Is GDXJ "A Thing"?
From the HRA Journal: Issue 270
You can sense the frustration when you talk to anyone trading gold producers or large developers. Gold has staged something of a comeback and there are good reasons to think that should continue. You’d never know it to look at the main gold stock indices though. They are lagging badly.
The editorial in this issue deals with that subject. I increasingly believe the large restructuring of the GDXJ ETF is having an outsized impact on the trading of many gold producer stocks. At a philosophical, and rational, level that concept seems ridiculous to me. Why should the ETF drive the stocks? But yes, I think that is exactly what is happening. The good news is that, if that’s our problem, it’s a problem with a defined end date. The ETF changes come into force on the 16hth of this month so things hopefully get back to “normal” on or before that date. We may have to wait for the Fed meeting on the 14th and let the effects of that wash through the market too but I think we’ll see immanent improvement in the gold stock space.
The update section is chock full of companies that are drilling, starting drilling or about to start drilling. Based on my thesis about ETFs I think we’ll have an improved backdrop for all the drill results that will be coming at us through the summer. Drill results, especially early stage ones, are where the rubber meets the road in the resource speculation game. Start your engines.
June 5, 2017
One continuing issue has plagued the gold sector, junior and senior. Its been causing frustration and helps explain the negativity of many technical analysts about the space recently.
The issue is underperformance of the main gold sector ETFs, GDX and GDXJ, compared to the gold price. Industry observers read much into this underperformance though most know there is an immanent, and massive, rebalancing due for these ETFs. The rebalancing itself may be the cause of the underperformance. We’ll know in a couple of weeks.
Traders, myself included, don’t like seeing large divergences between assets that should, in theory at least, trade together. When two assets like that diverge it usually means one of them is being impacted by something that will soon impact the other. Divergences have a way of closing over time. You’ve seen comments from me recently about the divergence between opinion based economic surveys and hard economic readings. Technical analyst’s concerns about the widening gulf between gold prices and gold miner ETFs is much the same. Something’s gotta give.
Most analysts are assuming it’s the gold price that’s “gotta give” though the chart below makes it pretty clear that hasn’t been happening. Compare the gold chart to the GDX chart below and the divergence is obvious. Technical analysts will point out, correctly, that this gap has been growing for months. Gold saw a higher high in April but the GDX didn’t. That’s a fair point but partially explained by how much “politics” was behind the April move.
Gold traders rightly distrust political price moves. Miners tend to be less impacted by them unless they last, which they rarely do. The current price move is different. Gold moved down through April as the markets grew more optimistic about growth and “risk off” trades were abandoned. It fell even though the US Dollar was also weakening as seen on the chart below.
Things changed again through May. That IS reflected in the gold price but not in GDX or GDXJ. Resolution of a couple of European problems and better economic news there strengthened the Euro. That, and couple of negative surprises in US data, accelerated the USD downtrend as you can see below.
Gold has been in a general uptrend for about a month, with a couple of good breaks to the upside. GDX followed it at first but totally stalled out in mid May, losing ground even as gold moved higher. I think there is a reason for this that has little to do with the chart “telling us something”. Other than telling us a lot of traders are freaking out because of the GDX and GDXJ rebalancing slated for June 16th.
The Tail and the Dog. Not Always Easy to Tell Which is Which.
We’re in the age of the ETF. These trading vehicles have become so popular that they have largely superseded the underlying securities they are supposed to represent. You probably know already that this is not a trend I’m totally comfortable with.
I get that ETFs allow for targeted sector investments in an easily tradable form often with lower transaction costs. So far, so good. They have gone hand in and with the massive rise in passive investing, a trend that could end badly in a crash. The biggest problem I have with them is that lines have become blurred, with traders treating ETFs as the exact equal of the sector, index or asset they track. They are not.
To see what I mean by that, look no further than a blog like Seeking Alpha. Unless a poster is talking about a specific stock they almost never refer to industries, or specific commodities anymore. They don’t write about the gold price, they write about GLD, the gold ETF. The same applies to myriad other sectors. Traders have lost sight of the fact they are talking about passively managed funds, and treat them as interchangeable with the underlying asset. What’s going on with GDX and GDXJ is a perfect example of the flaw in that thinking.
GDX and GDXJ have become extremely popular in the past couple of years, with assets under management basically tripling. The two EFTs seek to match an index of senior and “junior” gold companies constructed by Van Eck, which created and manages the ETFs.
