Gold Bugs Index (Hui): Buy, Hold Or Sell?

Up-date N° 10 / April 13, 2011

NYSE Arca Gold BUGS Index

The NYSE Arca Gold BUGS (Basket of Unhedged Gold Stocks) Index (HUI) is a modified equal dollar weighted index of companies involved in gold mining.

The HUI Index was designed to provide significant exposure to near term movements in gold prices by including companies that do not hedge their gold production beyond 1.5 years.

The HUI Index was developed with a base value of 200.00 as of March 15, 1996. Adjustments are made quarterly after the close of trading on the third Friday of March, June, September & December so that each component stock represents its assigned weight in the index.

The two charts, showing the HUI and the gold price, illustrate many aspects of market behavior that an investor needs to know, most importantly:

• in the long-term, gold shares tend to go up three times as fast as the gold price
• gold shares are more volatile than the price of gold
• gold shares generally outperform gold - but not always - at times the situation is reversed

The underperformance of gold shares in relation to gold since the beginning of 2008

The bull market of the gold price started in 2001. During this time, gold shares went up three times as fast as the price of gold. However, since the beginning of 2008, gold shares remained flat while the gold price increased by 50%.

A higher gold price leads to gold producers having higher earnings (and possibly to higher dividends) even if the cost of production keeps increasing. Most gold producers will now show massively increased earnings, often a multiple of what they earned in 2010.

These positive fundamental developments will show up in gold producers share prices sooner or later - a thing that has not happened up to now.

The medium-term picture of the gold price

The financial crisis of 2008 also hit gold stocks hard, dropping even more than the S&P 500. The price of gold was also affected, having receded 30%. Gold, however, staged a remarkable comeback and traded almost 20% above the price of early 2008 a year later.

It was forced selling that drove gold and gold stocks down because investors needed liquidity to survive.

The gold price is now 45% higher than it was at the beginning of 2008 but gold stocks have hardly moved.

We think that this is now going to change and the breakout to a new high is a signal that the next move is unfolding.

Silver

From a technical standpoint, silver looks overextended. Nevertheless, as long as gold keeps rising, the silver price will do so as well. One should, however, not forget 2008 as such a crisis could hit again any time.

Should you own gold rather than gold shares?

Gold and gold shares do not always move in a parallel fashion. At times, gold is leading, at times the gold shares are leading. From 2000 to 2006, the Gold&Silver Index ratio fell by 40%, telling us that gold and silver shares outperformed the price of gold.

At the beginning of 2006, the trend started to reverse as the ratio continued to increase and reached a level of 5 points, or 33% higher, by mid 2006. The crisis of 2008 hit gold and silver shares hard as the index spiked to 11 points. Gold and silver shares were sold across the board as investors were forced to sell to create liquidity.

This extreme, created by panic selling, produced a once-in-a-lifetime buying opportunity. However, few were able to benefit from this situation as fears for the worst dictated investors' behavior.

The ratio has since fallen back to 6.4 points but it is still roughly 25% higher than the long-term average.

From now on, we expect gold shares to fare better than the price of gold.

The long-term average of 4.5 would mean a HIU at 780 points if the gold price stays where it is.

Conclusion:

BUY GOLD AND SILVER SHARES NOW!

Peter Zihlmann

The Timeless Precious Metal Fund