Wednesday, August 17, 2011


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View Profile View Forum Posts Private Message View Blog Entries View Articles on 04-19-2011 at 05:15 PM (2134 Views)
Hedge Fund Ratio Spread Trades Continue to Distort the Value of the Mining Shares

I hope to have further on this topic sometime this weekend depending on time constraints but I wanted to at least get some charts up to demonstrate how severely undervalued many of the mining shares are in relation to the underlying metal as a result of the plying of this particular trading strategy.

One of the factors that I believe are involved with this severe underperformance of the shares in general is the advent of the ETF's. Those who want LEVERAGED EXPOSURE to either or both gold and silver can now use the ETF's to do so.

Formerly, there were two methods available - commodity futures or mining shares. Since the charters of some funds prevents them from investing or trading in commodity futures, funds who wanted this leveraged exposure to the metals were forced to go into the mining shares in the past. That implied that bull markets in the metals were going to see substantial money flows coming into the shares.

Since the ETF's came along, those institutions looking for leveraged exposure to gold can now directly purchase the silver or gold ETF's instead and margin those up to obtain leverage. In other words, they are no longer captive to using only the mining shares.

Additionally, the hedge funds, which have proliferated like mushrooms after a summer rain, are able to offer prospective clients exposure to the commodity markets since there is nothing in their charters preventing them from investing in the commodity markets. That attracts further funds that in time past would have flowed into the mining sector directly.

Keep in mind what is necessary to drive prices higher - sustained investment flows. Now, if the investment flows that formerly would be diverted directly to the mining shares have been split and are now moving directly into the commodity futures markets and the ETF's, that pulls a portion away from the shares. That means that there is a bit of an exploitable weakness, a chink in the armor if you will, in the sense that the amount of firepower coming into the shares, is weaker when compared to the other alternative forums for investing in the precious metals.

The hedge funds understanding this then employ a strategy designed to take advantage of the "weaker sister" which suffers somewhat from the smaller money flows heading its direction - they short some of the mining shares while buying the commodity futures and the ETF's. That selling then further absorbs the buying interest that is still heading into the mining sector shares.

The reason they do this is because it helps them manage their risk. When the market sells off in this volatile environment, they are able to profit from the short leg of this trade as the shares head lower generally at a faster rate than the metals themselves do. In other words, they might be losing $1.00 on their long gold or silver positions in the futures or ETF's, but making $1.10 - $1.20 on their short share position. In effect, they have a permanent put option.

This trade has been extremely effective for them which is why they seemingly refuse to give it up but at some point, the effect is to so distort the price of the mining shares in relation to the underlying metal, that something has to snap to bring the share price back in line to historical norms. After all, the higher the metals run in price, the more profitable the well run miners become. Stock prices are eventually determined by profits - Eventually some of the hedge funds plying this trade will begin to realize that they are pushing the trade too far and will begin to exit. That will set off a rush by the others to do the same.

We got a brief taste of this April 5 of this year when the HUI shot up nearly 30 points in a single day. That was the first sign that the days of this trade are drawing to a close. There is an old adage in the trading world which is apropos for this situation:

Bulls make money; Bears make money; but Pigs get slaughtered.

Hedgies beware. The time is coming when there are not going to be any sellers on the other side of your trade when you need to unwind it.


  1. All,

    bookmark this and ALWAYS remember it:

  2. I remember it well. The question is at what point does it make sense to buy they miners. I would guess that the point to buy them is after the who market bottoms and turns. This explains your caution to Kli on the the miner trade right now? The second question I have is: are the prices already distorted right now?

    My guess is that prices are distorted right now, but will distort much more when the market crashes. At that point, they become a VERY strong buy. This would also mean that they are not a buy right now.

  3. beware of the game.....hedges that are the last ones out without a chair when the music stops will light a fire under the miners. Joe is seeing the same thing I have been seeing for a week now. He knows very well what happened last week with the market crashing. He is trying to paint you a picture.

  4. I have been wondering who/what existed to take money from in this market (by the big boys). with the retail investor out, the hedge funds money is the target. They are the ones with skin still in the game. What you are saying makes sense to me.
    small fish are dead or out. time to go for the slightly bigger fish.

  5. Ken,

    In the overall GOLD bull market which started in 2001 and will last another 8 to 10 yrs, the miners go thru stages of explosion and heavy retracements, between 2002 and 2007 miners did well, then they lagged in compare to physical performance and once September of 2008 got here, they got crushed along with overall market between september and end of October of 2008 while the physical only retraced 30%, and after that they have been on the bull market till April of this yr. When overall market starts retracement which you saw the past couple of weeks intensly, hedgefunds dump or short the miners heavy eventhough the physical price has kept going up, once the physical starts retracement, then miners sell off intensifies, so double trouble of not appreciating as much as physical and then more beating once physical retraces some, how ever that also means they recover once the trade has become one sided and it starts another round of miners bull market outperforming the price appreciation of the physical and overall market.

