Thursday, 9 June 2016

Gold relative to the Philadelphia Gold & Silver Miners index

The past cyclical gold bear market has been both lengthy and severe for the precious metals, but for precious metal miners it has been detrimental. 'How devastating the gold and silver miner bear market has been' is well illustrated when plotting a miners index together with gold on a comparable scale.

Long term Synoptic Views

The Philadelphia Gold & Silver Miners sector index (ticker symbol ^XAU) started off on Jan 19, 1979 at 100. For the record: gold quoted at $230.5 on that date, the USD was weakening and inflation (9.3%) was accelerating to double digits. The POG/^XAU ratio started off at 2.305. Miners lagged the speculative surge of the gold price late 1979 and in Jan 1980. (See Decades of Under-performance for more evidence.) Therefore that low ratio value was not sustainable.
The Yahoo historic time series of the ^XAU starts on Dec 19, 1983 when the ^XAU closed at 107.06. Back then gold quoted at $375, down over 50% since its Jan 1980 intraday high of $850.
A ratio of the gold price in USD/Oz divided by the Philadelphia Gold & Silver Miners index is commonly used and also published daily on Kitco. Its value on Dec 19 of 1983 is 3.503.
Throughout the 20th century, the Gold Price used to be between 3 and about 5.5 times higher than the Philadelphia Gold & Silver Miners index. A reading of 3 used to provide a good opportunity for arbitrage from overvalued miners to bullion, while the opposite boundary was a decent moment to sell bullion in favour of gold miners. (Note that there were no ETF's for either asset classes in the 20th century).

Fig. 1: Very long term graph of gold (blue graph on the left axis) and the ^XAU (red on the right axis)
Main divisions are 4 years, smaller divisions are 1 year. (click for maximum enlargement)

On the long historic graph, scales for gold an the ^XAU differ by a factor of 5. Trading opportunities existed when the ^XAU peaked distantly above the POG or dipped below. During the 1999-2000 gold bear market, the Gold/^XAU ratio never weakened below a reading of 6.338, reached on Nov 17, 2000. During the early 21st century gold bull market, the ^XAU is still following closely the gold price, whereby the ratio of 5 now has become more indicative and miners less often look far overbought. We have a look in somewhat more detail on the below 21st century graph:

Fig. 2: 21st century graph of gold (blue graph on the left axis) and the ^XAU (red on the right axis)
Main divisions are 2 years, smaller divisions are 6 months. (click for maximum enlargement)

The 2008 financial crises is disruptive for gold miners which slide far more than the relatively mild (albeit nearly 30% from its March 2008 top) retreat of gold. Though the ^XAU recovery is swift, a permanent impairment remains: miners are never going to reach their previous value relative to gold.

Makeover of the Philadelphia Gold and Silver miners index

The ^XAU and the HUI used to have approximately the same number of components. The main difference being that, in order to be eligible for the HUI, miners ought not to have any hedging contract on their precious metal production for a period more than 18 months. Hedging, if any should be restricted to a tactical forward sale, not a strategy of forward sales.
Recently the coverage of the ^XAU has been extended. The index now counts 30 components. They are gold or silver miners and also include a few major explorer/developers that have proven and probable reserves. The ^XAU is a capitalization weighed index. Miners need to have a listing on the US Stock market: e.g. Newcrest Mining and Fresnillo plc are not eligible because of this. Index weights of the individual components should not exceed 30% and the top-3 should not exceed 60% of the total market capitalization of the index. You can find the complete index methodology here.
Currently the larger three components are Barrick, Newmont and Goldcorp with index weights of 14.4%, 12.1% and 9.9% respectively on June 8, 2016. Eight components have an index weight less than 1%.

Gold / ^XAU ratio

The disruptive 2008 financial crisis ended many trading rules that had held for decades. This also applied to the ratio of Gold to the ^XAU value. The below graph gives a 21st century overview of that ratio.

