A Pair Trade In Gold And Gold Miners Offers Significant Upside While Hedging Risk

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Includes: GDX, GLD
by: Douglas Ehrman

Summary

The metal has dramatically outperformed the miners over the past decade.

Over the last year, the relationship between the two has stabilized.

A GDX/GLD pairs trade has significant upside while hedging risk.

While gold prices continue to face swirling pressures from factors including the expected tightening by the U.S. Federal Reserve and strength in the dollar, one trade exists that, after 10 years in the making, appears ready to perform over the long haul: long gold miners and short gold. Over the last decade, the SPDR Gold Trust (NYSEARCA:GLD) has outperformed the Market Vectors Gold Miners ETF (NYSEARCA:GDX) by over 130%. Over the past year, however, the relative performance of the two is fairly close. While the outlooks for precious metals remains murky, there is evidence that a bottom is within reach. This pairs trade provides significant long-term upside, while protecting against further weakness. Additionally, it allows you to capitalize on the management efforts made by the miners to address costs and streamline operations.

A Decade of Divergence

Over the last 10 years, GDX is down about 65% while GLD is up about 66%. This has been driven by a weak stock market, operational issues in the miners, and price sensitivity that has been higher for the corporate entities than the commodity itself. Over the past year, however, the relationship between these two ETFs has stabilized a great deal.

The correlation between GDX and GLD has been over 90% during this period, and, while the trend has been down, there is also evidence of bottoming in the price ratio; the correlation over the past 50 days is over 90% as well.

While looking at only the most recent period distorts the longer-term view of how this price relationship has behaved, when placed into the context of the overall fundamentals, playing gold by attempting to exploit the relationship between these broad ETFs is quite attractive.

Can Gold Find a Bottom?

In a recent piece, Dana Lyons explains the extremely low sentiment for gold speculators relative to commercial hedgers: "as of December 1, Speculators have not been this close to going net short since late 2002 when the gold bull market was just getting started. On the other side, Commercial Hedgers have not been this close to net long since that same time." The conclusion that Lyons draws from this data is that, based on the CFTC's Commitment of Traders report, the so-called "dumb money" is as pessimistic as it has been in over a decade. He sees this as a necessary condition for gold as a commodity to establish a sustainable bottom.

The other big fundamental factors likely to drive gold prices are the Fed, the U.S. dollar, and physical demand. The FOMC is expected to raise rates this week, for the first time in nearly a decade. This is typically bearish for gold, but the gold market has been trying to digest competing forces and decide what direction to go. Last week, weakness in the dollar - usually bullish for gold - was overcast by other forces. Uncertainty in the crude market has not provided any help to the gold market either, but increased demand from Indian and China on weak prices, has provided some support.

Conversely, gold miners like Newmont Mining (NYSE:NEM) have been finding new support as their management teams revamp operations to keep costs down and assure future supply and mine life. Newmont, and the other majors that make up the GDX, have had ample time to streamline operations and position themselves to capitalize on a reversal, or endure a protracted decline. As such, I expect that the miners will begin to outperform the commodity itself looking ahead, making this pair very attractive on an absolute basis. Once the down side protection of a dollar-balanced pairs trade (owning the same dollar-value of GDX as you are short GLD) is included, this trade should provide safety and performance to gold investors.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.