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December 30, 2005

Why Are Gold-Hedgers 'Winning'?
by Alex Wallenwein

It makes no sense for the XAU, which is said to be composed mainly of gold miners who sell their production forward (for newcomers: so-called 'hedging' against feared future price decreases) to break out of its two year sideways pattern before the HUI, which is supposed to be made up of 'non-hedgers' (i.e., those who rarely or never follow that practice).

This is true especially during times when everyone and their brother are reportedly selling into their hedge books (clipping their forward sales contracts) to reduce the "risk" of rising gold prices.

Why is this happening, then?

The XAU broke out with gusto in mid-November, and the HUI is only now barely poking its head above the two-year old water line at 255-260.

Why?

The HUI's lagging to gold itself has been analyzed ad nauseam as the list of articles in the appendix shows (1), but there appears to be no normal, market-related reason why the HUI should significantly undershoot the XAU. Both are gold stock indexes, each supposedly operating under the same conditions and in the same markets, and attracting the same kinds of investors as the other.

So, why is there this difference in their breakout patterns?

The only (to gold bugs) immediately perceivable difference between the two indices are the fact that one is indeed supposed to be composed of gold miners who are hedgers, and the other is not.

Hedgers were supposedly hampered in their profit margins by the fact that they had sold a considerable amount of their future production forward (at prices azt prices so low, they make gold investors of today almost nostalgic), and are now forced to cover their hedges at consistently higher and higher prices.

Having to operate in a profit-crimping environment like this, how can hedgers command better stock prices than non-hedgers during any particular run?

When it comes to non-hedgers, there was supposed to be virtually nothing to hold them back during the last two years. Yet, their performance relative to hedgers was virtually equal during that period, and that despite the fact that all other costs and barriers to profit expansion affecting non-hedgers were, on average, the same as those of the hedgers.

Did all of the non-hedgers for some reason have lower production than the hedgers?

Did they for some reason have less success at exploration, as a group?

Were their reserves on average less accessible than those of the hedgers - as a group - thus resulting in higher transportation costs?

From a pure probability standpoint, none of these possible answers seem likely candidates.

Another possible answer is that the XAU is composed of gold miners with a somewhat more significant proportion of silver production as a by-product of gold operations than the HUI, and silver has enjoyed a slightly better run since September than gold. However, during that period in which the XAU has outrun the HUI, silver's price increase has bettered that of gold by only about ten percent, and the average percentage of silver production compared to gold production of these companies is too low in terms of dollar revenues to account for such a result.

Next on the list of factors muddying the picture is the to me (who doesn't normally analyze gold stocks or stock indexes) previously unknown fact that the XAU and HUI, each listing 13 and 15 companies respectively, actually share more companies in common than one would think from reading general articles and references about them.

They share exactly nine listed producers: Newmont, Gold Fields, Gold Corp., Freeport McMoran, Meridian, Glamis, Harmony, Kinross, and Agnico-Eagle. The XAU has only four pure hedgers, while the HUI has only six pure non-hedgers. So, in the end, the only real difference between the two indices lies in the fact that HUI has two more pure non-hedgers than the XAU has pure hedgers, and in the relative weighting of each company within each index, as can be seen from the following table.

Were Barrick and its super-hedging XAU peers that much more profitable then, during the last three months? We won't know until their Q4 reports come out - but it's doubtful, precisely because we won't know until then whether that particular quarter was that much better for the pure non-hedgers than it was for the hedgers. No investor, no matter how sophisticated, could possibly anticipate such excess profitability in the face of such a low likelihood of it, so as to drive up the price of XAU-listed stocks faster and earlier than that of HUI stocks.

We know that the HUI stocks once outran both the XAU and gold itself by a magnitude of about nine or so back in 2003, during the HUI's heyday. Whatever it was that has changed since then has obviously affected both the HUI and the XAU in the same way, or else they would not have traced virtually identical patterns during these past two years.

Well then, what's up?

Why did the XAU break out of this pattern earlier, faster, and stronger than the HUI? It's really puzzling.

Are ordinary Joe-Blow investors like you and me on average more inclined to buy stocks of hedgers than those of non-hedgers? I shouldn't have asked that question. You know the answer already.

Alright, so what is it, then?

Could it be that hedgers have more "friends" in the institutional investor community than non-hedgers, who usually offend the banker crowd by refusing to sell their valuable product short? Could it be that hedgers have a few more favors to cash in on than the other group?

Could it be that it appears more effective to some to try and demoralize the gold bugs by suppressing the stocks of those gold miners the gold bugs tend to favor? I have addressed that issue once before - and caught a lot of flak for it from a more or less prominent trader who couldn't help himself but to try and 'rip me a new one' in public. He may have been right back then, or he may not have - but the question persists.

Interestingly, the two indexes have once before shared a similar slump. Between April 2002 and July 2003 they were bot caught in a similar pattern as can be seen from the two charts below. But back then, they broke out at exactly the same time.

Well, the HUI actually broke out a couple of weeks earlier than the XAU - as one would expect - not the other way around.

So ... what's different now?

I suppose that, if someone really wanted to spend the time to prove or disprove this, he could do so by checking up on all of this. I, for myself, don't feel the need to do that. I'm happy with just raising the question that is literally screaming to be raised - since no one else appears to be doing it. (2)

But, now that the HUI finally DID break out ...

Whatever the reason, let's focus on what is likely to happen from here on forward.

If the HUI's breakout is sustained, what's coming after that?

Barring any manipulatory ambitions which certain quarters might entertain, this breakout could quite possibly be the precursor of a humongous gold stock run. This run, if it is indeed coming, could conceivably become the mania that puts all other past manias to shame - the "mother of all manias," to say it with Saddam Hussein. (And, needless to say, when that happens, it won't matter one bit why the XAU broke out before the HUI. You'll be too busy watching your holdings grow - on paper - to worry about such arcane issues)

How soon could this happen?

Could be very soon. US stock investors are currently spooked by the newly inverted yield curve - despite constant haranguing by the media that this does "not necessarily" mean a recession is coming.

The dollar, already wobbling away from its recent uptrend, has maybe two more rate hikes left - on the outside. Given the fact that it's already flat to sinking while the Fed is still hiking, it could go - well - anywhere ...

... except up, that is.

Home prices? Yep. The money could surely go there as long rates have broken down recently - but even that won't last. That story is already old, and fears of an impending collapse have been stoked aplenty by the mainstream and the alternative press alike. How about bonds. Can they go higher? Yes, a little higher - but not much.

Could be soon - but nobody really knows when. Please keep that in mind.

So, if you were Joe Blow investor out there, where would you put your money? (SMACK!) Ouch!! Yes, I know, I know. I shouldn't ask these silly questions. Forgive me. Forgive me!!!

Got gold?

Alex Wallenwein
Editor, Publisher
The Euro vs Dollar Monitor

Just like driving your car, investing only makes sense if you can see where you are going. The Euro vs Dollar Monitor is your golden windshield wiper that removes the media's greasy film of financial misinformation from your investment outlook. Don't drive your investment vehicle without it!

Copyright © 2003-2008 Alex Wallenwein

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