Fig. 3: 21st century graph of the Gold/^XAU ratio (click for maximum enlargement)

The Gold/XAU ratio on this 21st century graph indicates the autumn 2008 breakdown of the long existing trading range. The Gold/XAU peaks above 10, meaning that gold miners have slid to half their relative value that could be upheld during the decades before. Even the 1999-2000 gold bear market only seems a minor blip on the scale of this graph. Contrary to many investor expectations, the old trading rule never gets re-established post 2008. During 2009-2010 a new equilibrium around POG/^XAU ranging about 6-8 seems imposing itself as a new norm. Yet, even before the onset of the gold miner bear market, it has become obvious that the former logic is not sustainable any longer.
We therefore focus on this second graph of the Gold/XAU index.

Fig 4: Gold to ^XAU ratio since 2010 and throughout the gold miner bear market, click to enlarge

During 2011 precious metals continue strengthening: Silver to its late April 2011 $49 top and gold to its late Aug / early Sept $1920 double top. Miners however are lagging the metals: ^XAU rises less percentagewise than does gold. This is quite unusual: for several decades, any metal strength translated into miners outperforming the metals. During a 'transition phase' after the gold peak, miners continue weakening with gold moving more or less sideways. It's increasingly clear that any previous 'proportional logic' between Gold and ^XAU has gone after the 2011 gold all-time-high. The paradigm shift is towards a trendline dependency of between ^XAU and Gold.

Bear market / Bull market logic

A few articles have been dedicated to deriving a new dependency between the HUI index and Gold, using a least squares regression. See for example Gold miner rally: Bull market logic (May, 2016) or The bear market logic for Gold Miners: Continuation and Analysis (July 2015).

The same procedure has successfully been applied to the Philadelphia Gold an Silver Mining sector index. Below you notice a last graph showing the transition to the Bear / Bull market logic.

Price of gold in USD/Oz in blue on the left scale and ^XAU index in red on the right scale, click to enlarge

Scales have been adapted to reflect the parameter values obtained from the least squares fit:

^XAU = 0.2036 * (Gold Price - $857) or equivalently:
^XAU = (Gold Price - $857) / 4.9116

As the gold price rises during 2010, the ^XAU makes its last run to the absolute top. During 2011 the gold price rally is not reflected any longer by any sustainable advance of the ^XAU. The index moves sideways, topping at the same level several times, with a very last top as gold reaches its all time high. Afterwards the ^XAU starts mimicking gold moving sideways with a few more failing rallies topping around $1800/Oz.  The fit between Gold and the ^XAU is excellent starting from summer 2012 onward as reflected by a correlation coefficient of 0.9614 for the period from July 1, 2012 till today.

The above linear relationship both quantifies to what extent miners were likely to leverage down during the 2012-15 gold cyclical bear market and how much miners are likely to outperform gold during its recovery. It also quantifies what investors use to call 'optionality'. Miners outperforming gold is expected to be more obvious during the initial phase of the gold recovery. This is exactly what we have been observing so far. The effect should be more moderate as the gold bull market progresses and the gold price gets over twice the above $857 intercept level, nearing its 2011 all time high.

Parameter interpretation

The $857 gold price intercept value that would make the ^XAU reach zero does not imply that miners would massively go bankrupt if such price level were to be maintained for some time. (There would probably be some casualties among the high cost miners in a shaky financial condition.)
All in sustaining costs are highly different among the several mining sites of all mining concerns. Moreover costs are in local currencies and hence are highly influenced by the USD exchange rate.
Instead the $857 is the 'collective investor apprehension 'of what is the 'cut-off' gold price level that would make most gold miners worthless.
In the second formula you recognise the previous Gold to XAU ratio 4.9116 (or almost 5): the indicative value it was having for several decades before 2008.

The parameter interpretation is similar to that for the HUI. This corroborates the model.

Other articles on this topic

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