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September 14, 2007

HUI Upleg Cycles
by Adam Hamilton

Remember the brutal first hour of trading on August 16th? That was the fateful day when a mini-panic ripped through gold stocks like a tornado. The HUI plunged 10% in the first hour of trading and some high-potential smaller gold stocks plummeted over 25%! For leveraged PM-stock speculators, it felt like Armageddon.

Sentiment that morning was about as bad as it has ever been in this precious-metals bull. Gold and silver miners were loathed and calls for much deeper lows abounded. Yet just 15 trading days later, gold powered above $700 for the first time since May 2006. This gold breakout drove a strong PM-stock surge and the HUI quickly shot above its pre-August-mini-panic levels.

Such extreme swings in sentiment, going from abject despair to guarded hope in less than a month, are really challenging for PM-stock investors and speculators. Were the markets right about PM stocks' dire outlook in the first hour of trading on August 16th? Are they right about the PM stocks' newly rosy outlook today? Can any sense be made out of such a manic-depressive sector?

I think it can. This bull-market in precious-metals miners and explorers is not new. It started stealthily from humble origins in late 2000 and has already soared 996% higher at best. As a student of the markets and active PM-stock investor and speculator over this whole period of time, I have been fascinated by cyclical behavior in the HUI. Strategic price patterns, driven by swings in prevailing sentiment, are quite evident.

Just as looking at a road map can dispel the confusing ambiguity when trying to navigate in the streets of a strange city, considering the great HUI patterns brings order out of the seeming chaos of day-to-day trading. A strategic big-picture focus renders tactical volatility in proper perspective and gives traders a much better idea of what is likely coming.

Like all bulls, the HUI's nearly 11x surge in value over the past seven years has not been smooth and linear. Every point of its awesome progress was painstakingly achieved through fits and starts. PM stocks would enthusiastically power two steps higher in uplegs, and then they would morosely retreat one step down in corrections. Today's extreme volatility is really nothing new for this hyperactive sector.

From a pure technical, or price-oriented, perspective, a bull is nothing more than a series of higher highs and higher lows. Bulls' uplegs ultimately climax at new interim highs and their corrections run out of steam at new interim lows. Observing and measuring these great swings, from interim high to low and vice versa, really offers a wealth of insight into a particular bull market's character and near-term probabilities.

Over the past seven years of this HUI bull, there have been six major interim highs and six major interim lows. These boldly stand out on any long-term chart, so they are really not disputable in any way. Over the last couple months we may have seen a seventh major interim high and major interim low, but for the moment these are provisional until more data confirms they are indeed the extent of recent extremes.

All of these major interim highs and interim lows, including the likely seventh ones, are marked in this chart. As you examine it, note that PM stocks definitely have not risen in a nice orderly fashion. Like a bumper car, they have careened constantly from one interim high to the subsequent interim low and vice versa. While this bull market has been extraordinarily profitable, it has never been for the faint of heart.

When seen in secular context, neither the sharp plunge of mid-August nor the equally sharp recovery over the last few weeks really stands out at all. They are just the latest in a years-old string of sharp opposing moves carved by the ever-volatile PM stocks. But despite all this volatility, the most important strategic truth evident here is that the HUI has been climbing higher on balance since late 2000.

With all the major interim highs and lows numbered above, some interesting observations emerge. First, note that subsequent interim highs are not always higher than their predecessors. Although higher highs are certainly the norm for a secular bull, an occasional lower one doesn't mean the bull is over. Note that high 5 was lower than high 4, which troubled many in late 2004, yet the HUI still soon rocketed higher to the next far-higher high 6. So today's high 7 being lower than May 2006's high 6 isn't unprecedented.

This same observation applies to major interim lows too. Low 5 was lower than low 4, a troubling portent at the time. In fact, since the HUI's bull-to-date support was broken by low 5, in early 2005 countless traders and analysts had given up and assumed this PM-stock bull was over. Yet, right out of the overwhelming despair near low 5 the massive upleg was born that propelled the HUI to high 6. And the subsequent low 6 was much higher than any previous major interim low. Low 5's dismal sentiment reminds me of what we just saw on August 16th at the provisional low 7.

