Gold Vs Gold Miners, the Classic Pair Trade for 2013

on December 04 2012 1:58 PM
gold-deutsche-bank_low

JEF, GDX, GDXJ, GLD

We all know and understand that the overprinting of money is a disaster waiting to happen. The US Federal Reserve balance sheet sits at almost US$3-T after 2 rounds of QE and Operation Twist.

That’s US$3-T acquired out of thin air. So in addition to artificially lowering interest rates in an attempt to boost the economy, they have increased the specter of future inflation with inevitable interest rate increases.

The tried and true method to hedge interest rate and inflation risk is what, buy Gold right?

But according to Jefferies Group Inc. NYSE: JEF, there is a problem with that trade if you are Long the Gold miners.

In theory, owning the miners gives you exposure to the Gold’s Spot price.

The downside to owning the miners is that Gold mining is a capital intensive business, often performed in very volatile locations like Africa and other high risk locations.

Jefferies sees no reason for investors seeking Gold price exposure to own high multiple mining stocks, which due to their very nature expose the investor to even more inherent risk.

This is bad news for Market Vectors Gold Miners ETF NYSEArca: GDX)and for Market Vectors Junior Gold Miners ETF NYSEArca: GDXJ if Jefferies is right.

You can hedge the miners by purchasing Puts or using a costless collar whereby you sell a covered Call against your purchased stock and use the proceeds to buy protective Put options.

But you may just be adding more layers to an already risky holding.

It is Jefferies contention that large cap miners like Newmont Mining Corp. NYSE: NEM will find it extremely difficult to replace current reserves with ounces acquired at comparable costs.

The Big Q: Why?

The Big A: for the same reason an investor is Long Gold in the 1st place, inflation. Costs are continuing to rise, from equipment to labor, and will only stay on the same track as central banks around the world continue their appetite for large stockpiles of Gold to hedge their currency risk.

The answer, a Gold pair trade.

Buy the ETF that attempts to track Gold pricing, SPDR Gold Shares (NYSEArca: GLD). Then, you are Short a basket of large cap Gold-mining stocks that have been under performing and/or Market Vectors Gold Miners ETF (NYSEMKT: GDX) and Market Vectors Junior Gold Miners ETF (NYSEMKT: GDXJ).

Newmont Mining has declined in price this year despite materially higher Gold prices. So if that trend continues, the investor benefits as SPDR Gold Shares rises, and the price of the large cap miners continues to decline, or stays flat. Short and Long, the classic pair trade.

Paul A. Ebeling, Jnr.Paul A. Ebeling, Jnr. writes and publishes The Red Roadmaster’s Technical Report on the US Major Market Indices, a weekly, highly-regarded financial market letter, read by opinion makers, business leaders and organizations around the world.Paul A. Ebeling, Jnr has studied the global financial and stock markets since 1984, following a successful business career that included investment banking, and market and business analysis. He is a specialist in equities/commodities, and an accomplished chart reader who advises technicians with regard to Major Indices Resistance/Support Levels.

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