HUI-Gold Ratio Strategy

Part 2

May 3, 2003

In my previous article, www.gold-eagle.com/editorials_03/nate_33042903.html , I described a trading strategy using the HUI/gold ratio to determine buy and sell points for the HUI index. The system is based on an algorithm which identifies an upper limit and a lower limit for the HUI/gold ratio based on the 100 day moving average of the price of gold. When the HUI/gold ratio is too high, sell the HUI index, when it is too low, buy the HUI index. Here is an updated graph of the strategy starting June 1996. I tried to clean it up a bit so that it renders better in a 600-pixel-width image. The red and green lines show the upper and lower limit for the HUI/gold ratio, the black line is the 3-day moving average of the HUI/gold ratio, and the red and green dots show the actual buy and sell values on the HUI index (the blue line).

Here is a close-up of the last 400 days. We are currently in the "buy zone" of the HUI index. If the HUI/gold ratio gets above .39, we will leave the buy zone and enter the "hold zone". The strategy dictates that you sell your PM's if the ratio gets up to about .46.

The system has been very successful but, being greedy by nature, I find myself looking for ways to modify the system for even greater profits. The system requires that one sell the HUI and hold cash for extended periods of time. But where can one put the cash to earn a greater return than a money market fund? Let's take a look at the relationship between the HUI Index and the S&P 500.

Looking at a chart of the HUI versus the S&P 500, one can plainly see that the major trend of the HUI tends to be the inverse of the broad market. The HUI has formed a giant "V" with the S&P 500 forming a giant upside down "V". However, if you look carefully, you will note that the short term cycles of the HUI index actually correlate fairly well with the S&P500. See how the yellow dots line up? My theory is that although PM's are fundamentally the anti-thesis of the stock market, all types of stocks are driven primarily by liquidity factors and tend to move together over the short term. Therefore, it might make sense to short the broad market when the HUI/gold strategy gives you a sell signal on the HUI.

The following chart shows a HUI/Short Strategy. With this strategy, you buy the HUI when the HUI/gold ratio gives you a buy signal. When the HUI/gold ratio gives you a sell signal, sell the HUI and buy the Rydex Ursa fund (symbol RYURX). The Ursa Fund mimics the inverse of the S&P 500.

Since June 4, 1996, a follower of this strategy would be up 300%, during a time in which the HUI has fallen 40% and the S&P 500 had risen 36%! Follow along here on this close-up graph of the last 400 days. You would have been holding the HUI as he came into the graph from the left side of the page. You would have sold the HUI at 131.00 to by RYURX at 10.93. You would have sold RYURX at 13.78 to buy the HUI at 95.00 and so on.

For those hardcore goldbugs who cannot stomach the thought of having no gold holdings during the HUI sell period, I've also experimented with a HUI/physical gold strategy. In this strategy, when you receive a sell signal on the HUI, you sell your PM shares and buy physical gold. When you receive a buy signal on the HUI, you sell your physical and buy PM's again. That way, you are always invested in gold and will be ready for the "10 sigma" financial shock that could hit anytime. Interestingly, this strategy fared almost as well as the simple HUI/cash strategy, even though one was forced to hold physical during the brutal bear market in gold. The strategy returned 133% in a timeframe when the HUI lost 40% and gold lost 18%.

The strategy worked particularly well in the past year, achieving positive returns in physical even while the HUI was falling dramatically.

A note of caution: these strategies were developed by backtesting data. I was able to tweak the formulas to fit the historical pattern of the markets. As with all backtested strategies, it is likely that this strategy will not be as successful going forward.

The purity of gold is measured in carat weight.