Long-Short Opportunity: Gold Or Gold Miners

Includes: ABX, GDX, GLD
by: Efficient Alpha

In his speech at Jackson Hole, Bernanke failed to increase the probability of another round of quantitative easing, though his language did not rule it out. This is generally negative for the gold trade as gold bulls were hoping for some form of dollar-debasing, inflation-producing program that would continue the metal’s historic rise. Standard & Poor’s chief technical strategist now puts gold prices into a correction that will take it to around $1,500 or a drop of -16.5% from current prices.

While I would not normally step in front of a speeding train, I will on occasion jump in front of the unstoppable asset. In a recent article presenting ways to protect your portfolio in volatile markets, I warned investors of using gold as a safe haven investment. Granted, many investors are moving into the asset as a store of value and consumer demand in emerging markets is increasing, but the number of speculators and ‘arm-chair’ investors has also increased greatly. The commercials on television enticing people to turn their gold into cash or selling newly-minted gold coins reminds me of the advice on technology stocks given out by cab drivers in 1999. I am not fully willing to bet on gold’s swift decline, so will be looking to hedge my bet with a related asset.

The SPDR Gold Shares (GLD) offers investors exposure to volatile gold prices through partial ownership in trust shares which are invested exclusively in gold bullion. The fund pays no dividend, and has an extremely low correlation with the S&P500 of -.04 which means it is statistically not correlated with the index. The fund plummeted 8.1% in the first half of last week until clawing its way back to a loss of 2.7% for the week. Despite the drop, the fund is up over 50% over the past 12 months.

The Market Vectors Gold Miners ETF (GDX) seeks to replicate, gross of fees and expenses, the performance of the NYSE Arca Miners Index. The fund holds 30 publicly-traded companies involved in gold mining. Companies domiciled in developed markets are heavily favored with Canada, the United States, and the United Kingdom representing 82.5% of the total fund but providing some exposure to emerging markets through operations. The fund has an extremely low correlation with the S&P500 of .41 and trades at a price to earnings ratio of 18.4 times. The miners fund saw relative strength last week against the gold fund with a mid-week drop of -6.4% before closing the week with a gain of .4%. Despite its relative short-term strength, the miners fund has significantly underperformed the gold fund over the last 12 months only returning 15.3%. The correlation between the miners fund and the gold fund is .81 meaning that approximately 65% of the price movement in the miners fund can be explained by the gold fund.

The graph below presents the historical relationship between the gold miners and the gold fund. Data is limited and only goes back to May of 2006. A comparison of the miners fund’s largest holding, Barrick Gold (ABX), and the spot price of gold shows similar results. Historically, the gold fund has traded at a premium to the miners. This relationship held fairly constant from 2006, and with ABX from ’93, until breaking down significantly starting in February 2008. The disequilibrium reached its peak in October of 2008 when the world was coming to an end, but has lately approached its lows. If the relationship were to hold today, either the gold fund would trade at $104 or the miners fund would trade at $106. This represents a drop of -41% in the gold fund or an increase of 71% in the miners fund.

(Click to enlarge)

Comparing the returns to the two funds shows a similar story. The returns tracked almost identically until about March of 2008 where the miners took a huge hit along with other stocks, but then reestablished itself in January of 2009. Throughout 2009 to May of 2011, the relationship in returns held fairly consistently with miners managing to outperform for short periods. The relationship broke down in a big way in April of this year and the disequilibrium has only increased. The difference in returns over the past four months has reached 16.5%.

With any trade made on a historical relationship we need to establish whether the current price inequality will regress to the mean or if the relationship has fundamentally changed. One possible reason the relationship might have been altered is that, as a store of value, investors and governments are shifting reserves to gold as U.S. debt and fiscal problems change the world’s perception of the stability of the United States. This may be true in the long run, but I believe the current breakdown is due to other factors. Foreign demand for treasuries has been strong lately, and rates have decreased on strong demand despite the loss of AAA status of U.S. debt.

While I am not yet willing to fully jump in against the gold trade, I do think there is overheating in the asset. Whether this proves to be true in the short or long-run, there is a disequilibrium between the performance of the commodity and those companies that extract it. If investors are truly correct about the continued rise in gold prices, then the miners should benefit as well and the relationship between the two funds should come back to the mean. If losses in gold continue last week’s run, miners should do relatively well considering they have not benefited as much in the run-up. Either way, a long bet on the miners with a companion short of the gold fund could provide relative returns. Comparing the performance of the miners fund and the gold fund reminds me of the comparative returns of the real estate market in California versus the Midwest. While real estate in California has plummeted over the past few years, those prices in the Midwest have done relatively well because they were not subject to the speculative behavior seen in other parts of the country. The same may be true for these two funds.

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

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