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August 09, 2006

My View on HUI and Gold
by Thomas Tan

I have been reading many articles on the topics of gold and gold miners for a few years now. Here I would like to share my view on both gold and especially HUI, many of which are results of my own research and haven't been read from other publications. The main point of this article is if we view HUI as a derivative of gold, it will give a better understanding of HUI movement, resulting better indication and wave count than gold itself for the purpose of future projection. My forecast on gold is also discussed here.

Part One - HUI

HUI is composed of 15 large and mid size gold mining companies (with equal dollar weighting) which do not hedge beyond 1.5 years. Due to this unhedged or light hedged nature, I look at HUI more as a very long term call option of gold. As everyone knows, the best movement of HUI is from the bottom of $38 at the end of 2000 to $155 in 2002, 400% return in 1.5 year. However, gold itself has gone only from $250 to $325 in the same period, or about 30% return. In other words, return on HUI is over 10 times higher than gold for this period which I would call phase I, the best so far. However from 2002 to now for 4 long years, HUI is up only from $155 to $320, or 100% return, in par with gold from $325 to $650, also 100%. Does anyone ever ask why there is such large disparity in behavior and return between the two periods?

5-Year Weekly Chart of AMEX Gold Bugs Index.

Even gold mining companies vary differently in their costs of excavating gold from ground, the average on the HUI miners is believed to be around $325 including overhead. If you look HUI as a very long term call option of gold option (expires only when miners are in bankruptcy), it makes perfect sense why HUI return was over 10 times higher than gold in phase I. When gold reached the bottom of $250, HUI was way out of money. Option traders know they don't worth a lot. HUI during 2000 at $38 behaved like 100 calls ($0.38 per call) with strike price at $325 when gold traded at $250, $75 out of money. Then gold slowly rose to $325 in the next 1.5 years and finally put HUI at the money (at its strike price), what would you think HUI should be traded at? I think $155 per 100 calls ($1.55 per call) would be a very reasonable market price due to the time and volatility values from the Black Scholes model. This is phase I.

Now for phase II, when gold price keeps creeping up, HUI again as a call option of gold, becomes more and more in the money, the ratio of change in HUI vs. gold is approaching one, the so-called delta hedging of a call option. That is exactly what has happened last 4 years when HUI has moved from $155 to $320, or 100% return, "magically" matching gold from $325 to $650, also 100%.

The behavior of HUI last 6 years has proved exactly that HUI is a derivative of gold, at least from a long term view. This is not a coincidence and makes perfect fundamental sense. Stock option traders know that option leads stocks, so is HUI as a leading indicator of gold.

If we accept this view, the implications are: 1) We should never view HUI independently, have to be in conjunction with gold at all time; 2) Any technical analysis (TA) on HUI alone such as Elliot Wave Projection (EWP) would only make sense if the same analysis on gold is correct; 3) The deviation of HUI from gold is a important TA indication due to its leading and lagging natures.

I have read several editorials from TA standpoint that HUI will go to stratosphere by repeating the 1st phase rise from $38 to $250 in the near term. The fractal TA target is based on extrapolating the same length of movement as the previous one on a log scale. In other words, they expect the current % gain will repeat the $38-$250 run in about the same length of time. I think they will be disappointed. It is obviously incorrect to expect return of in the money calls to match out of money calls. HUI might go to stratosphere only if gold goes to stratosphere in the near future. Anything is possible in the market, but not likely (see my discussion on "Part II - Gold" below).

HUI has deviated short term from gold from time to time. The longest deviation happened and lasted for the whole year of 2004. Gold was able to creep up to a higher high but HUI couldn't and lagged behind. I think this is due to the lack of arbitrage mechanism between HUI and gold. For option arbitrage, we have something called put call parity, or c-p = S-X. For example, if call is undervalued, we can buy call, short put, short stock, buy US treasury to generate a risk free arbitrage profit. However, it is not true for HUI, since there is not a good basket of companies or index which is closely but inversely correlated to gold.

Why is the deviation in 2004 then? I think the main reason is people's expectation and perspective view on gold. At 2004, even gold rose slowly and made hew high, no one believed that gold would stay at the level of $400-$450 very long, the general public view was that gold would eventually go back down to $300-$350 level (again close to the strike price). HUI as a composition of gold miners, correctly reflected the mass view at that time by discounting the future earnings, and traded at "discount" to gold. This however won't happen in stock option due to arbitrage discussed above. It explains the following chart why HUI vs. gold ratio dropped from 0.6 to 0.4 during that period, a 33% reduction. Will this happen today? I don't think so. The public consensus has accepted gold price in the range between $550-$650, not far from current level, much more positive sentiment than in 2004.

