Gold/XAU Ratio Signals Market Froth

NEW YORK () -- When trading in and out of any bull market, such as the one that currently exists in the precious metals market, it pays to make use of the best tools out there. In the case of gold and silver stocks, the Gold/XAU ratio is probably one of the single best determinants for the relative valuation of mining stocks - having signalled almost all the major turning points in the precious metals markets over the past five years. So when the ratio is starting to reach an extreme, as it is now, it pays to take heed.

Constructing the Ratio: The Basics

Calculating the ratio is an easy task - it's simply the current spot price of gold divided by the level of the Philadelphia Gold & Silver Miners Index (the XAU), the longest running mining stock index. While the XAU is less leveraged to precious metals stocks than the HUI, the long history of collected data on the index make it a more valuable trading tool. When the ratio is high, it means that gold mining stock prices are cheap relative to gold itself. When the ratio falls, the exact opposite is true.

Using Gold/XAU as a Buy/Sell Signal

Generally speaking, when the Gold/XAU ratio moves toward 5.0, it's an excellent time to buy large-cap gold miners. On the below graph, the points circled in green denote the recent lows in the ratio - which all but precisely mark tops in the XAU. Recently, when the ratio has been below 4.0, the mining stocks have been close to reaching their peaks, and it was a fair time to sell.

Employing this trading strategy over the past four years would have yielded spectacular results. While it's obviously not possibly to buy the XAU itself (short of purchasing all of the stocks in the index in the exact proportions), investors can still employ a synthetic version of this trading strategy by purchasing shares in the largest gold miners - companies like Newmont Mining [NYSE:NEM], Barrick Gold [NYSE:ABX; TSX:ABX], Goldcorp [NYSE:GG; TSX:G] and Kinross Gold [NYSE:KGC; TSX:K], to name a few.

At the late 2003 mining stock peak when the XAU traded above 100, for example, the ratio went down to about 3.6. Months later, in May of 2004, it was below 80 - and the ratio hit 4.75 - signalling a great time to buy. In the late 2004 peak, the ratio traded down toward the 4.0 level as the XAU again went above 110. And when the XAU bottomed below 80 this past May, the ratio was trading above 5.25.

But while surging stock prices have pushed the ratio down below 4 recently, this does not necessarily mean the miners' rally has come to a close. If the price of gold were to rally further than stock prices, for example, the ratio itself would not go any lower. And, although the 3.75 range has more or less been the extent of the ratio's depths the past few years, there's no reason that this will remain the case. Back in 1996, for example, the ratio bottomed below 2.75, which corresponded with the peak in mining stocks.

In fact, if the ratio were to break out significantly below the 3.75 level, this in and of itself would be noteworthy - suggesting that the indicator might be making a move toward the 3.0 level last reached in the late 1990s.

Dr. John Hussman, a former University of Michigan Professor and the founder of the Hussman Funds family, has done some valuable historic research on the Gold/XAU ratio.

According to Hussman, since 1974 the Gold/XAU ratio has been above 5.0 about 15% of the time. At these levels, the XAU has followed with average annualized gains of 89.6% on average. When the ratio has been above 4.0, the XAU has obtain average annualized gains of 27.4%. But, when the ratio is below 3.0, the XAU has declined at an average annualized rate of -36.6%.

Conclusion

While the Gold/XAU ratio may have been pushing the envelope of late, this doesn't necessarily mean that the rally in mining stocks is over. Active traders, however, would probably do well to take some partial profits in their most ebullient stocks at this point. If the ratio gets anywhere near the 3.0 level, it's definitely time to cash out. And during the next correction, when the ratio spikes above 5.0 again, get ready to buy back those shares at a lower level.

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