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March 09, 2007

Gold-Stock Fears
by Adam Hamilton

Echoing the mini-panic in commodities in early January, the past couple of weeks have once again been trying for gold and gold-stock investors. In just five trading days ending this past Monday, gold fell 7.2% while the HUI gold-stock index plunged 13.0%. The raw fear spawned by this pullback has been pretty extraordinary.

This cascading fear driven by the falling prices created a negative sentiment storm that buffeted gold, and especially gold stocks, like a hurricane shredding a seaside town. By the time the dust settled a few days ago, investors were deathly afraid that everything from central banks, to bear markets, to overextended Chinese stock-market speculators, to Martians were threatening to blast gold and gold stocks far lower.

But fear in the markets, while compelling at the time, is a totally irrational and useless emotion. Investors and speculators, if they ever want to become great, have to systematically train themselves to totally ignore fear. While there are rare situations in life that warrant true fear, such as plummeting to earth in a crashing airplane, nothing in the financial markets should ever scare us. We are merely talking capital here, not life and limb! And the markets are supposed to rise and fall.

As always, the best way to fight irrational fear is to confront it with rational perspective. One trading day considered in isolation, like last Friday's $21 plunge in gold, can be scary. But one trading day, no matter how ugly, considered in the light of the months of action that led to it is almost never frightening. Traders need to concentrate on the trends, not the day-to-day noise, if they want to remain prudently rational.

So although the interesting 3.5% single-day decline in the S&P 500 a couple weeks ago led the easily excitable to believe that full-on global economic Armageddon was nigh, the charts remained coldly rational. Like many other commodities, the gold technicals looked fantastic throughout the entire mini-panic. Provocatively the Continuous Commodity Index hit an all-time nominal high two weeks ago soon after the stock markets peaked and only fell 3.2% overall compared to the S&P 500's 5.9% total decline.

Gold's 7.2% five-day decline was much worse than commodities in general fared, which is incredibly ironic considering gold's elite safe-haven status. The traders who sold gold because stocks were retreating must have no history books, because gold tends to thrive in times of downside general-stock volatility. Adverse market turbulence increases overall gold investment demand on balance, so selling gold on stock weakness alone is foolish.

Yet this is exactly what happened in the midst of the irrational excitement of the moment. But even after this illogical sentiment storm, gold's new uptrend still looks flawless. All gold did in response to the mini-panic in general stocks is pull back from the upper resistance of its textbook-perfect uptrend to its lower support. Curiously this minor move spawned a mini-panic in gold stocks, which has very bullish implications as I will discuss below.

This is a simple one-year gold chart. During this time gold had two distinct tactical trends. From early May to early October, gold was retreating on balance in a necessary and healthy correction after it hit a dazzling new bull-to-date high last spring. But since early October, gold has been climbing in a textbook-perfect uptrend. As you can see clearly here, gold's uptrend channel has been rock solid and inviolable so far.

As in any uptrend, the highest tendency for a price to pull back occurs when it nears its upper resistance line. It is really interesting that prior to its recent pullback gold had surged up to its resistance after a powerful seven-week rally that launched in early January. So even if the sharp plunge in the parabolic Chinese stock market had not yet happened, gold was at a technical point where a pullback was due. Any catalyst could have kicked it off, and often no visible news catalyst is necessary to spawn a pullback from resistance.

And after gold fell $49 or 7.2% in just five trading days and terrified the weak-willed, it was still above both its lower support line and crucial 200-day moving average when the dust settled. How on earth can a normal pullback within a strong uptrend channel scare traders? Sure, it happened in five days this time around instead of five weeks like the similar December pullback, but the overall magnitude was not threatening at all.

Being in the newsletter business, when our subscribers get scared they write in to share their fears with me. I really appreciate this as it helps me better understand what concepts are feeding a particular sentiment storm. In gold's case, at least judging from my e-mail inbox, the ever-present gold boogeyman of the central banks once again loomed its ugly head. Last week many investors feared that central banks would dump gold to support their currencies and try to avert a cascading global financial panic.

Discussing central banks in the gold world is like talking about abortion or global warming. No matter what you say, 50% of the people are going to want to rip out your still-beating heart and drink your blood from your newly-cleaved skull. Personally as a gold investor I used to fear central banks quite a bit from 1999 to 2002 or so. But the more I observe their actions and the greater my own fortune grows in this secular gold bull despite central-bank machinations, the less I respect their fabled power.

