Why you shouldn't get wedded to any market indicator

Over the years, I have had a number of discussions with traders who have religiously embraced specific trading systems and investment disciplines. This is a cautionary tale of how systems fail.

Charlie Bilello won the NAAIM Wagner Award for his work on the lumber/gold ratio:

Lumber’s sensitivity to housing, a key source of domestic economic growth in the U.S., makes it a unique commodity as it pertains to macro fundamentals and risk-seeking behavior. On the opposite end of the spectrum is Gold, which is distinctive in that it historically exhibits safe-haven properties during periods of heightened volatility and stock market stress.

When you look at a ratio of Lumber to Gold, it is telling you something about the risk appetite of investors and the relative strength or weakness in economic conditions. When Lumber is leading Gold, volatility in equities tends to fall going forward. When Gold is leading Lumber, the opposite is true, and equity volatility tends to rise.

History shows that the lumber/gold ratio has been an excellent indicator of risk appetite. The bottom panel of the accompanying chart shows the rolling correlation of the lumber/gold ratio (cyclical indicator) to the stock/bond ratio (risk appetite indicator). The lumber/gold ratio is rising, which is a buy signal for risky assets.

Does that mean that you should bullish on stocks? Maybe.

Consider the copper/gold ratio, which is another cyclical indicator based on a similar theme. The copper/gold ratio is telling a story of economic softness.

Should you be buying or selling? Which indicator should you believe?

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