By
SL
Advisors
:
Towards the end of last year, we felt there was an interesting
opportunity to be
long
equities hedged with a short position in the Euro. Our thinking was
that equities were attractively priced as long as a crisis was
averted, and most of the bad things we could imagine would either
begin in Europe (i.e. Euro collapse) or affect it more than the
U.S. (such as an Israeli strike on Iran given the EU's greater
reliance of Middle East imports than the U.S.). We employed this
bias in Fixed Income where long positions in bank debt were
combined with short Euro positions.
That trade is no longer interesting, because a short Euro is a
less effective hedge now that it's weakened. But a similar concept
exists with gold miners and equities.
Gold and Silver miners have for many months been trading at a
healthy discount to the NAV of their reserves. Although the
optionality provided by a long position in a miner should be worth
something (since a rising gold price ought to create a
disproportionate increase in the stock through operating leverage
while if gold falls to unprofitable levels they can simply stop
digging), the market continues to price the sector at a discount.
One obvious move is to buy the Gold Miners ETF (
GDX
) and short gold itself (
GLD
). However, this means simply betting on a reversion to the mean of
the relationship, and there's no knowing when that might
happen.
Instead, long GDX and short S&P 500 is an interesting trade.
Gold is out of favor and a short position isn't likely to provide
much protection from here. If gold does sink, along with GDX, it's
likely to be in response to slower growth so the short equity hedge
should provide some protection. But in that scenario, the odds of
QE increase, so reflation ought to provide some support for the
yellow metal. Conversely, if the world avoids all the various
disasters that may afflict it, rising markets are likely to lift
commodities with them, and the weaker US$ that would result in that
scenario would also provide support for GDX.
The correct hedge ratio is less than 1:1 - we prefer something
closer to $1 of GDX versus short $0.75 of SPY. And the correlation
between GDX and SPY is not as strong as with GLD, but we think this
combination of exposures makes more sense. In the long run (i.e.
years), we don't think gold will perform as well as equities.
Warren
Buffett
and others have articulated most eloquently the problems with an
asset that does nothing, pays no dividend and costs money to store.
But we're entering a period where developed world central banks
will be redoubling their efforts at reflating, with the ECB likely
to adopt their own form of QE in the next several weeks. Long GDX
allows one to invest in mining stocks at a current discount to
their reserves without direct exposure to the relationship
continuing to deteriorate. This is why we are currently invested in
GDX in our Deep Value Equity Strategy, since we think it offers an
attractive risk/return profile compared with the broader equity
markets.
The chart below shows the last two years of a position long
GDX/short 75% SPY, and also the S&P500 itself, both rebased to
100 on August 2, 2010.
(click to enlarge)
Disclosure:
I am long [[GDX]]. I wrote this article myself, and it expresses my
own opinions. I am not receiving compensation for it. I have no
business relationship with any company whose stock is mentioned in
this article.
See also
Tesla: Profit Point
on seekingalpha.com