A Reliable Buy and Sell Indicator For Gold

Speculating in gold mining shares is a natural reflex for traders who like to bet on the future price of gold. But trading in gold mining shares also carries additional risks, such as general stock market conditions and company specific risk. For instance, if a wide war in the Middle East involving Iran begins to unfold, that could send crude oil to $100 per barrel, and gold prices might jump by $100 per ounce, but the S&P 500 index could tumble by 10%.

Under that scenario, what performance can we expect to see for gold mining shares? Would the Gold Bugs Index [symbol: HUI], which measures a basket of 16 unhedged gold and silver miners, rise with gold prices, or fall with the broad stock market? Would the two conflicting influences lead to a stalemate and an unchanged miner share price? Are traders better off owning the gold ETF?

The chart above shows the price of gold (US$) in blue, and the HUI to Gold ratio in red. Dividing the price of the HUI Index by the price of gold, tells us how gold miner shares are performing relative to the price of gold. Typically, gold miners outpace the yellow metal on upside rallies, then starts to slip when gold prices are steady, and miners get hammered when gold prices are falling.

So when the HUI to Gold ratio was gyrating in a sideways range in April, while gold was soaring by $150 per ounce, traders in gold mining shares were casting doubts about the long-term sustainability of gold’s initial rally to $730 per ounce. Hindsight is the best sight of course, but the breakdown in the HUI to Gold index on May 4th below the 0.568 level, signaled a top in the price of gold. The HUI to gold index continued to fall another 10% to the 0.48 ratio by May 18th, and gold prices followed suit with a wicked drop of $192 /oz to as low as $542/ oz on June 14th.

Yet on June 14th, with gold plunging to a climactic low of $542 /oz in Hong Kong, the HUI to Gold ratio was simultaneously building a “double bottom” pattern at the 0.48 level. A market always has a better chance of standing up on two legs, instead of just one. So when the HUI to Gold ratio built the double bottom at 0.48 and began to move up strongly, it was flashing a buy signal for the yellow metal.

Both the HUI to Gold ratio and the yellow metal moved up together for the next three weeks, helped along by rising crude oil prices. But the HUI to Gold ratio flashed a sell signal for gold on July 12th, when it fell below horizontal support at 0.53 and then tumbled to the 0.51 level. Sure enough, five days later on July 17th, gold topped out at $675 in London, before plunging by $35 to $640 /oz in New York.

What is the HUI to Gold ratio signaling now? The breakdown in the HUI to Gold ratio below 0.53 might signal a further slide towards the double bottom lows at the 0.48-level. That could signal further losses for the price of gold towards $630 /oz. At that point, traders can start bargain hunting in the Gold ETF (GLD) near $63 /share, or the Gold miners ETF (GDX) around $35 /share, with much less risk, if the HUI to Gold ratio appears to be building a triple bottom at the 0.48-level.

Fundamentally, the post June 13th gold rally is somewhat linked to fears of a wider war in the Middle East and higher crude oil prices. More importantly, traders are split on the Federal Reserve’s next move on interest rates. Any sign of a pause in the rate hike campaign in August, would be very bullish for GLD and GDX. (An August rate hike however, could put a lid on gold, and threaten the ratio’s low at 0.48).

- Gary Dorsch writes Global Money Trends, an investment newsletter covering global asset markets.