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April 20, 2007

Bullish HUI Technicals 2
by Adam Hamilton

The flagship HUI gold-stock index has had quite a run over the last six weeks or so. It has already rallied 17% just since it swooned with general stocks in response to the late February selloff in the Chinese stock markets. But this week the HUI returned to the technically-feared 360 level that has stymied it for nearly a year now, leaving us at a key technical crossroads.

Thus gold-stock investors and speculators are keenly watching the HUI today with a mixture of excitement and trepidation. On the greed side of the coin, the HUI could be poised right on the verge of a major breakout higher. But on the fear side, it could be ready to collapse back down after it loses yet another battle with its 360 resistance nemesis. Which fork in the road are we headed down?

Although we mere mortals can never know the future in advance in order to answer such a question with certainty, I believe probabilities definitely favor the road higher today. Not only do the gold stocks enjoy a highly-favorable fundamental environment with gold again approaching $700, but the HUI technicals still look quite bullish today from a variety of perspectives.

In fact, there are a lot of similarities between today's HUI technicals and those of early autumn 2005. I wrote the ancestor of this essay in September 2005 during a period of time much like now where enthusiasm for the HUI was rather tepid at best. Yet nevertheless from that very week until the May 2006 high, the HUI ended up soaring 83.4% higher in the second half of a massive upleg.

Back in late 2005 before that stunning run, the HUI had been grinding sideways for two years and its 200-day moving average had flatlined. It was at 225 resistance which had beaten it back mercilessly earlier in the year. Not surprisingly without any big gains or new highs for such a long period of time, gold-stock sentiment was pretty ugly. Bearish theories abounded about why the HUI was heading back down under 180, about 20% lower than where it was trading at the time. Now fast forward to the present.

Today the HUI has been grinding sideways for nearly a year, and its 200dma has flatlined suggesting its secular bull has run out of steam. And it is struggling with 360 resistance which has steadfastly repelled all attempts to break through. After a year with no big gains or new highs, investors and speculators are standoffish and lukewarm towards this sector and loath to commit serious capital. Bearish theories are ubiquitous arguing the HUI has to fall back under 280, 20% lower from here, before it can make any more real bull-market progress.

Déjà vu, no? In late 2005 I used the HUI/Gold Ratio and composite HUI volume to argue that our then-unloved upleg was just getting started. Provocatively today, the HUI/Gold Ratio is once again near secular support suggesting that a period of gold-stock outperformance relative to gold, or a major HUI upleg, is due. Our newsletter subscribers can find current HUI/Gold Ratio charts in the private Subscriber Charts section of our website to review the uncanny similarities.

Over my years of speculating I have both learned from others and created from scratch a broad array of technical tools. The really wild thing about the HUI today is its technicals look bullish almost across the entire spectrum of these tools. When one technical perspective looks bullish but a host of others look bearish, it isn't worth getting excited. But when most of them are bullish and confirming each other, then we have to take their bullish accord very seriously.

It is not just the HUI/Gold Ratio that helped us throw aggressively long during this stage in the last major upleg, but simple technical analysis, the Relative HUI, and the HUI's bull-to-date upleg rhythms and precedent that are arguing for further gains. From most perspectives, today's HUI technicals are resoundingly bullish.

Now at first glance, this simple technical snapshot of the HUI's performance over the past year is not exactly awe-inspiring. From a strategic perspective this index has just been grinding sideways, unable to even approach its highs of last May. This lack of big rallies and new highs is the primary contributor to the ambivalent sentiment the HUI faces today even from long-time gold-stock investors and speculators. They want it to rally, but they don't have much hope that it will.

This view arises from a common psychological distortion in interpreting technical analysis. During secular bull markets, traders naturally look to high prices as landmarks on charts. When new highs are being made they are happy and assume all is well. They usually don't even bother considering the rest of the chart buried beneath the surface of the exciting peaks like an iceberg under the sea. The farther in the past the last bull-to-date high recedes, the more traders' interest in a sector fades.

But just as an oceanographer wouldn't presume to draw broad conclusions about an iceberg by merely observing the top fraction of it poking out of the ocean, prudent technicians won't write off a sector solely based on its interim highs. Indeed the center of mass of a trend, where a price usually meanders and where it is usually headed, is far more valuable for traders to consider than concentrating on extremes. There is a lot under the surface in this HUI chart.

