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March 23, 2009

Gold: Gold Stock Index Ratio Analysis
by Lorimer Wilson

Trading without indicators is like running blind and it encourages emotional trading that is the bane of successful investors. Below are brief descriptions of 5 of the most popular gold mining company indices and how they should be used in conjunction with the price of gold to determine the future movement of gold bullion and gold mining stocks. (For a much more indepth understanding and analysis of these indices please refer to my recent article entitled "Gold Indexes: Comparing and Evaluating the HUI, XAU, GDX, XGD and CDNX".)

The HUI Index

The AMEX Gold BUGS (Basket of Unhedged Gold Stocks) Index (HUI) is a modified equal dollar weighted index of 15 large cap (80%) and medium cap (19.5%) gold mining companies that do not hedge their gold beyond 1.5 years. The 3 largest companies make up approx. 37%* of the index by weight with the remaining 12 companies, at 4-6% each, making up the balance. (*as of March 4th, '09) See: http://amex.com/othProd/prodInf/OpPiIndComp.jsp?Product_Symbol=HUI for more current information.

The XAU Index

The Philadelphia Gold and Silver Sector Index (XAU) contains of 16 large (82.5%) and medium (15%) capitalization weighted companies engaged in the mining of gold, silver and copper. Here the same 3 largest companies account for 48.6% (as of March 4th, '09) of the index by weight. See: www.nasdaqtrader.com/Dynamic/PublicIndex/XAU.txt for more current information.

The SPTGD Index

The S&P/TSX Global Gold Index (SPTGD) consists of 19 modified market capitalization-weighted companies (77.5% large cap; 18.7% medium cap) involved in precious metals (primarily gold) mining. The 3 largest cap companies dominate the index with 51.5% (as of March 4th, '09) by weight. A proxy for the index is either XGD or CMW and both trade in Canadian dollars on the Toronto Stock Exchange. See: http://.ca.ishares.com/product_info/fund_holdings.do?ticker=XGD for more current information.

The GDM Index

The NYSE Arca Gold Miners Index (GDM) is a modified market capitalization weighted index of 31 companies (72% large cap; 22% medium cap and 5.5% small cap) involved primarily in the mining of gold and silver. The 3 largest cap companies again dominate the index (at 30% by index weight) but to a much lesser extent than in the HUI (37%), the XAU (48.6%) or the SPTGD (51.5%). The GDM Index represents the largest cross-section of precious metals mining companies exploring, developing and mining around the world. A proxy for the index is GDX. See: http://www.amex.com/othProd/prodInf/opPiIndComp.jsp?prod_Symbol=GDM for more current information.

The CDNX Index

The S&P/TSX Venture Composition Index (CDNX) consists of 558 micro cap companies of which 44% are involved in the early stages of the exploring, developing and/or mining and 18% in oil and gas exploration. This is the only index that gives insight into the price trends of micro cap companies almost exclusively (99.4%). See: ftp.cdnx.com/SPCDNXIndex/Components.txt for more current information.

So what are the ratios and indicators that should be considered in determining the movement of precious metals stocks and their warrants (where available)? Well, some provide a macro view of how the sector is trending while others indicate trends of a more immediate nature and, as such, when to buy and when to sell. The latter will be addressed in my article next week entitled "Time the Market with these Technical Indicators." This article we will deal exclusively with the macro view.

How Best to Apply the Gold:HUI, Gold:XAU, Gold:GDX, Gold:XGD and CDNX:XGD Ratios

The Gold/HUI, Gold/XAU, Gold/GDX and Gold/XGD Ratios divide the daily close of the price of gold by the daily close of the price of the particular index and when charted over time provide an excellent running representation of relative strength and weakness between the two variables.

When a gold/gold stock (G/GS) ratio is climbing on a chart, it means the top number is outperforming the bottom number. In the case of a climbing G/GS ratio, for example, the gold stocks, as represented by the particular index, are either rising faster than gold or falling slower than gold in order for the G/GS ratio to rise. Conversely, when a ratio is falling, it means the bottom number is outperforming the top. For a G/GS ratio this happens when gold rises faster than the index gold stocks or, far more typically, when gold falls more slowly than the basket of gold stocks.

Usually if any one of the G/GS ratios mentioned here is rising significantly it is during a major index up-leg because gold stocks tend to rise much faster than the gold they mine. Why is that? Well, let's look at it this way: if gold is $800 and the cost of production is $400 and a year later gold is $1000 and the cost of production has gone up by 10% to $440 then the profit of mining the gold has increased from 50% to 127%. As such, the cash flow of the mining company goes up and the size of the resource and the value of the company go up. Therein lays the leverage. If this ratio is falling significantly though, it usually means a major correction is underway in the stock components of the various indices. Leverage is a double-edged sword, so gold stocks fall faster than gold in their periodic corrections. If gold falls more slowly than these various indices it is outperforming these indices and lowering the various ratios.

These various G/GS ratios are best used only as secondary confirmation and not as primary trading signals. Never the less, due to their ease of use and seeming clarity many investors and speculators have been using them as primary decision making sources of information. It is crucial they understand their limitations because their use is subjective at best. For example, should a G/GS ratio sell signal, such as a break under its 50-day moving average, be at 0.1% under for 1 day or 1%+ under for 5 consecutive days or whatever? What if the G/GS ratio goes back above the 50dma? Was it not a real failure then? No matter what decision criteria are used, they are subjective. That's the rub!

