If you are a gold-stock
investor, the dark cold days surrounding the winter solstice seem
exceptionally fitting this year. As the warm sunlight has largely fled
the northern hemisphere, so has bullish sentiment largely fled the gold stocks. Thankfully as inevitably as sun returning to
the north, gold-stock sentiment too will thaw.
Today’s terrible
gold-stock sentiment is really something of a paradox. The gold price
is the primary long-term driver of gold miners’ profits and hence their
stock prices. And gold is really looking good these days. After
powering over $800 nominal for the first
time in a quarter century in early November, gold has since casually
meandered near $800 like it was born to trade here.
Over the 33 trading days
since gold’s first foray over $800, it has averaged $804 on a closing
basis! Gold-stock investors and speculators ought to be dancing in the
streets, jumping for joy, as it is hard to imagine better news for gold
miners. $800 gold seemed impossibly high for the first six years of
this gold bull, but it has now become the new reality. Nevertheless,
gold-stock traders are very discouraged.
Sentiment is so bad that
even long-time gold-stock investors are considering moving their gold-stock
capital into gold bullion. This week I saw a professional gold-stock
fund manager on CNBC saying he was considering deploying all his
capital in gold because he thought
gold stocks’ profits would wane due to operating cost increases. This
is amazing to hear from a professional gold-stock investor!
I love physical gold
investing and have always thought that it needs to be the foundation of every
investment portfolio. But while 10% to 20% of one’s portfolio
should always be in gold, I think 100% is a bit extreme. Over the
course of entire commodities bulls all throughout history, mining stocks far
outperform their underlying commodities. Gold stocks are the classic way
to leverage and multiply gold’s gains.
But although stocks
outperform commodities over entire bull cycles, despite inflationary cost
increases, their outperformance is highly
cyclical. Sometimes the underlying commodity soars, leaving the stocks
in the dust for a season. Later the stocks catch a bid and blow past
the commodity, far more than making up for lost ground. Stocks’ outperformance of commodities is certainly not a smooth
linear phenomenon.
And much like the endless
greed and fear cycles in the markets, after a long period of one type of behavior (either stock outperformance
or underperformance) traders naturally start to extrapolate it out into
infinity. You know the thought pattern. “Well, since gold
has outperformed stocks for so long now maybe they will never outperform gold
again. To heck with gold stocks, I am going solely with gold.”
But this is the same type
of flawed logic that gets traders in trouble at major interim tops and
bottoms. Remember the NASDAQ top in March 2000? “Tech
stocks have gone up for a decade now so they will probably keep going up
forever. We are in a New Era now.” Whenever one condition
lasts long enough for traders to assume it is permanent, the markets tend to
quickly change and crush that flawed perception.
I suspect we are reaching a
similar inflection point regarding gold and gold stocks. Gold has
outperformed for a long time now so traders assume this new status quo is
going to last forever. But in reality, relative performance is very
cyclical. Gold outperforms for a while, then the stocks outperform for
a while. After long periods of gold outperformance
is actually when the stocks are the most likely to suddenly rocket higher.
This cyclical nature of outperformance is readily evident in our gold-stock bull
to date. My favorite way to look at it is via
the HUI/Gold Ratio. The HGR is very simple just like it sounds.
The closing price of the flagship HUI unhedged
gold-stock index is divided by the closing price of gold on an ongoing daily
basis. Then the resulting ratio is charted over time. It creates
a continuing chronicle of relative outperformance.
Since the HUI is in the
numerator of this ratio, a rising HGR line means the gold stocks are
outperforming gold. Conversely with gold in the denominator, a
falling HGR means gold is outperforming the gold stocks. Now please
realize this doesn’t necessarily mean both are rising. If gold is
falling at a slower pace than gold stocks in a correction, for example, gold
is still “outperforming” gold stocks to the downside.
If today’s popular
thesis that gold is destined to outperform gold stocks forever is correct,
then the HGR will perpetually grind lower. But the reality of this bull
is quite different. Since early 2001 when gold’s secular bottom
arrived, the HGR has been meandering higher on balance. Standard
technical analysis applied to this ratio, rendered below in blue, is very
illuminating. Perhaps gold stocks aren’t doomed to forever linger
in limbo in gold’s dark shadow.