  6. More trouble....

  7. Ken,

    In October of 2008, market was bleeding heavy and it was couple of months since overall market started real bleeding as well, Physical Gold retraced from 1040 to 640 by October of 2008, meanwhile GG which is one of the best Gold miners in the world droped from 40 to 14 , SLW droped from 21 to 2.5, which is much heavier loss than price depreciation of physical, and then while rest of market kept bleeding till March of 2009, gold/silver stocks bottomed in October 2008 and started a new phase of bull market and outperformed both the overall market and the physical.

  8. Joe. Thank you. What you just wrote is what I understood to be the case. It seemed like you were implying that the trade is already one-sided. My premise had been that the miners will pull back with the general market over the near future and that in this pull back, the hedge funds will be forced to unwind positions, which includes the short miners. This should send miners into the bull. The question I have is from what level it will start. Sometimes I am not sure if we are talking past each other or I am not understanding. I know I have a tendency to over analyze.

  9. Off topic:
    Corn crop in eastern Kansas is pretty well burned up. Much is not even good for silage. This is corn crop failure that is in addition to flood problems elsewhere.

  10. Ken,

    What I implied is that the one sided trade is in progress since April, if price of physical does not retrace much then one sided trade in miners will be over sooner than usual, if physical itself goes thru 20% to 30% retracement before resuming upside then the beating on miners would be heavier than what you noticed past couple of weeks, either way I do not see any form of bleeding for miners past October of this yr assuming overall market takes a beating as well along with physical retracement.

  11. agree Joe.....with the movement in miners during the crash the past week the smell of blood for guys like Paulson is in the air....they'll pick him clean if he is weak enough. Plus don't forget seasonality of strong gold is getting closer.....

  12. By the way folks I am not in the camp that believes in Gold to 10,000 or 20,000. This super-cycle is deflationary depression cycle and Gold does well as safety net during deflation as well as hyper-inflation, how ever I do not see price of physical past $5000 an ounce, which means between now and end of bull market for Gold, you got another triple coming for physical before bull market is over.

  13. Of course we all might have bought are last cars and don't know it yet...

    The story coming soon will be how many arrows you can make without energy to keep other tribe from taking your garden...'ve_entered_the_age_of_mass_extinction%3A_goodbye_fish_and_a_whole_lot_more

  14. read it and weep...

  15. I'm holding a core of miners, which is in the money right now (caught some bids last week near the bottom). It sounds like I should take profits and then sort of wait things out.

    But the physical has given no signs of correcting yet. Gold had a quick reaction ($1820->$1740) after the margin hike, and now it's once again hovering near $1800. Silver has been flat near $39-40 for weeks. So, if Joe's assessment was to play out, then we need to watch physical closely.

    Joe, what happens if physical continues higher, while the overal markets tank? Silver and the miners will still take a hit, but gold has proven to be in a class of its own so far.

  16. budfox,

    If physical does not correct and just keeps going higher while the overall market tanks, the miners will go down with overall market initially eventhough the tanking might not be as bad as other sectors since hedge funds will short or sell miners and go long DGP or GLD( Gold ETF) until miners become decoupled from other stock sectors and then they will start turning up. If physical starts correcting while overall market tanks, then you get a real intense retracement by miners which makes them very attractive to buy and ride to the upside. The cheaper the miners , the better the upside from percentage point of view since hedge funds will shift their focus from shorting miners to going long and real intense money will shift from short to long. This is true in the oil sector as well. Oil stocks past couple of weeks got crushed, especially ATPG, look at high of the yr which was 20 and they took it down to 6.30 last week and that generated intense short covering. The more intense the shorting and take down, the better and intense the squeeze and reversal.

  17. The best case scenario for miners to give a nice return percentage wise for those who want to stay long for a while is both physical and overall market go down. Physical will correct since nothing just keeps going up straight till end of bull market. The main question which none of us know the answer is at what price and what percentage physical Gold will correct before resuming upside.

  18. The best gold miners in the world especially from resource perspective are ABX, GG, and RGLD. keep your eye on how much they retrace since that would give you a good perspective of whether intense correction on miners have taken place or not and the answer so far is NO. Companies like TLR or PZG do not count since they are not considered major producers and therfore they are already hammered. In the silver area look at SLW, PAAS, and SSRI as a measurement for silver mining retracement vs physical silver.