Relative Strength In Gold Miners Favors Miners Over Gold

Includes: GDX, GDXJ, GLD, SIL
by: Market Scholar

Last week I wrote an article suggesting that portfolio allocation to gold miner (GDX and GDXJ) stocks was not an effective way to gain exposure to gold (NYSEARCA:GLD). The article illustrated how the correlation between miners and gold had recently approached zero.

Many people took this to be an outright bearish article on miners, and that was not the intention. I just wanted to highlight that the relationship had changed, and offered a couple reasons perhaps why the relationship had changed. Further, miners have significantly underperformed gold over the last two years, and until that trend showed signs of a change, I suggested one would do best to respect the trend and invest alongside of it.

Given all the comments made, I decided to explore the relationship further. Historical relationships don't last forever, and what is in focus today is often forgotten tomorrow. The analysis completed was longer term, and I personally had no opinion on the current direction of miners.

The best way to look at miners in relation to gold is to look at the relative strength; most clearly illustrated through ratio analysis. Whether you are a fundamental or technical analyst, both schools of thought support the notion of investing in sectors that exhibit positive relative strength. For those unfamiliar, the idea is that relative strength tends to persist over time and that it is often best to invest in securities that exhibit positive relative strength.

Interestingly enough, it appears that ratio analysis favors the miners since the summer, and this could be the start of a new trend. There has been a series of two higher lows and a significant break of the downwards trend that existed for 2011 and the first half of 2012. More plainly stated, relative strength appears to favor the gold miners over gold recently.

A similar pattern is seen in the junior miners; there has been a break of the downwards trend and the Novembers low was higher than the summer lows.

It should come as no surprise that the correlation between silver miners and gold miners is quite high. The 20 and 100 day correlations between silver miners and gold miners are .98 and .97, respectively.

That being said, despite the high correlation, gold miners have underperformed silver miners (NYSEARCA:SIL) over the last year.

From this analysis, there does seem to be evidence that miners may outperform gold in the future. It appears that there is a bearish mainstream consensus on miners due to the poor performance over the last couple of years (respectively so). The change in trend recently however suggests that the future could be different. Typically, mainstream consensus develops well after a trend has reversed. If such a change were to take place, gold miners could see a significant bounce as they catch up to both silver miners and gold. When a security all of a sudden hits the spotlight after being hated on for an extended period of time, there is opportunity for significant price appreciation in a short period of time. RIMM provides us with a timely example of such a change in sentiment, and can often be predicted by performing similar charts analysis (see my instablog for three articles on RIMM that advocated a long when it was in the $7 range).

However, before getting too excited about miners, one must keep in mind that relative strength in miners can still be accomplished with negative returns. Further, the recent change in relative strength is still a relatively new trend, and any deterioration in this trend could point to further weakness in miners. Given the relative strength being displayed in miners, I would say that I am more bullish than bearish on miners, however that opinion could change with the slightest evidence of resumption of prior trends.

Finally, the correlation between gold and gold miners, for whatever reasons, has approached zero recently. Despite this article suggesting that gold miners may outperform gold in the future, one should still consider owning outright gold in a portfolio over gold miners when trying to develop an optimal portfolio. Miners could be a great component of your equity allocation, but shouldn't be considered for your commodity allocation in your portfolio.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in GLD, GDX, GDXJ, SIL, SLV over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.