Gold has a strong inverse correlation with the USD. When the USD is rising in value, gold is typically falling in price because it is priced in dollars and it takes fewer stronger dollars to by an ounce. When the dollar is losing value or inflating gold will rise in value because it takes more weaker dollars to buy an ounce. This rule is true 80% of the time. However, periodically these “twins” will diverge and this is what presents opportunity to traders.

As explored in detail in this video on Learningmarkets.com, about 80% of the time the price of gold and the U.S. Dollar are correlated.

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Let’s compare an ETF that tracks the price of gold, GLD, with the EUR/USD forex pair as a proxy for the value of the US Dollar. Because the US Dollar is the quote currency in that forex pair these two instruments should have a very positive correlation. Currently, this positive correlation has broken down and the two markets are diverging. This has happened in the past and will happen again in the future.

For another take on the relationship that gold prices have to the forex, click here.

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What traders look for when this divergence occurs is a reversion to the normal correlated relationship. The divergences are typically short term and the subsequent correction can be quite dramatic. In the current case, gold is rising in value at the same time that the USD is also rising in value driving the EUR/USD down. The question is not whether they will come back into line with each other but whether that correction will be a decline in gold prices or the value of the USD.

Strategically this opportunity could be addressed in the same way you may approach a pairs stock trade. Shorting the instrument that is rising (GLD) and taking a long position on the falling instrument (EUR/USD) could provide a nice opportunity to profit. What you are trying to accomplish with this trade is to capture the the profits available when these two assets merge back together. 

Alternatively this signal can be used as an indicator that volatility is coming for forex or gold traders already in the market. In the video I will cover two recent examples of divergences that corrected very quickly and could have taken traders by surprise. Traders can take action to remove some of their market exposure in light of the pending volatility by covering long gold positions or short EUR/USD.  

Contributed by John Jagerson via Learningmarkets.com

The past year has been gloomy for most investors. But the brave souls who bet on American Italian Pasta Company (AIPC) would disagree.

As you may have deduced, the company produces pasta — 300 different varieties of it. Its stock price jumped by over 350% in the last 9 months, while the S&P 500 plummeted 40%. Historically, such stunning results have been confined to companies that became overnight monopolies by virtue of research. In most cases, however, those companies did not produce pasta.

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It makes one wonder whether AIPC has invented some sort of revolutionary hi-tech pasta. While an awesome concept, more likely is that investors have been gravitating towards consumer staples for fear of recession. Pasta is about the cheapest filler food Americans know – almost like the end of the line in terms of saving costs – and, should the economy continue to degenerate, more and more people would find it appetizing.

While I cannot claim to be an oracle for American dietary fad, I find the story of the superstar pasta company to be baffling. With a market capitalization of $471 million and earnings of $19 million in 2008 the price to earnings ratio for the company stands at a stellar 24. To put that into perspective, both Google and Kraft Foods have P/Es of 19. Traditionally, higher P/Es have been the prerogative of companies expected to grow rapidly. Thus the ratio, in this case, would indicate investors are expecting AIPC’s growth to outpace both Google’s and Kraft’s.

And amazingly, odds are they’re correct… but only in the short term. If the recession positively affects America’s love of pasta, AIPC is well placed to be a beneficiary. The real question is whether the benefit is worth a 350% premium over last year’s price? After churning in loses of $100 million in 2005 and another $30 million in 2006, the company became profitable in 2007. Revenue growth between Sept. 2006 and Sept. 2008 was nearly 30%. What this suggests is that the company needs to maintain production above a certain level to cover its fixed costs. Once that has been achieved, its high gross profit margins allow it to pocket most revenues.

