As we continue our
fascinating journeys of discovery as students of the markets, we do a lot of
charting work at Zeal. Recently a chart that I hadn’t given much
thought to for the better part of 8 months caught my attention again.
It was a HUI/Gold Ratio chart, also known as HGR in this essay.
The HUI/Gold Ratio is as
simple as it sounds, it is calculated by merely dividing the daily close of
the HUI unhedged gold-stock index by the daily
close in the price of gold. When this resulting ratio is graphed over
time, it vividly illustrates the ever-shifting relative strength of the gold
stocks versus gold. As their bulls mature, one is stronger and then the
other, back and forth. They are engaging in a great secular tug-o-war.
At times the gold stocks
are thriving, rising much faster than their golden underlying primary driver,
so the HGR rises. At other times much like what we’ve witnessed
so far this year, the gold stocks are languishing in consolidation mode so
gold has the chance to rise faster than them and thus drive the HGR
lower. Over time this evolving dynamic carves some interesting chart
patterns.
In the early years of this
bull, a friend of mine came up with an elegant trading system for actively
trading the gold stocks based on the HGR’s technicals. Like most trading systems, it was very
successful for years but then its efficacy started to fade. Prior to
2005 its buy and sell signals were rare and useful, but later that year the
wild HUI made them start to thrash. With buys and sells happening
constantly, this system’s utility waned. I discussed the
limitations of this particular HGR trading system last year.
After that experience, my
focus drifted away from the HGR. But last month as I was updating some
of the charts in the subscriber chart section of our website, the secular
trend of the HGR caught my eye. It looked like a long-term trend
channel had emerged in this indicator and that it was nearing the place where
gold stocks started to really outperform gold in the past,
or a major HUI buy signal.
So is the venerable
HUI/Gold Ratio once again suggesting that a major gold-stock upleg is drawing nigh, that gold stocks are due to
outperform the metal they mine? Yes, it sure is. And considering
how horribly dismal the HUI sentiment has been so far this year, a ray of
hope shining in from the HGR is certainly most welcome.
Here is a smaller
essay-sized version of the chart that caught my attention. Note the
well-defined secular uptrend channel rendered below, which shows that the HUI
has been rising faster than gold on balance for many years now. Also note
that the HGR is once again near the lower support of this trend channel
today. Each time in the past this happened, soon after the HGR soared
as a mighty HUI upleg launched.
The HGR is the blue series
in these charts, with accompanying key moving averages. It is
superimposed over the raw HUI itself, shown in red. Not surprisingly,
when the underlying HUI shoots higher in a mighty upleg,
it rises much faster than the gold price and hence drives the HGR
heavenwards. And the beginnings of such hugely profitable major HUI uplegs in recent years have occurred at HGR support.
The HGR secular support
line shown here is well-defined. The HGR bounced off it decisively in
mid-2002, early 2003, and mid-2005. In each case the HUI surged sharply
after its HGR support approach. And today the HGR is once again
converging to this same support line that has been so bullish for the HUI so
far in its bull market to date.
And interestingly a top
resistance line perfectly parallel to the lower support is also readily
evident in this chart. At the end of major uplegs,
the HUI would get ahead of itself and correct, falling faster than gold which
leads to gold’s relative outperformance which
drives the HGR down. While there was a massive above-resistance surge
in late 2003, this parallel resistance line held strong in mid-2002,
late-2004, and early 2006.
So the complex and often
tactically chaotic interrelationship between the gold stocks and the metal
that drives them can be distilled down into a simple technical uptrend!
The strength and potency of any trend channel is directly proportional to the
number of years that it has remained in place. With this uptrend
starting way back in 2002 and showing no signs of failing yet, odds are it is
pretty important to consider.
Its simple message today is
buy gold stocks because they are probably on the verge of a major upleg. When the HUI performance has been bad for so
long that the HGR is driven down to support, a period of gold-stock outperformance is once again due. We are very near
such a critical bullish inflection point today.
This is very exciting, but
as a lifelong student of the markets I am usually more interested in why
particular trading signals work rather than just trading blindly on their
mere existence. So the logic underlying this HGR secular uptrend, and
the alternating cycles of gold then gold-stock outperformance,
is very intriguing to me. Having pondered this question for some weeks
now, this pattern makes sense.
All financial markets are
driven by never-ending sentiment waves. These waves are the collective
sum of traders’ emotions regarding a particular sector. Their
crests are driven by greed, euphoric times when new
highs are being carved and traders think prices will never stop rising.
Then inevitably the troughs driven by fear follow, dark times in the bowels
of major corrections when traders think prices will never quit falling.
All tactical price action is ultimately the result of aggregate popular greed
and fear.
