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Gold: Gold Stock Index Ratio Analysis

Commodities / Gold & Silver Stocks Mar 24, 2009 - 04:04 AM GMT

By: Lorimer_Wilson

Commodities Best Financial Markets Analysis ArticleTrading 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 ( B asket of U nhedged G old S tocks) 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 4 th , ‘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 4 th , ‘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

Lorimer Wilson is an economic/financial analyst and commentator who has written numerous articles (do a Google search for details) 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, analyses of gold mining indices and gold:gold mining index ratios and market timing indicators.

He is a Contributing Editor to www.preciousmetalswarrants.com and contributor to a large number of other precious metals, financial, economic, investment and op/ed sites. He can be contacted at lorimer.wilson@live.com .

© 2009 Copyright Lorimer Wilson- All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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