Gold and the Miners: Who has the Midas Touch?

By Joshua Enomoto, Founder of and contributor

Often when discussions of gold investments come up, one of the first objections raised towards this asset class is that “it’s too expensive now.” Although a significant pullback has occurred, gold is currently trading at over $1,650 per troy ounce and is therefore only about 12% off of its all-time nominal high. Even if the yellow metal were to hit $2,000 as many experts have forecasted, it would represent a 21% profit from its most recent valuation: not the greatest margin of error considering that gold would have to negotiate extremely strong overhead resistance to get there.

However, many novice investors make the mistake that precious metal investments only involve physical bullion. On the contrary, there are many ways to handsomely profit off of the gold market without ever having to touch the actual metal. One of those methods is through the mining industry: an investor can either choose to place their bets on a specific company or an ETF that tracks the performance of a mining index. It’s a great way to gain exposure to the gold market without the hassle of bullion storage and the potential upside may be far more advantageous.

Let’s review the Gold Miners Index, which is featured on the NYSE Arca exchange:

One of the key characteristics of this index is how closely correlated its market action is compared to the movement of spot-gold. From the beginning of 2010 until September of 2011, both the index and spot-gold matched nearly every bump, bruise and tick-bite as they made their way to new record highs. However, the ninth month of 2011 represented a divergence: while there was still a correlation between the two, the gold index took a major brunt of the volatility that ensued due to corrective pressures. Spot-gold was chopped down, but its overall trend maintained a positive trajectory. The index, on the other hand, took a decidedly bearish turn, at one point inversely retracing the entire mega-rally that began in 2010. In August of this year, it managed to rise along with gold and silver bullion, with the index actually leading the charge a few weeks in advance. The end result was a move from long-term horizontal support at 1,120 to roughly 1,525 (near the 61.8% Fibonacci retracement of the September 2011 peak), a +36% profit.

Of course, with the disappointment evident in the precious metal blogosphere, neither the physical bullion nor the index managed to sustain the late-summer rally.Despite the emotional turmoil the metals occasionally cause, there is an opportunity to be had here due to the fact that the mining index may have hit, or is very close to approaching, a bottom.

The above chart is a simplified version of the technicals for the Gold Miners Index that we have been discussing. It demonstrates that a mathematical pattern of rallies and consolidations is emerging in the index. First, there was the 18-month rally that started in early 2010, which experienced consolidation in September of 2011. This resulted in a full retracement. The next, shorter rally was also consolidated, but currently, it appears that the correction has stopped at its 38.2% Fibonacci level. This would make sense, considering that this correction is only based off of a 2-month rally and I do not expect a full retracement as occurred previously.

From here, as long as the underlying asset can regain some bullish momentum off of its heavy (and overdone) selloff, we can easily see a scenario where the index can challenge its 61.8% Fibonacci level, or in nominal terms, roughly 1,350 points. From the current price point, this would represent an 8% move. It doesn’t sound like much, but this is a short-term, conservative forecast. The real play will be the 61.8% Fibonacci retracement of the Sep 2011 peak. A move there from current levels will net a cool +23% profit.

Yes, there are considerable risks in this or any investment vehicle, but for the gold mining index, I believe much of the downside has been accounted for. Recall that while spot-gold remained in a relatively positive trajectory following September 2011, the same was not true for the index. It fell hard to its February 2010 price point (1,120). A similar move for the bullion will see it at $1,050: a most alarming metric at a time when investors are fretting over $1,600 gold! Just from a numbers standpoint, it is more advantageous to invest in the mining sector as their current valuations are nowhere near their all-time high, and is only a few percentage points above extremely strong support. With so much overhead resistance built into the current spot-gold technicals, those that believe in a bullish outlook for the underlying asset may be better served with the miners, not the metal.