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December 15, 2006

HUI Leverage to Gold 3
by Adam Hamilton

For investors riding this ongoing gold bull in stocks, leverage is one of the most important concepts to study and understand. While the word leverage has many different financial meanings, in this context it refers to the degree of gold stocks' price moves as compared to the price moves in the underlying gold they produce.

If gold rallies up 10% over a particular period of time, and gold stocks rally 20% over this same period of time, then gold stocks have a leverage to gold of 2 to 1, or 2.0x. The ironclad tendency of gold stocks to have positive leverage to gold, to gain far more than gold during its bull market, is the primary reason why investors and speculators choose to own them. While gold is vastly safer, gold stocks' gains ultimately dwarf gold's.

We have already seen this tendency confirmed during today's secular gold bull. Bull to date since its April 2001 lows, gold was up 183% at best as of this past May's interim highs. Meanwhile the HUI unhedged gold-stock index, which bottomed a little earlier in November 2000, was up 996% at best at the same May interim gold highs. With the HUI up 996% versus gold's 183%, gold stocks have leveraged gold by 5.4x.

Although this leverage is wonderful on the upside, it is a double-edged sword. It also applies to downside moves in gold. During any particular gold correction, gold stocks are likely to fall much faster and deeper than gold itself. If gold fell 10% over a given period of time, and the HUI fell 25% in sympathy, then gold stocks would have downside leverage to gold of 2.5x. Thus leverage amplifies both gold's good and bad.

As an investor and speculator I have been long this gold bull since its earliest days and have seen leverage's tremendous positive impact on my own portfolio and those of our subscribers firsthand. Thus as a student of the markets, I want to study and understand leverage as this bull marches higher. Why? Leverage is continuously changing and highly variable, so traders who understand leverage trends definitely have an edge.

So this week I updated my research analyzing HUI leverage to gold. A few reasons are converging today to make now a good time to reconsider HUI leverage. After their dazzling May highs gold and gold stocks largely consolidated into early October. Thus the rally in gold since likely represents the early days of a major new upleg. Early on in uplegs understanding likely leverage can help set proper expectations.

And with the upleg that ended in May and the consolidation that ended in October finally behind us, we have some important new leverage data to analyze. Less relevant than the new data is the fact that I haven't updated this thread of research since last December, so I was curious to understand how gold-stock leverage unfolded during the huge swings in gold in 2006.

The methodology employed in this pursuit is identical to earlier iterations of this research. Basically the entire six-year bull market in the HUI gold-stock index is sliced into major uplegs and corrections. There have been six of each so far. Then the moves in the HUI during these big swings are compared to the underlying moves in gold over identical periods of time. By dividing the HUI moves by the gold moves we arrive at leverage.

The primary limitation of this approach is the fact that major HUI moves are often not perfectly synchronized with major gold moves. For example, gold could hit an interim high 10 trading days after the HUI. So by using the HUI to define timing, gold's major moves aren't always fully captured. But I can live with this. As a gold-stock trader I am more interested in gold-stock fortunes in this particular research. And even if big gold swings aren't perfectly captured, 95%+ of their moves are reflected in the HUI moves' timing.

I call this first chart segmented leverage. All six major uplegs and all six major corrections in the HUI since late 2000 are sliced out and considered individually. For each of these twelve major moves in the HUI three numbers are given. The blue one is the absolute gain or loss in the HUI. Next the yellow one is the gain or loss in gold over the exact period of time of the particular big swing in the HUI. These two numbers are divided to arrive at the final red one, the HUI leverage to gold. Bull-to-date upleg and correction averages are reported to the upper left.

This segmented leverage approach offers some interesting insights into the HUI's constantly changing and highly variable leverage to gold. Not only is the HUI leverage to gold gradually declining on balance as this bull matures, but the HUI leverage during gold's latest immensely powerful upleg was surprisingly the worst of this entire bull!

This past May when gold briefly hit $720 was certainly the most exuberant time of this entire gold bull so far. Very few people were warning about a major interim top and some high-profile gold commentators were even ridiculing the notion that a correction was possible. In such a hyper-bullish environment where nearly everyone was captivated by gold's rapid progress, for some reason the gold stocks couldn't keep pace.

While gold was up a phenomenal 68% during the HUI's sixth upleg, the HUI itself only managed 137% gains. This yields HUI leverage to gold of just 2.0x, easily the worst yet seen in any upleg. Here we had gold's first Stage Two upleg, where its gains nearly tripled its previous best upleg, but the HUI couldn't fully capitalize on this. The HUI's absolute gain in upleg six was actually lower than its gain in upleg two, when gold only went up 20%.

Over the summer I received a fair number of inquiries concerned about the HUI's recent poor performance relative to gold. Why did the HUI merely leverage gold by 2.0x when its previous upleg average was running 6.6x? If the HUI had maintained this high leverage it would have ran 450% higher in upleg six and would have topped at a staggering 914! Instead the HUI only hit 394. Had something gone terribly wrong in gold stocks?