This graphical depiction of
relative outperformance drives home just how
cyclical it really is. While the HGR has risen nicely on balance, it
has been one wild ride. This chart is extremely volatile, witnessing
dazzling spikes rocketing higher followed by long periods of
sideways-to-lower grinding in between. If you can internalize the
relative outperformance trends so far in this bull,
you’ll have a much better idea of what to expect going forward.
First consider the temporal
division of outperformance. This whole chart
covers 28 quarter-year periods. Within this seven-year span, there have
really only been four episodes of sharp HUI outperformance.
They are numbered in blue above. If you count the quarters over which
these massive gold-stock rallies unfolded, the number is somewhere around
10. So gold stocks have only radically outperformed gold in 10 of 28
quarters since 2001. This works out to 36% of the time, not much more
than a third.
So everything else being
equal, based on this bull so far we should expect gold stocks to not be
radically outperforming gold almost 2/3rds of the time. In reality
gold-stock traders are far less patient. If gold rises in a single
trading day, but gold stocks don’t dutifully leverage this gain
instantly, traders get worried and start spinning bearish theories. This
is very irrational from a long-term perspective though.
The 1/3rd of the time when
gold stocks radically outperform gold is cyclical in nature and readily
apparent in the HUI/Gold Ratio. This ratio tends to surge up to major
interim highs on gold-stock outperformance. This
happens when the HUI is powering higher in massive uplegs. (For
reference, the raw HUI is charted above in red off the left axis.) But
after these huge HUI uplegs, the HGR drifts
sideways for a season. These drifts are just as important as the
surges.
Whenever gold stocks rocket
to new bull highs, traders get uncomfortable. They wonder if the bull
is over and if such lofty prices are sustainable. So gold stocks enter
high consolidations after massive HUI uplegs.
This trading sideways not only bleeds off the excess greed rampant at the
preceding upleg top, but it gives traders time to
acclimate to new high prices. Drifts build the technical base off of
which the next surge eventually launches.
This surge-drift pattern
drives the HGR higher in fits and starts. The ratio surges
higher on relative HUI outperformance, but then it
drifts sideways for a long period of time to acclimatize. Often
these sideways drifts angle lower too, which shows relative gold outperformance. Since these drifts last longer than
the surges, relative gold outperformance is the
norm rather than the exception. Nevertheless, the relative outperformance is highly cyclical and eventually the next
HGR surge will come despite the naysayers.
As this chart shows, over
time this surge-drift pattern has created a secular uptrend in the HUI/Gold
Ratio. With the exception of an impressive surge above this uptrend in
late 2003/early 2004, the HGR has been very comfortable within this secular
support and resistance channel for six years now. This rock-solid
uptrend has huge implications for gold-stock investors and speculators today.
Since early 2006 at the
apex of the last major HUI upleg, the HGR has been
drifting sideways to lower. On balance, gold has been outperforming the
gold stocks which is increasingly discouraging traders. But this
typical post-upleg drift has accomplished a great
deal technically. Where the HGR was way up near its resistance after
the early 2006 surge, today it is down near support thanks to the subsequent
long drift.
Over the last six years,
there have only been five major support approaches including
today’s. It is provocative that the first four couldn’t
remain near support for long. Whenever sentiment got bad enough to
drive the HGR to such dismal lows, soon after the HUI blasted higher. Some
support approaches, like 1 and 4 labeled in yellow
above, simply resulted in sharp and fast HUI rallies.
But other support
approaches, 2 and 3 above, resulted in some of the biggest massive uplegs seen in this entire gold-stock bull! They
occurred right at the very beginnings of huge surges higher in the HGR driven
by extreme gold-stock outperformance. So
worst case a support approach calls for a sharp and fast HUI rally, but best
case it can portend a new and highly profitable massive upleg
in the gold stocks. And we are right at this ultra-bullish long-term
support line again now!
