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November 06, 2009

HUI and SPX Pullbacks
by Adam Hamilton

After India's central bank gobbled up half of the gold (200 metric tons) the IMF recently offered for sale, gold surged 2.4% on Tuesday to a new all-time nominal high near $1085. Naturally traders flooded into the gold stocks to leverage such an exciting day, driving the flagship HUI gold-stock index up by 8.0%.

Although this surge was certainly fun, considered in context its results were disappointing. Believe it or not, in the hyper-volatile HUI an 8% up day isn't very rare. There was a 9%+ one in early September and a 7% one in early October. Considering gold rallied $25 in a single day and exceeded its old record by $21, the HUI ought to have done much better on Tuesday.

Even more disturbing though was the HUI's closing level that day, just 426. In this post-panic environment, the HUI was at this same 426 back in mid-September when gold was only at $1006. Seeing the HUI dead flat over a 7-week period where gold soared 7.9% reveals dreadfully poor performance. And back in October 2007 when the HUI originally hit 426, gold was only trading at $791! Gold stocks have really lagged.

Of course the stock panic explains this long-term disconnect, as precious-metals stocks are still recovering from their brutal panic beating. Eventually they will fully reflect today's much-higher prevailing gold prices. And it is echoes from this panic that are driving the short-term disconnect over recent months. Investors and speculators must realize that gold is no longer the sole driver of PM-stock price action.

Ultimately from a long-term fundamental perspective, the gold price is all that matters for gold stocks. The higher the gold price, the fatter this industry's profits grow for mining this increasingly rare metal. And over the long term in the stock markets, higher profits always translate into higher stock prices. But over the short term, traders often choose to ignore fundamentals and instead trade on emotions.

When greed and fear are controlling trading decisions, gold-driven fundamentals take a back seat to prevailing sentiment. And all kinds of things affect sentiment, including gold. This is why the HUI's surge on Tuesday amplified gold's own by 3.4x. But more often than not in this past year, gold has not been the dominating ingredient in the HUI's sentiment mix. This has really frustrated traders.

Eclipsing gold time and again lately, the general stock markets have often been the overshadowing influencer of PM-stock sentiment. When general stocks are doing well, PM-stock traders feel good and are more willing to buy. But unfortunately this relationship is asymmetrical, far more potent to the fear side. When general stocks start sliding, PM-stock traders' fears multiply rapidly leading them to aggressively dump their PM stocks.

Traders who understand the general stocks' sometimes overpowering influence over gold stocks are thriving in this post-panic environment. But traders still mired in the old only-gold-matters paradigm are really struggling. If you start considering tactical HUI moves in terms of not only gold action but general stocks' influence on prevailing sentiment, everything becomes much clearer and frustration vanishes.

The quickest way to reach this mindset is to consider the HUI's performance in the context of the general stock markets' performance this year. The definitive proxy for the latter is the broad S&P 500 stock index (SPX). And since it is the SPX's periodic pullbacks that are really wreaking havoc in the gold-stock world, we need to focus on them. The mild fear they spawn has really had a disproportional impact on the HUI.

The following chart overlays 2009's HUI price action (blue) on top of the SPX price action (red). Then these indexes' performances are compared during SPX pullbacks. These SPX pullback spans are the same ones I defined a couple weeks ago in an essay on the then-coming overdue SPX pullback. In addition to the HUI and SPX performances over these SPX-pullback spans, I included those of gold and silver for reference.

Before we dive into the particulars of the SPX's outsized influence on the PM stocks, it is crucial to keep the strategic context in mind. Since its early-March despair-driven low, the SPX has entered a new cyclical bull market. Mid-upleg pullbacks to rebalance sentiment are natural and healthy within all bulls, no matter how powerful. But today with traders still on edge thanks to the panic, the SPX's pullbacks poison sentiment universally. When this SPX bull wavers, even unrelated markets get nervous.

And the HUI is enjoying a powerful bull-market upleg of its own, trending steeply higher within the well-defined uptrend channel rendered above. So realize that the SPX action's influence on PM-stock-trader sentiment is operating within the bounds of this trend channel. SPX pullbacks are not really a threat to this strong HUI upleg, but more of a thorn in the side of PM-stock traders who haven't studied them.

Interestingly, since the March 9th SPX low the HUI has had a strong positive correlation with gold. It yields an r-square of 86%, indicating that 86% of the HUI's daily price action is statistically explainable by gold's own. But provocatively over this very same span, the HUI also had a similarly-strong positive correlation with the SPX. The HUI/SPX r-square ran 76%, nearly as intense as the HUI/gold one. Statistically, the SPX has almost influenced the HUI's day-to-day performance as much as gold!

