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August 24, 2007

What the HUI?!?
by Adam Hamilton

After weathering a consolidation running for 16 months now, the remaining precious-metals-stock investors and speculators are a pretty hardened lot. Used to being the ridiculed black-sheep contrarians, it takes quite a bit to faze us. Yet the brutal downside action in the HUI last week certainly fit the bill.

Between Monday the 13th and Thursday the 16th, the HUI unhedged gold-stock index shed 18% of its value on an intraday basis. Wednesday and Thursday were the particularly nasty days, with 3/4ths of these losses occurring between the open Wednesday and the first couple hours of trading on Thursday morning.

While this sounds bad enough at the index level, the 14% HUI loss over about 8 trading hours really belies the real carnage underneath the surface. Excellent gold and silver juniors with outstanding fundamentals were trapped in a sickening freefall. Some plummeted on the order of 20% per day at worst during the HUI mini-panic of mid-August 2007. It was truly an extraordinary event.

Although this sector has started to recover since last week, the psychological aftermath of this event will continue to wreak havoc on PM-stock sentiment for some time to come. The fact that the HUI can plunge so fast with no warning, off a technical low no less, has really damaged confidence in the struggling precious-metals-stock sector.

Relatively conservative speculators who own their stocks outright and prudently run trailing stops saw almost all of their speculative positions get stopped out last week. While their capital was recovered with just modest losses thanks to their stops, they now find themselves with a blank PM-stock slate and trying to decide whether or not, and when, to redeploy this capital in PM stocks.

And aggressive speculators who borrow money to buy stocks were eviscerated in the carnage. Margin is great when stocks are rising and gains are multiplied, but when stocks fall fast this same leverage leads to spiraling uncontainable losses. I have no doubt that some heavily-margined PM-stock traders lost nearly everything last week and are now out of the game for good. They'll never buy another PM stock again.

In light of this, the most common question I hear as traders try to digest last week is "what the heck is going on here?" In addition to trying to understand just what happened last week, PM-stock traders are very concerned about the health of the PM-stock bull today. I don't blame them. Last week was a real wake-up call on the ever-present risks and dangers always inherent to, but usually ignored in, speculation.

As always, my detailed tactical analysis of the HUI mini-panic events as well as specific trading strategies and stock recommendations going forward are being discussed in depth in our subscription newsletters. Our subscribers fund Zeal and make all of our research possible, so they naturally get the best actionable information. But zooming way out, important strategic questions have also arisen about the integrity of this HUI bull that are very appropriate for an essay.

With support so decisively broken, is this HUI bull over? Was the record PM-stock trading volume witnessed last week a bullish or bearish omen? Does the HUI's relentless underperformance of gold lately suggest gold is no longer the primary HUI driver? Is the once-alternative PM-stock sector doomed to trade in lockstep with the general stock markets? Such questions are really vexing PM-stock traders today.

As always, the history of this bull offers insights that help frame the present in proper context. Although Thursday the 16th, a two-hour mini-panic off of technical lows, was largely unprecedented in this bull, there are certainly broader parallels between last week and past HUI behavior. The selling last week may have been unusually temporally condensed, but it certainly wasn't the first setback in this seven-year-old bull market.

To address these concerns, this first chart combines HUI technicals with its trading volume. The latter is daily composite HUI volume, or the individual trading volumes of all of the HUI's component companies added together. If you look at a HUI chart of just the past month, it looks pretty darned ugly. But pulling back to see the mini-panic in broader context really helps put it in perspective and calm seething fears.

Let's start with the technicals. Since last week's sharp selloff broke the HUI's latest support line decisively as well as drove the index well below its crucial 200-day moving average, a growing number of technically-oriented traders are fearing this bull market is over. Support failures are indeed events worthy of paying attention to. But last week's failure was not only not particularly major, it wasn't the HUI's first by a long shot.

If you look closely at the upper-right corner of this chart, the support line that was just broken and is causing all the commotion is labeled with the blue 4. While there is no doubt it failed spectacularly, it wasn't a very old support line. In fact, it just started trending higher at the January 2007 lows. So the particular support line that failed last week wasn't even secular in nature, but a short-term one less than 8 months old!