Questions and concerns like these are one of the reasons I think it is really important to study markets on an ongoing basis. If we can study trends such as the one in leverage, then a fresh data point roughly along an existing trend is not a surprise and it cannot shake us into making suboptimal emotional decisions. The truth is HUI leverage to gold has been declining on balance for years so upleg six's low leverage is probably nothing to fret about.

In its previous five uplegs as this chart shows, the HUI's leverage to gold ran 14.7x, 7.2x, 2.9x, 5.5x, and 2.6x respectively. While this upleg segmented leverage is volatile, the trend is definitely towards lower leverage results. Although it would be fantastic if the HUI continued its first upleg's enormous 14.7x leverage to gold into the future, there are very good reasons why this unreasonable expectation won't be realized.

I suspect one key reason simply has to do with size. Back in 2001 during this bull's early days, the total market capitalization of all the HUI gold stocks was vanishingly small. I don't remember the exact number, but at the time all of the publicly-traded pure gold stocks on the planet were worth something like one-tenth the market value of just one of the big blue-chip tech stocks. Gold stocks were incredibly unloved.

From such a trivial capital base, not much bidding is needed to drive prices considerably higher. If you have a $5b company and a $50b company, and $1b of new capital bids on each, obviously the smaller one's price will climb much faster than the larger one's. As this gold bull continues, gold-stock market caps are gradually rising which means exponentially more capital is needed to drive similar percentage gains as in the early days.

But don't let this factor discourage you. As of earlier this month, all the HUI stocks added together still had a total market cap of just $97b, still ridiculously small by stock-market standards. This compares to General Electric alone running a $364b market cap and Microsoft at $291b at the time. Gold stocks as a sector are still plenty small enough to see really big gains going forward, especially when the general public eventually gets interested.

But the primary reason why the HUI's leverage to gold was so poor in upleg six probably has to do with a fairly rare schism in gold-trader psychology. Back in February the HUI hit an initial interim high. Some contrarian gold players, including me, figured the probabilities were fairly high that the HUI's sixth major upleg was finished and a correction was due. Neutral HUI technicals rendered a sizeable fraction of HUI players temporarily bearish.

At that time at Zeal, for example, we ratcheted up our trailing stop losses on existing gold-stock positions and simply quit adding new positions since the probability of a correction seemed high. The HUI did dip initially, but then it soon climbed to its new May highs as gold rocketed higher on sharp dollar weakness. So during the latter third of gold's latest upleg when the HUI's gains could have really exploded, many contrarian traders were just not buying since the whole sector looked really overbought.

I chose to ride our existing gold-stock positions higher without adding more at that time. This same skeptical sentiment multiplied across many traders led to far less new gold-stock demand than normal during a maturing major gold upleg. Indeed as the chart below will show, nearly 80% of the HUI's gains for the entire upleg six were already achieved by early February. But only 54% of gold's upleg-six gains were racked up by that time.

With a growing number of gold-stock investors and speculators skeptical from February to May, less capital was available to bid up the HUI fast enough to maintain better leverage to gold. Exacerbating this situation was the fact that newer traders who hadn't yet weathered many corrections were more likely to be excited than veteran battle-hardened traders. And of course the latter, by virtue of their greater market experience and longevity, control a lot more capital than the newer folks. This sentiment schism crippled the final ascent of the HUI's upleg six.

Interestingly though the HUI's downside leverage in the subsequent correction six was also well below expectations, so the loss of leverage was proportional. Prior to correction six as this chart shows, the average major HUI correction witnessed 4.6x leverage. But instead of falling 4.6x as far as gold in correction six which technically ended in June, the HUI only fell 1.5x as far. Since fewer traders bought near the top, fewer needed to sell on weakness which would have amplified this correction.

On downside leverage, it is also interesting to examine the trend. The previous five major corrections witnessed HUI leverage to gold of 4.6x, 5.2x, 2.3x, 5.5x, and 5.5x. Thus, somewhat curiously, there is not a similar down-on-balance leverage trend during corrections like the one during uplegs. Downside leverage is generally staying pretty stable with the exception of our recent correction six. I am still pondering this particular peculiarity of the data, and have yet to reach any useful conclusions.

Now segmented leverage is really interesting, but I am even more intrigued with adding time to our analysis. For example, in a particular upleg or correction how does HUI leverage to gold evolve during the life of that major move? The following chart examines this concept, rendering effective HUI leverage as a continuously changing variable over the lives of individual major uplegs and corrections.

My approach to this analytical puzzle is to take the same uplegs and corrections in the first chart and individually index each one of them. So each new HUI upleg or correction starts at an indexed base of 100 and then moves higher or lower from there. Identical indexing is applied to gold. The difference between the red HUI indexed line and the yellow gold indexed line is the HUI leverage to gold.

