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November 09, 2007

Trading the Gold-Stock Bull 6
by Adam Hamilton

Gold, which was a scoffed-at pariah not too many years ago, suddenly finds itself on the verge of being almost sexy again. With this metal now challenging its all-time nominal high from January 1980, I am hearing from more ordinary non-market-following folks who are newly interested in gold investing.

And why not? Despite its higher prices of late, gold's global supply-and-demand fundamentals remain dazzlingly bullish. Worldwide investment demand far exceeds the ability of miners to ramp up their production. And if you adjust gold's early 1980 high by CPI inflation, it works out to about $2300 in today's dollars. So most of gold's bull probably remains ahead of us, not behind us.

After having studied and traded this bull since its birth in early 2001, I remain convinced that quality gold stocks are the most profitable way to play it. Gold miners have extraordinary profits leverage to gold. Ultimately a given percentage increase in the gold price translates into a far higher percentage increase in profits. And over the long run it is profits, and the prospects for future profits growth, that drive stock prices.

During its bull to date since April 2001, the Ancient Metal of Kings has powered 225% higher. This is very impressive, not to mention vastly superior to the S&P 500's modest 29% gain over the same period of time. But meanwhile the HUI gold-stock index has rocketed 1167% higher since November 2000! The staggering returns in gold stocks have utterly crushed those of gold itself.

Trading gold stocks has proven very lucrative for us at Zeal and our subscribers. Since its debut in August 2000, our monthly Zeal Intelligence newsletter has launched and closed 55 gold-stock trades. Including all of our losses, the average annualized realized gain across all of these ZI gold-stock trades has run 74%. So trading gold stocks has been very, very good to us and fortunes have already been won.

As a speculator and student of the markets, trading is my passion. I love it. So over the years as I have actively traded gold stocks, I have used and developed various tools to help game the timing. In order to buy low and sell high, you have to have some idea of what "low" and "high" are at any particular point in time.

The latest great buying opportunity for gold stocks was during their irrational mini-panic in mid-August. At the time I wrote about how bullish it was since the selling was just plain silly. Since those mid-August lows, gold is up 28% and the HUI 52%. We aggressively started adding fresh gold-stock trades right after this scare and most are already up 50% to 90% as of this week, still unrealized of course.

So after such a big and fast surge in gold stocks, is this run over? Is it too late to add new gold-stock positions? I don't think so. True, the easy low-hanging-fruit gains off the irrational panic lows have already been won. If your market advisor wasn't telling you to back up the truck to buy gold stocks in the last couple weeks of August, you ought to get a new one. But these already-witnessed gains don't necessarily mean this upleg is mature yet.

In order to offer my case here, I updated some of our trading charts already explained in other recent essays. This was a nostalgic exercise for me, as my original essay in this series was published in June 2003 when gold was trading just over $350 and the HUI near 150. While the charts and indicators of choice have changed over the years, their overall utility in gaming gold-stock probabilities has not.

My first exhibit on why it is probably not too late to trade gold stocks in this run was discussed in depth in mid-September. All bull markets advance in fits and starts, surging higher in mighty uplegs and then drifting lower in corrections. This two-step-forward-one-step-back modus operandi keeps sentiment balanced. Over time tradable rhythms tend to develop, the HUI upleg cycles in the case of gold stocks. Examining these helps us understand what is possible and probable in any given gold-stock upleg.

What a magnificent 1167% bull run, eh? Seeing this gorgeous chart has to make mainstream investors weep. While their capital was stuck grinding sideways in the worn-out market-darling stocks left over from the 1990s bull, brave contrarians were earning fortunes in this new 2000s bull. As a sector, the gold stocks certainly have to be among the best-performing in the world since their late-2000 secular bottom.

Since the HUI is to gold stocks what the NASDAQ is to tech stocks, I use it as a proxy to analyze this sector as a whole. So far we have seen seven major uplegs and seven major corrections, all labeled above. The eighth major upleg, which was born in mid-August during the irrational mini-panic, is already underway. In order to get a better handle on what is possible and probable in this eighth upleg, we can look at the seven that came before it.

All seven of these completed major HUI uplegs have averaged gains of 94% over 8 months! This is why gold stocks are such a traders' paradise. Our current upleg 8 is only up 52% so far over 3 months. So it looks pretty immature compared to the average gold-stock gains we have seen since this bull began. Interestingly if you take the average 94% gain and apply it to the mid-August closing HUI low, you get a target HUI level over 580.

So if our current upleg proves to be merely average, this index ought to challenge 580 before it gives up its ghost. Obviously this is a long way higher yet even from today's levels. Thus from this HUI-upleg-cycle perspective, it doesn't look too late at all to buy gold stocks for this upleg. No your gains won't be as great as if you had bought in mid-August when few others wanted to, but they should still be excellent nevertheless.

