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Trading the HUI/Gold Ratio

Adam Hamilton
November 6, 2004

With gold pushing shiny new 16-year highs this week, contrarian investors and speculators continue to earn dazzling profits in this young bull market. But even though gold's mainstream notoriety continues to gradually increase during exciting weeks like these, it remains a very small sector in the grand scheme of the markets.

As I discussed a couple weeks ago, actively trading an up-and-coming sector can be quite challenging. Young bull markets in traditionally overlooked sectors lack the amazing array of highly specialized trading indicators which the mainstream stock markets take for granted. As such, contrarians are constantly striving to create innovative tools to aid their trading decisions.

In response to my thoughts on designing custom HUI-specific indicators carefully tailored for today's gold-stock bull, I have been blessed with some fantastic feedback. I am very grateful as generous speculators, investors, and analysts from around the world have shared some outstanding ideas with me. I have learned a great deal so far thanks to these people graciously helping me expand my perspectives on trading indicators.

One gentleman sent me a neat idea last weekend that led to this essay. He developed an innovative and elegant way to cull crystal-clear major intermediate trading signals out of analyzing the ongoing relationship between the HUI and gold. This really caught my attention since ratio analysis is becoming increasingly popular among contrarians these days.

A ratio, which in market terms is one price series divided by another, provides an excellent way to precisely quantify the relative performance between two different market prices. When a ratio is created with price A as the numerator and price B as the denominator, the interrelationship between A and B is far easier to understand. The single A/B ratio graph is vastly more intuitive and easier to assimilate than the challenging exercise of trying to mentally combine two separate graphs of A and B to understand their relationship.

With this A/B ratio example, if A is outperforming B the ratio will rise. But if A is lagging B, the ratio will fall. Thus the ratio distills and illustrates the relative performance differences over time between two separate price series. Ratios can reveal subtle trends in relationships that are difficult to detect when comparing two conventional price charts.

The popularity of ratio analysis has exploded in the past five years or so. I suspect a key factor in this development is the emergence of powerful websites like www.StockCharts.com that enable traders to instantly and effortlessly create any kind of ratio they wish. By entering any two financial symbols in StockCharts.com separated by a colon, new ratios can be created as fast as one can think them up.

One particular ratio that has long intrigued contrarians is the ratio of gold stocks to gold itself. During any major bull market in gold, there are times when gold stocks radically outperform gold during uplegs. Naturally these are the very times when investors and speculators want to be heavily long gold stocks. Conversely, there are also inevitably times when gold outperforms the gold stocks. While this can be due to gold rising faster than stocks, more often than not it is the result of gold stocks correcting far faster than gold. These are not good times to be long.

Since today's premier unhedged gold-stock index is the HUI, the gold-stock-to-gold ratio of choice today is the HUI/gold ratio. This is easy to pull up at StockCharts by typing in the symbol $HUI:$GOLD . While this ratio is discussed and debated almost constantly on Internet gold forums, I hadn't yet seen a comprehensive and elegant way to trade it for major intermediate trends until last weekend.

My friend and fellow analyst/financial commentator, Matthew Frailey, graciously shared a simple and brilliant approach to trading the HUI/gold ratio with me. Mr. Frailey runs www.BreakPointTrades.net where he shares comprehensive technical analysis and speculation signals with his subscribers. He publishes a weekly newsletter covering many sectors including gold as well as periodically contributes essays to gold portals. In addition, as a technician's technician he is an adept chartist ranked high in the StockCharts.com Hall of Fame. If you love charts as much as I do, you owe it to yourself to check out his website.

While pondering how to help his clients ride the same major intermediate trends in gold stocks that we chase, Mr. Frailey pointed out the following to me. "Rather than analyzing a chart of the HUI, I think a ratio between the HUI and gold metal is far more useful. Gold stocks tend to outperform or underperform gold metal at various times. Obviously, it is the times when gold stocks outperform the metal when you want to own gold stocks."

In order to discern these times when gold stocks are due to outperform gold in a major upleg, Mr. Frailey developed a great system that parses the undulating HUI/gold ratio to ferret out key buy and sell signals to ride major intermediate trends. By deftly combining linear resistance breakouts with 50-day moving average failures, his system throws out very clear signals that are unambiguous and easy to interpret. As an added bonus, these signals are easy to watch for in the future on a StockCharts.com $HUI:$GOLD ratio chart.

Our three charts below detail this trading system, beginning with a bull-to-date HUI/gold ratio strategic view to outline the general thesis. After this, we zoom into the latest major upleg and correction in gold stocks in additional graphs to observe how the most recent HUI/gold ratio trading signals unfolded on a tactical level.

Before we delve into how to trade it, the HUI/gold ratio itself is quite interesting. Notice above how this ratio systematically marches higher during our current secular bull market in gold and gold stocks. Powerful uplegs unfold as the HUI outperforms gold stocks. After these uplegs when the HUI and gold inevitably correct to take a healthy breather though, the ratio tends to consolidate, either grinding sideways or retreating. If you compare this ratio graph with a conventional HUI-only graph, of course the ratio uplegs precisely match the HUI uplegs' timing.