Interestingly the current secular, or long-term, support line remained intact despite last week's mini-panic. It is the only one labeled as Support above. It was born off the June 2006 HUI lows following the index's all-time high. Later it was cemented in place by the October 2006 lows. They ran near 274 and 283 respectively. On the Thursday of the mini-panic, the HUI closed right at 300 which keeps this quasi-secular line intact.

Now not all technicians agree with me, but for long-term technical analysis I am convinced only closing prices are relevant. While all kinds of sentimental distractions can drive wild intraday trading from time to time, it is the closing price that truly distills what the markets thought stocks were worth on any particular day. Big intraday swings just don't mean all that much in the grand scheme of things.

And on a closing basis, this latest HUI support line that was not broken last week is about 14 months old. It isn't exactly secular in duration yet as that term usually applies to multi-year spans of time, but it isn't tactical either since it has persisted for over a year. And this older, and hence more important, line held strong while short-term support failed.

But even if this quasi-secular support line had failed, or it does fail in the coming weeks, it is hardly evidence that this PM-stock bull is ending. Prior to this, there have been at least three major support breakdowns in the HUI that are labeled above with the blue numbers. In each case the HUI fell decisively under its most important long-term support line, panicking pure technicians, but its bull soon recovered and continued higher to establish new support lines. Support always evolves throughout a bull.

The most relevant of these major support breakdowns to today was the second, starting in early 2005. The HUI had been powering higher along secular support established way back in late 2002. During its 2.5 years of existence, this crucial support line had even held through the sharp correction following a massive upleg in mid-2004. So when it suddenly failed in early 2005, technicians started freaking out.

Naturally when this earlier breakdown happened, sentiment was horrible just like today. Investors and speculators alike were giving up on PM stocks and throwing in the towel. Ever the contrarian, I was trying to fight the irrationally pessimistic HUI sentiment back then just as now. In February 2005, I was writing about the bullish gold fundamentals and about how the gold-stock bull was healthy despite popular perceptions. By April, as the HUI started to bottom, I wrote about the very bullish opportunities in unloved gold stocks.

Most tellingly though, also in April 2005 near the major HUI lows I felt the need to write about the HUI's correlation with the general stock markets. Back then, just like today, traders feared that the HUI was joined at the hip to the SPX so any stock-market selloff would crush PM stocks too. Despite it being irrational in light of history, folks were using a perceived HUI/SPX correlation as an excuse to avoid being contrarians and buying near oversold lows. There is really nothing new under the sun in the markets!

In many ways, the early summer of 2005 is very analogous to today. As you can see in this chart, the HUI seemed to be growing weaker as its long consolidation kept grinding forward. And the HUI was unable to revisit its pre-consolidation highs again despite trying for over a year. And it continued to get weaker as despair set in and traders gave up on PM stocks. Sounds just like today, no?

Most everything witnessed today in 2007 also happened in 2005. The job of a long consolidation is to spawn despair, shake weak hands out of a sector, and build a base for the next fundamentally-driven upleg. Once despair is maximized and no one is left in a sector but fearless true believers in the fundamentals, then the sector can soar. Indeed the HUI's latest massive upleg was born out of the naked despair of the mid-2005 technical and sentimental lows. The next one is probably being born today.

So yes, even long-term support fails from time to time. Yes, traders succumb to fear and despair during long consolidations when new highs aren't achieved quickly enough to slake their greed. But ultimately all that matters is fundamentals. If the HUI's fundamentals remain bullish, it will rise. Since the HUI's primary driver is the price of gold, it is gold's fundamentals that traders should consider today. If gold demand growth is going to continue to exceed gold supply growth worldwide, then the HUI will continue higher sooner or later.

With the HUI really doing nothing particularly appalling technically last week other than its intraday Thursday panic selling, we can move on to volume. Volume in gold stocks soared to record levels on Thursday the 16th as leveraged speculators were skewered and forced to dump their PM stocks at any price. This mini-panic only lasted for a couple of trading hours, which is why I call it "mini", but composite HUI volume still rocketed up to a massive new all-time record.

On that Thursday alone, 160m shares of HUI component companies changed hands. Prior to this the record was 106m on February 27th of this year, the day the US stock markets sold off sharply on the back of a wicked single-day 9% slide in Shanghai. Prior to August 16th the average daily HUI volume in 2007 was running around 62m shares. So to see 2.6x normal volume is pretty extraordinary.

