Saturday, February 26, 2011

HUI - Gold Ratio, GLD and the Ratio Spread Trade

The following chart details this ratio from which one can determine the performance of the gold shares in general against the price of the actual metal. It was in 2006 when I believe that the hedge fund world began implementing their ratio spread trade, in which they are going long the metal or the ETF and shorting some of the various gold shares. Since that time, the shares have acted as if there was a lead weight upon them compared to the price of gold itself with the exception of course being the announcement of the QE program in late 2008 alongside of the TARP.

You will note that this was not the case during the infancy period of this decade+ long bull market in gold. For nearly 3 years, the gold shares outperformed the metal itself as one can easily see by noting the soaring ratio. (2001 - late 2003).

I do not think it is any coincidence that once the GLD ETF was formed, the HUI - Gold ratio never exceeded the previous peak reached late in 2003. That ETF was formed and open for trading in November 2004. While the ratio did manage to move higher into early 2006, it peaked and then moved lower failing to better its high water mark from late 2003.

If there was ever a vehicle invented to siphon money out of the mining sector shares, GLD was it. Hedge funds and other large players seeking leveraged exposure to the gold price no longer had to go the mining share route but could instead margin up on GLD and play it that way. They also could make a pure play on the metal without worrying about geopolitical surprises, environmental issues, labor disputes, management issues, or dwindling gold reserves. In other words, they could get leveraged exposure to gold without dealing with the other risks associated with buying shares in a particular mining company.

For some hedge funds in particular, this became an opportunity to establish a spread trade in which they could go after companies which might be inherently weak but were merely being pulled higher along with the overall gold sector. Thus was born the ratio trade.

Since 2006, this trade has made a huge amount of money for the hedge funds. When the credited crisis erupted in the summer of 2008, they rode that trade all the way to bottom making a fortune out of it as the stock market collapsed dragging everything remotely resembling a paper share violently lower. Even as gold and silver prices imploded, the price of the gold and silver shares imploded even faster. Translation - the hedge funds playing this ratio trade made a fortune.

That changed rather abruptly in late 2008 when the Fed announced the beginning of a Quantitative Easing policy on the heels of the TARP program. The equity markets saw that as a bonanza for stocks in general and up went the Dow, the S&P, and the Nasdaq. In such an environment, hedge funds and other large players did not want to be short any kind of stocks at all, and they began a violent wave of short covering in the mining shares which sharply reversed the downward trend in the HUI-Gold ratio. The shares began outperforming the metal once again until the summer of 2009 when it appears that the hedgies then began treating the sector differently and re-established the ratio spread trades once again.

As you can see, the ratio has gone nowhere since then and has ground lower reflecting the poor performance of the mining shares in general against the metal price itself.

I believe that we will need to see a pattern emerge on this chart informing us of when this trade is falling out of favor with these gigantic hedge funds before we can expect the mining shares to outperform the metal once again.

The net of all this is that those who buy gold and silver shares will need to do their homework and analyze what they are buying carefully. There are miners out there whose shares are doing very well even in this ratio trade environment. Hedgies will not lean on the shares of these stronger companies because there is not as much profit in it for them. Instead they will go after those issues which they view as having inherent weakness somewhere. One cannot just blindly throw money into the gold or silver miners just because gold and silver are in a bull market and expect to get ahead while this ratio trade is in operation. Do your homework and choose carefully. Getting frustrated and discouraged will not make the hedge funds feel sorry for you and take their marbles and go home just to suit your wishes. It is a ruthless business out there and in order to survive, you must learn to be unemotional about these things.