So subsequent major interim highs are generally higher than their predecessors, and subsequent major interim lows are generally higher than their predecessors too. But this is not always the case. Major interim extremes are heavily influenced by prevailing sentiment at the time, so if greed or fear get too far out of whack the interim extremes can temporarily drive prices out of their secular uptrend.

And like everything in the markets, sentiment is the key to these HUI cycles. New uplegs are born out of major interim lows, when fear prevails and few want to buy. But after early contrarians lead the way, more and more buyers return. Eventually prices climb high enough for long enough to spawn widespread greed. This greed peaks right at major interim tops. Then selling bleeds off the greed and fear gradually returns. This fear then peaks right at the major interim lows and this HUI upleg cycle begins anew.

The endless greed-fear-greed-fear cycles that gradually drive bulls higher are easy to understand. Traders naturally oscillate between sentiment extremes over time, and these emotions drive their trades which lead to the major interim highs and lows. But in the HUI's case, a provocative and very profitable meta-pattern has emerged beyond this typical cycle. Even more interesting, so far it has proven to be fractal in nature.

In this usage, a fractal is a repeated technical price pattern at ever-larger scales as the HUI bull evolves. There have been several of these fractal patterns so far in this bull to date. I chose not to draw them in this chart so you'd have the opportunity to see them leap out with your own eyes. They are defined by their two phases, a surge and a drift. Each fractal pattern starts with a surge higher and ends with a drift sideways.

The first big fractal runs from late 2001 to early 2003. The HUI surged higher in a massive upleg to levels not seen since the late 1990s. Around 150, greed climaxed and all traders who wanted to deploy capital in this sector already had. Prices had nowhere to go but down, so they fell sharply to major interim low 2. After the surge part of this fractal ended in mid-2002, the HUI generally drifted sideways until early 2003.

The second big fractal started right after the first ended. It witnessed a massive upleg driving the HUI to 250, all-time highs since this index was only born in the mid-1990s. Euphoria peaked and the surge ended at major interim high 4. Then PM-stock prices drifted sideways for over a year until major interim low 5 arrived. Like the initial fractal, this second one was defined by a big surge followed by a long drift.

The latest big fractal picked up right where the second left off. It started with a huge surge from mid-2005 to mid-2006 which drove the HUI near 400. Since those highs, the index has largely been drifting sideways. So we've seen this surge-drift pattern several times in the HUI, in three increasingly larger fractal shapes. Obviously our current position within today's fractal has huge trading implications.

But before we get into them, it is useful to understand why these giant fractals are likely occurring. Not surprisingly sentiment is the answer. Bull markets climb walls of worry. So especially when prices drift sideways, traders dream up an endless series of reasons why they are never going any higher. The longer prices drift, the more these bearish theories gain traction. Eventually few bulls are left and a price hits a major interim low.

So during drifts, everyone who wants to sell for any reason sells. This leaves very little selling pressure and lots of fear by the end of the drift. But in the case of the HUI, its underlying driving fundamentals remained strong despite the poor sentiment. Gold and silver continued to rise on balance, developments which lead directly to higher profits and hence higher stock prices for their miners. So even after long discouraging drifts, prudent fundamentally-astute contrarians continued to buy.

With no sellers left, the surge stage starts. Contrarian buying finally succeeds in driving up prices. And of course higher prices beget more buying. Momentum traders start to nibble, then technical guys move in when upside breakouts happen, and eventually emotional traders flood in to buy as the top of the surge approaches. But greed becomes unsustainable by this time as everyone who wants to buy has already bought. So a major interim high occurs as selling overwhelms buying and prices fall fast.

These corrections after uplegs tend to hurt the emotional traders the most. They buy in late during uplegs and often lose money by selling out late in corrections. These losses drive a lot of unrest and unease. Since a surge pushes the HUI to levels never before seen, traders always wonder if they are sustainable. Buying and selling are roughly balanced in the drifts, which leads to sideways price action. Some traders sell assuming the bull is over, while others buy because gold and silver fundamentals remain strong.