Will HUI ever trade in "premium" to gold in the future? My view is unlikely, the reasons are: 1) Companies have too many risks such as geopolitical (foreign government, manpower, unions, environment, health & safety, regulation), reserve uncertainty, capacity limitation, management, operating issues, capital & refinancing, especially costs (as we see HUI is currently depressed by the high energy costs). 2) Reserves will eventually run out and finding and securing new reserve is always the biggest risk. If we believe that the World is running out of gold mines, this risk is huge. 3) Even if people expect gold trading at stratosphere level, unhedged gold miners can only excavate gold so much and so fast each year up to the longevity of reserves, reflecting profit or earnings based on an average gold price substantial less than the peak price. Even reserve estimate might increase with higher gold price due to low grade ore becoming profitable, but no matter what the peak gold eventually reaches, HUI will reflect a much lower average gold price due to operational constraints.

I expect in the future which I call phase III, the delta between HUI and gold will drop gradually from current 1:1 down to somewhere 0.75:1 or lower (see my chart on HUI vs. gold future correlation below). For example, when gold reaches $2000 (500% return from $325 gold level), I only expect HUI to get to $750 (400% return from $150 HUI level). The main reason is simply because the risk associated with owning gold is much less than all the risk associated with owning some mining companies as discussed above. I strongly believe that gold offers a better risk/reward profile than HUI, and is a better investment vehicle than HUI in the future.

However I am only talking about the large and mid tier gold miners in HUI. For small miners, exploration and early discovery companies, I view them as events driven similar to biotech firms finding drugs. If jackpot is hit by finding a new gold mine with good quality and large reserves, the return can be unimaginable, whether gold trades $1000 or $2000 makes little difference.

When HUI is more in the money, market will evaluate gold miners less by earnings or P/E ratios, more by the values of their reserves minus excavation costs. Analysts will use models to discount future profits from the existing reserves and will probably assign very little value of their ability to hit future jackpot due to the scarcity and low probability of finding new gold mines. I think the best return in the future is in the companies with the highest and good quality reserves. Barrick Gold's current offer to NovaGold proves this. Barrick Gold is in XAU not HUI due to its heavy hedging on gold, it makes perfect sense for a XAU hedged miner to acquire an unhedged one, increasing reserves at the same time reducing hedge.

Part Two - Gold

Since HUI basically moves with gold, I want to discuss here my view on gold's long term target and its EWP. There is no lack of such views from many resource websites, and I have learned so much from various authors, I will repeat some of them here but also give what I believe.

Long Term Gold Target

I expect gold peaks at $4000-$5000 at the end of this bull market. I agree with many people that the best way to forecast peak is by comparing gold vs. other major indexes:

Gold vs. DJIA. With a secular bear stock market, DJIA should drop to $5000, a 50% reduction, the DJIA/Gold ratio could reach 1:1 at the bottom from current 18:1, thus gold at $5000.
Gold vs. CPI. If we use the pre-modified CPI formula prior to mid 1990s, economists have calculated the current inflation should be around 7-8%, double the 3-4% claimed by the government. Compounding for last 26 years, coupled with likely future higher inflation, gold should reach $3000-$4000 range to be comparable to $887.5 of 1980 dollar.
Gold ties more to money supply than any other factors. There is a reason why government stopped publishing M3, probably not to save $1M cost for compiling the data, but because M3 has been running out of control, rising exponentially. Economists have come up with $4000-$5000 gold in order to tie back to M3 in 1970s. Due to the lack of transparency on M3, people would think M3 is even worse than it really is (even the real data is already bad enough). There will be a time public view greenback worthless as in the period of late 1970s to early 1980s.
Gold vs. Oil. At the peak, Gold vs. Oil ratio might reach 30 (not a historical all time high), putting gold to $4000 with oil at $133 or $5000 with oil at $170.
Gold now vs. 1970s. Gold was up from $35 to $887.5 in 1970s, 2500% return. Using the same ratio from $250 bottom low, gold could reach over $6000.

At the same time, I have reservation on gold peak much higher than $5000 at this gold bull market. I have seen some authors projecting a gold price at $10,000 and/or higher with 5 digits. Even anything is possible in the market, but I seriously doubt 5 digits will happen in this bull market, mainly due to the ratio analysis above. Maybe it will happen in the next gold bull if someone can wait for another 40 years.

