As a stock-market
sector, gold stocks are obscure, increasingly volatile, and seemingly
perpetually unloved. Yet investors and speculators choose to own them
anyway. Why? Because
in the past gold stocks have greatly amplified gold’s underlying
gains. Traders are betting this outperforming behavior
will continue in the future.
The outperformance
so far in this bull market has been enormous. At best in recent weeks,
the flagship HUI unhedged gold-stock index was up
1237% since its bull was born in November 2000. This incredible run was
driven by a 262% gain in gold since its own bull launched
in April 2001. Thus bull to date per simple math, the HUI has leveraged
gold’s underlying gains by 4.7x!
This awesome leverage has
helped early gold-stock investors and speculators earn fortunes in this
bull. We’ve been actively trading gold stocks since its birth, so
our subscribers have reaped massive rewards. Yet despite this very
profitable history, I wouldn’t hesitate to exit this sector in a
heartbeat if I thought gold stocks no longer leveraged gold.
Gold mining is a very risky
business, riddled with inherent perils including gold-price risk, geological
risks, operational risks, and geopolitical risks. Gold itself, on the
other hand, only has price risk. So gold stocks have to amplify
gold’s gains to compensate for their far greater risks. If they
fail to leverage gold, there is simply no reason to own them. Traders
would be far better off owning gold alone in such a scenario.
This explains why
gold-stock traders are growing uneasy today. Since the mid-August 2007
lows, at best gold is up 42.6% while the HUI is up 60.3%. This yields
HUI leverage to gold of just 1.4x so far in
this upleg. This is indeed disturbingly
low. Are gold stocks dead? Are we better off saying to heck with
them and trading gold alone?
After meticulously studying
HUI leverage to gold and listening to traders complain about it for many
years now, I’m convinced this concept is woefully misunderstood. HUI
leverage to gold is very real and powerful, and has generated vast profits
for gold-stock traders. Yet it unfolds gradually in its own good time,
defying trader attempts to shoehorn it into some artificially short time
frame.
It is amusing to watch
naïve traders try to force this long secular phenomenon into a tiny
intraday space. They will see gold up on some particular day, say 1%, so they will expect a perfectly parallel 4%
to 5% gain in the HUI. If the HUI doesn’t cooperate immediately,
they wither in fear and run around like Chicken Littles
proclaiming the sky is falling and gold stocks are dead.
But as these charts reveal,
HUI leverage to gold is not an ironclad minute-by-minute rule we can expect
day in and day out like clockwork. Instead it is an overarching secular
theme that gradually flows and ebbs over months and years. Like
many gradual secular tendencies in the markets, traders can easily miss it if
they get so lost in the daily trees that they miss the far more important
secular forest.
There are different
approaches to analyzing HUI leverage to gold, including looking at the HUI/Gold Ratio. But a
more direct method is to study the raw leverage itself over time frames
particularly meaningful to traders. As a long-time gold-stock trader
myself, no time frames are more important to me than major HUI uplegs
and corrections. Traders long these uplegs
and short or neutral on these corrections can earn vast profits.
Here the bull-to-date HUI
(blue) is superimposed over the gold bull (red). So far in their bull,
gold stocks have completed seven major uplegs
and seven major corrections (collectively “segments”). Over
each segment, which are defined by major interim HUI
highs and lows, the actual gains or losses in both the HUI and gold are
noted. Dividing these results yields the yellow numbers, segment
leverage.
For example, back in 2003
the HUI surged 125% higher in the 4th major upleg
of its bull. Over that same period of time to the day, gold rose
23%. This yields HUI leverage to gold in upleg
4 of 5.5x. Realize that these segment-leverage
comparisons are HUI-optimized. We are concerned about the HUI’s leverage to gold here, not gold’s
nonexistent leverage to the HUI.
Major interim gold extremes
occur near the HUI’s but not always on the
same day. They are generally pretty close temporally though, with gold
usually topping or bottoming within a week or so of the HUI. Thus the
gains/losses in this chart tied to specific HUI segments are precise, but
gold’s aren’t necessarily since they are reckoned within the HUI
segments’ time frames regardless of actual gold tops/bottoms.