For example, note the HUI trend since the index's early October lows. It has been climbing relentlessly higher at a nice pace on balance despite some significant psychological setbacks. Remember the early January panic out of commodities and the late February Chinese stock market selloff? While gold stocks were sold on these events, rather irrationally in my opinion, they only retreated back down near their latest support line at worst.

And this solid uptrend in the HUI's support over the past year, especially since October, is a very bullish omen. Bull markets are not just a series of higher highs, but a parallel series of higher lows too. When the latter occur without the former, it kind of feels like a stealth bull. Higher lows are not sexy and do not command the attention that higher highs do, but nevertheless they are crucial as they build the base from which attempts at higher highs launch.

This little-watched-but-very-bullish higher-low trend started last June. The HUI essentially crashed off of its bull highs, an event that was not unexpected since the euphoria had grown so great at its May top. Interestingly the week gold and the HUI topped in May I had to write an essay fighting the absurd popular notion of the time asserting that "corrections are impossible". Corrections are inevitable from time to time and one was certainly overdue and expected in May.

So the HUI corrected sharply in May and early June, just as it has done many times before in its secular bull in order to bleed off excessive greed and rebalance sentiment. Technically the HUI hit its absolute lowest point in June and started its long climb higher. But despite this sharp move lower and V-bounce, the HUI's sentiment still remained unbalanced to the greed side in June. Time too must pass in order to rebalance sentiment, and one month wasn't enough.

So sometimes after particularly massive uplegs, which the one ended last May certainly was, a major consolidation is necessary. A consolidation is a long period of prices moving sideways on balance. It has the dual function of gradually eroding greed due to lack of excitement as well as establishing a new base, getting traders comfortable with new higher price levels before the next upleg can launch.

The HUI's consolidation period ended in early September. As you can see on this chart, the HUI was heading higher in July and August despite gold trending lower. This disconnect was caused by residual greed, traders remaining too optimistic after the May tops. But when gold corrected sharply in early September, the HUI finally collapsed for good and the excessively optimistic were driven out of the market. This proved to be a really devastating psychological event that led to the true sentiment low in the HUI.

Note above that this sentiment low of early October was higher than the technical low of mid-June, despite gold making a slightly lower October low. Thus even in the midst of the wicked sentiment carnage wrought by last summer's consolidation and collapse, the higher-low trend in the HUI was already subtly starting.

This higher-low trend is now becoming readily apparent when comparing the interim lows of early October, early January, and early March. They are marching higher nicely to form a solid upleg uptrend, a strong support line. But this has not happened on the high side, as disgruntled and irritated gold-stock traders will be quick to tell you. In early September, early December, and late February, the HUI was beaten back rapidly by its 360 resistance. These failures have really sapped the wills of many bulls.

But provocatively, note that this vexing flat 360 resistance on top and the rising support line have created a tightening wedge. As the HUI's support zone climbs higher, the distance between it and the 360 resistance contracts. Thus at each subsequent breakout attempt, the HUI does not have to climb as far to attack 360 again. Coming off a higher support base, sooner or later the 360 line will crack.

In fact, the best attempt we have seen at breaking out above 360 just happened this week. Not only did the HUI hit its highest close since last May's bull-to-date highs, but it spent the most time above 360 that we have seen in the last year or so. Every single day the HUI trades at or over 360 weakens this number's psychological intimidation factor for traders and creates confidence that leads to buying to drive a true breakout. In a week or two we'll know whether this particular 360 breakout is the real deal or not, but sooner or later the fall of 360 is inevitable.

Another bullish observation arises from the HUI's black 200dma line. All bull markets flow and ebb, soaring upwards away from their 200dma in an upleg before collapsing back down to it in a correction. Thus the 200dma is a kind of mathematical anchor around which a secular bull gradually powers higher. The closer to its 200dma that a price retreats, and the longer it remains near, the greater the odds it is due to once again surge higher and away in a new upleg.

Since the HUI's lower support line is trending higher, each subsequent pullback doesn't drag it as far under its 200dma as the previous one. This will work to get traders comfortable again with buying the gold stocks when the HUI is near its 200dma, which is statistically the highest-probability-for-success time to add long positions within any secular bull.