Readers will notice that AIPC’s growth has correlated with the tanking of the US housing market. However, no recession lasts indefinitely, and thus we can hardly expect AIPC to continue doubling its net income every year. In order to maintain its stellar revenue and earnings growth, the company needs to add production capacity. That does not happen overnight. Additionally, the possibility of increased US prosperity (and decreased pasta consumption) means that the management has to be careful about this option. Even if AIPC doubles its net income to $40 million in 2009, the company would find it difficult to maintain that level of profitability in the long-run. This is because the company does not operate as a monopoly — there are other pasta producers in US, including Kraft Foods, the Goliath of the food industry. Basic economics suggest that, due to competition, high margins do not last forever. Basic economics also suggest that Wal-mart will wrangle out every bit of margin out of its suppliers. Unfortunately for AIPC, Wal-mart accounts for 23% of their sales.

To their credit, the company does have a decent operating cash flow. But a 13x price to operating cash flow is hardly impressive, especially for a company that pays no dividends and makes minimal stock buybacks. Investors could do better by holding on to corporate bonds.

AIPC tells a great story. But it is yet another stock that made its investors forget that a share is not a claim on just next year’s earnings, but on earnings forever. Unfortunately, in this story, the forever is not so thrilling.

Disclosures: None

Lately we’ve been talking a lot here at the Daily Angle about book value, and for good reason; with the economy down like it is, investors have a (potentially) once-in-a-lifetime opportunity to buy some high quality stocks at bargain prices. One of the metrics value investors have long used for finding undervalued stocks is the price to book ratio. It is thought, conventional wisdom states, that a company trading below book value (i.e. a price to book below 1 ) is generally a sign of a bargain stock. However, depending on the source of your information (that is to say, the financial portal from which you are doing your stock screens) the price to book value that you are heeding may be incredibly misleading. Despite the fact that Benjamin Graham’s monumental Security Analysis defines book value as the sum of all tangible assets, many screeners and finance portals include intangible assets and/or goodwill in their calculations of book value. So common is this practice that, to get to the heart of the matter we have decided to devise a new metric (which is actually an old metric in disguise). We’re calling it Price to book to Price to Tangible book to clarify the impetus for the derivation, but really that just works out to tangible book value to book value. In otherwords, what percentage of total book value is made up by tangible assets? We ran a screen for big(ish) companies with a low (under 1) price to book, then opened up their balance sheet and calculated our own metrics to look further under the hood. (Incidentally, these numbers are coming from manual calculations using the current market cap, rather than book value per share.) Here are three interesting stocks, we found in the screen.

1. Dow Chemical Company (DOW)

Price to book: .745

Price to tangible book: .970

Price to book to Price to Tangible Book: .768

To be honest, I was expecting the P/B/P/TB to come out much lower for a company like Dow, whose products have tremendous brand recognition (did you know that styrofoam is a proprietary brand?). I would expect that sort of thing to rack up the intangible assets and goodwill points, but interestingly, it does not. Still, while the difference between a price to book of .734 and a price to tangible book right around one is a testament to the strength of DOW’s intangibles (e.g. their brands) a price to tangible book under 1 may be an indication of an overly deflated stock price. 

2. Alcoa (AA)

Price to book: .643

Price to tangible book: .971

Price to book to Price to Tangible Book: .662

The balance sheet lists no intangible assets, but a fair amount of goodwill drags the company’s P/B/P/TB somewhat lower than I expected for a company that does nothing but create industrial grade aluminum. While a price to tangible book below 1 is nothing to scoff at, the value here is not nearly as stark as it initially appears upon first glance at the simple price to book.

3.Pioneer Natural Resources Company (PXD)

Price to book: .604

Price to tangible book: .663

Price to book to Price to Tangible Book: .911

Pioneer Natural Resources is a major oil and natural gas drilling company. The P/B/P/TB is an intriguingly high .911, something I wouldn’t have expected even from an oil company. A quick run down their balance sheet indicates no intangible assets whatsoever and very little change in goodwill year over year. Likely, the deflated price can be pegged directly to the financial crisis of October and the resulting plummeting oil prices. That said, the company also has a suspiciously low current ratio (.842) that raises a red flag for a business of this size. If and when oil prices rebound, expect Pioneer to bounce back with them.

Disclosures: none.