What the gold-to-oil ratio may be saying about Indian stocks

Are you in the market to sell a few ounces of gold? Check out how many barrels of crude oil the proceeds could buy. The answer might just give you an insight into the direction of Indian shares in the near future.

Okay, no one is asking you to actually empty your bank locker, make a hurried trip to the jeweler and drive home a tanker full of Brent. But calculating the gold-to-oil ratio is an exercise that analysts over the years have found useful in predicting the behaviour of stock markets.

This is how it works:  Take the price of gold (in ounces) and divide it by the price of a barrel of crude. The long-run ratio is about 15 globally, a figure that is considered positive for equities.

A Moneycontrol scan of 22 years of data shows that the Nifty has a low degree of correlation (0.27) with the gold-to-oil ratio. But look a little closer, say, at times where oil has been costly (above USD 90 a barrel) and gold prices have been high or oil has been cheap (below USD 60) and gold moderate, the correlation is more than -0.5, which is considered moderate to strong. Through 2008, when markets were roiled by the financial crisis, the ratio rose, with the correlation a strong -0.6.

In other words, the data suggests that in periods where certain conditions obtain, if the gold-to-oil ratio falls, there is a strong chance that share prices will increase.

Currently, gold is at USD 1,249 an ounce, dipping from a one-month high as strong US economic data drove a rise in the dollar, and oil at just over USD 51 a barrel, gaining on hopes of continued OPEC output cuts. This means the ratio works out to 24.5, much lower than around a year earlier and suggesting a benign environment for equities.

Rewind to early 2016, when oil traded at a ridiculously low USD 27 a barrel. A barrel contains 160 litres of oil; so, applying the exchange rate then prevalent, a litre of oil was cheaper than a litre of your favourite bottled water. Gold then traded at USD 1,100 per ounce, taking the gold-to-oil ratio above 40, a high figure that would have made some market observers nervous.

In the event, nothing untoward happened. That was likely because the ratio was skewed by an artificially low oil price (willfully high Saudi output, plentiful shale oil and the return of Iran to the market); it would have meant real trouble if it had been driven by a high gold price.

That’s because rising gold usually suggests that people are looking for an inflation hedge, or a safe haven. Gold usually goes up when people are uncertain about the future; India is thought to have a domestic gold stash of about 20,000 tonnes and our tendency to hoard the metal over the years has adequately reflected a traditionally pessimistic view of our economy.

A moderately high oil price is ideal because it suggests global demand for goods is robust; too high a price and it begins to pinch big importers like India.

So, with both yellow gold and black gold at moderate levels, equity investors have reason to feel happy.

But just to rain on your parade somewhat: Correlations are open to question, especially the interpretations one makes of them. For instance, the rise in the number of bearded Indian cricketers doesn’t necessarily mean that they are too poor to shave, and that the economy is slowing.