HUI
Leverage to Gold 4
Adam Hamilton
Archives
Feb 8, 2008
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
Feb 8, 2008
321gold Ltd

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