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August 15, 2008

Epic Gold-Stock Buying Op
by Adam Hamilton

The precious-metals stocks did not take kindly to gold's steep selloff this week. On Monday the flagship HUI gold-stock index plunged 6.0% at the climax of what can only be described as a crash. In this event's final 3 days, the HUI bled 13.1% of its value. In less than a month, it had plummeted 33.1% by the time the dust settled!

Although the HUI has a well-deserved reputation for extreme volatility, this selloff was still exceptional. Typically, sharp HUI declines emerge after major uplegs from high levels. But as you'll see in these charts, the HUI wasn't high technically when this heavy selling started battering it as August dawned. In fact it was already pretty beaten-up pre-crash, under both its summer support and 200-day moving average.

To drive such an ugly scenario, especially off of lows, sentiment among PM-stock traders had to be exceedingly bad. Great fear was necessary, and the catalyst for this fear was a technical breakdown in gold sparked by a sharp surge in the US dollar. Since gold stocks ultimately follow gold, sellers dumped PM stocks aggressively as they watched gold get hammered.

In the aftermath of such an extraordinary technical and sentimental event, most PM-stock traders feel shell-shocked and confused. Have gold stocks just weathered such a catastrophic event that their recovery will probably be measured in years? Or was this crash a short-term anomaly that has led to an epic gold-stock buying opportunity?

Of course much depends on gold for the answers to these questions. If its bull market is over, its stocks aren't likely to fare well as its price gradually retreats in a bear. But if this gold bull is alive and well, then gold stocks will probably recover rapidly. While it's beyond the scope of this essay to discuss gold's fundamentals in depth, I suspect the latter is the case. It takes a lot more than a speculative dollar surge to end a secular gold bull!

Global demand for gold, especially on the investment side, continues to grow. We live in a fragile era of economic disruption and rapidly inflating currencies which makes gold increasingly attractive for investors worldwide. Diversifying a fraction of one's capital into gold is almost always a very prudent investment strategy. Meanwhile global gold-mining output is actually declining despite very favorable price levels compared to history.

Gold is very challenging to mine which severely limits its mined-supply growth. It is unbelievably difficult and takes many years to explore for and find this elusive metal, secure permits and financing, sink mines, and bring new supplies to market. With global demand growth outpacing global supply growth, this gold bull remains healthy and should continue climbing higher on balance for years to come.

On top of these gold-specific bullish fundamentals, fiat-currency growth rates (say 7% to 8% annually on average globally) are several times greater than the growth rate of the world's above-ground gold supply (under 2%). Thus it is inevitable that relatively more units of any paper currency will be competing for relatively fewer ounces of gold. This fact alone ensures gold's bull will continue for many years to come.

So if gold's fundamentals still look bullish to you, then gold stocks are all but certain to follow their metal higher. Higher gold prices ultimately lead to bigger profits for mining this metal, lower valuations for gold stocks, and more investment demand chasing these companies to participate in their big profits. This is my own worldview today, so this essay is written from the perspective of gold's bull being very much alive and well.

And if gold's secular bull does indeed continue its resolute march heavenwards, then odds are we just witnessed one of the greatest PM-stock buying opportunities of this entire bull. The following charts highlight just how extraordinary this selloff was, how incredibly deeply oversold the HUI plummeted, and what a blessing it is for buyers to be presented with such low fire-sale prices deep within a powerful secular bull.

This first chart offers a short-term technical overview to provide perspective for the more important long-term charts below. From August 2007 to March 2008, the HUI was powering higher in a modest 71.5% upleg that carried it to all-time highs. It then corrected sharply, driven by a plunging gold price sparked by the Federal Reserve's "restraint" in not cutting US interest rates by 100 basis points on March 18th.

By late April the HUI had fallen 24.4%, but then it started gradually climbing higher again in its usual summer consolidation. By mid-July the PM stocks had rallied 20.6% and were near the top of their summer-doldrums trading range. Not surprisingly they started correcting around summer resistance, and within a couple weeks the HUI was back down to its summer support in late July. Everything was normal to this point.

But then unfortunately gold, also very low in its own summer range, took a big hit on a surprise dollar rally. The US dollar rocketed to its biggest daily gain against the euro since September 2000 on Friday the 8th after the ECB president said the weak European economy meant further rate hikes were unlikely. This led to an unfortunate chain of technical and sentimental events, described in this week's Zeal Speculator, that drove gold well under its own support.

On this chart, most of the crash from 400 or so on the HUI in late July to this week's appalling 314 low is the direct result of this dollar-spike-driven gold plunge. Sequential technical failures in gold sparked a devastating panic among PM-stock traders who raced for the exits. The result was a HUI close just 4.6% above August 2007's HUI low despite gold running 25.0% higher over this same low-to-low time frame.

