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- Written by Sara Nunnally, Editor, Macro Trader
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Is this the next "bubble" predictor? If the data falls in line, this indicator says we're in for troubling times.
I'm working on a new indicator.
You see, in our eyes, you can't trust the economic indicators the government puts out: unemployment, CPI, GDP... they're all manipulated, adjusted and revised.
I'd rather deal with real numbers, pure and simple. Things like the price of gold, oil and markets.
You might argue that speculators can come in and skew these prices. And you're right. But these skews are also important. They point to bubbles and oversold situations that can be very profitable.
If you play them right.
The indicator I'm playing around with is a comparison of the Dow to the gold-to-oil ratio. I'm calling it the DOG indicator, since it takes the Dow, oil and gold into account.
Historically, the gold/oil ratio is about 15.6, meaning one ounce of gold can buy 15.6 barrels of oil. From a trading perspective, if the ratio climbs above 21, this means gold is overvalued and oil is undervalued.
The reverse is true if the ratio falls below 12.
Here's the chart from BullionBarron.com, but there are several other places you can find this:
Now here's a chart of the past 40 years for the Dow.
What my indicator is trying to do is match up those points of overbought and oversold ratio territories with major fluctuations in the market.
I'm not quite ready to show you the data yet, but there are some interesting points after 1986 that seem to show investor sentiment.
In the buildup to the 1987 crash, the gold/oil ratio was soaring... jumping from its historical average to 25, then to 30.
We know that oil prices were falling... from $22 a barrel in early 1986 to $11.50 by the end of July that year. That accounts for the huge spike above 30 in the ratio.
But then oil prices started climbing again, and the ratio stayed high... well above 20 through 1987.
That is a key sign of a bubble.
Markets were trending higher, which supported oil prices. By August 1987, oil prices were back above $21, nearly a 100% climb in a year.
But gold buyers could feel a change in the wind... the price of the shiny metal climbed and climbed. By the October crash in 1987, gold prices had climbed to $460, more than $100 above January 1986's price.
This move -- if caught by investors -- could have helped protect portfolios from the crash and could have even made investors money.
During the first decade of the 21st century, the gold/oil ratio was sinking... Oil prices were starting to take off from severely low prices in the late 1990s. Gold prices were also dropping. These were the Clinton heydays, when the economy was doing very well, and folks were turning to riskier investments.
Gold took a back seat while the Dow rocketed from about 3,300 in 1993 to 10,729 just before Bush was elected president.
Is it any wonder that the gold/oil ratio fell below 10?
A robust economy was supporting higher oil prices and investors were not interested in gold. The bubble was at full speed.
And the longer the ratio was below 12, the choppier the market got.
This instability was a huge cue for gold buyers to step back into the market. At the end of 2008, as the financial crisis hit, the markets were still higher than they had ever been prior to 1998, but those 10 years' worth of gains were wiped out in six months...
And the gold/oil ratio went from below 7 to above 24 in that same time frame.
All this data is going to take a little while to crunch, and to find out exactly what it all means, but the DOG indicator could be the next bubble predictor.
With both oil and gold seesawing, the ratio has come back down into more of a normal range, but the ratio is trending higher.
Combine that with a market that's back above 12,000 and you could have the makings of a big aftershock in our future.
Protect all your bullish bets with hedges right now. With gold flip-flopping with the dollar/euro tango, it might be best to go with some put options on the major indexes for the time being.
I'll keep you updated on what the DOG indicator is doing, and be on the lookout for more of these real indicators that take all the lies and misinformation from the government out of the equation.
One Lie and One Fact About the VIX
By Jared Levy, Editor, Option Strategies Weekly
My first lesson in the stock market had nothing to do with stocks at all. My mentor sat me down, looked me in the eye and said, "As long as you can understand human emotion and math, you'll make a great option trader."
Since that time, I have studied method after method and indicator after indicator in my quest to master the markets. What I found most interesting is that just about every indicator and method revolves around the emotions of market participants and how you can profit from investor reactions.
It has become more and more difficult in our fast-paced, technologically driven world to gauge what the masses are thinking. Traders are using all sorts of things to look into the minds of investors.
