A Hedged Gold/GDX Trade

I had previously written about the Gold/XAU ratio and some hedged investment opportunities. The strategy was inspired greatly by the research of John Hussman. According to Hussman, since 1974 when the ratio is above 5, the XAU has followed with annualized gains of 89.6%. When the ratio is above 5 and the economy is weak as signaled by an ISM Purchasing Managers Index below 50 (indicating a contracting manufacturing sector), gold miner shares have appreciated 125.6%. The current Gold/XAU ratio is 7.01 and ISM PMI for March is 36.3.

After nearly 13 weeks since the original article was written, here is an update on the performances of the gold ETF (GLD), the short gold ETN (DGZ), and the gold miners ETF (GDX) as well as ratios:

Symbol	1/13/09 Open	4/3/09 Close	Return
GDX	28.97	34.87	20.37%
DGZ	27.64	25.43	-8.00%
GLD	80.94	87.59	8.22%
Gold	823.9	893.3	8.42%
XAU	106.86	127.56	19.37%
Gold/XAU	7.71	7.01
Gold/GDX	28.44	25.62
Symbol	10/28/08 Open	4/3/09 Close	Return
GDX	17.16	34.87	103.21%
DGZ	31.7	25.43	-19.78%
GLD	73.03	87.59	19.94%
Gold	731.6	893.3	22.10%
XAU	64.37	127.56	98.17%
Gold/XAU	11.37	7.01
Gold/GDX	42.63	25.62

I had originally suggested a conservative investor could purchase GDX and short GLD (or as a substitute, use the short Gold ETN, DGZ) until ratios regress closer to the mean. Obviously, GDX does not perfectly represent XAU but is highly correlated and holds many of the same companies. One could purchase all of the holdings of the XAU index in order to duplicate it exactly; as easier strategy for the common investor would be to use the GDX ETF. The other suggestion was that more aggressive investors could just make a one-sided trade by going long GDX or shorting gold, depending on one's analysis of the previous metals sector and the conviction of that analysis. The easy money in the mining sector was made at the end of 2008, however given the ratio is still at high levels, I think there is some money left to be made using a long/short strategy on the gold/xau(gdx) ratio.

If we were to assume the gold/gdx ratio would return to a ratio of around 19 or less (a rough equivalent to a ratio of 5 on the gold/xau using the current gdx/xau ratio of .273), then that would project to a price of $47.02 on GDX, an appreciation of 34.9%, if we assume the current gold price of $893.3. If GDX were to remain unchanged, using a ratio of 19 gives us a price of $662.5 on gold, a decline of 34.8% in gold.

Using the Gold/XAU ratio, we come up with similar numbers using a ratio of 5. At current gold prices XAU would be at 178.66, an appreciation of 40%, or at a constant XAU of 127.56 and a ratio of 5, gold would be at $637.8. A more likely scenario is we end up somewhere in between in the near term. The risk in this trade is that the gold/xau (GDX) ratio reverses its recent downward trend. However, given the current distance from historical levels this is unlikely in the intermediate term. To mitigate this risk, one could use stop losses in this trade.

Below is a chart of the recent returns of gold vs. GDX, weekly gold/GDX ratio and a chart of the weekly gold/XAU ratio.

click to enlarge images

Disclosure: No Positions.

Comments

[Scott's Investments]

The new Seeking Alpha 'instablog' system did not allow me to upload images - I have contacted Seeking Alpha for a resolution. In the meanwhile, just click on the links to view the charts.

2009 Apr 06 06:17 PM

[blog.kerdos.com]

As we mentioned before , we think the gold price is going to trade in a range and the best strategy is to sell naked strangles on GLD and GDX.
e.g. short GLD June 95 calls and short June 80 puts. If GLD ends anywhere within that range, you will get to keep the premiums, and gold fanatics can go buy some physical gold to caress, admire, and cuddle up to.

2009 Apr 07 11:39 AM