Are Gold Miners Set to Explode?

 |  Includes: DGZ, GDX, GLD, SLV
by: Scott's Investments

In January 2009 I wrote an article detailing John Hussman's research on Gold and Gold Miners and I suggested at the time that GDX could be a very profitable trade. The subsequent 6 months GDX performed very well, soundly outperforming Gold (via GLD), returning over 32% and returning over 123% between October 2008 and June 2009.

Hussman's analysis showed that gold miner's perform very well historically when the economy is contracting and the ratio of gold to XAU (Gold and Silver Index) is above 5. The current spot gold/XAU ratio is 8.09:

To put some historical context on this measure, since 1974, the Gold/XAU ratio has been greater than 5.0 about 15% of the time. When the ratio has been this high, the XAU has followed with annualized gains of 89.6%, on average – a figure that remains high even if the data is split into multiple samples. When the ratio has been greater than 4.0, the XAU has followed with average annualized gains of 27.4% (though the finer profile of returns has been sensitive to other conditions such as interest rates, economic trends, and inflation). In contrast, when the ratio has been less than 3.0 (meaning that the gold stocks are very elevated relative to the actual metal), the XAU has declined at an annualized rate of -36.6%, on average.

Importantly, the return/risk profile for precious metals shares is strengthened further if the economy is experiencing weakness. For example, when the Gold/XAU ratio has been greater than 5.0 and the ISM Purchasing Managers Index has been less than 50 (indicating a contracting U.S. manufacturing sector), gold shares have appreciated at an average annualized rate of 125.6%. In contrast, when the Gold/XAU ratio has been less than 3.0 and the Purchasing Managers Index has been greater than 50, precious metals shares have plunged at an average annualized rate of -49.9%.

In 1999 Hussman also wrote a piece that detailed some additional econometrics that correlate to the price of gold miners:

Not surprisingly, the combination of all of these is rare but extremely powerful. In the rare instances when 1) The rate of inflation has been higher than 6 months earlier, 2) Treasury bond yields have been lower than 6 months earlier, 3) the NAPM Purchasing Managers Index has been below 50, and 4) the Gold/XAU ratio has been above 4.0, the XAU has soared at an astounding rate of 123.63% annualized. In contrast, when none of these have been true, the XAU has plunged at -53.21% annualized. That's a gaping difference.

The historical analysis suggests XAU, and its components of gold and silver mining companies, do very well under cetain economic conditions. GDX does not perfectly represent XAU and its holdings, but is probably the closest, liquid reprensentation of XAU availble to individual investors.

Are we currently in the optimal period for investing in gold miners?

1) GOLD/XAU ratio above 4-5? As previously stated, the spot gold/XAU ratio is at 8.09, suggesting miner's are undervalued when compared to the price of gold. Answer: Yes

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2) NAPM PMI below 50? The NAPM Purchasing Mangers Index for May was 53.5 so obviously it is not below 50. A number above 50 means the economy is expanding, so current data suggests that the economy is still expanding, albeit slightly. However, keep in mind that all of the previous months in 2011 saw a PMI above 60, so the rate of expansion decline signifantly in May. Answer: No

3) Rising inflation? The current inflation numbers for May came in at 3.57%, above April's 3.16% rate and well above the rate 6 months earlier, Decembver 2010 was 1.50% and November 2010 was 1.14%. Core inflation, while lower, has also been rising versus 6 months earlier. Answer: Yes

4) Falling Treasury Bond Yields? The current 30-year treasury yield is 4.203 versus 4.409. Answer: Yes

Thus, we currently meet 3 of the conditions referenced by Hussman. If or when the NAPM PMI falls below 50, gold mining stocks could be in an optimum position to outperform several asset classes, including gold itself. As it stands now, gold mining stocks still appear undervalued when using the gold/XAU ratio but there is no guarantee that "optimal" conditions will be reached if the NAPM PMI does not breach 50.

There are two bearish considerations that complicate what looks like a devloping bullish case for gold mining stocks. The first is that commodities and gold tend to underperform in the summer. Gold historically tends to perform best in September and generally shows some weakness from March-August. Why is the metal's performance important if we are considering the miners? Gold and gold mining stocks tend to be heavily correlated. While it appears miners are poised to outperform the metal, I would expect a fairly strong correlation between the two to hold. Thus, summer weakness in gold should also lead to weakness in GDX.

Second, the technical picture for gold and gold miners are mixed, at best. GDX recently broke below its 50 and 200 day moving average and the near-term technical picture looks bearish.

GLD remains above both averages, but we have recently stated mixed pictures for the gold - while it is too early to say with any certainty, a double top could be forming. However, there is certainly a bullish techincal case to be made for Gold and GLD - strong support remains at 1500. In the short-term I believe it is too early to say with certainty the direction of gold; however, a break above/below 1500 and the recent high around 1560 should offer some clarity in the near-term direction.

Charts courtesy of Finviz:

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I detailed in June 2009 an alternative trade to simply going to long the miners. An investor "could purchase GDX and short GLD (or as a substitute, use the short Gold ETN, DGZ) until ratios regress closer to the mean. " This pair trade would simply be betting on the miners outperforming gold over the length of the trade. As long as GDX performed better relative to GLD, the trade would be profitable, even if both declined.

In conclusion, with a mixed short-term technical picture, traditional seasonal headwinds, and the economy not yet in "retraction" mode, it may be too early to enter a GDX long position. However, as economic (a declining NAPM PMI), seasonal, and technical conditions develop this summer it will be a trade to keep a close eye on for an optimal setup.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.