I analyze macroeconomic issues from a fundamental perspective, and I analyze market behavior from a technical perspective. Original macroeconomic analysis can be found here and both macro analysis and commentary can be found on my Caps blog. If you like or appreciate my analysis, please add yourself to my Following List

Monday, January 11, 2010

Gold Miner Performance Relative to Gold

My last post looked at Gold Miner Performance: A Look Miner Cost Inputs vs. Gold Price. In this post I want to look at the performance of Gold Miners (GSMs = Gold/Silver Miners) relative to Gold.

Let's first start with the HUI/Gold Ratio. I like using the HUI since it is a basket of unhedged (no gold hedges) GSMs. You will notice there are times then the HUI advances more relative to gold and vice-versa. I have drawn (somewhat arbitrarily) some lines defining when Gold or GSMs are overvalued with respect to it's opposite. The point is to notice how this ratio is trending and when it gets to an extreme reading it is likely to reverse and oscillate the other direction.

In 2000, in the aftermath of the Tech crash (as the markets were still crashing) the HUI sold off faster than gold. In 2001, GSMs were so oversold relative to their profit making ability (the price of gold) that they represented a good "value" with respect to gold. Now, keep in mind, this is a ratio. When a ratio is increasing, it means that the numerator is increasing faster than the denominator OR the numerator is not dropping as fast as the denominator. Outperformance means either moving up faster or not dropping as quickly.

But I have also included the chart of both the HUI (above) and Gold (below) with the HUI/Gold ratio. And you can see during this time, the HUI is growing faster than gold (both are trending up).

This is an important fact that was helping to signal the next bull market (2003-2007).


Because you need to understand what gold is and what it has historically meant: Gold is sound money. Now you may be a gold bear, and think it is a useless shiny piece of ... metal. But the odds of someone of that mindset actually making it far down this post is probably unlikely. However, my point is, there are *many* people who feel this way, even if you don't happen to agree with them. And so it is important to understand what many other investors think. My $0.02, and take away from that what you want.

Gold is sound money, which means it represents safety. It is a safe haven move in times of crisis to go to physical gold or to funds that have claims on physical gold (there is a *very important* distinction to be made here about gold / gold funds / types of gold funds. But I have made them many times before and this is beyond the scope of this post).

GSMs, on the other hand, are leveraged plays on gold. They have reserves in the ground that have to be extracted. You can think of it as a vault (and that is a very good way to think of it) but the economic conditions (GSM cost inputs) may be different when the GSM goes to extract its gold. As such, they are leveraged *future* gold plays. There is more than simply the Gold Price and available liquidity that drives the price of miners. See this post for the HUI correlation with the Gold/Oil Ratio: Gold Miner Performance: A Look Miner Cost Inputs vs. Gold Price

Which brings us to the first key observation: During times of increased liquidity and leverage, GSMs tend to outperform Gold.

This is why I say that the HUI/Gold ratio, in 2001, was pointing to a stock market recovery. Because speculative money (liquidity and leverage) began to increase again in 2001 after the tech crash. GSMs (which are equities that produce a leverage play on gold) began to rise in a rising gold environment. This is why it was primarily a liquidity event and not a sustainable economically driven stock market rally. If this were the case, then gold should have been falling (gold prices and stock prices should *NOT* be positively correlated).

GSMs continued to outperform gold for several years, staying at a very high ratio up until 2007. When the stock market peaked, the HUI/Gold ratio started to trend down. Then in 2008, it crashed. Almost all US Dollar denominated assets crashed. But the HUI/Gold ratio is telling us a key fact about the current market behavior: It is a liquidity / leverage crisis. And your response should be, "No sh**, Sherlock. Everybody knows that's what happened". But what I am getting at is that is still happening (that the bounce was a reliquification act by the Fed, not because of some magic recovery) and the ratio is forecasting another move down. More on that in a minute.

Another key observation is that the HUI and Silver correlate very well.

This makes sense. Silver is as much as commodity as it is a monetary metal (whereas gold is almost exclusively a monetary metal and a commodity only a very distant second). Which makes Silver much more correlated to positive economic activity (where we have sustainable growth in commodities as fuel for productive economic endeavors). This optimism typically occurs during times of leverage and liquidity. Silver is a tricky animal though, because besides it straddling the line between money and commodity, it is also warehoused at a tiny fraction in comparison to other commodities or to gold. My next post in this series will talk about Silver and the Gold/Silver Ratio. I will leave it at that for the moment.

So what does all this mean?

I will, of course, give you binv's take on the issue (after all, how could I give anybody else's taken besides my own ... unless I am actually somebody else ... ?).

First I am bullish on Gold, Silver, and GSMs. I think Gold is is a massive bull market. I have discussed these in many other places (Gold Miner Performance: A Look Miner Cost Inputs vs. Gold Price, Crazy Bullish Gold Count, The Gold Blog. Gold/Silver/GSMs (and a little Oil for good measure), Thoughts on the US Dollar, Analysis of the USDX Long Term, Follow up on the Gold Blog, Steve Saville: Dubai, Inflation, and Gold, Thoughts on the Dow/Gold Ratio) and I think the worst possible call would be to short one of the few asset classes in a legitimate bull market. This, of course, is my $0.02.

But let me get to the unanswered question about the HUI/Gold ratio. I think the ratio is projecting another large leg down. Since March, the ratio has been tracing out a bear flag. A bear flag is a pattern, with a lot of overlapping price action that generally trends up in almost a channel. The tighter the channel with the more touches on the upper and lower trend lines makes the pattern more valid. And this looks like a big bearish flag to me.

So what does this mean for the equity markets?

Remember what I was saying above bout the HUI/Gold Ratio back in 2001. It started from an oversold condition and started to rally up. In fact, the move up looks very much like an impulse move (O Mandelbrot, O Mandelbrot). Compare this to 2007-now. The move started at a high condition (GSMs high relative to Gold) and is trending down, which indicates a flight to safety. On top of that, the rally in the HUI/Gold ratio is *very* corrective looking (my bear flag observation above), which means there is another downleg in the ratio to come. And the first leg was brought on my deleveraging and liquidity locking up. I think the next leg down will be brought on my similar conditions as well as a major loss in confidence of current government central planning activities. But since the Fed, through its massive POMO and liquification efforts, has ameliorated the liquidity situation, the next drop will be primarily based on a loss of confidence. I think this ratio is signaling another large leg down for equities.

What does this mean for Gold, Silver and GSMs?

Like I have said above and before, I believe gold is in a bull market. And all the things I just said that are bearish for equities, are bullish for gold. Gold and equities should *NOT* be positively correlated. And I think the next phase of the crisis will break that correlation. I think the HUI/Gold Ratio is going to take another sharp leg down, which means that Gold will outperform GSMs. I don't think GSMs will crash, and I think it will be one of the few equity sectors that posts gains during the next crisis. But I expect another liquidity crisis and I think that will hold GSMs back, which is why Gold will outperform. Which is also what I think the HUI/Gold ratio is telling us. I could make a somewhat similar case for Silver, but I will make it in my next post.


The point of this post, just like the point of any of my posts, is *not* to try to convince you of anything. I am an analyst who is sharing observations. That's all. It is immaterial to me whether you agree or disagree with my observations or conclusions. But I do hope that my observations are useful in helping you to formulate your own opinion, even if your conclusion is completely opposite of mine.
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