Such a new massive upleg today would carry the HGR up to its upper
resistance. Since these take a couple quarters to unfold, HGR
resistance would probably be near 0.70 by the time this happened. Where
would the gold price climb to drive such a massive gold-stock upleg? Probably at least to $900 to $1000. At
$900 gold, a 0.70 HGR yields a HUI target of 630. At $1000 this jumps
to 700. Incidentally these HGR-HUI targets are right in line with the HUI upleg
cycle targets of 580 to 700 for the HUI in this upleg.
So just because the HGR has been drifting for some time now
doesn’t mean it is permanent. HGR drifts are more common than
surges, but the surges always erupt late in the drifts when most traders have
largely given up hope. In both time and technical terms, we are now
overdue for a surge where gold stocks radically outperform gold for a couple
quarters and the HUI surges to incredible new highs.
Before we move on, I want
to address one more aspect of this long-term HGR chart. The HGR hit its
bull high in late 2003, and wasn’t able to exceed it in early
2006. So measured from a top basis, the case can be made that gold
stocks haven’t outperformed gold since late 2003. While technically
true, this is misleading. As I discussed last week in reference to euro gold, extreme
outlying highs are not the optimal measure from which to consider a
bull’s progress.
At highs, euphoria reigns
supreme. Unbelievable greed can drive mind-blowing prices, but they
just aren’t sustainable. As soon as the greed abates, prices
plunge. So over the long term, interim lows far better reflect
sustainable fundamental realities than interim highs. At major interim
lows, euphoria is nonexistent. Most traders have abandoned a sector
temporarily, and the remaining ones are quite discouraged. So interim
lows offer a superior fundamental picture (not greed-tainted) of true
sustainable price levels.
Much like euro gold’s support was rising on
balance for years yet traders ignored it in favor
of a few outlying highs, the HUI/Gold Ratio’s support has also been
rising for years. This means that even at the worst of times
sentimentally, fundamentals supported a rising HGR. On balance gold
stocks have outperformed gold for years. This is confirmed by the HGR’s rising-on-balance 200-day moving
average. And if you drew a mathematical best-fit line into this chart,
it would rise at a strong slope to the right.
So I wouldn’t get
hung up on the late 2003 HGR high. No it hasn’t
been exceeded yet, but it was an extreme extra-trend outlier. I
strongly suspect that either in this gold-stock upleg
or the next the HGR will climb over 0.65, achieve new bull highs, and hit its
rising resistance. Due to the nature of secular gold bulls, I am almost
certain that we will see higher HGR levels to come. It is only a matter
of time.
This next chart zooms in a
bit to focus on our current HGR drift since early 2006. While this
tactical perspective isn’t as important as the strategic perspective
above, it still offers some additional insights. Once again the raw HUI
is rendered in red behind the blue HGR for easy comparison.
As the down-sloping initial
drift resistance shows, gold was really outperforming the HUI on balance for
most of this drift. This trend started to change back in July, when the
HGR made an upside breakout above this drift resistance line. Since
then, the HGR has showed a lot more strength indicating that this drift is
maturing. It is the worst possible time for traders to extrapolate gold
outperformance out into infinity.
The HGR’s
drift support line was also trending lower, but only slightly. Almost
like clockwork, every two or three months in this drift the HGR would hit
this support line and bounce. But several times, including today, the
HGR suddenly knifed under its drift support. These sub-support episodes
were very short-lived though. Whenever they happened, a sharp HUI rally
soon ensued to yank the HGR back up into more normal territory.
With sharp HUI rallies
occurring in both June 2006 and August 2007 after the last deep sub-support
HGR episodes, I suspect we can reasonably expect another sharp HUI rally
today out of our latest sub-support episode. And as late as we are in
this drift, as irrational as fear and pessimism surrounding gold stocks have
become, a massive upleg is just as likely as a
simple rally. We are sure overdue for one!
The sharp HUI run starting
in mid-August out of the last sub-support HGR episode is also interesting to
consider. While the HUI itself soared to easily break out of its long
consolidation, the HGR did not. Before the HUI rally even got halfway
to its early November interim high, the HGR stalled. After that the HUI
was merely pacing gold, not outperforming it. While this
discouraged a lot of traders, I think its interpretation is actually bullish.