Compared to you or me alone of course, a central bank is awesomely powerful. But compared to all of us investors together, a central bank is totally impotent. Think of an elite commando, a Navy SEAL, versus a single bee. No matter how many times the bee stings the commando, the commando is going to eventually crush it like a grape. Victory was never in doubt. But imagine this same elite commando versus a swarm of killer bees. It doesn't matter how tough this soldier is, it doesn't matter how many bees he kills, the swarm is eventually going to overwhelm and annihilate him in the end. Defeat is inevitable.

Worldwide the ever-growing ranks of gold investors are like a massive horde of killer bees stinging the central-bank commandos. Individually we are nothing, but collectively we rule the gold world. Every year the total amount of gold held by hostile central banks dwindles as they sell and expend their very finite supply of ammunition. And every year the total amount of gold held by investors swells. As long as central banks continue to sell and investors continue to buy, the balance of power in the gold world will continue tilting towards investors.

So for you folks who feared potential central-bank action to somehow lessen the recent general-stock mini-panic, please consider this. Gold bottomed six years ago in April 2001 at just above $255. During this entire six-year period, western central banks sold gold and badmouthed it every chance they got. They dumped huge amounts of physical gold onto the markets. The central banks can never do more against gold in the coming years than they did over the past six years because their "market share" of global gold holdings continues to decline.

What was the net result of their long campaign? From April 2001 to May 2006, despite their best efforts, gold soared 181% to $720! Investors worldwide including myself and our Zeal subscribers are getting rich, building big fortunes, by actively betting against central banks in the gold market. Now if gold had only gone from $255ish to $260ish over six years, then I can understand fearing central banks. But to fear inept government bureaucracies that "allowed" gold to nearly triple under their watch? I have infinitely more fear of my dentist.

So this gold bull's stellar performance to date proves that fearing central banks is not rational. They are big and tough and mean like commandos, but swarms of investors always overwhelm them in the end all throughout history. Odds are the recent sharp pullback in gold had nothing at all to do with central-bank selling and was merely the result of temporary stock-market fears.

And it is interesting that even at the bottom of this latest gold pullback the metal was still looking fantastic within its newest upleg. From early October to early March, bottom to bottom, gold was still up 13.3% over six months. Now if the S&P 500 was up 13%+ over six months, investors would be ecstatic. But not in the incredibly surreal and paranoid world of gold. Gold-stock traders ignored gold's awesome technicals and sold their stocks in a blind panic. The sky was apparently falling.

This next chart shows the behavior of gold stocks over the same period of time as represented by the HUI unhedged gold-stock index. For reference, the closing gold data is rendered in red underneath the HUI technicals. Even though gold, not the stock markets, is the primary driver of the HUI, the latter's performance has been terrible. Many of our fellow gold-stock investors have been acting like preschoolers on Halloween, trembling in fright at the smallest odd sound or temporary selling streak.

Not that you'd notice lately, but believe it or not the HUI is in a young upleg too! Although it has struggled a bit on the higher-high front since early October, it is carving higher lows. The really interesting thing to me about this upleg is how pathetic it has been so far. Gold-stock investors and speculators are so steeped in fear, so ridiculously paranoid about everything under the sun, that even after a $124 and 22.1% gold rally since early October they still don't believe this gold upleg is real so they are not buying gold stocks.

This surreal disconnect is most evident when examining the HUI's leverage to the gold price. Leverage is a simple concept. If gold rises 10% over any given period of time and the HUI rises 20%, for example, then the latter has 2.0x leverage to gold. While I have done extensive studies on this leverage in the past, here is a quick benchmark for comparison. Overall in their respective bulls to date, the HUI has outpaced the gains in gold by 5.4x. Sometimes its leverage is higher, sometimes lower, but 5.4x is the final six-year result so far.

In both of these charts today I drew in some gray arrows that mark the four major moves we have seen in our current gold and HUI uplegs. While these moves don't match to the very trading day between gold and the HUI, as usual both assets have followed very similar big-picture patterns. They rallied and retreated. Then they rallied and retreated again. Of course this is very typical behavior within an upleg, two steps forward followed by one step back.

But what is not typical this time around is the HUI's abnormally low leverage to gold. In the initial surge off the early October interim bottoms, to point 1 in these charts, gold rose 15.2% by late November but the HUI only managed a 27.4% gain. This represents leverage of only 1.8x. Early on in an upleg is when it is hardest to believe in and it has the fewest converts, so I can understand this low initial leverage. We've seen it in the past too when new uplegs are first born.

