Trading Strategy: Gold vs Gold Stocks

Last month I shared a strategy that used the ratio between oil stocks and the price of oil itself to trade the oil sector (read part I and part II).

Keeping with that theme, in this post I’ll look at using the ratio between gold stocks and gold to trade very short-term moves in gold. I’ve been wrestling with this observation for a while, and I’m sharing the basic concept here because I think the strategy is not ready for primetime (more on this later).

First, a look at the ratio of gold (represented by the ETF GLD) over the gold sector (XAU) from 2005:


Over the last 4+ years, the two have traded in a fairly narrow range versus the other, but in mid-2008 the ratio exploded as investors embraced the “safe” (good for gold) and abandoned all things equity-related (bad for gold stocks).

Note: I’m using the ETF GLD to represent physical gold, and the index ^XAU to represent the sector, because I think those two are the most familiar to readers, but the observations in this post have more or less held for other vehicles such as futures (gold) and the ETF GDX (gold sector).

The Strategy

The ratio of gold vs the gold sector has exhibited a fairly strong contrarian tendency. The following graph shows the results of two strategies, the first (green) going long gold at today’s close if GLD underperformed XAU for the day, and the second (red) going long if GLD outperformed XAU, frictionless from 2005 to present.


[logarithmically-scaled]

The observation hasn’t been foolproof (note late 2005, early 2006, late 2007, and early 2008), but generally speaking, gold has been consistently stronger tomorrow when yesterday it underperformed gold stocks (and vice-versa).

For the number-lovers:

This strategy is exploiting a very small daily advantage (similar for example to adaptive daily follow-through), and therein lays a problem.

Most of the strategies that I talk about on this blog could be traded using leveraged mutual funds (not to be confused with leveraged ETFs). These are the only thing that I trade. Because they incur no transaction fees or slippage, most of the tests I’ve performed on this blog could have been duplicated, for all intents and purposes, as well in the real world.

Not so here. To the best of my knowledge, there are no mutual funds suitable for active trading that track gold (the gold sector yes, but not gold itself). Trading this strategy with ETFs/futures would bring trading frictions that would close an already very fine advantage.

I’m struggling now with a way to improve upon this advantage enough to make it tradable. I share it here in hopes that I’ll generate a spark amongst fellow quant’ish folks who frequent the MarketSci Blog. As always, more to follow.