However I also believe gold will take us much higher than just the current CPI adjusted $2000 level, equivalent to $887.5 of 1980 dollar. The main fundamental reason is globalization, which brings much higher demand for gold across the globe than 1970s with more severe scarcity of gold supplies. Globalization is a double edge sword. It brings economic growth and trades but also instability for all countries alike. It exports western consumption and lifestyle to the whole World population, causing natural resource consumption increasing exponentially as well as prices for all commodities. It brings competitions to devalue paper currencies of all countries alike to gain trade advantage. If greenback as the dominant and strongest currency in the World, collapses in the future, all paper currencies will collapse together, resulting gold as the last currency standing and the only universal currency everyone can trust. Central banks (CBs) will have to compete to increase their gold reserves, developed and developing countries alike. CBs in developed countries have been net gold sellers, while CBs in all developing countries have very little gold in their reserves.

It is a pity that CBs such as Bank of England sold large shares of gold reserves at the absolute bottom of $250-$300 in 2000. From cycle standpoint, gold should have bottomed in 1999 or earlier. The early 2001 bottom according to GATA is more a manipulation and collusion of CBs than real demand and supply driven. But this kind of manipulation if true, plus discontinued M3 and new CPI "adjustments" will backfire in the future, just as $250 was an anomaly of gold at the low side, public dissatisfaction, anxiety and insecurity will cause anomaly at the other side, bringing gold to a much higher level than CPI adjusted. When Greenspan was asked by a congressman how stupid Bank of England was to sell gold at the absolute bottom, worst timing ever possible, he strongly defended them by saying "The British knew what they were doing". This led people to believe that Fed might actually involve too, maybe by lending gold or even selling at the same time, act of collusion as GATA has always suspected. No matter what happened then, three things are true: 1) Rise of gold is a nightmare for all CBs; 2) All CBs have less gold than they claim having, and will gradually have less ammunition to depress gold and eventually defenseless to protect their paper currencies; 3) At the end all CBs will have to turn into net gold buyers from sellers.

EWP of gold

This is purely based on my view on EWP. Different people have different opinions on EWP. I will give mine and I also think using EWP long term makes more sense than short term, especially in conjunction with HUI. The key here is to define where major wave II was for this gold bull after wave I started in 2001. Many people think we are currently at wave II due to the sharp drop in gold from $730-$550. I tend to disagree. If you look at HUI instead of gold from 2000, the major wave I was obvious from end of 2000 to end of 2003, lasting 3 years, while wave II was during end of 2003 to mid 2005, lasting 1.5 years (half of the time of wave I). This makes sense for EWP, all other drops are not long enough to qualify as wave II. During the same 1.5 years, gold did creep up slowly, forming a diamond shape wave II, unusual but possible and bullish for wave III. As I indicated before, EWP of HUI is more logic and accurate than gold EWP, due to both its derivative nature of gold and its ability to deviate to better reflect the real psychological level of public expectation and perspective on gold.

If my view is correct on wave II, we are currently at wave III. With wave I lasted about 3 years, wave II half of that, it is reasonable to expect wave III to last at least 2-3 years. Today wave III is only 1 year, should have at least another 1 or likely 2 more years to go until 2008, bringing us to $1800-$2000, 400% return from wave II bottom. The current sharp drop from $730 to $550 is a necessary correction within wave III, although from the COT report, the last $50 drop from $600 to $550 was more due to manipulation by large commercials to shake the weak apples. Gold will recover sooner than expected. After wave III, I expect a serious correction of wave IV, lasting for 2 years similar to 1974-1976, bringing us down to about $1200 (50% correction) before a run away to my final $4000-$5000 target, another 400% gain.

If gold reaches this level as forecast, by using the same ratio of peak of $887.5 at 1980 to $250 at 2001, I project gold will bottom at $1100-$1400 as the absolute bottom at the next major gold bear market which again can last for 20 years or so. If it happens as expected, gold will still remain at 4 digits for this and next generation and probably forever as far as gold remains as the universal and last currency for the whole World. I believe once gold securely and convincingly overcomes the $1000 mark, and current wave III reaches $1800 to $2000 range, gold will never go back down below $1000, thus never be 3 digits again. When will be the best time to buy gold? Answer: If not now, when?

Thomas Tan, CFA, MBA
www.investorwalk.com

Disclaimer: The contents of this article represent the opinion and analysis of Thomas Tan, who cannot accept responsibility for any trading losses you may incur as a result of your reliance on this opinion and analysis and will not be held liable for the consequence of reliance upon any opinion or statement contained herein or any omission. Individuals should consult with their broker and personal financial advisors before engaging in any trading activities. Do your own due diligence regarding personal investment decisions.