And in the coming weeks, the HUI's new uptrend support line and its 200dma will merge, creating a kind of super-support zone that will probably provide the base from which 360 will be assaulted and finally shattered. The HUI's behavior relative to its 200dma over the last seven months or so has been excellent. This interaction is a typical early-upleg signature, not what we'd likely see if the HUI was heading significantly lower.

One of my favorite technical tools for trading secular bulls is Relativity, or dividing a price by its own 200dma. Over time this construct creates a general horizontal trading range. Traders should expect an upleg when a relative price is low in its trading range and expect a correction when it is high in its trading range. Today the Relative HUI, or rHUI, remains quite low within its very-well-established relative trading range, a bullish technical sign.

Since its secular bull launched back in late 2000, the rHUI has generally run between 1.00x on the low side to 1.50x on the high side. In other words, most of the time the HUI has oscillated in a range running from right at its 200dma to 50% higher than its 200dma. If you are looking for a new upleg, the highest probability for one launching occurs when the HUI is at or under its 200dma, under 1.00 relative.

On the right side of this chart, check out the rHUI action over the better part of the past year. Since its early October sentiment low, at best the HUI has only been able to trade 11% to 12% above its 200dma. These are very low relative values totally devoid of all euphoria, suggesting we are nowhere near a major top. If you carefully examine the past years in this chart, you'll note that each time the HUI traded between 1.00x to 1.10x relative following a sub-1.00x post-correction low was a fantastic opportunity to throw long. This time around ought to follow precedent too.

Before all the past major uplegs in this index, including the monster ones topping in 2002, 2003, and 2006, the HUI traded under 1.00x relative. While the very best time to buy was when the HUI was the farthest under its 200dma, traders who waited until the HUI recovered back up to being 10% above its 200dma also did incredibly well. Since the HUI doesn't tend to top until it extends 50%+ above its 200dma, buying in at 1.10x relative still leaves a lot of room to run.

Now if the HUI is still in a secular bull, which is almost a certainty since the gold price ultimately drives the gold-stock bull and the metal is still powering higher for global fundamental reasons, then the best time to buy it is when it is low in its relative range. Traders buying gold stocks in the past when the rHUI traded at the same levels as today following a correction were richly rewarded. We'll probably reap similar big gains again by buying in today.

Besides the HUI's low and bullish relative position today, there are a couple other technical observations from this long-term chart that are worthy of considering. First, note the initial secular support line drawn above called "Support One". If this old support zone is extended to today, it ends up near 280. This is why some traders are expecting a sharp correction to 280 (or lower if the line is drawn through the mid-2005 lows) before the HUI's next real upleg can begin.

This thesis is problematic though because throughout the lives of secular bulls, they do not remain locked to their initial shallow secular support lines. As the bull marches higher and more capital floods in, prices start climbing more steeply. This creates new support lines that have sharper slopes that supersede earlier ones. Since all bulls outgrow old shallow support lines and gradually morph into progressively steeper ones, it doesn't make much sense to expect an old shallow one to extrapolate out into infinity.

Second, note the major basing zone the HUI has carved over the past year between 300 and 360. Just two years ago the notion of the HUI trading in this range would have seemed ridiculously optimistic, but now we are all bored with it thanks to this solid basing. Because the HUI has traded sideways for a year, it has created a perfect base from which it will almost certainly launch to much higher highs in the months and years ahead.

Traders are seldom willing to commit serious capital in anticipation of higher levels until they are really comfortable with current ones, and this comfort with today's HUI levels now exists thanks to the past year. Yet despite this new higher base and increased comfort with 330ish (middle of this range) levels being normal, HUI sentiment still remains lukewarm at best. I suspect this is because our current upleg has been so slow and subtle.

My final chart indexes the mighty HUI upleg that topped last May, the sixth in its bull to date, in order to compare it to our current seventh one. Both uplegs are indexed at a starting value of 100 at the major interim bottoms from where they launched, and the horizontal axis represents trading days after those points. With each calendar month running 21 trading days on average, each horizontal chart square essentially represents one month.

Since there are two possible starting points for our current upleg 7, its true technical low in June or its slightly-higher sentiment low in October, upleg 7 is indexed from both points for comparison. When this current upleg is observed in perfectly-comparable terms against last year's huge upleg 6, it really highlights why HUI sentiment remains so uninspired. Upleg 7 has just been too anemic so far to generate any excitement.