But I have a hard time envisioning this particular HUI upleg merely being average with gold on the verge of hitting its highest nominal levels in history. Nothing on the planet is a more powerful seductress for investors than rising prices achieving all-time records. The higher gold goes in this run, the more investors worldwide are going to start paying attention to it for the first time. And they will pour increasing amounts of capital into gold stocks to ride this trend. So I really doubt today's HUI upleg will end up being just average.

Most investors today have no idea how tiny the gold-stock sector really is, despite its phenomenal gains. As of October 31st, the total market capitalization of all the elite gold stocks in the HUI was just $142b! On this same day, the company Google alone had a market cap of $217b while the entire S&P 500 weighed in at $14,004b. So if mainstream investors start chasing gold stocks with real capital, this tiny sector should just explode higher. It could make our bull-market gains to this point seem modest.

Obviously it is impossible to game just how high the HUI would soar if new gold records drive major new mainstream investment. But interestingly there is another way to look at the HUI upleg cycles. Throughout this bull, the HUI has seen an alternating pattern of giant massive uplegs followed by modest consolidation uplegs. The massives catapult gold stocks to dazzling new bull highs and then the consolidations gradually get traders comfortable with these once-inconceivable new levels.

Uplegs 2, 4, and 6 rendered above were massive, and they had average gains of 136%. The recent upleg 7 was a consolidation upleg lasting long enough to make 310 to 360 look like a normal basing level. So today's upleg 8 is on deck to be massive again. If it proves to be just an average massive, we are looking at a potential HUI level over 700 in this upleg!

So with the HUI upleg cycles arguing for the next major interim highs to hit between 580 to 700 even without mainstream investors migrating into gold stocks, it doesn't look like today is too late to add new gold-stock positions. Compared to such targets, today's 450ish HUI looks like a bargain. When gold stocks run, they tend to run big.

The second exhibit on why it is probably not too late to trade gold stocks for this upleg is a Relative HUI chart. This is based on my Relativity trading theory, dividing a price by its 200-day moving average and then gaming the resulting horizontal trend channel. As any bull flows and ebbs, it stretches above its 200dma in uplegs before returning to it in corrections. This provides a technical measure of just how far above its 200dma the HUI can surge when traders get excited during massive uplegs. This red rHUI line effectively renders the HUI as a constant multiple of its 200dma, creating a horizontal trading range.

The same uplegs numbered in the first chart are also numbered here for comparability. Since today's upleg 8 is due to be massive, the relative HUI highs in massive uplegs 2, 4, and 6 are of particular interest. As you can see above, they were 1.829x the HUI's 200dma, 1.554x, and 1.476x respectively. This averages out to 1.62x, but I have long used 1.50x as the rHUI topping zone to be conservative.

What this means is the HUI doesn't tend to get radically overbought, thus in danger of its upleg burning out, until speculators and investors drive gold-stock prices high enough fast enough so the HUI stretches more than 1.50x above its trailing 200dma. Until today's upleg crosses this crucial bull-to-date threshold, we cannot argue that it is overbought for a massive upleg.

At best as of the middle of this week, our new upleg 8 only hit 1.298x the HUI's 200dma. So even though this upleg has been fast and furious since mid-August, it hasn't even come close to looking extremely overbought from a Relativity perspective yet. While it is obviously far better to buy gold stocks when the HUI is close to its 200dma rather than well above it like today, they can still be added as long as the index doesn't look too overbought technically.

And how overbought or oversold the HUI becomes is easily the most important key to profitably trading gold stocks. Bulls advance in sentiment waves, greed-driven uplegs followed by fear-driven corrections. Smart traders buy gold stocks when fear abounds and few others want to buy, like in mid-August. Then they sell when greed grows extreme and everyone wants to buy, like during the May 2006 top where I warned of a sharp imminent correction.

While the extreme fear surrounding gold stocks in mid-August has largely been driven out, we haven't seen any extreme greed yet. Instead of virtually everyone being super-excited about gold stocks, claiming they are heading for the moon, most contrarians still seem to be fairly cautious today. They continue to worry, despite abundant historical evidence to the contrary, that the gold stocks will get hammered in a general-stock-market selloff.

With the wall of worries still very much intact, and gold-stock traders nowhere close to being euphoric today, greed has not yet reached enough of an extreme to trigger a major interim high. As long as greed remains in check, this gold-stock upleg ought to run higher. The lack of universal greed and euphoria now, as evidenced by the rHUI and other technical indicators, also suggests that it is not too late to add gold-stock trades today.