This chart yields all kinds
of interesting insights. Starting with the uplegs,
note that the HUI’s leverage to gold is
trending lower as this bull matures. Major upleg
2 ending in June 2002 witnessed incredible 7.2x leverage while upleg 6 ending in May 2006 only managed 2.0x. Although
individual uplegs vary considerably, there is
definitely a general compression trend in HUI leverage to gold.
A couple major factors are
contributing to this. First, as the HUI climbs higher and its component
companies grow larger, it takes a lot more capital to drive similar
gains. Doubling the HUI from 36 to 72 off its secular bear low of late
2000 was much easier to accomplish than doubling it again from 300 in mid-August 2007 to 600 in the coming
months. Bigger companies have more inertia and are slower to move.
Second, the uplegs in gold itself are getting a lot bigger in Stage Two. The HUI’s 6th major upleg
that ended in May 2006 rocketed 137% higher, the second biggest upleg of this bull. Yet because gold simultaneously gained 68% in its first
mighty Stage Two upleg, the HUI’s
segment leverage plunged to 2.0x. Did this
make gold stocks a bad trade? Heck no! No trader in his right
mind would pass up a 137% sector gain in one year.
Bigger, and hence
slower-moving, gold miners combined with much larger gold uplegs
are gradually compressing HUI leverage as these bulls mature. I
don’t think this is a problem as long as the HUI’s
absolute upleg gains remain large and it still
amplifies gold’s gains. Personally I believe the gold stocks are
worth their risks as long as leverage remains above 1.5x
across entire major gold uplegs.
While amplifying
gold’s gains by over 1.5x sounds acceptable to me, it may not to
you. Each trader, based on his own individual assessment of the
relative risks of gold stocks versus the risks of gold itself, has to make
this judgment call. But a good decision on this front cannot be made
until you have a solid strategic understanding of how HUI leverage to gold
has evolved in this bull.
Provocatively the HUI’s major downlegs
really haven’t witnessed this leverage-compression trend, with 5.0x-ish
levels remaining pretty consistent. Nothing frightens gold-stock
traders into selling like a falling gold price. This increasingly
asymmetric downside risk is one of the reasons why it is so important to game
the HUI’s upleg and correction rhythms. Corrections
must be avoided or shorted to maximize overall gains.
One problem with any
long-term chart is early percentage gains are no longer comparable
visually. For example, today young upleg
8’s 60% gain since mid-August looks way bigger visually than upleg 1’s far-larger 113% gain in early 2001.
So in order to eliminate this distortion, I individually indexed each
segment in this next chart. Each major upleg
or correction starts at 100 and runs from there.
When these segments are
individually indexed, percentage gains and losses become perfectly comparable
over time. While HUI upleg leverage is
compressing, absolute HUI gains in its massive uplegs
are not. Gold’s underlying gains in Stage Two are much larger as upleg 6 shows, but this doesn’t negate the enormous
absolute upleg profits in the HUI.
This is a complex chart
built from a complex spreadsheet, so it is not without peculiarities. The
raw HUI (gray) is rendered in the background to help place major
segments. The same individual HUI (and gold) segments shown in the
first chart are indexed and slaved to the right axis here. While it
appears some segments don’t start at 100 graphically due to charting artifacts, they all do mathematically. The
underlying analysis is sound.
HUI leverage to gold is
apparent here in any given segment as the relative difference in performance
between the blue HUI line and the red gold line. In every case
the HUI amplified gold’s underlying gains and losses, but to varying
degrees. While it is tricky to see at this long time scale, it is very
important to note the difference in slopes of the gains in HUI uplegs versus the underlying gold gains.
Generally during
major HUI uplegs, the underlying gold uplegs gradually move higher in a linear
fashion. In other words, gold tends to meander higher consistently
within a fairly tight uptrend. Since the world’s aboveground gold
supplies are worth at least 25x the market capitalization of all the
world’s gold stocks combined, gold is simply a bigger and slower
market. Its gains are usually pretty even across an upleg.
