"When misguided public opinion honors what is despicable and despises what is honorable, punishes virtue and rewards vice, encourages what is harmful and discourages what is useful, applauds falsehood and smothers truth under indifference or insult, a nation turns its back on progress and can be restored only by the terrible lessons of catastrophe." … Frederic Bastiat

Evil talks about tolerance only when it’s weak. When it gains the upper hand, its vanity always requires the destruction of the good and the innocent, because the example of good and innocent lives is an ongoing witness against it. So it always has been. So it always will be. And America has no special immunity to becoming an enemy of its own founding beliefs about human freedom, human dignity, the limited power of the state, and the sovereignty of God. – Archbishop Chaput

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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.


  1. Thanks, Dan. Have a great weekend! TF

  2. This is very important info regarding miners. I've been trading some, but am not in the "60%" that you hear on some sites, where some of the subscribers think a full portfolio of miners is the key to their future wealth...

    Thanks, Dan!

  3. This is such an insightful blog Dan. In light of the reference by Jim yesterday to the imminent rule changes for those holding short positions what are the implications fort the ratio trade?

  4. Greetings Dan, just a quick note to thank you for all your efforts. Much appreciated.

  5. Thanks Dan! As always right on the money. Extremely timely.

  6. GREAT article Dan.....I've played the gold mining sector and have noticed that several of them have underperformed .......such as AUY GG GFI ....but not my special baby.....ANV oooo yeh

  7. Another great article Dan. A must-read, keeper post for all that invest in mining companies.

  8. good stuff dan. i agree that gld has hurt the performance of the shares. i've been saying that for years. the fact is,it is a lot easier for folks to buy/trade gold than it was in the last bull. folks that weren't savvy enough to trade gold futures settled for the next best thing-the shares. on the one hand,i continue to expect the shares (esp the juniors) to someday deliver eye-popping returns. on the other,it is getting harder to see the catalyst that really kicks the trend off in a meaningful way. positive actions like aggressively increasing dividends(esp the majors) certainly can't hurt their cause. and income is something that physical gold or paper gold or leveraged paper gold doesn't pay

  9. speaking of a catalyst to light a fire under the shares.....a few more acquisitions in the space might be just what the Dr. ordered. i was hopeful that nem's recent move with frg would do just that...not so much,at least not yet. apparently even MORE PATIENCE will be required of the pm share investor

  10. Is there a list of non-hedging miners anywhere?..

  11. Hi Dan, I believe the rules regarding exemptions for the short sale of shares are being re-introduced this week. Do you think this will have any effect on the Ratio Spread Trade?


  12. WE all have known that GLD was introduced to better control the price of gold by the bullion banks. Anyone -I would say gold bug reading this blog- buying GLD is just giving the ammunition to the bullion banks and should not be surprised by the lack of performance by the miners. Are the new regulations going to stop this miers's shares killer is what Dan should explain here.
    I will add that many juniors are not DIRECTLY affected by the trade but INDIRECTLY following the general gold indexes.

  13. I third the motion for an explanation in laymen's terms as to what the new FINRA rules effective on Monday FEb 28th are all about!

    a) What do they mean (in english)?
    b) What are the likely implications on spot price?
    c) I'm confused as to who has the higher authority over the silver comodity market, the CFTC or FINRA?
    d) How might the FINRA rule impact the likes of JP Morgan whom are supposedly naked short ridiculous ammounts of silver? Didn't the CFTC recently rule that they were exempt from position limits?

    Thanks in advance!

    Here's the article we are referring to:

  14. Great article ... and I suppose if they hedged the currency then they could make the same play on Gold stocks in Australia ...

  15. great list of miners here

  16. I think GLD could blow up and be uncovered as a scam when enough big investors demand delivery. The HUI did reach new highs last year and will reach new highs this year as well. The shorts are challenging for sure but in due time I think the HUI can go to 2000

  17. This was a terrific article but, to adopt military parlance, it lacked actionable intelligence. It would have been useful if you had provided a methodology to sort the miners whose shares you believe will not be "leaned on" by the hedgies from those whose shares will. Or better yet, a list of companies that fit your criteria.

