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I’m talking about S&P 500 Versus GOLD…

If all you ever look at is price charts, you’re missing out on some very powerful hidden intermarket relationships that can help you evaluate markets and make decisions about where and when to be bullish or bearish.

Trading can be like trying to take a drink from a waterfall. There is a torrent of information vying for your attention. Professional traders know how to cut through all the surface level noise and find the key relationships driving the next big move.

As a trader, you can sometimes get preoccupied with the minutiae of trade execution, where to put your stops or your targets or what types of orders to use, and forget that the success or failure of many trades has as much to do with broader trends and how they are playing out.

We can take a helpful lesson from large portfolio managers: Rather than getting mired in the details of any one trade, they first want to have a better understanding of the bigger picture. Is the overall sentiment bullish or bearish? Where is the money flowing?

A Hidden Way to Measure Market Sentiment

One of the best ways to measure the “risk-on” (bullish) or “risk-off” (bearish) sentiment is through ratio charts. A ratio chart compares two stocks, ETFs, or financial instruments and shows which one is outperforming on a relative basis.

We create the chart by dividing the daily closes of one instrument against the other. This gives us a ratio value that will go up and down as the two instruments change in relative value. Most trading platforms support this type of chart.

By adding a moving average to this ratio line, we can further improve our ability to see significant or important changes in the ratio (relative value) of the two instruments.

When the ratio is above its moving average, we are in a “bullish” or “risk on” condition, and when the ratio is below its moving average, we are in “bearish” or “risk off” condition.

The chart above shows the ratio between the SPY ETF (S&P 500) and GLD ETF (Gold). The red line in the upper box is the ratio. The dark-blue line is the 20-day average of that ratio. The red ratio line will move up when SPY is outperforming GLD and will move down when SPY is underperforming GLD.

Rather than just compare the ratio at one moment in time, we can add a 20-day moving average and more easily identify times and trends when one is outperforming the other. The ratio chart with a moving average makes this analysis much easier.

Key Intermarket Relationships

There are a variety of different relationships between stocks or asset classes that tell us a lot about the state of the markets and investor sentiment.

The S&P 500 index (ETF: SPY) is a broad basket of 500 large U.S. companies. When economic conditions are good and these companies and their investors are optimistic about their growth potential, the SPY will go up.

Conversely, gold has a long history of use as a safe haven an alternative currency or store of value. In periods of turbulence or a market downturn, gold tends to hold onto its value better than many other riskier assets. Gold also tends to have a low overall correlation with stocks. Because of this, many investors diversify their portfolio with gold, and this tends to increase during periods of market turmoil.

Actually, I experienced the critical nature of this relationship when I started my career as a floor trader at 4 World Trade Center specializing in trading gold futures. The oil shocks that devastated the US economy and the stock market during the 1970s were a result of wars in the Mideast and oil embargoes by OPEC.

This resulted in gold running hitting $850 an ounce, running up from $35. The price of the Dow Jones at that time was about the same price. So, it took 1 ounce of gold to buy 1 share of the Dow Industrials. Currently this ratio is over 20 to 1, almost 40 years later. Once that ratio moved back in favor of stocks  it was obvious the landscape had changed and the bull market in equites began in the early 1980s.

By comparing the ratio of these two instruments, we can see when the bulls (SPY) are winning out and more money is flowing into “risk-on” assets and we can see when the bears (GLD) are winning and more money is flowing in “risk-off” assets.

We have used an intermarket relationship and ratio chart to show us the strength of the bullish or bearish sentiment.

If we take this ratio and overlay the bullish and bearish ratio sentiment on a chart of the SPY, we can see when this intermarket relationship was telling you to be bullish and when it was telling you to be bearish.

The chart above shows the bearish and bullish sentiment of this ratio from mid-2008 through mid-2009, covering the worst period of the 2008 financial crisis. While it didn’t get every move correct and there were some short signals that didn’t last very long, following this ratio could have helped you avoid most of the drop in the markets and put you back in not too far from the lows. On balance, as you can see from the chart above keeping track of this and other key intermarket relationships is critical for understanding market sentiment and market timing.