Understandably such utterly dismal PM-stock levels drove much wailing and gnashing of teeth. To see the HUI languishing near 315 while gold was running around $825 was incredibly demoralizing. The HUI first hit such levels back in January 2006 while gold only traded around $560! It took fast and furious selling this week, with few offsetting buyers, to drive PM-stock prices back down to such bygone levels.

Now I have to digress into market psychology here. Just because the HUI hit 314 this week doesn't mean it is a valid appraisal of PM-stock prices. Extreme greed or fear can sometimes drive stock prices far above or far below where they would normally trade. And sentiment among PM-stock traders was definitely exceedingly bad, dripping with fear. But just as a beach ball held under water will spring to the surface once you release your hands, stock prices driven too low by fear will roar back as soon as that fear abates.

Legendary investor Benjamin Graham's favorite allegory humanized this phenomenon as Mr. Market. Mr. Market is a manic depressive. Sometimes he is very happy and high on stocks and only offers them to you at expensive prices. Other times he is deeply morose and depressed and readily willing to depart with his stocks for very cheap prices. Mr. Market is often very irrational and his most severe mood swings can drive serious short-term price anomalies.

Graham's key point was that investors shouldn't misinterpret Mr. Market's radical mood swings as representing the true value of the stocks they hold. Excessively skewed sentiment will soon pass. A strange confluence of one-time events led to this week's deeply oversold HUI. The dollar rallied sharply out of the blue right when gold was at a critical technical point. Gold broke down and PM-stock traders panicked. This all happened late in the summer doldrums when PM sentiment was already poor.

With PM-stock traders already spooked at best, selling quickly snowballed. Gold's breakdown scared some traders, compelling them to sell. The falling stock prices driven by these guys soon drove rational traders' stocks down to their stops too, putting more shares on the market and igniting a vicious circle. With few buyers around, in a usually low-volume span of time, prices had to fall sharply before PM-stock buy-side demand and sell-side supply finally equalized.

So while the technical damage in PM stocks was indeed severe, it was driven by unsustainably frightened sentiment. Prices can only remain deeply oversold as long as the fear that drove them there persists. But the markets abhor sentiment extremes so they never last for long. The same traders who sold aggressively this week will soon be buying back in once they realize the sky isn't falling.

These next two charts show just how extreme the HUI fear was relative to the history of this bull. As all contrarian investors and speculators know, the greater the popular fear the better the time to add new long positions. This latest irrational selloff in the PM stocks drove them down to levels not seen in a year despite gold being far higher now than it was the last time these levels were witnessed. If gold's bull remains intact, this week was one of the most epic buying opportunities of this entire PM-stock bull.

My Relativity trading theory applied to the HUI offers a great read on prevailing PM-stock sentiment. It simply takes the HUI and divides it by its own 200-day moving average on an ongoing basis. The resulting multiple forms a horizontal trading range. High rHUI points represent extreme greed and low rHUI points represent extreme fear. The greater the numerical extreme, the more intense and unsustainable the emotion driving it.

Note above that the rHUI low driven by this week's selloff was the lowest of this entire bull! Relative to its 200dma, the HUI has never been cheaper! This extreme oversoldness is absolutely unsustainable. How do I know? Check out the HUI's actions after previous rHUI lows. They never persisted for long since the sheer levels of fear necessary to hold the HUI this far underwater cannot last. Neither will today's.

Interestingly the secular rHUI support line had actually been gradually rising until this latest selloff. Fear extremes were becoming less intense as this gold-stock bull matured. This makes sense. The longer any bull runs, the more true believers it creates. These true believers aren't weak hands that are easily scared in any selloff. Despite this trend, rHUI support failed as our recent selloff was exceptional in its intensity.

Per Relativity trading theory, which has been very successful in trading this PM-stock bull, the HUI has never been more oversold than it was this week. This stunning development really buttresses the case that we just witnessed an epic once-in-a-bull buying op in irrationally beaten-down PM stocks. So if you have been looking forward to deploying capital in this sector ahead of the usual autumn gold rally, rejoice!

Before we move on, there are some interesting technicals readily apparent at this long-term scale that aren't obvious on short-term charts. First, check out the broken head-and-shoulders technical price formation in the HUI. Late in 2007 the HUI formed a left shoulder, then it surged higher to a head in early 2008. And then in mid-July the right shoulder formed. The neckline ran between 380 and 385 or so.

