Junior has been misbehaving

All measurements are set as an index = 43.80 at 12/31/2004 (GLD price)

When investing in gold, one has several options. Everything from collectible coins, bullion, stocks, and ETF's are on the menu.

I track, and own, three dinstinct categories.

GLD is an ETF that holds gold bullion. For me, it is the best way to own gold without having to figure out how to handle and store it. It also tracks well to the price of gold. There are a few indices that track gold stocks; I prefer the GOX index. It is comprised of the major gold producers, like Newmont and Barrick. The Juniors - the explorers and developers - are the most difficult to track, so I made my own index. I use 10 junior stocks, then advance an index based on the median price change each month. My results mirror everything I have read lately, in that junior gold miners are lagging.

I started my comparison at the end of 2004 when gold was in the $430 range. Since then staying as close to bullion has been the best way to go; a CAGR of 21.6%. Major gold producers have been challenged by high energy costs, political risk and their own price hedging stumbles. Despite those drags, one would think the price of the base commodity could not be any more favorable and these majors should be well leveraged to the price of gold. If your costs are $700 per ounce and gold travels from $1200 to $1400 - it's not just a 17% (2/12) gain for them - it is a 40% gain to the bottom line ($700, versus $500).

The juniors, who are very important for the major producers to expand their finite capacity, just have not delivered. One of the most frustrating aspects to owning the juniors is the way their management always hypes their opportunities and never acknowledges risks until they experience them. The management all speak effortlessly in terms of probable reserves, but usually contradict themselves when they project their long term cash needs - as they continually issue more shares to advance exploration and production. Those "probables" always seem to undeliver in the present, but always look so good in the future. Meanwhile machinery failure, environmentalists, nationalists, you name it, detracts from current results.

Despite their lagging performance, juniors are returning an average 6.2% over the six-plus years I have tracked them. That compares very favorably to the 1.8% CAGR on the Dow Jones in that same time frame.

Some of the underperformance can be laid at the feet of the majors. Eventually these giants will buy the juniors to expand capacity - but they always wait until they get expensive before they start buying. It is as if they don't like a bargain. Most likely they just move in herds and only start buying when inflation in the price points to the fact that if they don't buy now, it's going to cost them more in the near term future.

The juniors are the only group here that have not come back to their pre-credit-crisis high. For that reason alone, I like them here - I just try not to listen to their management.


It's a Horse Race

Here is the 12-year battle between the DJIA 1982 bull and the Jim Rogers Commodity Index of 1999. The DJIA was at 4,000 in February 1995 which is the equivalent time on the DOW to June 2011 on the Commodity Bull.


A Quick Statistical Analysis

Today the market was up and the VIX was down - a normal occurance. The VIX, a measure of market volatility, is typically inversely correlated to market direction. Periods of high volatility occur in declining markets - markets don't melt-up.

Today was the fifth day in a row, or every day this week, that the market increased. The DOW ended last week at 11955 and finished today at 12583. Conversely, the VIX fell each day this week, ending last week at 21.10 and closing today at 15.87.

While observing this toward the end of close, with the VIX at 15.39, I was inclined to buy some call options on the VIX. But having a rule that I don't invest in options unless I can calculate an edge, I pulled up my spreadsheet on closing VIX prices since 1990 to do some statistical analysis.

With a check of the option tables, I saw that I could buy a November 17 option for $5.20.

That means that sometime between now and November, the VIX must hit 22.20 for me to break even on that option. There are 94 trading days remaining until the November 15, 2011 expiry date.

I took my spreadsheet of daily closing prices and wrote the formula, where "B" is the column of prices:

=max(b2..b94)/ b1 -1

For every price point I looked forward across the range of 93 days-forward and found an average expected maximum price. Over 20-plus years that figure averages 42.8%.

Using my current price of 15.39, that resulted in a max price of 21.98. That would make the November 17 option worth 4.98 intrinsically - so paying $5.20 looked like a bad tradeoff.

However, since I'm buying the option for the reason that the VIX has fallen five successive days, I put that logic in the spreadsheet; only calculating the max value if the price had fallen five consecutive days. Interestingly, there were 70 times that occured in 20 years.

The result was 48.0%. That increased my max price expected from 21.98 to 22.77. That made the option's intrinsic value go from 4.98 to 5.77. Now a $5.20 entry price is looking at a 10% return; more if you consider that if it happens before expiry date, there will still be some time premium in the price of the option.

And with that analysis, I clicked a few keys in my Optionsxpress account and became the owner of 10 contracts.

There was still another hour left in the trading day, so I was anxious that my price may not be favorable. Recall that all my analysis was done on closing prices and I extended the price at 2:41 p.m. when it was 15.39. I was then lucky to have the VIX strengthen to 15.87 at the close. That means my analysis of 48% increase on closing price after 5 days of decline now calculated to 23.35, or an intrinsic option value of $6.35.

All of this analysis, with spreadsheets ready-to-go, takes less than 15 minutes. But it gives a nice documentated case as to why one should or should not take a position.