Now in volume-based studies of the markets, high-volume selloffs are usually much more relevant than low-volume ones. If a selloff happens on low volume, it can just be attributed to lack of buyer interest in a thinly-traded market. But if it happens on high volume, then technicians fear the mass exodus may mark the beginning of a major trend change. So today traders are concerned the stellar HUI volume during the mini-panic suggests that this HUI bull is in jeopardy.

While the 16th was extraordinary, it was certainly not the first time in this bull that a sharp selloff happened on very high volume. Three other high-volume selloffs are labeled above with the red numbers. During each, the HUI volume soared to levels that were very high or even records in the context of the bull to date up to those points. Yet after each, the HUI recovered nicely and continued higher on balance. Why? Volume doesn't drive secular bulls, fundamentals do.

Although I agree that high-volume selloffs are more ominous than low-volume ones, I disagree based on the HUI's bull-to-date precedent that last Thursday's selloff volume alone is enough to build a bearish case upon. Traders get scared from time to time, especially the leveraged ones. When some news spooks the markets and the margined guys are forced to sell in a hurry, volume can spike dramatically. Yet so far it hasn't heralded the end of the bull, just the end of aggressive speculators who borrowed too much money. One of the most basic lessons of market history is leverage tends to eventually bite those who use it.

Just as with technicals, it is probably wiser to interpret volume within strategic context rather than dwelling too narrowly on one particularly stunning episode. Note the impressive uptrend in general HUI trading volume since the despairing summer of 2005, which even persisted through our current consolidation. Higher trading volume over long periods of time is a characteristic of bull markets, not bear markets.

As more traders get interested in the PM-stock sector, more capital will chase the PM stocks. Since all of the market capitalizations of all the PM stocks combined remain incredibly small, like a quarter the size of a single big oil company, it doesn't take much capital to drive prices higher. The rising volume in the HUI shows rising interest in trading it despite the consolidation. And the more traders and capital migrating into this small sector, the bigger its fundamentally-driven uplegs will be.

With more capital paying attention as evidenced by volume growth, as soon as the HUI starts following gold again big buying should flood in and drive it higher. And of course rising prices in the financial markets create a virtuous circle. The higher prices rise the more traders want to buy in to ride the action. So they buy in and drive prices even higher, enticing in a whole new round of traders, and so on. It is higher volume that starts this whole cycle, so the growing volume in the PM stocks is encouraging.

The final two concerns I want to address today are like two sides of one coin. Why is the HUI not following gold and why does it seem to be following the general stock markets so darned well? Interestingly neither of these concerns is anything new. Just like worrying about support failures, for the past seven years of this HUI bull traders have been worried about the HUI's correlations with gold and the SPX. Yet this PM-stock index has still powered nearly 1000% higher over this period of time. Bulls climb a wall of worries.

We'll start with gold, and the easiest way to understand the HUI's interaction with the metal that ultimately drives it is through the HUI/Gold Ratio. HGR trends offer insights into whether the PM stocks are outperforming the metal or vice versa. Interestingly this is very cyclical, with the metal doing better for a considerable period of time and then the PM stocks finally catching up and exceeding the metal. When the blue HGR line below rises, PM stocks are outperforming. When it falls, gold is outperforming.

Overall in their respective bulls to date, the HUI has outperformed gold dramatically by exceeding its gains by 5.5x to one. Yet this outperformance is not a constant linear thing, it is achieved sporadically in big HUI surges. Today a lot of traders are concerned because the HUI isn't responding to gold's impressive strength. How can the HUI sell off so dramatically when gold remains so stable at high levels?

As you can see in this chart, gold has been outperforming the HUI since just before the May 2006 tops, or for this entire consolidation. On balance the HGR has been declining. And this key ratio really fell during last week's mini-panic, driving it to the lowest levels seen in a couple years. So is the HUI's poor relative performance telegraphing that its bull market might be running out of steam? I really doubt it.

Once again historical perspective is the key. Gold outperforms the HUI during every PM-stock consolidation. Or more literally, the more volatile HUI falls farther during its consolidations than gold falls during its own. The latest episode of the HUI underperforming gold is the fourth we've seen so far in its bull. Yet just as the first three episodes didn't mark the end of this bull, odds are this fourth won't either.

