Trading without indicators is like running blind and it encourages emotional trading that is the bane of successful investors. Below are 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.
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)
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.
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.
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.
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%).
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 falling 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 rising, 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.
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.
Use 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.
About the Author:
Lorimer Wilson is an economic/financial analyst and commentator who has written numerous articles on the major economic and financial crises (past, present and impending) of our times plus articles on precious and rare earth metals, investing in times of crisis, market timing indicators and analyses of gold mining indices and gold:gold mining index ratios. He is a contributing editor to
www.preciousmetalswarrants.com can be contacted at lorimer [dot]wilson[at]live[dot]com.