Gold Miners Only if it's Hedged

by Jay Pestrichelli on May 10th, 2012

On April 17th we wrote about Gold and the technical pattern it was forming. Since then it has broken through to the downside and continues to support the bearish bias we’ve seen since its high close in late August 2011. The pattern failed to support the Symmetrical Triangle when it dropped down from 1638 to 1600 May 8th. Let's also mention the 50-day moving average continues to diverge down away from the 200-day moving average.
Due to this breakdown and the pressure of a stronger dollar, we’re not all that bullish on gold right now at Buy and Hedge. However, the question has also been raised, “What about the gold miners ETF, GDX, instead of the commodity itself?” Our answer is an even stronger bearish one. Stay away from the miners as it has severely underperformed the commodity.

The chart below maps 1 year of gold futures against GDX. The chart tells the story that the gold stocks underperform the metal The miners participated in the gold bull run up to May 2011, but in the last 12 months have disappointed dropping 24% vs. the commodity itself that is up 5%.
But for those that feel gold will rebound and the miners will come back even stronger than the underlying commodity, consider creating a pairs trade. Going long GDX and short gold or GLD, the gold ETF, would profit if the gap between GDX and gold closed over time. It doesn’t matter which way the underlying symbols go, as long as the difference in price closes.

Historically, back to May 2008, GLD and GDX have had a high correlation, over 80%. But in the last 12 months, that correlation has dropped to 61%. This means there is still correlation, but not as strong as it used to be. For example if we take out the last 12 months and look from May 2008 to May 2011, the correlation is 91%. If GDX and GLD were to return to that ratio, then this pairs trade would work well.

We can also see that the spread or difference between the prices of GLD and GDX is at a high for the last year. The chart below illustrates the price difference of two equally weighted price positions. This analysis was done using and compares 3.5 shares of GDX vs. 1 share of GLD.
So if there is an expectation that this gap will reverse, then playing a pairs trade will pay off. The great thing about that trade is it is hedged and directional bias is irrelevant. However, we need to remember that the trade will lose money if the current trend continues and GDX continues to under perform GLD. This is not an absoule hedge and while the odds of a total collaps of the relationship between the miners and the metal itself are low, it can occur and can be damaging ignored, so be careful.

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