The only times that the HUI strongly outperforms gold are during the HUI's massive uplegs. While these PM-stock uplegs are driven by underlying uplegs in gold, sooner or later greed grows too excessive in the HUI so it tops. Then it starts consolidating sideways to bleed off greed and get the markets comfortable with a new foundational base at higher HUI prices. Gold always exhibits relative strength during these periods of time, retreating a lot less than its miners do.

It is provocative that the weakest HGRs are seen late in consolidations. Like today, PM-stock traders who refuse to study market history start to lose faith when a new upleg tarries. The longer a consolidation lasts, the more traders give up on the entire sector. Naturally the HUI gets weaker and weaker as this despair grows, so the HGR tends to hit its lows for a consolidation near the very end of the consolidation. PM-stock traders capitulate and leave despite strong gold prices paving the way for the next upleg.

Looking at this chart, it is readily evident that last week's HUI mini-panic drove the HGR to the lowest levels it has seen during this consolidation. The HGR actually fell to its secular support line, which has held since early 2003. It was from this very line that the previous two massive HUI uplegs launched. Given today's levels of despair and disgust with the HUI, it wouldn't surprise me at all if the HUI's next massive upleg is starting higher now. The HUI tends to start outperforming again just when it looks the worst.

So based on the history of this bull, it is hard to make the case that something is fundamentally wrong with the HUI's relationship with gold today. Sure the HUI has been underperforming for this whole consolidation, but it did the same thing in all its past consolidations too. Once again there is nothing new under the sun. I think if traders understood this history, they wouldn't get so worked up about the SPX.

Thanks to the HUI swooning with the general stock markets a few times this year, the vast majority of the PM-stock-trading realm is now convinced that the fortunes of the SPX are the primary driver of the HUI. So therefore if the US stock markets continue lower, the HUI will have to sell off in sympathy. This pervasive belief continues to boggle my mind as it defies the lessons of market history.

Either precious-metals stocks are still classical alternative investments or they are not. If they are, they tend to thrive the most when general stocks are the weakest. The HUI actually did phenomenally well during the last wicked general-stock bear between 2000 and 2002. But if PM stocks are now suddenly not an alternative investment, then there is no reason whatsoever to own them. If we truly live in a world where the SPX drives everything, then traders would be better off owning Wall-Street-darling sectors.

The primary driver of the mini-panic last week, before the margined guys started getting squeezed, was this overriding fear that the HUI is just another mainstream stock sector correlated with the SPX. So as the stock markets sold off, HUI traders who believe this thesis panicked. Just as in 2005, this is stratifying the PM-stock market. Traders who fear the SPX are selling. But traders who believe in history, that the price of gold drives gold stocks, are staying deployed in the PM-stock sector despite all the fears today.

At this stage it really boils down to a faith issue, as it does late in all consolidations when popular despair reigns. If you believe the price of gold is heading higher for global supply-and-demand reasons, and therefore the profits for mining this metal will rise, then there is no reason not to buy PM stocks. If you don't believe this is the case, then there is no reason to buy PM stocks. This consolidation will end when the latter group has largely sold out and the former remains. Good riddance to these weak hands.

Of course at Zeal we remain very bullish on gold and commodities and the stocks of the companies mining them. After countless thousands of hours of research, writing, and trading since these bull markets launched, it is readily evident that probabilities remain overwhelmingly on the bulls' side. So we continue to ignore popular fears and buy elite PM stocks at technically-opportune times. Subscribe today to our acclaimed monthly newsletter and ride the next decade of this commodities bull higher with us!

The bottom line is the mini-panic last week, while crazy tactically on the 16th, really wasn't all that exciting in strategic context. It wasn't the first time the HUI has broken key support, nor the first time the HUI sold off on high volume, nor the first time it underperformed gold. Such events are par for the course deep in consolidations and are nothing to write home about. Massive uplegs are born out of such fear and despair, as the best times to buy are when the fewest traders want to.

While emotions can easily dominate short-term trading, over the long term all that matters is fundamentals. For PM stocks, it is the prices of gold and silver that ultimately matter. Higher metals prices mean higher profits, and higher profits mean higher PM-stock prices.

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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