Note that these two ETFs are not matching some third-party index like the S&P 500. Van Eck created its own index for each ETF, composed of a portfolio of stocks it believes should collectively match the performance of the sector.
As traders buy and sell ETF shares Van Eck will issue or redeem shares to keep the value tracking the portfolio of underlying stocks. The funds, in turn, use the cash to buy shares in the gold stocks the indexes are composed of.
GDXJ holds positions in 57 companies. Problems arose, ironically, because of the popularity of both GDX and GDXJ, particularly the latter. As the size of the GDXJ float grew the manager had to buy increasing amounts of shares in the component companies to keep their value matching their percentage representation in the fund.
GDXJ was limited to buying companies with a market value below $1.5 billion. As the fund grew Van Eck found itself owning percentages of companies that bumped up against legal limits for shareholdings (20% in most jurisdictions) above which it would be forced to make a takeover offer. Obviously, that is not the intent here.
To avoid that, Van Eck is doubling the maximum market value a component company can have to $3 billion and will undertake a huge rebalancing of the fund, adding larger cap companies and lowering the percentage of the ETF fund holdings in smaller companies and, presumably, increasing the overall number of companies in the underlying fund.
We won’t know the exact composition of the new index until the 16th. That hasn’t stopped traders from second guessing it and trying to get in front of it.
The impending changes were announced in early April, about when the gold price topped last. Gold and GDXJ continued to track each other until mid May. Since then, gold traded sideways before breaking higher and rising a couple of percent in the past few sessions. By contrast, GDXJ has lost about seven percent since the middle of May. That large divergence has kept many from shifting their trading stance from bearish to neutral, much less bullish.
Van Eck isn’t saying whether its already trading so that GDX and GDXJ will match the new index compositions on June 16th or will wait until the new list is announced. It is clear there will be huge changes in fund shareholdings required to match new allocations. Several analysts have drawn up lists of the largest probable changes to existing GDXJ holdings and guesses to which companies in the $1.5-3.0 billion market cap range will be added.
We may see continued relative weakness until mid-June when the announcement is made. The key word is “may”. I think GDXJ probably bottoms before June 16th. There has been a ton of front running. The fact we don’t know the new allocations doesn’t matter. Most of the heavy selling should be close to done now.
The only way I see the impact getting much larger is if Van Eck does all its trading in a couple of days after the announcement. I don’t think the fund is run by idiots. Fund holdings have already strayed from the “official” list to allow for growth in overall market value of the fund. Van Eck isn’t matching a third party index. For all we know its already selling.
The bottom line is that GDXJ trading has been heavily influenced by coming changes in fund composition. Trading doesn’t necessarily have much to do with short term gold price moves or fundamentals of the companies involved for that matter. In short, I think the large number of traders assuming poor sentiment based on trading levels of an ETF are getting spoofed.
If gold continues to hold its own or strengthens through June, this short term ETF relative weakness should get reversed mid month. We could get a good rally after the changes are announced. That should have the chart readers changing their tune and adding volume to the buy side. It’s bizarre that so much of the market sentiment hinges on an ETF but that’s the market we’re in.
All this feeds into my underlying thesis that, as 2017 is an early bull market year, “Sell in May” is not the way to go, at least for some stocks. We should have a decent summer market. Active companies and companies reporting exploration success should be fine.
That Other mid-June Thing
The next US Fed meeting ends June 14th. The market assumes we’ll see another rate increase and so do I. As always with quarterly meetings, it’s the dot plots and press conference that will have the impact. If the Fed doesn’t raise rates, I’d expect both equities and gold prices to take off.
I think they will raise them but the more important issue will be forward guidance. Fed governors have been talking 3-4 rate hikes this year and a similar number next year. I don’t buy into that and neither does the bond market. It’s well worth remembering that bond traders have a much better track record of forecasting forward yields than FOMC members do.
I’ll leave you with a one year chart for 10-Year US Treasury Yield. As you can see, yields have dropped back to the top of their post-US election spike. The latest drop came after a weak payroll report and yet another month where wage gains didn’t increase.
Keep in mind, we’ve had two 25 basis point rate increases since the start of November which shifted the entire yield curve upward. Factoring those in, yields are back where they started. If that trend continues we’ll see increasing strength in precious metals prices. Many seem to have abandoned the resource space recently. Don’t be one of them.
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