…..and going long gold mining shares (GDX). 

This is what a bottom looks like, not necessarily today or tomorrow, but definitely within 1-2 months:

GDX/GLD Daily (5 years)

GDX_GLD_Chaikin_Money_Flow

The volume expansion in the GDX during 2013 has been monumental; volume expansion amid waning selling pressure are two of the key characteristics of every major market bottom (GDX is exhibiting both of the above).

There is now also a chance for a double-bottom within the falling wedge which has formed during the past couple months:

GDX_Daily_12.13.2013

While GDX is certainly an attractive long speculation from current levels, a long GDX/short GLD pairs trade is even more attractive trade from a risk-adjusted standpoint. A brief history lesson…..

The GDX exchange traded fund was launched on May 22nd, 2006 shortly after an important short/intermediate term top in gold mining shares:

HUI_Gold_Monthly

Gold mining companies were bloated and living off the fat of a secular bull market in gold which showed little signs of stopping. The capital markets were valuing firms who barely had any drill results at $100 million valuations, and the senior gold miners were trading at lofty 40+ price/earnings multiples.

The salad days are long gone. Gold has been proven to be a mortal asset class just like any other and capital markets have ruthlessly punished the mismanagement and bloated cost structures of the publicly traded miners.

The right sizing of the gold mining industry which has occurred recently has offered a tremendous risk-adjusted trading opportunity via a long GDX/short GLD pairs trade:

GDX_GLD_Fib

The 38.2% Fibonacci retracement of the 2009 peak to the current low is a very reasonable target for this pair over the next 12-18 months. A GDX/GLD ratio of .30 could come about in a scenario in which gold rallied up to ~$1450 and GDX moved back above $40 – quite reasonable given that gold miners are currently being priced for $1050-$1100 gold.

The real benefit of this pairs trade comes about under a scenario in which the gold price treads water or moves slightly higher. I anticipate that GDX could rally as much as 20% in such scenario as the market reduces the probability of the gold armageddon scenario and deeply undervalued stocks move back up closer to book values.

The worst case scenario (and from my estimation, the only losing scenario for the pairs trade) comes about if gold completely falls apart below $1,000/ounce. In such a scenario we will see many mining bankruptcies and the survivors will trade at deep discounts to book value. Some will argue that such a scenario is impossible due to the high cost of gold extraction (~$1,200/ounce), however, I will simply say that it is highly unlikely but certainly not impossible.

In summary, we are shorting gold via the GLD but only in the exact same dollar amount which we are buying the GDX.