On a final note on this chart, check out the major basing zones above. Each massive upleg of this bull was preceded by a long period of sideways-consolidating prices. These basing zones are critically important for two reasons. First, the sideways trading bleeds off the ridiculous levels of euphoria that mushroomed at the previous massive upleg's top. Sideways-trending markets rebalance sentiment because they are so boring that they eventually drive away previously ecstatic speculators in disgust.

Second, the major-basing-zone consolidations get all traders comfortable with new highs. Back in mid-2005 when the HUI struggled to claw back over 200, 350 looked impossibly high. But after the long consolidation since May 2006, 350 is now boring and pretty much every gold-stock trader feels it is normal. So major basing zones get traders comfortable with newly-high levels that would have once been considered inconceivable earlier in this bull.

The interesting part about all of this is the HUI just completed another major basing zone before it started shooting higher in mid-August. So the whole technical foundation has already been laid for much higher HUI levels than we have yet witnessed in this bull. With such a strong base, the 580 to 700 levels the HUI upleg cycles argue for don't seem excessive at all. Massive uplegs to major new highs follow long consolidations, and this is just where we are today.

Finally I would like to share the least-important reason to add long gold-stock trades, the seasonal tendencies of gold stocks. As discussed in depth in early October, the HUI seasonals are not precise enough to be a primary trading tool like the rHUI. If the rHUI is like the gasoline propelling your car down an interstate highway, the HUI seasonals are like the prevailing winds buffeting you. While you can get where you are going without a tailwind, it is sure pretty nice to have one.

Over their entire bull since 2000, the HUI seasonals have their strongest tendency to rally from mid-October to February. Needless to say, we are early in this very period today. If the HUI lives up to its seasonal tendency for its strongest rally of the year just getting underway, we could really have an exceptionally awesome few months ahead in gold stocks.

Considered in isolation, these seasonal tendencies aren't particularly useful. But when considered in concert with hardcore primary technical indicators like the rHUI, these strong HUI seasonals add a nice probabilistic tailwind to this gold-stock advance. While I won't trade on seasonals alone, the fact that they are blowing in a bullish direction works to buttress the near-term bullish case for the HUI. Even the HUI seasonals argue that this upleg has not yet matured and fully run its course.

So if you see gold heading to new highs, and the gold stocks flying, and you want to ride this upleg, odds are it is not too late to deploy capital. While your gains going forward won't be as good as those of the prudent contrarians who deployed back in late August and September, there should still be plenty of profits yet to be won in this upleg. And of course if new all-time nominal gold highs finally bring in the mainstreamers, all bets are off as this upleg could vastly exceed anything yet seen in this bull.

While these prospects really excite me as a long-time investor and speculator in gold stocks, it also saddens me that this is new information for many traders. I have been writing about and preparing our subscribers for this new massive upleg all year. Despite the increasing general frustration with gold stocks' long consolidation, we continued to buy on the dips each time the HUI traded near its 200dma. Since we were willing to buy when few others would, we'll reap the greatest profits.

But being a contrarian and fighting the crowd is hard. It inevitably draws ridicule and derision. So most traders act like weathervanes and simply reflect the popular sentiment around them. When others are scared like in mid-August, they argue for far deeper declines and sell aggressively. When others are euphoric like in May 2006, they argue for a moonshot and buy aggressively. But buying extreme greed (buying high) and selling extreme fear (selling low) is a recipe for disaster that has destroyed much capital even within this gold-stock bull.

So if this concept of a new massive gold-stock upleg is new to you, and your capital wasn't already deployed and ready for it, join us at Zeal. Our subscribers were ready and deployed in advance. We are hardcore speculators who have never and will never care what others think. We just want to study the markets, conform our trades to the markets, and win on balance. Popularity be damned. We expected the correction in May 2006 and we expected this upleg in late August 2007.

We offer an acclaimed monthly newsletter for investors, a weekly trading-alert service for speculators, and detailed fundamental reports outlining our research into our favorite individual stocks in key sectors. If all you do is read these weekly web essays, you are really missing out. While they form the foundation of our research, we only actually apply this research to profitable real-world trading for the subscribers who support us. Subscribe today and multiply your capital before it is too late to buy gold stocks in this upleg!

The bottom line is it doesn't yet look too late though. This upleg remains young and small compared to its predecessors, it is not technically overbought yet so greed isn't excessive, and even the tailwinds of the seasonals have lined up behind it. And all this isn't even considering the impact that a sudden mainstream interest in new gold highs could have to drive mainstream capital flooding into this tiny sector.

If you have been trading gold stocks since the beginning as I have, congratulations on being a rare contrarian able to fight the crowd. I hope you are enjoying your greatly multiplying profits! If you are new to trading gold stocks, welcome aboard! With gold now at just over 1/3rd of its famous inflation-adjusted January 1980 high, odds are the majority of this gold-stock bull is still yet to come.

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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