There is a problem with this chart due to limitations in our graphing software though. At the end of each upleg or correction, there is a sharp move back towards 100. These vertical moves at the end of segments are charting artifacts that shouldn't exist so they should be ignored. Each segment should be considered as a discrete unit with no connection to the previous or next, despite the erroneous graphical inter-segment connections.

This indexing approach ensures that past and present are perfectly comparable in percentage terms. By visually comparing the red HUI segmented indexed line to the yellow gold line over the lifespan of any particular upleg or correction, we can easily see how the HUI's leverage unfolded over time. The results are quite interesting.

To start, I think it is important to note that the absolute gain in the HUI in its recent upleg six was right in line with the gains in its three previous biggest uplegs. So despite the fact that the HUI may not have leveraged gold as much as expected this past year, it was still up 137% in a single upleg. Any investor or speculator who believes that 137% sector gains in one year are not excellent has to be nuts. Gold-stock traders were still richly rewarded despite the declining HUI leverage to gold.

Examining leverage over time is very interesting. We'll start with gold. Note above that during the HUI's middle four major uplegs the gold price largely gradually climbed in an even-paced linear fashion. There really weren't any spikes in gold's gains, it went smoothly from an indexed level of 100 to an indexed level around 120 during its Stage One days. But interestingly the HUI does not follow this smooth pattern.

In HUI uplegs one, two, and four, the largest of this bull market before our latest, HUI gains and hence its leverage to gold were very nonlinear. Unlike gold which saw its gains rise in a line during most uplegs, the HUI generally had modest early gains relative to gold. Early on in new uplegs, like today, gold-stock traders remain skeptical and fear that the correction they just experienced isn't over. So not much capital bids up the stocks.

Then in the middle of major HUI uplegs, their gains tend to accelerate as gold-stock traders start to believe the new upleg is for real. In this stage the traders are acting pretty rationally, buying gold stocks and driving up their prices but not driving them up fast enough to necessitate a correction to rebalance sentiment. Where fear dominated the early upleg progress, rationality reigns in the middle of uplegs.

But then in the latter third of major HUI uplegs, suddenly the HUI gains soar. Gold-stock traders get caught up in the excitement and they just throw capital at gold stocks with reckless abandon. This causes the gains in a particular upleg to rocket vertically in its final third. Sometimes half the gains of an entire upleg are achieved near the end when traders become irrational to the greed side, getting too excited and forgetting that periodic corrections are a certainty in any bull.

This observation has a couple interesting implications. First, in regards to our recent upleg six, this end-of-upleg surge never really happened in the HUI. This is almost certainly due to that sentiment schism I discussed above. If the HUI would have had a proportional end-of-upleg surge in May to its previous uplegs, it could very well have gone up another 40% or so. This would have yielded a HUI top near 460 and leverage to gold of 2.6x. Without that February pseudo-top that faked many out, this upleg could have been much bigger.

Second, if you are a gold-stock investor or speculator you should have a fairly good amount of time to buy into each upleg. Of course the earlier you buy in the better off you will be and the higher your gains will grow, but since HUI leverage is low at first, accelerates gradually, and then explodes in the latter days of an upleg, as long as you buy before the last third you should still be able to achieve excellent gains.

A corollary to this is I often hear from concerned folks after an upleg is several months old. They point out that gold is up X% but the HUI is only up Y%, and Y is not much higher than X. They fear that there is some problem with gold stocks and wonder if they are better off buying gold instead. This leverage research shows that HUI leverage should be low early in an upleg so it doesn't make a lot of sense to worry about the HUI seemingly underperforming gold early on in new uplegs. The HUI should have no problem catching up later.

I am glad to see this as it suggests we are safe adding new gold-stock positions at least for the first half of an upleg, rather than just the first tenth as I have done in the past at times. This time around we have been adding new gold stock and gold-stock options positions in our newsletters since late September and have already been blessed with some excellent unrealized gains, already exceeding 100% in some of our open gold-stock options trades.

But since this new gold and gold-stock upleg remains young, we should be able to keep deploying new trades. The parabola-like nature of the HUI leverage to gold within uplegs strongly suggests the best is yet to come in major upleg seven. If you are interested in mirroring our new high-potential gold-stock trades as they are added, please subscribe to our acclaimed monthly newsletter today.

The bottom line is HUI leverage to gold is gradually declining as these bulls mature. Despite this, the gains have been awesome and gold stocks' performance is almost certain to continue to leave gold's in the dust. And within individual uplegs and corrections, HUI leverage tends to grow like a parabola. It is low at first, starts accelerating in the middle, and then quickly screams to an extreme in the end.

By understanding these leverage tendencies, gold-stock investors and speculators can enjoy more trading opportunities and likely achieve superior gains. In addition, the mere knowledge of how HUI leverage to gold has worked so far will greatly reduce future anxiety whenever leverage temporarily seems to be broken.

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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