This H&S failure spawned major fear among long-term technically-oriented traders. When its neckline failed on the third trading day in August, that event called for a sharp decline in prices. Of course this pattern isn't always proven right, but countless traders watch for it so it can become a self-fulfilling prophecy. If enough traders act on any technical signal, their collective trading can actually transform it into market reality.

Second, this week the HUI bounced at an old support line that goes back to early 2006. This support now intersects a major basing zone established when the HUI consolidated between mid-2006 and mid-2007. So chances are there are tons of strong hands within 30 points on either side of 330. The HUI's huge year-long base in this range also argues that further sharp PM-stock selloffs are highly unlikely from here.

Another way to measure how overbought or oversold gold stocks are, and hence how much greed or fear is present, is to look at the HUI compared to gold. The HUI/Gold Ratio simply divides these two and the resulting multiple shows relative strength. When this ratio is rising, the HUI is outperforming gold. When this ratio is falling, gold is outperforming the HUI. This week incredible HGR extremes were also hit.

Prior to 2008, the HGR was climbing higher in the secular uptrend defined above. This started to fail earlier this year when the gold stocks failed to adequately leverage the underlying gains in gold. But this ongoing HGR secular support failure really became decisive this week. Since the HUI plummeted far faster than gold, gold effectively outperformed it which drove the HGR down to extremely oversold levels.

In fact, this week the HGR fell to its lowest levels witnessed since mid-2003! It has been over 5 years since the markets valued PM stocks so cheaply relative to the gold price. But like any other fear proxy that measures oversoldness, extreme HGR lows never persist. Look at past sharp HGR declines to deep lows in this chart. They never lasted for long because the HUI inevitably rallied sharply out of these dismal lows. Abnormal fear never persists, and big rallies emerge out of it once this fear abates.

Thanks to the HGR's poor performance in 2008, some traders including me are wondering if its old secular uptrend is obsolete. For example, it could now be in a giant horizontal range between 0.40 and 0.60 or so. Even in this unfavorable scenario (compared to the secular HGR uptrend), the HUI could still rally sharply. To go from a 0.40 HGR to 0.60, the HUI would have to rally 50% if the gold price merely remained constant. But odds are gold will rise, meaning the HUI will rally by far more to maintain this potential HGR range.

As the rHUI and HGR show, by virtually any measure the HUI was just hammered to the most extreme oversold lows it has witnessed in many years or this entire bull. The raw levels of fear necessary to drive multi-year extremes are staggering and never sustainable. As this irrational and intense fear dissipates, the HUI will rise until PM stocks more fairly reflect their long-term fundamentals in today's higher-gold-price environment.

And all this assumes gold is just flat, that it can merely sustain these levels. But odds are it is due for a major upleg in the coming months! I explained why last week in my latest essay on gold seasonals. A fascinating variety of cultural customs all converge in autumn to drive big increases in gold demand across all the world's largest gold consumers. Gold is traditionally very strong between August and February.

And if gold rallies this autumn as usual, the case for the HUI looks all the more bullish. Today's PM-stock buying opportunity looks epic even if gold stays flat. It is hard or impossible to find more deeply oversold levels than we saw earlier this week. But the higher gold meanders, the more anomalous today's PM-stock prices look. If gold starts climbing rapidly, and PM-stock traders quickly grow greedy, the resulting HUI rally could be truly explosive. The deeper the pre-rally lows, the more potential the rally offers.

At Zeal we've been preparing for early August seasonal lows in PM stocks for some time. We mostly sat out the summer doldrums, just trading GLD calls to ride the summer range. But in the last couple weeks we've started layering in new PM trades for the probable autumn gold rally. If you want to join us, please subscribe today to our acclaimed monthly or weekly newsletters. In the latter we picked up some incredible blue-chip PM-stock bargains just this week. And we will be buying more soon.

The bottom line is PM stocks hit incredibly oversold levels this week, their most extreme in many years or for this entire bull. It took exceptional fear to drive so much selling, and the catalyst that sparked this fear was a strange confluence of one-time events. Now that the huge daily dollar spike and resulting gold breakdown are behind us, the fear should rapidly abate and PM stocks will seek more rational price levels.

If the underlying gold bull driving the PM-stock bull remains alive and well, the buying opportunity in PM stocks today is nothing short of epic. And all signs indeed point to a continuing climb higher by the price of gold. Global supply and demand fundamentals for the metal remain very bullish while fiat-paper currencies are expanded by central banks at frightening rates. PM-stock buyers should rejoice!

Adam Hamilton, CPA
Zeal LLC.com

Do you enjoy these essays? Please help support Zeal Research by subscribing to Zeal Intelligence today! &www.zealllc.com/subscribe.htm

If you have questions I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/financial.htm for more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I WILL read all messages though, and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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