Now since this ratio reveals the relative performance of the HUI compared to gold, it offers deeper clarity in some senses than a HUI chart alone. While a HUI-only chart shows an effect, gold stocks leveraging a gold bull, this ratio chart illustrates the relationship between the cause (gold bull) and effect (gold-stock bull). This ends up filtering out some of the incessant noise that plagues HUI charts.

For example, during every major post-upleg consolidation to date, late 2001, late 2002, and late 2003, the HUI appeared to carve double tops which spooked some players. Double tops tend to be bearish, since the standard interpretation is that a price is hitting major bull-to-date resistance for a second time but remains woefully unable to punch through.

In the ratio chart shown above though, the HUI interim highs of mid-2001, mid-2002, and late 2003 are very unambiguous. The ratio topped and headed lower into the necessary correction without any technical lollygagging. No ratio double tops formed. Many intriguing comparisons like these become evident if you compare a HUI/gold ratio graph to a HUI-only graph. The ratio expressing the cause and effect as one seems to act as a filter to helpfully moderate the high noise levels inherent in the pure HUI data.

Matthew Frailey's elegant HUI/gold ratio trading system is drawn in above. A combination of the blue top resistance lines during consolidations and the white 50-day moving average during uplegs is used to define major buy and sell signals. If you look at the actual green and red buy and sell signals drawn on this chart, it is readily apparent that buy signals flash right as major uplegs launch while sell signals sound soon after these uplegs top. This system's timing for gaming intermediate gold-stock trends is quite good.

In order to define a HUI/gold ratio buy signal, the ratio must first decisively break out above its latest consolidation's upper resistance line. In the past four years there have been three major consolidations with three resistance lines, all drawn above in blue. These resistance lines connect the latest bull-to-date ratio high with the inevitable subsequent descending highs as gold stocks correct after a major upleg.

For months after a major interim top, the HUI/gold ratio struggles but continues to fail near the consolidation resistance. But, eventually, sooner or later sentiment waxes too negative so a major new upleg is due to erupt. The actual advent of this upleg, and the end of the preceding correction, is announced when the ratio finally musters the strength to blast up through and shatter the consolidation resistance lines.

Such buy signals flashed in early 2002 and mid-2003 right on the door step of the two most powerful gold-stock uplegs in this bull to date. Investors and speculators alike would have done very well to throw long quality unhedged gold stocks as these buy signals triggered. Incidentally, the latest buy signal just flashed in August and suggests we are already in the early months of the next major gold-stock upleg today.

Mr. Frailey defines sell signals as times in major uplegs where the HUI/gold ratio collapses back down below its 50-day moving average. During the uplegs the ratio's 50dma tends to act as strong support until the upleg reaches maturity. But once a major upleg crests, soon after the event its 50dma fails as support. It is these very moments when the HUI/gold ratio decisively pierces through its 50dma to the downside when speculators should consider selling their gold stocks to ride out the coming correction.

Three of these HUI/gold ratio sell signals are drawn in the graph above, each of which occurred after one of the major bull-to-date uplegs in the HUI. Any speculator who heeded these signals could have avoided 80% or so of the subsequent corrections following the major uplegs. Naturally this would put speculators way ahead in the capital game, since they could ride the uplegs but then deftly pull out their capital early in the corrections so they don't suffer serious losses. Then this prudently preserved capital can be plowed right back in when the next buy signal triggers.

So a HUI/gold ratio buy signal is triggered whenever the ratio decisively breaks out from a descending resistance line during a consolidation/correction. The subsequent sell signal then triggers when the ratio's 50dma fails as primary support following a major upleg. Definitely simple, yet elegant and very effective so far in this gold bull to date!

Now that you have seen the big strategic picture, these signals become even more clear when considered from a tactical perspective. In order to illustrate this, we zoomed in to consider last year's massive upleg to show a buy signal and this year's ugly correction to highlight a sell signal. The blue dashed squares in the strategic chart above show the zoomed in areas from which our next two tactical charts have sprung.

Calendar 2003 was a phenomenal year for contrarians invested in gold stocks, and this ratio certainly shows it. Between March and early December, the HUI took off and vastly outperformed gold. This period of relative strength does a fantastic job of illustrating how to combine HUI/gold ratio buy and sell signals to ride a major upleg in gold stocks.

The whole process begins during a consolidation following the last major upleg. During this time gold stocks, since they are leveraged paper, tend to fall farther and faster than gold. The relative underperformance of the gold stocks creates a downtrend in the HUI/gold ratio. This ratio grinds lower within the confines of this trend, periodically rallying but usually failing to break back above its descending resistance line. Until the ratio resistance breakout actually occurs, investors and speculators can bide their time while the correction fully runs its course.

In March 2003 gold stocks bottomed as Washington prepared to invade Iraq. The HUI/gold ratio started trending higher from that point but didn't break out until the beginning of June. While the HUI did rise between March and June, one thing I really like about this particular trading tool is it demands conservatism. Trying to catch falling knives, picking the exact HUI bottom, can be hazardous. Speculators can use other tools to attempt this if they wish, but investors don't need to trouble themselves with this exercise.