Contrast this with the
HUI. The gains in its major uplegs, while
often very large, were not linear. They are often closer to parabolic,
with a large proportion of an upleg’s total
gains accruing quickly near its very end. Of course with parabola-like
slopes, the gains in the middle of a HUI upleg must
slow down considerably to leave room for the big spikes in the end. This
harmless behavior causes
much angst since it isn’t well understood. Gold keeps climbing mid-upleg, but the HUI seems to fall behind irritating
traders to no end.
If you’ve read one of
my essays on HUI upleg rhythms, you recall
that this index tends to alternate between massive and consolidation uplegs. Massive uplegs,
such as 2, 4, and 6 above, drive the HUI to major new bull highs and witness
gains exceeding 100% in less than a year. But after massive uplegs, smaller consolidation uplegs
are necessary for traders to get comfortable with the new high prevailing
gold-stock levels. Uplegs 3, 5, and 7 above,
which are much smaller, are consolidation uplegs.
Since our latest completed upleg, the HUI’s 7th, was
a consolidation upleg that ended in July 2007, odds
are today’s young upleg 8 will prove to be
massive. Indeed it has already easily driven the HUI to new bull
highs. Since today’s upleg is probably
massive, we can get a better idea of what to expect in leverage terms by
studying the HUI’s leverage to gold in its
previous massive uplegs.
Thus these next three
charts zoom in on the indexed renderings above of massive uplegs
2, 4, and 6. When you individually expand these uplegs
to fill a whole chart horizontally, the differences in how HUI and gold
performances evolve within an upleg are much easier
to see. The actual upleg-to-date daily HUI
leverage to gold is also rendered in yellow. Its trends are much
more chaotic than most traders realize.
You’ll see some
common themes emerge in these indexed charts of major HUI uplegs
2, 4, and 6. Generally
linear gold gains combined with generally parabolic HUI gains yield wildly
swinging leverage readings throughout the life of an upleg.
With such high volatility, dwelling too much on upleg-to-date
leverage on any particular day is probably useless. All that matters is
the uplegs’ ultimate gains and leverage.
In the HUI’s
2nd major upleg ending in June 2002, there was a
huge initial leverage spike. This is common in virtually all uplegs. Major uplegs are
born in times of despair, when gold stocks are beaten down and only the
hardcore contrarians will even consider buying them. When gold starts
climbing in such an environment, it doesn’t take much gold-stock
bidding to drive an initial sharp spike in the HUI.
But after this initial
excitement, HUI leverage plunges. Old bearish theories popular during
the preceding consolidation create a wall of worries and enthusiasm
wanes. Meanwhile gold continues higher in its linear fashion which
moderates the HUI leverage to gold. Then about a third of the way into
a major HUI upleg, a gold surge typically ignites a
sharp HUI rally. This drives HUI leverage back up again.
After this second surge, a
consolidation often ensues leading into the upleg’s
halfway point. Very few traders believe a HUI upleg
is the real deal in its first half, so they sell on the second HUI surge and
gold-stock prices drift sideways. But meanwhile gold continues rising
on balance, grinding HUI leverage lower. This is a very tough time
psychologically for most traders, as the temptation to sell is often too
great to resist.
After this first
consolidation, the upleg passes its halfway point
and buying resumes. The HUI surges again heading towards its second
half. This generally drives leverage higher again, as the HUI is
usually able to climb faster than gold. But after this another
consolidation looms, the HUI trades sideways for weeks to shake out the weak
hands before buying interest can once again drive it higher.
After its second mid-upleg consolidation, the HUI surges into its final
third. Often about half of an entire massive upleg’s gains are realized around its final
third! Traders who can fight their emotions and hold on this long are
richly rewarded in riding the HUI’s parabolic
ascent to its upleg’s peak. Leverage
generally, but not always, rises in this final third as the HUI’s gains easily outpace gold’s.
This general pattern of HUI
performance, gold performance, and the resulting leverage swings becomes more clear as you consider all three of these charts.
At some times in uplegs the leverage is high, at
other times it is low. The HUI’s
leverage achieved is certainly not linear, but occurs periodically in fast
spurts. This is why it is so pointless to fret about the HUI’s leverage to gold midstream in an upleg. It is like the weather, wait a week or
two and it will probably change dramatically.