In these giant HGR
surge-drift cycles, the surges are solely defined by massive outperformance of gold by the gold stocks. Clearly
this didn’t happen between mid-August and early November per the
HGR. This means that the sharp HUI rally we saw recently was not the
one that this mature HGR drift is calling for! In pure HGR terms,
this recent rally was irrelevant. The expected massive surge upleg is still entirely yet to come.
Now I know there are
legions of bearish theories surrounding gold stocks today, as there always
are prior to massive uplegs when traders are
discouraged from the preceding long consolidations. Many of these
theories focus on problems gold miners are having mining gold. While
gold mining is indeed very challenging, it is
important to realize that near-term profits growth is not the only driver of
gold-stock prices.
Like every other price on
the planet, gold-stock prices are set by supply and demand. If traders
want to buy more shares than are offered for sale over any given span of
time, a stock price has to rise. The rising price retards demand
and entices out more supply to create a new market-clearing price where all
traders who want to trade are able to do so. While profits help drive
long-term stock demand, they are irrelevant over this pure short-term share
supply/demand perspective.
A couple weeks ago I did a
study on the GDX Gold Miners ETF. Its 34
component companies represent the lion’s share of the entire gold-stock
world in market-capitalization terms. Back in early December, prior to
this week’s HUI carnage, all 34 GDX component companies added
together only had a market capitalization of $163b. This compared
to $220b for Google alone and $13,369b for the S&P 500. Gold stocks
remain an exceedingly small sector. There aren’t many shares
available to meet demand surges.
So as gold travels higher
as it ought to due to the US dollar woes and endless fiat-paper creation by the central
banks, will mainstream stock investors get interested? Will $900 or
$1000 gold get their attention? I bet it will. Like all
investors, mainstreamers want to chase momentum. Some will buy GLD, the gold bullion ETF, for exposure.
But I am sure the more speculative-bent will look to leverage gold’s
gains through gold stocks, just as we contrarians have done for over six
years now.
With today’s entire
tiny gold-stock sector probably in the neighborhood
of $175b in market capitalization, it won’t take a lot of bidding to
drive stock prices up fast. This is just a trivial amount of
capital in general stock-market terms. New mainstreamers flooding in
won’t be worried about long-term profits growth, but short-term
stock-price gains. If they are willing to own GOOG at 55x earnings,
they aren’t going to be the least bit worried about gold-stock P/E
ratios.
So despite rising operating
costs and profit pressures on gold miners, the speculators who will
rush in to drive a surge in gold stocks won’t care one bit. They
will be looking for short-term capital gains and have zero interest in the
long-term viability of gold miners. Massive HUI uplegs
have always been far more sentimental than fundamental in nature. It is
greed, not underlying stock profits growth, that
drives them.
At Zeal we have been
battered and bruised since early November like the rest of the gold-stock
traders. Nevertheless, we focus on the long-term picture and
don’t believe the fear-drenched status quo will last forever. So
we have been buying elite gold stocks in our subscription newsletters lately and
preparing for the next upleg. It is never
easy buying when sentiment is rotten, yet this is when the most favorable buying prices arrive. Join us today to ride this
coming massive surge upleg!
The bottom line is gold has
been outperforming the HUI since early 2006. But contrary to trader
fears, this isn’t going to last forever. Relative outperformance is highly cyclical. Gold outperforms
about 2/3rds of the time during HUI/Gold Ratio drifts. But when the HUI
outperforms the other 1/3rd of the time during surges, watch out! Truly
legendary gains can be won during these massive gold-stock uplegs.
The longer that
any given market condition has persisted, the harder
it is to believe that it could actually change. Yet change always
happens. The markets abhor all extremes and they are never
sustainable. Based on market history, there is almost zero chance that
we have entered a New Era where suddenly gold is going to outperform gold
stocks forever. Gold stocks will have their day in the sun again.
Adam
Hamilton, CPA
Zealllc.com
December
21, 2007
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