The VIX, oddly enough, has become a tool traders use to "gauge fear" in the market. Many folks even base their trades off this supposedly reliable indicator.
Let me tell you... It is one of the worst things the average investor can do.
Lie: The VIX Is a Fear Indicator
Without taking you to the bowels of math purgatory, the best way to think about the VIX is that it's a complex formula that blends the "implied volatilities" of the first two months of options for every stock in the S&P 500 (SPX). The equation produces a number that is expressed as a percentage.
As I write, that number is slightly over 20%.
But what's it mean?
To understand how the figure should affect your trading strategy, you need to know implied volatility (IV) is a value that is determined backward (hence implied) from the price of an option.
Basically, an IV of 20 says expectations are for that stock or index to fluctuate 20% up or down over the course of a year -- the higher the IV, the more volatility expected and vice versa.
Since options are derivatives of stocks, they are independent of each other. That means if XYZ is trading at $100, and someone is buying 10,000 call options on the stock, then the price of the calls will go up... even if the actual stock isn't moving.
The additional premium represents an increase in IV -- which would send the VIX incrementally higher.
The point of all this is VIX is measuring all SPX options and their IV, bullish or bearish. The number does not care whether fear is pushing prices higher or whether greedy investors are insuring a big bet.
While it is true that IV tends to go up when stocks are dropping quickly, the VIX is NOT a fear gauge. It is a common misnomer about the VIX and is grossly misused in an often ignorant media.
Don't believe the hype.
Truth: The VIX Predicts Movement
What the VIX will tell us, though, is how volatile the markets will be. It does it with incredible accuracy.
In the month of May, for example, the VIX averaged about 21%. Even though the VIX is an annualized measurement, there are ways to extrapolate its value to days, weeks and even monthly terms.
Saving you the math lesson, I will cheat and tell you a 21% VIX predicts an average monthly move of about 6%.
And guess what... that's EXACTLY how much the market dropped last month. But the S&P could have risen by an equal amount and the VIX still would have been an accurate measure of the volatility.
That means we could just as easily call it the "greed gauge" or even the "complacency gauge."
The next time someone tells you the VIX is high and there is a bunch of fear in the market, ask them to tell you just how much fear.
Better yet, ask them to explain how the VIX works. Chances are they won't have a clue.
The VIX can help us as traders, but not in the way you might think. At our upcoming summit in Las Vegas, I will hold a special breakout session on the VIX as well as other indicators you can use to gauge the markets' health in a world where traditional indicators just don't work anymore.
Chart of the Day: The Natural Gas Bottleneck
By Adam English, Associate Editor, Inside Investing Daily
Natural gas is a favorite topic around the ISG office. Quite often, we focus on unconventional plays on the low price of domestic gas. Sometimes it is the changing nature of the worldwide market.
Today, though, I want to look at a global bottleneck.
First, let's take a look at our chart of the day...
The opportunity is obvious when we glance at the chart. Energy companies want to get liquefied natural gas (LNG) on ships and into Asia, where they can take advantage of higher prices.
The problem is moving the natural gas. It's not easy. There is a severe lack of LNG tankers and it is going to get worse. The spot market has been limited to as few as three tankers over the past year and a half.
There are 372 LNG tankers in operation today. Another 140 LNG tankers are expected to be ordered over the next five years, according to the American Bureau of Shipping. At about $200 million per ship, that is about $28 billion in potential revenue on the table.
Chinese shipyards, supported by the state, have dumped container and freight ships on the market and driven shipping rates down by 18%. They lack the expertise to make the more complex LNG ships though. But companies in South Korea and Japan are picking up the lion's share of the business.
South Korean shipyards have won all 13 of the new LNG tankers ordered this year through April. Samsung Heavy Industries Co. and Daewoo Shipbuilding & Marine Engineering Co. have already seen an earnings boost this year as a result.
The bottleneck for worldwide LNG exports is in shipping, and it will take years for shipyards to work through backlogs and fulfill new orders. It is an opportunity we can't afford to overlook.