made up this precious metals excel program that helps me buy dips but its structured to be worry free. It’s a free download.

http://www.debtcrash.report/entry/debtcrash-metal-purchase-program

Wed, 04/15/2015 - 12:05 | 5994924 Ham-bone
Ham-bone's picture

All are welcome to read my latest post...

How Peaking Global Crude Oil Production is Being Trumped by Slowing Global Credit Creation, Resulting in an Oil Glut!

http://econimica.blogspot.com/2015/04/how-peaking-global-crude-oil-production.html

Wed, 04/15/2015 - 12:10 | 5994952 KnuckleDragger-X
KnuckleDragger-X's picture

Apples, meet oranges. They are worth what the market makers say they are and value discovery is completely ignored.......

Wed, 04/15/2015 - 12:06 | 5994927 A is A
A is A's picture

Not so. You are assuming that the the inverse of the sum of a series is equal the sum of the inverse of each of those numbers in the series, which is not the case at all. Try it.

 

Wed, 04/15/2015 - 12:03 | 5994914 Captain Debtcrash
Captain Debtcrash's picture

They are, its just the scale that is messing with you.

Wed, 04/15/2015 - 11:16 | 5994620 wrs1
wrs1's picture

Good points made in the article.  Oil got bombed below $75 by the middle east producers dumping it below market. This may have been due to Wall Street influence but whatever, it can't be maintained without repercussions and those repercussions bode ill for Wall Streets pet assets so I expect oil to get back to $75 in fairly short order, i.e by June.

Wed, 04/15/2015 - 11:26 | 5994682 Bell's 2 hearted
Bell's 2 hearted's picture

if wti makes $75/barrel, it won't stick

 

global economy (slumping) will be calling the shots

Wed, 04/15/2015 - 11:35 | 5994763 LawsofPhysics
LawsofPhysics's picture

"if wti makes $75/barrel, and military actions remain subdued, it won't stick"  -- fixed.

Wed, 04/15/2015 - 12:15 | 5994984 KnuckleDragger-X
KnuckleDragger-X's picture

Watch the spread between WTI and Brent. If there were any real problems in the system, Brent would be the one climbing and as an aside, the last time they neared parity the market dumped both and the price collapsed....

Wed, 04/15/2015 - 11:19 | 5994641 Bell's 2 hearted
Bell's 2 hearted's picture

Bullard ... with today's laugher:

 

WASHINGTON (MarketWatch) — A leading hawk on the Federal Reserve on Wednesday made a case for raising interest rates soon, arguing the level needs to be appropriate for the coming “boom” for the U.S. economy.

 

...

 

His biggest fear from keeping low rates — they have been near zero for 6.5 years — is that they could lead to financial-stability problems later. He said asset valuations currently look fairly valued, with the notable exception of bonds which Fed policy influences “So it’s hard to know what that really means.”

 

http://www.marketwatch.com/story/feds-bullard-says-rate-hikes-are-needed...

 


Wed, 04/15/2015 - 11:22 | 5994663 LawsofPhysics
LawsofPhysics's picture

To Bullard's credit, he did not say what sector of the economy the "boom" would be in, perhaps he means we get another boom in financial "products" of mass destruction.

 

So many paper fucking claims, so few real assets...

tick tock motherfuckers....

Wed, 04/15/2015 - 11:20 | 5994654 LawsofPhysics
LawsofPhysics's picture

I find all this talk of "prices" in the absence of price discovery fucking hilarious.

Wed, 04/15/2015 - 11:22 | 5994665 Smuckers
Smuckers's picture

^^ Great minds and all that.  Or jinx, buy me a beer.

Wed, 04/15/2015 - 11:21 | 5994660 Smuckers
Smuckers's picture

<raises hand> - Is this article founded on the assumption we have fair market price discovery?

 

 

Wed, 04/15/2015 - 11:28 | 5994704 SheepDog-One
SheepDog-One's picture

If the Fed were in charge of pricing buggy whips, because buggy whip manufacturers were too big to fail and friends of lobbyists, the Fed would declare the 'fair price' of a buggy whip to be around $1,500 or so....it's only fair after all and buggy whips have big subsidies so actually the banks pay you to buy one.

Wed, 04/15/2015 - 11:59 | 5994891 Latitude25
Latitude25's picture

Is a $2500 toilet seat a fair price?

Wed, 04/15/2015 - 11:34 | 5994757 actionjacksonbrownie
actionjacksonbrownie's picture

Oil being sold at a profit = too cheap

 

Gold being sold at no profit = fair price.

 

Equities being sold at ?? = printing press

Wed, 04/15/2015 - 11:58 | 5994862 Latitude25
Latitude25's picture

Gold at around $1200 is considered "fair".  So this is capitalism and supply and demand has determined that this is "fair"?  Is it fair that miners shut down due to lower prices?  Everything should be price fairly?  LOL.  Central planning at work.

Wed, 04/15/2015 - 12:15 | 5994988 Squid Viscous
Squid Viscous's picture

It's all Fugazi when the Fed is in the driver's seat

Wed, 04/15/2015 - 12:20 | 5995020 RaceToTheBottom
RaceToTheBottom's picture

HFT tells us what the fair prices are.  

It does, after all, provide all the liquidity to the market.  

There is no malice or self interest involved in this process at any level...

/SARC

Wed, 04/15/2015 - 12:21 | 5995023 NoWayJose
NoWayJose's picture

Wait a few weeks as the US gets into driving season -- Goldman is already pushing oil and oil stocks higher.  That will correct the anomoly!

The whole basis for this article is the assuption that low oil prices are based on supply and demand rather than on the prices set by Goldman's computers.  Just watch as oil goes higher despite any change in supply or demand.

 

Wed, 04/15/2015 - 12:41 | 5995127 Space Animatoltipap
Space Animatoltipap's picture

Actually the POG should be analised in the context of the amount of electronic and paper currencies in circulation. This will become apparent the next few years when "confidence" in the WW madhouse gets lost more and more.

Wed, 04/15/2015 - 13:53 | 5995505 GoinFawr
GoinFawr's picture
Tue, 04/07/2015 - 15:22 | 5966823 GoinFawr

"  if POBrent pops ~59.75  and WCS (Western Captured Supplier) discount holds <~13fiatscos..."

or cached (since Tylers are redacting faster than anyone can type):

http://webcache.googleusercontent.com/search?q=cache:5V9-i184Si4J:www.ze...

Can I get a witness?

 

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