The ultimate result of these long drifts is traders' expectations of "normal" price levels for the HUI are reset. In 2004 and 2005, for example, 200 to 225 on the HUI seemed normal. When it moved above these levels traders sold and when it moved below traders bought. Since 125 had been the normal price level during much of 2002 and 2003, it took some time for traders to consider a 200ish HUI to be normal and rational.

These consolidations following massive uplegs form a base off of which the next big surge can launch. Once an index trades at a particular level for long enough, it starts to get perceived as low. Eventually buying exceeds selling and the next surge upleg is born. Prior to the latest surge upleg that ended in May 2006, 325 on the HUI seemed impossibly high. But today after the long drift since then, 325 seems totally normal and rational. And even boring!

So when traders get excited about the bullish fundamentals of the precious metals, they get whipped into a frenzy and drive massive surge uplegs. Eventually these uplegs run out of steam though and then prices first correct and then drift sideways in a consolidation. They drift long enough for traders to get comfortable with first calling these new higher prevailing levels normal and later even considering them low. And then the next fractal surge is born.

These sentiment-driven HUI upleg cycles are extremely important and relevant today because the long grating drift since May 2006 is probably ending. Today's immense levels of negative and bearish HUI sentiment, not to mention how tired and irritated traders are getting with a 300 to 350 HUI, really suggest we are due for another surge. There is even a good chance it already started at the August lows!

Another way to consider the giant surge-drift fractals is to divide them into two distinct uplegs. The surge stages see "massive uplegs", truly legendary gains in the HUI that earn traders fortunes in just 6 to 12 months. But the drift stages, even within long consolidations, also hide "consolidation uplegs". They are much smaller than the massive uplegs since sentiment is rebalancing and traders are getting comfortable with new higher price norms, but they are still plenty profitable to trade.

So the HUI upleg cycles can be considered in terms of surge drift surge drift, or else in terms of massive uplegs followed by consolidation uplegs. By measuring from one major interim extreme to the next, we can gain an empirical idea of how big the various uplegs have been and are likely to be in the future. Using the same system above derived from numbering interim extremes, we can number individual uplegs and their subsequent corrections. Upleg 2, for example, is the upleg that culminates in major interim high 2.

By this designation, uplegs 2, 4, and 6 were massive uplegs while 3 and 5 were consolidation uplegs. And the recent provisional 7th upleg was also likely a consolidation upleg. If this proves to be the case, then we are now due for the next massive upleg. And if the upcoming upleg 8 is indeed massive, PM-stock investors and speculators have the opportunity to reap absolutely enormous gains in the next 6 to 12 months.

Measuring from interim extremes and using the same numbering system, the majestic upleg cycles in the HUI become readily apparent. The kinds of numbers seen above in these uplegs are staggering. They show why contrarian PM-stock traders are so longsuffering. While there is a lot of angst trying to trade such a volatile sector, the gains to be reaped in the uplegs are so huge that they are well worth the wait.

Although the index itself has climbed 996% from its secular low of late 2000 to its latest May 2006 bull high, traders willing to ride the uplegs had the potential to do much better. Idealized, riding every upleg perfectly and selling before every correction, the HUI has offered potential compounded gains of 8671%! Obviously this is not obtainable, but it shows the merits of trading compared to buying and holding.

And if you look carefully at the three categories of major moves in the HUI, the massive uplegs, the consolidation uplegs, and the corrections, there is remarkable consistency across all these years. Massive uplegs, for example, have ranged between 125% gains over 8 months to 145% gains over 6 months. They have averaged incredible gains of 136% over 9 months!

Consolidation uplegs are much smaller, but still profitable. If we include provisional upleg 7 which ran from the June 2006 low 6 to the July 2007 high 7, they averaged gains of 47% over 8 months. All 7 HUI uplegs together, including both types, averaged gains of 94% over 8 months. With so many opportunities to multiply capital in PM stocks in this bull to date, it is easy to see why contrarians remain so passionate about them.

