As you can see in the following chart, it’s been a fairly volatile year for the Direxion Daily Junior Gold Miners Index Bull 2x Shares ETF (JNUG) with share dramatically declining during the market collapse earlier this year.

Source: TradingView

In this piece, I will dig into the underlying strategy and correlations of JNUG and show why I believe that it’s a good time to buy the ETF.

About JNUG

To start this piece off, let’s dig into the strategy of JNUG. Put simply, this ETF is a 2x leveraged bet on the MVIS Global Junior Gold Miners Index. This index is provided by MVIS, and it gives exposure to the most liquid junior mining companies with a focus on gold production. The index requires firms to have a market cap of at least $150 million, and firms must generate 50% of revenue from mining. At present, there are 79 different holdings in the ETF with the following country-level breakdown provided by MVIS.

Source: MVIS’ publicly available materials

All this said, let’s take a step back and conceptually assess JNUG. The ETF is essentially a leveraged bet on a fairly risky set of assets. Junior firms in any industry tend to have more volatility than the more established competitors, and given that JNUG is giving a 2x leveraged return on these firms, volatility is the name of the game when it comes to this fund.

Earlier this year, we witnessed an incredible meltdown in JNUG as this leveraged bet on a volatile industry backfired terribly.

Source: TradingView

The key driver of this collapse was actually a few different factors. First off, JNUG was actually a 3x leveraged fund during the market meltdown and changed its methodology after shares were crushed. This change in leverage came too late for shareholders who witnessed losses of over 95% in the space of a month.

During this time period, gold itself witnessed a very rapid collapse during March as investors essentially fled many assets in light of the spreading coronavirus.

Source: TradingView

The issue was also compounded by the fact that investors were selling all kinds of stocks during this time period, and benchmarks like the S&P 500 were in the midst of some of the fastest declines ever seen. This resulted in additional bearish pressure on junior gold miners which translated into heavy losses for JNUG.

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All this said, however, from a high-level perspective, JNUG’s revenues ultimately largely are driven by gold mining. To that end, let’s take a look at the long-term correlations between changes in JNUG’s underlying index and changes in gold.

Source: Author’s calculations of LMBA and MVIS data

In the above chart, I have calculated the correlation between changes in the price of gold and changes in the underlying index which JNUG tracks. In essence, this chart shows the true correlation between junior gold miners and the outright changes in the price of gold.

To get an idea as per the magnitude of changes we can expect under various gold price environments, here’s a chart that shows returns bucketed by changes in gold.

Source: Author’s calculations of LMBA and MVIS data

What this chart shows is that, in general, junior gold miners tend to outperform the actual changes in the price of gold during most price appreciations in the commodity. For example, when gold rallies by 15-25% in a year, the index actually historically sees gains averaging 45%.

Using this data, we can clearly say that, if we expect gold to increase, then the best possible returns will likely come through holding junior gold miners as opposed to holding the outright commodity. In the next section, I’ll discuss why I believe that gold prices are likely going to increase and, therefore, JNUG is likely going to rally – but we must say a quick word about leverage.

I have stated this several times already, but it needs to be said again – JNUG is a leveraged play on a volatile index tracking a volatile commodity. For this reason, very large gains or losses can occur, and investors should manage risk aggressively. In my personal opinion, only a small percentage of a portfolio should be allocated to a product like JNUG in that sizable losses are possible.

This said, however, I am quite bullish gold and believe that JNUG is likely going to shine in the coming year.

Gold Markets

Over the past few months, I’ve been creating and calculating a number of studies to help me understand where gold is likely going to travel. These studies rely on what I believe to be broad fundamental drivers of gold markets, and many of these indicators are very bullish gold at this point.

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One of these indicators which I’ve frequently relied upon is the relationship between volatility in the equity markets and futures changes in gold. The VIX is an index which measures fear in the stock market, and it has been shown to call future change in the price of gold.

Source: Author’s calculation of FRED and Yahoo Finance data

What the above chart shows is the average 1-year return in gold following a VIX reading of a certain amount. To understand where we’ve recently been, here’s a chart of the VIX for the past few months.

Source: TradingView

Within the past month, we have seen the VIX rise as high as around 40. While this is fairly high by historic standards and interesting in its own right, what I am most interested in is the correlation between VIX readings of this magnitude and future changes in the price of gold.

For example, using data since 1991, we can say that, when the VIX has historically been around this territory, gold has rallied by an average of 15-20% over the next year. The data is fairly skewed into the bulls’ favor in that a strong 80% of all prior similar occasions have seen gold increase, and the average gains of 27% are 3 times larger than the average losses of 9%.

So, what does this mean? Put simply, this means that there’s a clear tendency in the market for large rallies in the VIX to be followed by strong gains in gold price. Fundamentally, I believe this captures the relationship between volatility and safe-haven assets: when markets are turbulent, it starts a process of investors seeking safety in alternative assets like gold. This search for safety results in higher prices for assets like gold as investors shift capital into the commodity.

What this data means for JNUG traders is that the future is likely going to be bright for the commodity – at least for the next year. History shows that there’s about an 80% chance that gold will rally over the next year (assuming, of course, that the future correlates with the clear tendencies of the past roughly 30 years). Unless we have very strong and convincing reason to believe that about 3 decades of financial data should be discarded, then we can say that gold is quite bullish at this point.

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The very bullish case for JNUG emerges when you take the above data and calculate it in terms of the underlying index which JNUG tracks. For example, in the previous section, I calculated the correlation between changes in gold and changes in JNUG’s underlying index. Put simply, if we see gold rally by 15-20% over the next year, then more than a decade of data would say that JNUG’s index will increase by around 45%. Given that JNUG gives a double-leveraged return of this figure, back of the envelope math says that the ETF could increase by 90%. Again, this 15-20% expected return in gold is the typical average gain we see in gold following a VIX rally in the territory of that seen earlier this month.

Put simply, I am very bullish JNUG. The ETF gives a leveraged bet on a volatile commodity, and the data is strongly suggesting that gold is going to rally over the next year. However, volatility is likely going to remain high in gold and especially JNUG, so I would suggest that investors aggressively manage risk through smaller trading size in the ETF.

Conclusion

JNUG’s underlying index is highly correlated to changes in the price of gold. Gold markets are likely going to rally over the next year due to equity market volatility. If we see the price rally in line with historic averages, JNUG could increase by 90% over the next year.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



Via SeekingAlpha.com

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