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Gold Mining Stocks: Still a Buy

|Includes: VanEck Vectors Gold Miners ETF (GDX), GLD, GOLD, SLV
On June 20th I wrote about a potential Gold Miner / Gold trade.  The basic premise is that a) a Gold / XAU ratio above 4-5 is bullish for Gold Miners or bearish for the precious metal gold, b) a NAPM PMI below 50 is bullish for gold miners, c) risking inflation is bullish for miners, d) falling treasury bond yields are bullish for miners, e) seasonality could create some headwinds for the price of gold this summer

This summer we have seen points a, c, and d come to fruition.  The recent NAPM Manufacturing PMI number, while relatively unimpressive, still shows a growing economy with a reading of 55.3 for June.

The current Spot Gold to XAU ratio is around 7.35.  This ratio will behave closely to the ratio of GLD to GDX.  The ratio of GLD to GDX is currently 2.6.  At the time of my original article in June, the Gold:XAU ratio was 8.09, meaning GDX has outperformed spot gold since the original piece.  A ratio of 7.35 is still high, however, by historical standards; thus, there is still value in gold and precious metal mining stocks relative to the price of gold itself.

 There are only two potential headwinds preventing GDX from reaching the "optimal" trade setup.  The first is seasonality, as commodities tend to under-perform in the summer.  However, this is not necessarily a hard-fast rule, it is simply an historical observation.  Thus, we could buck the trend this year.  The second headwind is that the economy, as judged by the aforementioned PMI, is still expanding.  This could change, but to date  the data does not yet put us in "optimal" position for a trade. 

Nevertheless, GDX has too many factors in its favor to ignore as a potential long trade.  For those investors nervous that gold could retreat this summer (despite hitting a new high this week), a long position in GDX could always be hedged by a short position in gold.

 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.

Hedging your GDX position in this manner could potentially hurt returns if both gold and the miners continue to move higher.  However, the purpose of the hedge is simply to reduce potential volatility if we see a decrease in the price of  both.  The hedged trade could turn into a losing trade if the ratio of gold to mining stocks reverses its recent course and heads higher again.  However, I expect any move higher in the ratio to be short lived.

For those looking to time an entry into either GDX or GLD, the next few sessions could give us a clue as to whether the recent move in gold is "for real", or just a headfake.  As Christ Vermeulenpoints out here:

As you can see from the chart below, gold is making a new high. The big question is if it will do what it has done many times in the past, which is make a new higher for only a few days to get the general public (herd) long, only to then get sold into and come back down? The next few sessions will give us a better feel for this breakout/rally.

If the recent high in gold holds in the short term, we may be bucking the seasonality trend and heading higher.  If so, I expect a position in GDX to be a more profitable long trade than simply owning the physical commodity.