Gold stocks and gold
certainly aren’t immune to these sentiment waves. In fact, given
the incredible gold-lust that burns deep within virtually all the hearts of
men, gold’s reactions to collective greed and fear are often
magnified. There is an old market aphorism stating “there is no
rush like a gold rush”, and history certainly validates it.
Although there are separate
sentiment waves echoing through both gold and gold stocks, for a couple reasons
gold’s usually steer both sets. First, the gold price is much
more fundamentally-driven than the stocks. Gold’s annual mined
supply is very finite, and nothing can rapidly speed its growth due to the
difficult and time-consuming nature of this industry. So gold’s
price should be closer to fundamentals than stock prices most of the time,
and far less noisy.
Stocks, ultimately, are
just paper. While they do represent fractional ownership in real gold
mines, existing companies can issue new shares at will and new companies can
form at any time and float stock. Both of these events add to existing
gold-stock supply. While gold supply growth is ironclad finite, theoretically
there are no limits on gold-stock supply growth. This means gold-stock
prices are not as fundamentally absolute as gold’s and hence more
susceptible to tactical sentiment-driven anomalies.
Second, gold is the
ultimate driver of gold-stock prices. Gold miners mine gold, so higher
gold prices lead to higher profits. The stock markets eventually reward
higher profits by bidding up stock prices to reflect them. And there is
a psychological element here too. Gold-stock traders are most likely to
buy gold stocks when gold is rising. So climbing gold is the primary
catalyst for bullish gold-stock action, leading gold to influence gold stocks
and not the other way around.
Although gold is being
driven relentlessly higher on balance by fundamentals, its path is
not arrow-straight. Sentiment waves force gold to oscillate around its
long-term uptrend, temporarily going above trend when traders get greedy and
excited and temporarily going below when they get scared and worried.
These sentiment flows and ebbs in gold largely drive the sympathetic yet
amplified gold-stock sentiment waves.
When gold strength gets
gold-stock traders excited, their capital floods into the relatively tiny
gold-stock sector. Stock prices soar as they try to absorb the capital
inflow. Eventually, as in all uplegs in all
sectors, greed grows too great and all the traders who want to buy have
bought. Then the inevitable correction arrives. The resulting trough
of the sentiment wave brings selling and ultimately fear,
and gold-stock prices are hammered.
I think these sentiment
waves are what we are seeing in the chart above, the logical cause for a
tight secular HUI/Gold Ratio uptrend channel carved over years. When
the greed part of a wave arrives both HUI and gold rise but the stocks rise much faster since they have such a tiny collective
market capitalization compared to the trillions of dollars worth of gold out
there. This dynamic drives the HGR higher to its upper resistance
line. These events are marked “surge” in this chart.
Then when the sentiment
waves crest, gold and the HUI tend to peak within close temporal proximity of
each other. Four of these peaking events, marking the ends of major HUI
uplegs, are numbered above. Note that they
generally occur at or above upper HGR resistance. Soon after when the
trough of the sentiment waves follows, it manifests itself in parallel
corrections in gold and the HUI.
But just as the HUI leverages gold’s gains to the upside
when greed is waxing extreme, it also leverages gold’s losses to the
downside. During the ebbing of the sentiment wave when the HGR is
retreating, it is often not because gold is rising faster than the HUI but
because gold is falling less fast than the HUI. This too
represents gold outperformance relative to the
HUI. These episodes are labeled
“drift” above, and they drag the HGR back down to its
support. We see this HGR surge, top, drift, bottom pattern over and
over again.
Thus there seems to be a
logical sentiment cause for the HUI and gold interaction that created the
stunning uptrend in this chart. Since these waves hit with some
regularity and tend to have similar amplitudes and durations, they are able
to gradually flesh out a linear ascent. It is really fascinating to
step back from the markets and try to understand sentiment and its effects
from a strategic level!
Even with a probable cause
outlined, the conclusion is the same. The HUI/Gold Ratio is near
secular support because the fear trough of a sentiment wave is passing.
Gold has outperformed the HUI for a year now, as evidenced by the falling
HGR, but since the HGR is near support this episode is probably drawing to an
end. In order for this cycle to continue and the HUI to outperform gold
and drive the HGR up to resistance again, we are going to have to see another
massive HUI upleg.
Although the regularly
alternating episodes of HUI-then-gold relative outperformance
driven by sentiment are the most intriguing part of this whole thread of
research to me, the tactical HGR is also quite interesting. If we zoom
into just the very right edge of the chart above, since gold’s and the HUI’s latest interim tops of last May, this latest
drift is forming a tightening wedge. It is rendered here.