It is this great degree of subjectivity that is the greatest limitation of the various G/GS ratios and most other trading indicators and systems. No matter how careful you are with these indicators you have to make many assumptions and they will adversely affect their utility without a doubt. There is absolutely no way around this fact. Thus the various G/GS ratios, as mentioned above, are probably best used as one of many indicators, not just in isolation.

Another problem with the various G/GS ratios is their frequency of flashing signals. They often flash during minor rallies and pullbacks and the more often they fire, the less likely their signals will be useful and profitable.

The point here is that in any G/GS ratio analysis, the more volatile of the two variables tends to overpower the less volatile. Since gold stocks are far more volatile than gold, their movements are more defining for the ratio than those of gold. With unequal volatility, there is never parity between the two variables in terms of their ultimate influence on the final ratio. (To develop your own G/GS ratio chart go to www.stockcharts.com and type in $GOLD:$HUI, $GOLD:$XAU, etc. for the time frame you wish to examine.)

For those interested in reading further on the intricacies of deploying gold:gold index ratios to determine the future direction of either component I suggest 3 articles written by Adam Hamilton over the years, namely: "Gold Bugs Index HUI/Gold Ratio (May, 2005); "HUI/Gold Ratio Limitations" (September 2006); and "GDX Gold-Stock ETF" (December 2007).

The CDNX/XGD Ratio

So what's an investor to do to identify developing macro trends in precious metal stocks and warrants? One ratio to follow closely is that of the CDNX/XGD and another is the level of the Purchasing Managers Index relative to the XAU Index.

As mentioned above, the XGD index follows the performance of 19 large (77.6%), medium (18.7%) and small cap (3.7%) companies and the CDNX that of 558 micro cap companies (99%). Comparing the divergence of each index to the other is an ideal way to determine if a developing trend is equally affecting all mining shares in general, just the large/medium/small cap sector or just the micro venture capital sector. The CDNX to XGD comparison works better than that of the CDNX to any one of the other mining sector indices in that both the CDNX and the XGD are traded on the Toronto Stock Exchange in Canadian dollars whereas the HUI, XAU and GDX indexes are denominated in U.S. dollars and, as such, are susceptible to the influence of exchange rate variances when comparing any one of them with the CDNX.

Gold sector analysts and commentators always assume that the large cap dominated indices, either alone or in relation to gold, indicate the true current trend of the entire precious metals mining sector but that is simply not the case. In doing so they ignore the health and, as such, the price performance of the micro cap gold and silver exploring/developing/mining companies which represents in excess of 80% of the total number of companies in the precious metals sector. A comparison of the CDNX with the XGD reveals a much more accurate picture of what is truly happening in the gold mining sector.

The Purchasing Managers Index

The Institute for Supply Management publishes a monthly Purchasing Managers Index (PMI) which indicates the extent to which the U.S. manufacturing economy is expanding or declining. According to research by John Hussman, when the Gold/XAU (G/X) ratio has been greater than 5.0 (it was 7.0 on March 20th 2009) and the PMI has been less than 50 (it was 35.8 for February 2009), gold mining shares have appreciated at an average annualized rate of 125.6% the year following. In contrast, when the G/X ratio has been less than 3.0 and the PMI has been greater than 50, gold mining shares have plunged at an average annualized rate of -49.9%. Hussman points out that since 1974 the G/X ratio has been greater than 5.0 about 15% of the time and when it has been that high the XAU has followed with annualized gains of 89.6% on average; 27.4% when the ratio has been greater than 4.0 but an extremely disappointing -36.6% when the ratio has been less than 3.0. Given the similar tracking of the XAU with the HUI and the GDX similar percentage changes can be expected from the HUI and the GDX. Such is not the case with the XGD due to the fluctuation of the Canadian dollar vis-à-vis the U.S. dollar in which gold is denominated. (Please refer to www.ism.ws/ISMReport/MfgROB.cfm for the latest monthly data.)

So there you have it. You now better understand the strengths and weaknesses of the more popular gold stock indexes; how ratios operate; the limitations and risks of using gold:gold stock ratios in isolation; how to track the performance of the micro-cap gold mining sector in addition to that of the large and medium cap sector; and understand the insightful relationship of the various indexes to the Purchasing Managers Index.

This knowledge needs to be used in conjunction with a number of technical indicators to determine the short-term direction, stability, strength and weakness of any trends in the price of gold, baskets of large/medium and micro cap gold mining stocks and most certainly individual stocks, be they those related to precious metals mining or any other individual security. Such will be addressed in next week's article entitled: "Time the Market with these Technical Indicators".

Lorimer Wilson

Lorimer Wilson is Editor of www.FinancialArticleSummariesToday.com (F.A.S.T.) and www.MunKnee.com (Money, Monnee, Munknee!) and an economic analyst and financial writer. He is also a frequent contributor to this site and can be reached at editor@munknee.com.

Copyright © 2007-2010 Lorimer Wilson

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