Diverging briefly here, there is a common factor explaining why the SPX, gold, and the HUI have all been so highly correlated. It is the US Dollar Index. During last year's stock panic, traders fled the stock markets and flooded into US dollars and short-term Treasuries. Echoes of this panic trade still persist today, as the dollar tends to be strong when stocks are weak and vice versa. And of course the dollar's performance helps drive gold futures, leading to the SPX effectively driving gold via the intermediary of the US dollar.

So far since the March 2009 lows, there have been 8 pullbacks in the SPX. Today's is the eighth, which I suspect has yet to fully run its course. If you consider how the HUI has performed during the exact spans of these 8 SPX pullbacks, it will clarify much. Without exception, this year's frustrating periods where the HUI has underperformed gold are directly explainable by SPX weakness. General-stock sentiment splash damage has been spilling over into PM stocks.

The SPX fell 5.4% during its first pullback in late March. This was a quick 2-day pullback, and gold itself was also weak with a 1.9% loss. So naturally the HUI slumped too, down 4.7%. This loss was a little larger than gold's own warranted though. As a general rule of thumb, the HUI tends to leverage gold by about 2 to 1 over any short span of time. So the SPX dragged it lower than the 3.8% that gold had justified.

The SPX's second pullback in mid-April was very fast, 4.3% over a single trading day. Interestingly the HUI bucked the trend here, surging 4.0% that day on a large 1.7% gain in gold. This helped define a rather important exception to this SPX-pullback-and-HUI relationship. When gold rallies big and gets PM-stock traders excited, the positive sentiment sparked by the gold surge can outshine the negative sentiment spawned by the SPX slump.

The SPX's third pullback ran 5.0% over 5 trading days in May. But over this span gold was strong, up 1.7%. Given gold's strength, conventional PM-stock analysis would have expected 3.4% gains in the HUI (2x leverage to gold). But provocatively the HUI slumped 0.4%, effectively splitting the difference between the SPX's losses and gold's gains. At the time, I told our subscribers about this critical clue warning that the HUI was torn between serving two masters. Gold was no longer its only concern.

The SPX's last meaningful pullback (fourth), its only significant one of this upleg until today's, dragged this elite stock index down 7.1% over 19 trading days in June and July. Gold weathered this weakness impressively well, only sliding 2.8%. But the poor HUI didn't prove as resilient, falling 10.2% (3.6x downside leverage to gold). And silver, a volatile commodity as affected by general sentiment as gold stocks, plunged 14.6%. Clearly SPX weakness was poisoning sentiment among PM-stock traders.

The SPX's fifth pullback in mid-August was much milder at 3.3% over 2 days. Gold, also pretty correlated with the SPX especially during pullbacks, fell 2.2% too. With both of its major drivers weak, the nervous HUI was really hit disproportionately hard. It plunged 7.3% (3.3x leverage). With gold in the $940s, this PM-stock weakness was very frustrating for traders. Gold remained very high in historical terms, yet gold stocks were still being sold aggressively.

The SPX's sixth pullback straddling the August/September border reignited that exception where very positive sentiment generated by a gold surge can drown out weak sentiment generated by an SPX slump. The SPX fell 3.5% over this 4-trading-day span, yet the HUI surged 6.7% higher on a 3.2% gold rally. But before the sharp 2.4% gold rally of September 2nd (same percentage gain as this Tuesday's), the HUI was down 3.8% in the preceding 2 days. Thus the HUI rocketing 9.3% higher on the third day masks its weak mid-SPX-pullback internals that existed for most of this sixth pullback.

Nevertheless, I'm thankful to know that when push comes to shove, even over the short term, gold still wins out in the hearts and minds of today's PM-stock traders. They will respond favorably to fast-rallying gold prices almost no matter what the SPX is doing. It is only when gold is flat or weak that spillover SPX fear really taints PM traders' sentiment.

The SPX's seventh pullback erupted in late September, witnessing a 4.3% loss over 8 days. And yet again the HUI was hit hard by the SPX weakness's impact on universal sentiment, falling 7.7%. Meanwhile the gold price was only down by 1.2%, so it certainly didn't justify the HUI's considerable retreat. Thanks to the SPX's sentiment-poisoning impact, the HUI leveraged gold's decline by 6.4x. This is no big deal if traders are psychologically prepared for it, but if they are caught unaware it is very discouraging.

