A Better Ratio Than GDX:GLD

Introduction

The Market Vectors Gold Miners ETF (NYSEARCA:GDX) and the SPDR Gold Trust (NYSEARCA:GLD) are very popular ETFs for precious metal investors. It is common to see precious metals authors and analysts referencing the ratio GDX:GLD (or alternatively the HUI to gold ratio) when discussing the relative valuation of GDX. The chart below shows the current GDX:GLD ratio from 2006.

Source: Viking Analytics

Some analysts will suggest that “since the GDX:GLD ratio is under 0.2, then GDX is a screaming BUY BUY BUY!” Even a very good publication such as Incrementum’s “In Gold We Trust 2016” suggests that a low HUI/Gold ratio means that “miners are cheap” and represent a better buying opportunity than gold itself.

While we may agree that GDX and the miners are a long-term buy due to a pending debt bubble and fiat currency gone awry, we don’t suggest that anyone makes an investment decision based upon the GDX:GLD ratio. It can provide misleading information.

There is a better ratio to consider for this kind of decision, and we will provide an overview and demonstrate its superior decision-making ability.

A Better Ratio and Indicator

We propose the following formula, which can be expressed in the price of gold in the futures market (GC1!), or in terms of the GLD ETF. This ratio is a revealing and refinement of a GDX:GLD indicator that we presented in two prior articles, one of which can be seen here.

Source: Viking Analytics

There is a simple reason that the new indicator is superior to GDX/GLD: the ultimate value of gold miners should be based upon the expected future cashflow (or income) from their mines. And a gold miner’s future income is based upon the price of gold minus that miner’s cost of gold production.

Adam Hamilton provides an excellent summary of the GDX gold miners’ quarterly financial reports on Seeking Alpha. The most recent example can be found here. The average all-in sustaining costs for the GDX gold miners covered by Mr. Hamilton have averaged between $850 and $900 per ounce over the last two years. It is important to note that our proposed ratio is only valid for the periods in which there are relatively constant gold production costs, such as the last two years. Of course, one might prefer using the “cash costs” of production ($650 per ounce) rather than the AISC – take your pick. We are merely proposing a new methodology that can be improved upon.

Below, we have graphed (GDX/(GC1!-875) and (GDX/(GLD-86) to show you how we iteratively arrived at the number 86. Not every reader will have a charting program that captures the futures market, and therefore can use the (GLD-86) denominator.

Source: TradingView

When we compare our new indicator GDX/(GLD-86) versus the old GDX/GLD ratio, we can see that there can be key divergences between the two, as below.

Source: TradingView

Our new ratio GDX/(GLD-86) is the blue line, and the old GDX/GLD ratio is the black line. There are two key periods of divergence (highlighted with the green vertical lines) where the GDX/GLD ratio would have led to inferior investment decisions.

For the purposes of showing how the new indicator can help to make better investment decisions, we have assumed that we purchase the recommended security at the green vertical lines, and sell such security when the two ratios intersect, represented by the red vertical lines.

In our prior articles, we visually showed the correlation between GLD and GDX, and reported that the “beta” between GDX and GLD is about 3.25. On average, if GLD goes up 1%, then GDX will tend to rise 3.25%. As a result, we view $3,250 of GLD as having the same “gold exposure” as $1,000 of GDX.

Look back at the graph above. If an indicator is in the green zone, it would be preferable to purchase $1,000 of GDX rather than $3,250 of GLD. If our ratio is in the red zone, it is preferable to purchase $3,250 of GLD rather than $1,000 of GDX.

The table below demonstrates how the new indicator can improve investment decision-making between GLD and GDX.

Source: Viking Analytics

On December 30th, 2015, the new indicator said: “buy GLD instead of GDX,” and the old indicator said, “buy GDX instead of GLD.” The new indicator had almost $120 more in profits from the trade.

On September 6th, 2016, the new indicator said: “buy GDX instead of GLD,” and the old indicator suggested the opposite. The new indicator lost less $ on the trade.

We have been successfully using this indicator for gold exposure allocations. At the moment, we have no preference between GLD and GDX (based upon the current indicator).

Good luck, and be careful!

Disclosure: I am/we are long GLD.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.