While this tactical wedge
is not as well-defined as the secular uptrend, it is still quite apparent
when drawn with best-fit lines. Interestingly it is symmetrical too,
with its upper resistance representing the same slope, but inverted, of its
lower support. This sideways action is technically a drift, a period of
gold outperformance, but with the HGR trending flat
neither the stocks nor the metal have pulled
decisively ahead for a year.
This wedge pattern is
getting ratcheted tighter and tighter the longer that gold and the HUI
struggle for the outperformer crown. At the
current wedge rate of convergence, it takes about two months for a 0.01 HGR
increment to be cut out of the wedge. With the wedge point now trapped between roughly 0.51 to 0.54, this means that this wedge
must mathematically break this summer and it will likely fail even sooner.
The big question is which
way will the HGR go once its tactical wedge fails? Will the HUI
outperform driving the ratio higher or will gold outperform driving it
lower? Based on the bull-to-date precedent discussed above, I think the
odds far favor the HUI outperforming gold so the
HGR breaks out to the upside. Here’s why.
Gold remains in a strong
secular bull market for fundamental reasons. I discussed the very
latest gold fundamental data in the new May issue of our monthly
newsletter just published this week if you are interested. It is
incredibly bullish! Gold’s global mined supply is falling
while its demand is rising, a sure recipe for higher prices. And if
gold is still in a secular bull, then gold stocks will ultimately
follow it higher.
As the history of the
HUI/Gold Ratio clearly shows, periods of HUI outperformance
alternate with periods of gold outperformance.
Over this past year we’ve been in a drift phase, where gold was outperforming
the HUI on balance. Thus we are due to reenter
the other state where the HUI outperforms. This can only happen if a
major new gold-stock upleg is on the verge of
launching. So cycle probabilities favor the
HGR breaking out to the upside.
This leaves one more
exciting question. If a major HUI upleg is
coming and it ultimately drives the HGR up to resistance again, how high
could the HUI go? Well, based on the first chart the next HGR
resistance intercept should be between 0.65 and 0.70. So let’s
use 0.68 as an estimate. And of course the level of the HUI at this
secular resistance line depends on where gold itself tops.
If gold was merely to top
at $700 when the greed-laden crest of the next sentiment wave passes, then a
0.68 HGR yields a potential HUI top of 475. This is 40% higher from
here! Imagine how a portfolio comprised of elite high-potential gold
stocks would perform if the HUI merely rises to 475. I suspect the
ultimate upleg gains would be pretty awesome.
But odds are gold is not
just going to stop at $700 in this upleg. The
massive gold upleg that topped last May,
gold’s first Stage Two investment-driven upleg, soared about 70%. Back in Stage One, gold uplegs tended to run around 20% each. Using a
conservative back-weighted average, let’s assume gold will run 40%
higher in this upleg. From its lows of this
past October, a 40% gain would carry gold to $785.
At $785 and a 0.68 HGR
resistance level, the HUI itself would have to soar to 535 or so! This
is 55% higher from here. As always these exact target numbers
aren’t all that important, just the understanding that if the HUI/Gold
Ratio sticks to bull-to-date precedent the next major interim high in the HUI
should be far higher than today’s levels. If such an upleg indeed materializes, traders riding it will win
enormous profits.
At Zeal we have been
preparing for this expected upleg since the October
lows. We have deployed a bunch of gold-stock positions already, and are
buying more on weakness. Some have been stopped out on the HUI’s various pullbacks since then, but the
survivors are thriving. This week even in the depths of the latest HUI
pullback, we had unrealized gold stock gains running as high as 65% on
individual stock trades.
If you are looking for
cutting-edge research and analysis on not only timing major gold-stock uplegs but on finding the highest-potential gold stocks
to buy to ride these uplegs, our acclaimed monthly Zeal Intelligence newsletter is
for you. In it, as we have done in every HUI upleg
since 2000, we research and recommend elite gold stocks when the technical
timing to buy looks opportune. The profits so far have been great and
should only grow as this bull matures. Please subscribe today and join us!
The bottom line is the
HUI/Gold Ratio is approaching its long-term support. In this bull to
date, each time this has happened the HUI has soared heavenwards soon after
in a mighty new upleg. With gold’s
fundamentals still awesome, and gold driving this
gold-stock bull, the odds favor the HUI soon
outperforming gold again and surging higher to drive up the HGR as it has done
in the past.
The HGR drift of
the past year has been a trying one psychologically, but it has built the
perfect foundation for a new upleg to launch.
Not only is HUI sentiment still pretty pessimistic today, the contrarian time
to buy, but it has built a new higher technical base from which to launch its
assault on new highs. On top of all this it is technically due to start
outperforming gold again in a cycle sense.
Adam Hamilton, CPA
zealllc.com
May
4, 2007
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information.
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comments, or flames? Fire away at
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messages though and really appreciate your feedback!
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