Today’s article updates the 10/29/08 Observation, "What Goes Down Must Go Up." The essence of the October commentary was to point out the statistical extreme that gold stocks were displaying on an absolute and relative basis. Gold stocks bottomed two days prior to the WrapUp after putting in the most oversold reading in more than two decades. The Philadelphia Gold & Silver Index (XAU) was 61.3% below its 200 days moving average, nearly twice the extreme seen in prior sell-offs that saw the XAU fall 30% to 35% below its 200 days moving average. The XAU has staged a dramatic rally since October, rising nearly 95% in a span of two months. If the XAU continues its bullish trend the next likely target for the XAU is 135 using a 50% Fibonacci retracement level, with the 200d MA closing in on that level as well, though a correction back to the 50d MA is also possible after a nearly 100% move in two months before it heads to a new high.
Figure 1
Source: Bloomberg
Figure 2
Source: StockCharts.com
While precious metal stocks may experience a pullback before moving higher, an intermediate to major low is likely in place as of the October bottom. The October panic saw investors throwing everything out the window in a mad scramble for liquidty as the markets were sprinting for the exit. With this type of environment precious metal stocks were sold along with everything else and decoupled from gold. The XAU (red bar) and HUI (blue bar) fell more than 50% from July to the October lows while gold (green bar) fell less than half that, declining 22.67%.
Figure 3
Source: StockCharts.com
Precious metal stocks fell more than the gold as their correlation to gold declined as they followed the general market lower. Prior to the October decline the correlation of the HUI to gold showed a strong positive relationship with a correlation coefficient north of 0.80 in September, which plummeted to a low of 0.70 in mid October. However, since then gold stocks have begun to display a stronger correlation to gold with the correlation coefficient of the HUI to gold coming in at 0.73 currently. In addition to an improvement in the correlation of precious metal stocks to gold is an increase in the beta of the HUI to gold, which fell during the October sell off to 1.23 in October but has since increased to 1.54 currently. Large spikes in the correlation and beta of the HUI to gold have often marked significant bottoms in precious metal stocks as seen in figure 5 below, lending more support for October marking a significant bottom for precious metal stocks.
Figure 4
Source: Bloomberg
Figure 5
Source: Bloomberg
One point that was brought up in the October article was that the strong move in oil prices was proving to be a headwind for precious metal stocks in the first part of the year as their profit margins were getting squeezed by higher energy prices, using the gold to oil ratio as a rough profit margin proxy for precious metal stocks. Because of this development, while gold was rising strongly in the first half of the year the XAU and HUI were lagging gold as the XAU to gold ratio fell. The explosive swing in the gold to oil ratio is positive for precious metal producers as their profit margins will be expanding ahead. Improvement in precious metal producer profit margins signals positive relative strength of precious metal stocks relative to gold. As seen in the figure below, the XAU’s relative strength to gold has some major catching up to do with the gold to oil ratio. Another similar comparison with the gold to oil ratio is the precious metal stocks (XAU) to energy stocks (XOI) ratio. As an improvement in the gold to oil ratio signals precious metal stock outperformance relative to gold, it also signals outperformance of gold and silver stocks relative to energy stocks.
Figure 6
Source: Bloomberg
Figure 7
Source: Bloomberg
Support for a significant rebound in the XAU’s relative strength ratio to gold is seen when looking at the statistical extreme the XAU reached to gold in October, falling to nearly 3.5 standard deviations from the multi-decade average. Major statistical extremes once reached typically see strong moves in the opposite direction, indicating there is plenty of room for outperformance of precious metal stocks relative to gold just to simply bring the ratio back to its historical average.
Figure 8
Source: Bloomberg
While the huge jump in the gold to oil ratio favors outperformance of precious metal stocks relative to gold, the caveat is to understand I am pointing to relative and not absolute numbers, meaning that while precious metals stocks are likely to outperform gold over the next several months, that does not mean that gold stock prices have to increase, they simply just have to rise relative to gold. To illustrate this point, the gold to oil ratio is currently at two standard deviations above the long-term average, a point that has marked previous peaks in the ratio (red arrows). What we could witness is for oil to stage a rally, which is conceivable considering its massively oversold condition and positive divergence seen with the RSI, while gold either consolidates or corrects, which is also conceivable as it is hitting its upper trendline resistance. With gold undergoing a possible correction, precious metal stocks simply have to consolidate to see their relative strength ratio improve, and with a gold consolidation they would have to rise.
Figure 9
Source: Bloomberg
Figure 10
Source: StockCharts.com
Figure 11
Source: StockCharts.com
While on the topic of ratios and pair trades, I’d like to also point out that the gold to silver ratio is also approaching its upper statistical extreme of nearly two standard deviations above its historical average, with silver offering cheaper relative value relative to gold, with silver potentially outperforming gold in 2009.
Figure 12
Source: Bloomberg
Figure 13
Source: Bloomberg
While the gold to silver ratio is nearing two standard deviations from its historical average, on a trend basis the ratio is still near neutral, indicating that the gold to silver ratio may yet have further room to rise in the first half of 2009. This would make sense as global economic conditions will continue to deteriorate for a couple more quarters until the fiscal and monetary stimulus efforts of global central banks kick in later in 2009, which would improve the industrial demand for silver and increase the relative strength of silver relative to gold.
Figure 14
Source: Bloomberg
Figure 15
Source: Bloomberg
In summary, precious metal stocks have been bludgeoned to death this year, reaching major statistical oversold extremes on both an absolute and relative basis. Significant improvement in the gold to oil ratio signals a strong relative performance of precious metals stocks to both gold and oil stocks ahead, with silver also beginning to show better value relative to gold. Using deductive reasoning, with precious metal stocks offering better value than gold, and with silver offering better value to gold, silver stocks may prove to be the top performing area within the commodity complex in 2009 as they pose the greatest relative value.