By patiently waiting for the HUI/gold ratio buy signal of the resistance breakout, investors increase their probabilities dramatically that they are not buying in until a major new upleg is already underway. Most of the false buy signals are weeded out waiting for the breakout so the gains should accrue fairly steadily if a buy is made once the signal is flashed. It probably won't deliver an entire upleg into your lap, but the ratio will certainly alert you to the strongest 80% of one!

After throwing long gold stocks at the buy signal, all investors have to do is watch the HUI/gold ratio relative to its major 50dma support. As shown in white above, the ratio tends to bounce at its 50dma during all minor pullbacks until the HUI upleg has reached maturity. Shortly after the intermediate top, the 50dma fails as the ratio plunges down through this support line. Once the 50dma is decisively broken, it is time to sell and wait for the next HUI/gold ratio buy signal.

Now this sell signal will not be triggered at an exact top either, but this too is a very conservative approach. By waiting until the 50dma is decisively pierced, investors vastly decrease their odds of being whipsawed out early by a minor pullback within an ongoing upleg. Instead, a true 50dma support failure probably won't transpire until a major correction is already underway. This sell signal helps investors and speculators stay in as long as possible during a major upleg, but then gets them out while a major correction remains young and mild. Avoiding 80% of major corrections is a great way to multiply capital!

On a tactical level these signals are as easy to understand and apply as they sound. Buy on a ratio resistance breakout during a consolidation and sell on a ratio 50dma failure after a major upleg. Our final graph, covering October 2003 to September 2004, shows how well this elegant system works during major corrections.

After topping in late 2003, the HUI entered a brutal correction in early 2004. The HUI/gold ratio declined because gold outperformed the HUI in the initial months of this correction and then gold sunk far less rapidly than the HUI in the correction's late capitulation stages last spring. This traumatic event is recent enough to remain seared in the memories of contrarians, so it is perfect to illustrate the HUI/gold ratio signals during a major correction.

After a major interim top is carved, at some point in the subsequent weeks or months the HUI/gold ratio's 50dma fails as support. This failure, which happened in December 2003, acts as a sell signal to warn speculators of an impending correction. In this latest example, the HUI was trading near 240 when this alarm signaled but only 170 at its May bottom, so heeding the sell in December would have saved speculators 29% in additional losses, not bad at all!

After the 50dma-failure sell signal triggers, the ratio starts grinding lower in general although this decline is punctuated with periodic relief rallies. After a couple of these relief rallies are burned into the charts, traders can start plotting a ratio resistance line like the one shown above. As this line is gradually defined over the correction months, it creates a reference point from which traders can watch for the first decisive breakout.

As long as this resistance line holds, no buy signal is triggered and odds are the HUI remains in consolidation/correction mode. As you can see above, the resistance tends to repel the periodic ratio advances and keeps the downtrend intact. But once a decisive breakout occurs, as in August 2004, then a buy signal is triggered and it is time to throw long again in anticipation of a major new gold-stock upleg.

Once again the conservative nature of this indicator really shines through. Using relativity tools, I went long our current upleg in April and May, which really was the interim bottom. Yet, even though the absolute bottom was indeed in May, the HUI still sputtered along and consolidated for several more months. This summer, which was psychologically grating for gold-stock investors and speculators, could have been avoided all together with this ratio indicator.

Conservatively this ratio breakout didn't occur until August, after the entire consolidation had fully run its course. While its buy signal wasn't triggered at the exact bottom near HUI 170, it did trigger around HUI 185 in August and therefore would have saved folks from enduring this summer's long demoralizing sideways grind. Once again, especially for risk-averse investors, it pays to err on the side of caution and wait until a new upleg is already underway rather than trying to catch falling knives.

The bottom line is Matthew Frailey's simple and elegant technical system to wring clear buy and sell signals out of the HUI/gold ratio is an excellent addition to any investor's or speculator's trading toolbox. Whether you use it as a conservative primary indicator as an investor or a secondary confirmation indicator as a speculator, it helps filter out the HUI noise to identify major intermediate trend changes early.

I am looking forward to observing this indicator myself as this awesome gold and gold-stock bull continues to unfold in the future. We will use it at Zeal to illuminate the HUI from a different perspective and provide confirmation for our other technical tools. It ought to help us continue to recommend superior gold stock and gold-stock options trades for our newsletter subscribers.

The better we can use technicals to illuminate the prevailing trends, the higher the probability we can detect major tradable trend changes early when they are still highly profitable to trade. As Mr. Frailey pointed out to me, the best time to own gold stocks is when they are due to far outperform gold in a major upleg.

Since the HUI/gold ratio quantifies the relative performance of gold stocks to gold, it provides vital clues of newly developing intermediate trends not readily evident in the HUI alone. And this neat HUI/gold ratio technical trading system defines simple rules to help capitalize on these new trends while they still remain young and promising.

November 5, 2004
Adam Hamilton, CPA
email: zelotes@zealllc.com

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