"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


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.

A technical look at the US Dollar

Following are some price charts of the US Dollar to give an overview of where it stands from a technical analysis perspective. We will look at all three major time frames, the daily, weekly and monthly as well as a shorter term 4 hour chart.

Let's start first with the daily.
As you can see, the Dollar is trading firmly below all 4 of the major moving averages that I have charted here; the 10, 20, 40, and 50 day. All are trending lower with the 10 day having just completed a bearish downside crossover of the longer 20 day moving average. This tells us that the market is in a decided downtrend as all the moving averages are speaking with the same voice.

The market has moved down right into a major chart support level near 77. On Friday, it briefly penetrated that level but then rebounded and managed to close higher on the day, but just barely.

I should note here that the particular technical indicator I am referencing in this study, the Relative Strength Index, or RSI, is showing a slight loss of dowside momentum and is registering a very faint bullish divergence signal. To validate this signal, the Dollar would need to pull off a strong close above 77.90.

Summary - the market is weak, trending lower but attempting to hold here. Whether it can or not remains to be seen as we head into next week.

Next is the weekly chart:

There are several things to note about this time frame. First all of the same period moving averages, 10, 20, 40 and 50 week moving averages are moving lower confirming the weak pattern. The shorter 10 week moving average however is above the 20 week but is now pointed lower. It made a bullish upside crossover of that same 20 week average on the end of the year rally but once the market failed to extend past the 50 week moving average and turned down it too began moving lower. It has not yet made a bearish downside crossover of the 20 week but is very close to so doing.

The RSI is confirming the weakness in the market as it failed to muster enough strength to even clear the 60 level on its rally of the last few weeks of 2010. This is textbook bearish action when a market in a prolonged bear trend stages a relief rally which cannot pull the RSI above the 60 level. I will not be convinced that there is anything significant going on with the US Dollar until and unless its weekly RSI reading can move past 60 and preferably 65.

Summary: - market is bearish with no signs of positive or bullish divergence with that being confirmed by an RSI reading signaling a bear trend. Price is sitting on top of a weekly support level, which if it cannot hold, will send the RSI down further adding confirmation to the bear move.

By the way, note the huge double top formation spread across two year's time up near the 90 level.

Then we move to the monthly chart:
As with the daily and the weekly charts, the price is trading below all of the major moving averages, 10, 20, 40 and 50 month. These moving averages however are not reflective of a market in a trending move but rather one in a sideways congestion pattern. Note that the shorter term moving averages are actually above the longer term averages but are all pointed lower. In other words, the market is not trending on a very long term basis.

This is also reflected by the RSI which is moving roughly between the 60 and the 40 level. Any pattern like this on the RSI is a congestion pattern with no clear trend.

Summary: The market is basically moving sideways but because price is currently below all of the major moving averages, the bias is to the downside.

Finally we come to the shorter term, 4 hour time frame:
What we see here is a market that tested support near 77 and uncovered buying which took it slightly above 77.50 before it ran out of steam. If the market is going to push higher early next week, it will take out the resistance zone noted on the chart with its top just below 77.60. The RSI is bearish and will remain so unless it takes out its blue overhead line at 60.

King World News - Weekly Metals Wrap

Dear friends:

You can listen to my regularly weekly radio interview with Eric King of King World News on the Metals Wrap segment by clicking on the following link:

Bill Haynes gives his usual great insight into the customer demand side for the metals in the lead in followed by myself talking about the metals action for the past week.