Although our current upleg looks pathetic compared to the last one at first glance, there are some subtle similarities that are very bullish and provocative. Looking at the gray rendering of last year's upleg 6, note that it carved two distinct support lines. In its first stage support rose gradually and in its second it rose much more aggressively. This comparison is interesting as it highlights the fractal nature of the markets, similar patterns appearing at many scales. Just as secular bulls see support slope increases, so do the relatively short major uplegs within those bulls.

Within uplegs, these slope increases correspond to different levels of belief and commitment by traders. Early on in a new upleg, traders are wary as they remember the preceding correction. They bid on gold stocks only sparingly which leads to a shallow climb initially. But after a long-enough period of shallow climbing, old fears start to fade and traders get excited again. At some point they really start to believe in the new upleg and want to participate. This leads to accelerating price increases.

In upleg 6, this slope inflection point is marked above. It divided that mighty upleg almost in the middle, a slow initial run higher when few believed followed by a sharp secondary run higher once traders started to believe and flocked back to gold stocks. Before that inflection point upleg 6 was unimpressive and doubtful, but after that inflection point it became one of the greatest uplegs in recent memory.

Now compare the blue line above, which is our current upleg 7 indexed from its October sentiment lows. Its initial uptrend has been slow and modest, even tracking the early days of upleg 6 almost perfectly in its initial three months. Although upleg 7 has lagged upleg 6's progress in the second three months, it is now near the point in time where last year's upleg hit its inflection point and really started powering higher.

I suspect we are near a similar psychological inflection point today, a moment in time when overall gold-stock traders' sentiment shifts from majority bearish and skeptical to majority bullish and hopeful. And the catalyst for the scales of sentiment finally shifting in our favor again will probably be the HUI's breakout above 360. As soon as this vexing level falls, perhaps in the coming weeks, traders are really going to start to believe and want to buy into the HUI once it clearly breaks out of its year-long trading range.

Interestingly the lion's share of the total gains in upleg 6, by far, occurred in the second strong half, not the weak first half. If we are indeed on the cusp of the second half of upleg 7, the HUI should really start accelerating higher soon. While all the true contrarian buying has already been done in this upleg since October when few believed in its potential, big momentum gains can still be won going forward if this upleg unfolds like previous ones.

While it is impossible to tell exactly how high the HUI will ultimately climb in this upleg, consider this. Of the HUI's six completed uplegs in this bull so far, their average gain was a staggering 104% per upleg! If this current upleg 7 is just average, and achieves a similar 104% gain from its lower June lows, then we are looking at a potential interim top above 550. Yes, that is 550, not 450! Please don't get hung up on this specific number, just realize that today's HUI levels are still very low compared to its recent-past upleg-gains precedent.

At Zeal, we have been actively adding high-potential gold-stock positions since the dark contrarian days of October, when few were bullish. While some of our trades have been stopped out at modest losses and gains during the HUI's couple of pullbacks since then, the remaining majority are thriving. This week our unrealized gains in gold-stock trades recommended in Zeal Speculator since early October range up to 80%.

And if this HUI upleg 7 we are experiencing today has a strong second half as precedent suggests it should once traders start to believe it is the real deal, the best gains in this upleg are still to come. With most technicals remaining bullish, we are still adding elite gold-stock trades on weakness in anticipation of a major HUI rally in the months ahead. Please subscribe to our acclaimed monthly newsletter today to mirror our trades and shoot for these potential big gains!

The bottom line is the HUI technicals look very bullish today despite the lukewarm sentiment. While the HUI hasn't made new highs for a year, it has been carving higher lows and is positioning itself to break above its 360 prison soon. This event will probably get investors and speculators excited about gold stocks again and spawn major buying. They'll believe in this sector's great potential once more.

This buying should lead to the typical psychological inflection point where our current upleg starts maturing into its more powerful and steeper second half. The higher the HUI goes, the more capital it will attract creating a virtuous circle of strength. And if this upleg even proves to be merely average in magnitude compared to the HUI's bull-to-date precedent, the gains ahead will be awesome.

Adam Hamilton, CPA
Zeal LLC.com

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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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