Finally the SPX's eighth pullback began in mid-October in the heart of a dazzlingly-bullish Q3 earnings season. While I doubt today's pullback is over yet, as of last Friday it had sliced 5.6% off the SPX over 9 trading days. Once again gold proved impressively resilient, only retreating 1.7%. Yet the excitable HUI was just crushed, down 12.9% over this short span of time. This 7.6x downside leverage to gold, the SPX splash-damage effect, was getting pretty excessive.

On average across all 8 pullbacks, the SPX fell 4.8%. Meanwhile gold only averaged a 0.4% decline over these spans, trivial. Yet the HUI's average decline across these SPX pullbacks ran 4.1%. Put into leverage-to-gold terms, this is 10.3x downside leverage! There is simply no doubt at all that the fear spawned by SPX pullbacks is spooking PM-stock traders, leading them to sell unless gold is surging.

This revelation has important practical implications for PM-stock investors and speculators today. First, next time the HUI is underperforming gold, look to the SPX for answers. If the general stock markets are weak, the PM stocks will follow them down unless gold is surging up so fast that PM-stock traders just can't ignore it. This shouldn't frustrate us though, as the HUI's 2009 upleg has still been steep, well-defined, and very profitable despite the periodic bleed-through of SPX sentiment.

Second, if you are trying to time short-term PM-stock purchases (either for long-term investment or short-term trades), pay close attention to the SPX. If the general stock markets are very overbought, full of complacency and greed, then they are probably due for another pullback. Rather than buying before the pullback and suffering the subsequent sharp PM-stock losses, it is much more prudent to wait until the SPX pullback matures and the PM stocks have been temporarily driven down to lower prices.

After having warned about this SPX-pullback splash damage in our subscription newsletters for months now, I do realize this concept really bothers fundamentally-oriented traders. I am not thrilled with it either, as the old days (early 2000s) when the HUI followed gold no matter what the stock markets were doing were immensely profitable and great fun. Looking at gold fundamentals to trade gold stocks is logical and intuitive, as the gold price will absolutely drive their ultimate long-term fortunes.

But as traders playing the markets to earn profits, we have to adapt to the current driving forces whether we like them (or agree with them) or not. I'll admit, at times this year when the HUI fell sharply with the SPX when gold was holding strong I was really irritated with my peers in this sector. I felt like they were acting like pansies by ignoring high gold prices and getting scared by relatively minor SPX weakness.

But in trading, all emotions are destructive. Getting irritated or frustrated because something is not working the way it used to be or the way it should be is as damaging as getting caught up in popular greed or fear. Ultimately what is driving prices is irrelevant, all that matters is that we recognize those drivers early enough so we can capitalize on them with profitable trades. And for now, the SPX's spillover impact on universal sentiment is nearly as important to PM-stock fortunes as the price of gold itself.

At Zeal we are constantly studying the perpetually-changing markets looking for the drivers wielding the most influence today. And as soon as we identify them in the raw data, we analyze and explain these relationships to our subscribers and start actively trading on them. Because of this research, we've been able to buy PM stocks cheap in January, February, March, June, and July. And we sold some at big gains and avoided buying more in May, September, and October when they were too expensive.

While our open PM-stock trades in our latest monthly and weekly subscription newsletters had average unrealized gains of 47% and 77% respectively, we've been eagerly anticipating buying more. But given that a meaningful SPX pullback was overdue (we are probably in it now), we wanted to wait for better prices in the near future. Join us if you want to capitalize on the rapidly-approaching SPX-driven buying opportunities in elite precious-metals stocks. Subscribe today and become an informed investor!

The bottom line is since the panic gold is no longer the sole important driver of PM stocks. The fortunes of the general stock markets, particularly when pullbacks spark fear, have become nearly as important as gold. While SPX action is meaningless fundamentally for gold stocks, it still really influences universal sentiment. Falling general stocks frighten PM-stock traders who in turn start dumping their PM stocks.

So whenever a disconnect arises between the gold-stock prices and the gold price, consider what the SPX happens to be doing. Odds are its weakness will readily explain any HUI underperformance relative to gold. And while there is no doubt that gold stocks' ultimate long-term gains will be driven by gold's fortunes, paying attention to other factors influencing near-term sentiment can greatly improve trading gains.

Adam Hamilton, CPA
Zeal LLC.com

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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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