HUI – Gold ratio reflects the return of a deflationary mindset

HUI – Gold ratio reflects the return of a deflationary mindset

by Trader Dan

If one examines the ratio of the HUI/Gold you can determine whether or not a deflationary mindset or psychology is prevalent among investors/traders.

Note that when the credit crisis erupted in full force in the summer of 2008, the mining shares underperformed drastically against the price of gold as the gold shares plummeted along with the rest of the broad stock market.

It was not until the Fed announced the inception of QE1 in the fall of 2008, that the gold shares began to outperform gold. As a matter of fact, they led the market higher.

Now that the Fed has announced the end of QE2, the gold shares are seriously underperforming against the price of gold bullion as you can see by the sharp move lower in the ratio early this year.

This is the basis behind the ratio spread trade being played by the hedge fund community and why they are able to push the shares lower seemingly at will. As long as a deflation mindset is in place, the shares will underperform against bullion. Not until we get a return of inflation fears (that will come if the Fed moves ahead with some sort of additional monetary stimulus) will the mining shares outperform gold.

I have had some critics rail against me for detailing this strategy but I can tell you from a trader’s perspective, it has been an effective and extremely profitable trade. It will stay in place as long as it works and makes money for those who are using it. The hedge funds are simply too large for any other market players to take them on and challenge them on this trade. Only a shift in the deflation/inflation mindset will shake them out.

If rumblings of another case of Fed action on the stimulus front begin to surface, this ratio trade will begin to turn as the smartest ones plying it will exit while they can still secure those paper profits.

In the meantime, one has to be extremely selective in which mining stocks they buy. The weaker ones will be and are the targets of the ratio trade while the stronger ones are more resistant to its effects, even though they are seeing weakness at the present time. Once the market for the shares turns, the strongest ones now will be the leaders on the way back up. Fundamentals will ultimately determine their share prices even while these technical plays are dominating at the present.

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