But incredibly the HUI's leverage has been getting progressively worse since late November, which is not supposed to happen. From early October to early January, point 2 in these charts, the HUI only managed 1.2x leverage to gold bottom-to-bottom. This is really bad. Since gold stocks are vastly riskier than physical gold will ever be, they need to outperform gold by a large margin or there is no reason to own them. At a mere 1.2x, they barely broke above parity with their primary driver.

As of point 3, the latest interim highs of late February right before the recent slide, the HUI's upleg-to-date leverage to gold since early October had improved modestly to 1.3x. Still pathetic. And this is readily apparent on this chart too. Although gold's latest high of late February was 6.0% higher than its late November high, the HUI was flat high-to-high with a mere 0.4% gain. Gold rallied $39 but gold-stock investors could only drive a break-even.

This is certainly ugly, but here's the real kick in the teeth. From early October to point 4, this week's latest lows, the HUI's leverage to gold sunk below 0.9x! From early October to early March, despite gold being up $75 per ounce bottom-to-bottom, the HUI's gains were only 0.85x those of gold. Is this the end of the world? Has something fundamental truly broken? I really doubt it.

All bull markets climb an endless wall of worries. Every step of the way in the 996% run higher in the HUI since late 2000 has been plagued by fears and doubts. It was never psychologically easy to be long gold stocks in this whole bull market. Sometimes, such as today, the fears and doubts overthrow the minds of investors and rule in their hearts, and they are paralyzed and just cannot buy regardless of logic or opportunity.

The really ironic thing is that today's fears and doubts, central banks and bear markets, are the very same fears and doubts of years past. Yet legions of today's gold and gold-stock investors, either because they are new or suffer from amnesia, have forgotten. I discussed central banks above. If they were powerless to prevent gold from nearly tripling over the past six years, why does anyone still think they can somehow pull off a miracle and stop gold from tripling again over the next six years?

And a potential general-stock bear market being perceived as a negative for gold and gold stocks? Are you kidding me?!? Back in the day, between 2000 and 2002, one of the primary reasons fearless contrarians originally invested in gold and gold stocks was because we expected a secular bear in general stocks. Gold and gold stocks are safe havens during stock-market declines throughout history. The worse the general stock markets do, the more mainstream investors flee to the safety and big gains in gold and gold stocks.

So when I saw the US stock markets sell off in response to the Chinese stock-market selloff, I was really excited. Bring on the bear! During almost any bearish episode in history that you research, gold and gold stocks have thrived while general stocks go down in flames. Alternative investments shine the brightest when mainstream investments are in their deepest and longest declines. Yet apparently our peers disagree, as they carelessly flung their valuable gold stocks away last week like used toilet paper while general stocks fell.

But while I am disappointed at the sheer levels of fear paralyzing the gold investment community, this is very encouraging from a sentiment standpoint. Fear is highest early on in major bull markets and uplegs. Later when bulls and uplegs near tops, no one fears anything and greed reigns supreme. So to see such suffocating fear today strongly suggests that the parallel gold and HUI bull markets remain quite young. And this applies to shorter time scales too, so this particular upleg also looks quite young.

During most major uplegs in gold stocks, the HUI's leverage to gold starts out low initially and then soars near the end. As paralyzed by fear as this HUI upleg has been so far, I suspect its leverage ramp in the coming months is going to be very impressive. Gold stocks have the potential for huge gains in the months ahead as investors shake off their blind fear and start buying rationally again in response to a powerful new upleg in gold.

At Zeal we continue to focus on the big picture and add new trades in elite high-potential gold stocks during all of these irrational selloffs. While bull markets fight back every step of the way and try hard to buck investors off, the rewards for those who hold on through adversity are enormous. Please subscribe to our acclaimed monthly newsletter today if you want to fight your fears and ride this tremendous gold-stock bull much higher.

The bottom line is gold's technicals look fantastic. The HUI's are much weaker, but the HUI always follows gold in the end so the catch-up rally in this beleaguered index has an excellent chance of being huge and fast. Although fear is a normal human emotion, it has no place in the financial markets. The fearful always lose money in the end.

And today's gold-stock fears are nothing new, they are just recycled from the previous six years. And the gold-stock investors who sold out in response to these very same fears in the past missed enormous gains. The only ones who get rich in bull markets are those who train themselves to laugh at the wall of worries and focus on the cold, hard underlying fundamentals. Of course they remain very bullish for gold and gold stocks.

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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