Corrections following these uplegs ranged from -19% to -36%. All of the corrections averaged, including the provisional 7th one from mid-July to mid-August of this year, weighed in at -28% over 3 months. And if you look at any of these three categories, the variances between events are impressively tight. There is not a huge statistic-extreme-skewed range between any two massive uplegs, or any two consolidation uplegs, or any two corrections.

And although it would be foolish to claim that these averages are precisely predictive, I do believe they distill out tendencies. Seeing how the HUI has acted during this bull in specific uplegs and corrections within its upleg cycles helps us better understand how future uplegs may unfold. And if you run the numbers here, the general projections for the next upleg based on these averages are amazingly bullish.

If major low 7 of August 16th, 300 on the HUI, holds, then it marks the start of the next HUI upleg. Assuming this coming upleg 8 is merely average, we can expect a rally in the neighborhood of 94%. This yields a potential HUI target for major high 8 around 580! Anyone who owns quality gold and silver miners and explorers would see tremendous gains, doubles or higher, by the time the HUI approached these levels.

And if upleg 8 proves to be another massive upleg in the surge stage of the next surge-drift fractal, then the upleg target is even more impressive. With 136% average gains in massive uplegs, the HUI target off the major low 7 exceeds 700! And with all uplegs tending to run 8 months on average, such a doubling or tripling of quality PM stocks could very well happen before next summer!

Now I know this sounds ridiculously optimistic, but regardless it is indeed what the bull-to-date precedent of HUI upleg cycles suggests is possible. And based merely on technicals alone, possible is as far as we can take this analysis. But when today's fundamentals for the HUI's primary driver of gold are also considered, I suspect the odds for an imminent massive HUI upleg move from possible to probable.

With $700 gold again, excitement is building for this long-neglected metal even outside of the usual contrarian circles. Gold fundamentals remain overwhelmingly bullish, with world demand growth far outstripping supply growth. On top of this, we are entering the most bullish time of the year for gold. In autumn and winter huge seasonal gold buying out of Asia tends to drive powerful gold rallies.

This is great news that should drive the HUI considerably higher, but there is an even bigger development that has the potential to ignite this new gold upleg like rocket fuel. The US Dollar Index has now fallen under critical support at 80 and is approaching new all-time lows! Lower interest rates in the US will drive even more dollar selling, but the Fed has no choice since the stock markets, bond markets, and politicians are all pressuring it to cut rates.

So as the US dollar enters uncharted territory, dollar selling by foreign investors ranging from individuals to central banks should accelerate considerably. Some of this flight capital will naturally migrate into the ironclad safety of gold, the only currency that has survived all of human history. The current dollar slide is so technically ominous and important that it could very well drive the biggest gold upleg of this entire bull.

And while mainstream commentators will claim $700+ gold is really expensive, this isn't really true in light of history. If you adjust the gold price for inflation by using the watered-down CPI, gold's real 1980 highs in today's 2007 dollars are now near $2300 per ounce. So going north of $700 or even $850 today isn't a big deal and is highly likely given gold's fundamentals and the dollar's troubles.

At Zeal we have long been preparing for this next massive upleg in the HUI. As technical opportunities warrant, we have been aggressively adding elite gold and silver stocks carefully handpicked via extensive fundamental research. We rode massive uplegs 2, 4, and 6 to large realized profits for our subscribers, and we plan to do the same for the likely coming massive upleg 8. Subscribe today to our acclaimed monthly newsletter to mirror our trades and ride the next mighty surge higher in PM stocks!

The bottom line is the HUI is now technically in position to launch its next massive upleg, its fourth surge to new high levels scarcely yet imagined in this bull. If you run the HUI upleg cycle average gains off of the recent August interim lows, it yields incredible HUI targets ranging from 580 to 700! And such uplegs have only taken about 6 to 12 months to unfold in this bull, so if historic precedent proves prophetic we won't have to wait long for legendary gains.

While the technicals alone are compelling, the unique position of gold today really ramps up the probabilities that the next major HUI upleg is imminent or already unfolding. Miners can't keep pace with gold demand growth and the big autumn buying season is approaching. And all-time US dollar lows could drive gold investment demand the likes of which we haven't seen in decades.

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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