Are PM Stocks A Screaming Buy Yet?

Ruben T. Varela
Aug 12, 2008

The $GOLD:$XAU Ratio chart below measures the value of precious metal (PM) mining stocks relative to the value of Gold. $XAU is a widely followed PM index comprised of 10 PM stocks. In this case, the ratio indicates the number of $XAU shares required to buy one ounce of Gold.

The ratio rises when:

1. The value of Gold increases and PM stocks fall, or remain flat.

2. The value of Gold is flat while PM stocks fall.

3. The value of Gold falls but PM stocks decline to a greater degree.

The ratio falls when:

1. The value of PM stocks increases and Gold falls, or is flat.

2. The value of PM stocks is flat while Gold falls.

3. The value of PM stocks declines but Gold falls to a greater degree.

As we see below, this ratio has moved into historically extreme levels, as it now requires more than 6 shares of $XAU to buy one ounce of Gold. This is an extreme level that was reached only one other time in 25 years - at the market bottom in 2001.

Obviously, the PM sector is in the midst of another bone shattering selloff. However, when something occurs for only the second time in over 25 years, investors and traders should take notice. Ultimately, all we have is history to guide us, and history has repeatedly shown that such extremes are rarely sustainable absent some fundamental paradigm shift. In this case, what would that be?

The 25-year average for this ratio is about 4.3 $XAU shares to buy one ounce of Gold. With Gold closing today at about $823/oz, this would equate to an $XAU value of $191, yet $XAU closed the day at $136, some 28% lower. Using the 4.3 average, $XAU at $136 equates to Gold at $584, so it would seem that an adjustment should eventually be in order. Despite the current negative sentiment, I haven't heard or read any calls for $584 Gold just yet [except for this chart!].

Of course, markets are anything but rational in the short term. Gold could continue to fall with PM stocks falling to an even greater degree, and extreme conditions could widen further. But as seasonal and fundamental factors begin to favor precious metals over the intermediate term, a more likely scenario is that, as with nature itself, we should begin to witness a reversion towards the mean of 4.3 $XAU shares to buy one ounce of Gold. Going forward, this would indicate that:

1. Gold will fall further but PM stocks will fall to a lesser degree.

2. Gold will fall further while PM stocks stabilize.

3. Gold will stabilize while PM stocks rally.

4. Gold will rally while PM stocks increase to a greater degree.

Ruben T. Varela
email: RVarela@TheGoldenBull.net.

Ruben T. Varela is an independent trader specializing in the Precious Metals sector.

More charts are available on his public chart blog at Stockcharts.com; TheGoldenBull.

You can also subscribe to receive weekly updates and commentary on the political and economic issues affecting the precious metals sector by visiting TheGoldenBull website.

[More about Ruben Varela here.]

321gold Ltd