In addition to the wild
leverage swings, it is really important to note that the HUI’s
gains are not linear. Their slope generally accelerates over time, in
parabolic fashion. Also in any given massive upleg,
you probably need to expect two consolidations running for a month or so
each. Every time this happens, gold-stock traders freak out and assume
the upleg is over. But as these charts show,
mid-upleg consolidations are par for the course
here.
Provocatively the big, fast
gains that everyone remembers only come near an upleg’s
final third. No one seems to remember the initial two-thirds of
past uplegs that were always challenging
psychologically. It is only near the final third when excitement really
catches hold, especially among individuals. The HUI tends to surge and
within a matter of weeks virtually everyone is bullish so a major interim top
draws nigh.
While half of a HUI upleg’s entire gains often rapidly accrue near its
final third, this disproportionate outperformance
is even more pronounced for juniors. Due to their low volume and small
market caps, juniors are generally not owned by professionals managing mutual
and hedge funds. The amount of capital the funds need to put into
positions would drive such big swings in juniors’ prices that the funds
couldn’t enter and exit without wrecking their own trades.
So it is individuals
that drive surges in juniors’ stock prices, and these investors
don’t get excited until the final third of major HUI uplegs. Thus traders should not be surprised if
juniors’ performances seem inadequate in the early or middle stages of
a major upleg. As soon as individuals start
to believe that upleg is real and
sustainable, they will start flooding into small gold stocks and their prices
will soar.
The last massive HUI upleg we witnessed was its 6th major one ending in May
2006. While the HUI itself had its usual upleg
profile described above, gold’s was quite different. In its first
Stage Two upleg of this bull, gold went parabolic
on excitement near the end of its upleg just like
the HUI usually does. This drove down the HUI leverage to gold throughout
this upleg. It ended up at just 2.0x!
While I’d certainly
prefer greater leverage given a choice, I don’t have a problem with
this. Upleg 6 witnessed the first Stage Two
gold upleg we’ve seen since the mid-1970s. Gold-stock
traders, used to gold rallying 20% or so in its major Stage One uplegs, were not expecting the enormous 68% gains in upleg 6. Thinking too early that gold was too
overbought, a lot of traders held back. So upleg
6’s final third wasn’t as great as it could have been. Still
though, 137% absolute gains in the HUI in one year are well worth it.
Now that we are
definitively in Stage Two, traders expect bigger gold gains. They ought
to be less skittish in the final third of this HUI upleg.
So I expect we will see today’s upleg 8
ultimately exhibit leverage greater than upleg
6’s 2.0x now that Stage Two expectations are more reasonably
aligned. Regardless of its final leverage tally, I have no doubts that
the HUI’s ongoing leverage to gold will vary
wildly in this upleg.
At Zeal we’ve been
actively studying the HUI’s leverage to gold
for many years. Thus we don’t get scared when it looks inadequate
midway into an upleg. Today we are layering
in high-potential gold-stock positions for the probable upcoming final third
of this new massive upleg. With fully half
of an upleg’s total gains usually accruing
around its final third, the profits to come should be excellent even from
this point. Subscribe today to our
acclaimed monthly newsletter and ride the
best part of this upleg with us!
The bottom line is HUI
leverage to gold is declining in a secular sense, but it is still
excellent. As long as leverage remains high enough to compensate for
the many added risks of owning gold stocks, then gaming
the major HUI uplegs will remain very compelling
for traders. And within any major upleg, the HUI’s upleg-to-date
leverage will vary wildly. It is pointless for traders to worry
about leverage mid-upleg.
Also realize
that until their exciting final thirds, all major uplegs
are difficult to ride psychologically. They are full of significant
consolidations and periods where gold’s gains grow faster than the HUI’s on a short-term basis which drives down
leverage. As always though, the traders who can transcend all this
daily noise and keep the strategic picture in focus reap the greatest
rewards.
Adam
Hamilton, CPA
Zealllc.com
February
8, 2008
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