  18. I've experienced this first hand as I started buying miners of every size a few years ago prior to most of the etfs. Most recently, GSS is getting smacked down hard. - Previously, I've seen other take a beating and come back. Dan - What are your thoughts on buying when these smaller miners are beat up and bleeding. If the fundamentals are decent, wouldn't it make sense that they will see large percentage gains somewhere down the road?

    Thanks for all your information

  19. blythe_masters;

    Thank you for the comments.

    Please understand that I am not in the business of giving out specific investment advice particularly in regards to individual equities as I am a professional commodity futures trader and not a financial advisor.

    Pull up the price charts of the issues you are interested in and compare those charts to the best performers in the sector and then do you own due diligence and choose accordingly.

    I can tell you that I would never invest money in any company that I did not understand their business model or business plan and had not first spoken with their investor relations department.

    Yes, that requires a lot of time but then again, investment capital is precious and well worth the time that one takes before investing it into anything.

  20. Visitor:

    One thing I have learned over the years is that in order for a stock or a commodity to advance, it must have a broad base of investor or trader partcipation.
    It does no good for example to buy a stock that you think might be a good bargain if no one else feels the same way about it. It will take more and more investors to take notice of the stock and want to buy it before it begins any sort of serious sustained advance.

    What I believe is a good path to follow is to do the type of research that you are doing, (due diligence) and then regularly (and i do mean regularly - daily) check that price chart of that stock to see if it is giving any sort of buy signal on the technical price charts. Then you can feel a bit more comfortable commiting capital to that issue.

    I look at my investment money as an extension of myself. in other words, it is a tool, a device let's say, that can be used to generate additional money if I invest it wisely. For that to occur, I need others to feel the same way as I do about a stock. That shows up when the stock breaks out technically to the upside as it tells me that others want to own it.

    If you invest in a company too early, you might eventuallly make money but while you are waiting, if the stock goes nowhere because no one else wants to own it, you have what I term a lost opportunity cost. In other words, your money could have been working someone else garnering a return on investment instead of sitting in a stock that is going nowhere for the time being.

    That is the name of the game - you invest because you want to make money and the way to make the most money is to buy the stocks that others will want to own.

    You can oftentimes we RIGHT, but be way too EARLY.

    Make sense?


  21. Dan, very good advice. Thank you.

  22. Dan, by the way, I owned a lot of Yamana in 2009 and could never figure out why it wasn't appeciating appropriately relative to the price of gold - very frustrating as I was very overweight in it. Now I know. Thx.

  23. Dan,
    What are possible scenarios as this trade is unwound? What if they just unwind their shorts and stay long the bullion? Seems bullish for the long term in general to the novice. Am I missing something?

  24. I read the article about the new FINRA rules on JSMineset, and Sinclair's view that they would cause a panic among the shorts.

    As much as I'd like to believe it - since I'm a long suffering holder of several juniorrs - the charts tell the story. If the new FINRA rules were a serious threat, these hedge fund guys would've seen them coming and closed their shorts and unwound their ratio trade months ago. No evidence of that in the charts. So I have to go with Dan on this one... as much as it pains me to admit it.

  25. Bron - just a bit of further elucidation on this - the ratio spread trade means that you are going to have to be selective in the miners that you choose for your portfolio. Before I bought any particular miner, one of the things I would do is to chart its performance against either the HUI or the XAU index. Then I would chart its performance against the leaders in its division. If it is a major compare it to the best performing major; if it is a mid-tier; to the leading mid-tier and if it is a junior, compare it to some of the leading juniors. You can spot the laggards by so doing.

    Now in some cases, the laggards might have been so beat up that they are undervalued and are good buys. However, until you get a concurrence of buy signals on that particular stock, putting money into it too early means that you are open to the pressure from the ratio trade. Once the stock generates a solid buy signal on good volume, there is then a chance that the hedge funds are blowing out of that particular issue. You just have to be much more active in your position management and stay on top of things.


  26. DocJim - I think that the trade will be unwound by rotation from individual miners onto different miners. I do not think that they will completely lift the trade as it has been too profitable but they will move out of a particular issue if it looks as if they cannot beat it down any further. then they will go and look for another weak sister to prey upon.
    One of the things that this trade can do is to so depress the price of particular shares that it renders that company a takeover or buyout candidate. In that case, hedge fund shorts will get slammed in that issue. Again, this will show up on the price chart.


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