Gold-Stock Record Highs

By: Adam Hamilton | Fri, Oct 8, 2010
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Inspired by gold's relentless momentum, investors drove the flagship HUI gold-stock index to new all-time highs this week. While great fun for all of us with capital deployed in this sector, seeing the best levels in history often spawns anxiety in those with a contrarian bent. Following gold stocks' run into record territory, are they in danger of an imminent correction?

Interestingly, the history of today's secular gold-stock bull suggests the answer is they're not. The manner in which the HUI achieved its new record highs this week has always led to big surges historically. And if today's upleg holds true to this extensive precedent, the gold stocks have a lot farther to run yet before a healthy correction arrives to rebalance sentiment.

Since mainstreamers are largely just starting to discover gold stocks, a lot of people assume this bull is fairly new. This couldn't be farther from the truth. The HUI bottomed in November 2000, a whopping 10 years ago, at 36. As of this Wednesday, this index has enjoyed a stupendous 1375% bull run since those humble beginnings! For comparison, the benchmark S&P 500 lost 16% over this exact span. Gold stocks have easily been one of the best-performing sectors, if not the top one, of this entire past decade.

Now 10 years is a great deal of time to observe the behavior of anything. Whether you're watching your kids, prairie dogs, or the financial markets over such a long span, definite patterns and tendencies emerge. And in gold stocks' case, these can be traded with great success. In our popular Zeal Intelligence monthly newsletter, we realized our first gold-stock trade in March 2001. Nearly 100 gold-stock trades later in this publication alone, ZI's average annualized realized gold-stock gain (including all losing trades) is +58.8%.

One of the HUI's patterns that helped us achieve such stellar returns over the past decade is its drift-surge tendency. Periodically gold stocks rocket higher in massive new uplegs, leading to enormous gains for investors and speculators. But these mighty runs leave this sector super-overextended. So gold stocks need to drift sideways and consolidate for a year or two after these surges, giving traders time to digest and ultimately accept the new prevailing price levels.

New record highs in the HUI are seen at a couple distinct times in these drift-surge cycles. The first is during a surge, within the gigantic uplegs. The second is after a drift, a year or more into a high consolidation. When record highs are seen late in surges, it is definitely a warning sign of an approaching top that traders should heed. But when they're seen late in drifts, they herald the birth of major new uplegs. Thankfully this week's HUI records fall into the latter category.

As a good chart is worth far more than a thousand words, all of this is much easier to understand visually. This first chart superimposes the HUI (blue) and some of its key technicals over the gold price (red). This sector's drift-surge tendency that is so incredibly profitable to exploit is crystal-clear from this long-term perspective. And provocatively we are finally exiting the biggest and longest drift of this entire bull.

Gold and HUI Chart

Massive gold-stock uplegs catapult their definitive index to major new highs, which are marked by numbers above. The HUI's entire 1375% gains since late 2000 were achieved exclusively during these mighty runs. Following these surges, this index drifted sideways for a year or two in high consolidations. But eventually gold keeps powering higher in its own secular bull, and traders get comfortable enough with prevailing gold-stock levels to start bidding them higher again. And the next surge emerges.

While the heights of the surges and lengths of the subsequent drifts varied a bit, this greater drift-surge cycle worked like clockwork. For our purposes today, let's start with the fourth major surge on this chart. It ultimately carried the HUI to new all-time record highs back in March 2008. There are many parallels between this last major surge and what certainly appears to be the next one already underway today.

That fourth surge technically began in mid-August 2007 when the HUI bottomed during the precious-metals summer doldrums. It started gradually gaining ground in August but really took off in September. It didn't exceed its previous surge's record high from May 2006 (number 3 on the chart) until late-September 2007. After that milestone the HUI was off to the races, powering higher on balance until March 2008's record high of 515. This fourth surge's top was 31% above the previous one's peak.

All of this ought to sound familiar. This year, the HUI bottomed in late July also during its summer doldrums. It rallied in August and September, but didn't exceed its March 2008 record high until just this week (early October). And this wasn't a late-surge record far above anything yet seen, it was merely a slight advance over a previous record set about 2.5 years earlier. Today the HUI is hitting new record highs emerging from a long drift, which means we are almost certainly in the next major surge!

This last drift was obviously much longer and messier than most, because it happened to straddle an epic once-in-a-century stock-market panic. Just like in all sectors, extreme fear drove traders to dump gold stocks at a frightening pace during this crazy episode. Between July and October 2008 alone, the HUI plummeted a sickening 68%! It was a bloodbath. But it was also an unsustainable anomaly as I pointed out often at the time. And indeed the HUI quickly recovered.

By autumn 2009, this index had fully regained its pre-panic drift zone. In terms of the greater drift-surge cycles in this gold-stock bull, the panic's impact is ultimately irrelevant. Gold stocks plunged far too low relative to gold prices and their own fundamentals, but immediately after that they started soaring back up again to completely unwind these irrational losses. You could erase the stock-panic anomaly and post-panic recovery from this chart, it was just a temporary distortion that soon righted itself.

This epic anomaly did serve to lengthen the HUI's latest drift cycle though. Its high consolidation that started in early 2008, the basing zone from which its next surge is launching, was essentially mothballed between summer 2008 and autumn 2009. But over the past year since this index regained its pre-panic drift range, it has resumed its high consolidation as if the panic never happened. So ex-panic, traders have had a couple years or so to get comfortable with higher gold-stock prices first seen in early 2008.

And after a high-consolidation drift, a new surge is due. This week's marginal new record highs in the HUI offer strong confirmation that this next surge is already underway. And this one ought to be exceptionally large. Gold prices are much higher today than they were in March 2008 ($1000) when the HUI originally hit these levels. Since the gold price drives gold miners' profits, and long-term profits drive stock prices, eventually the gold stocks will have to rally far to reflect today's much-higher gold levels.

A couple weeks ago I wrote an essay chronicling the massive undervaluation of gold stocks relative to gold. For 5 years prior to the panic, the HUI traded in a well-defined range relative to gold. The panic threw this all-important HUI/Gold Ratio into total disarray. And though the HGR has recovered much, it still remains way too low. In this entire secular bull, we've never seen a HUI surge start at such an undervalued level relative to gold. Thus gold stocks probably have a lot farther to run than usual.

While longer-term cycles like the HUI's drift-surge are very powerful trading tools, it is always critical to consider short-term technicals as well. If gold stocks get really overbought, they are bid up too far too fast, they need to correct to rebalance sentiment (eradicate excessive greed) regardless of where they happen to be in their longer-term cycles. So it's important to consider whether or not this week's records occurred in a wildly-overbought HUI.

My favorite way to measure oversoldness (lows, time to buy) and overboughtness (highs, time to sell) is through a trading system I created many years ago. I called it Relativity, as it looks at prices relative to a gradually-following baseline. When they get stretched too far beyond this baseline, they have rallied too far too fast, they are due for an imminent correction. The baseline that Relativity employs is the venerable 200-day moving average, which slowly rises throughout a bull yet still filters out all the chaotic daily noise.

The Relative HUI (rHUI) is derived from dividing the HUI's close by its 200dma. When charted over time, this multiple creates a horizontal trading range. It shows how far gold stocks as a sector tend to advance beyond their flagship index's 200dma before they are simply too overextended to continue higher. And today, despite the HUI's recent rally and its new record highs, this index isn't even close to being overbought yet!

Relative HUI Chart

The light-red line here is the rHUI multiple, and it is simply the result of dividing the blue HUI line by its black 200dma line. In Relativity-based trading, I generally consider the latest 5-to-6 year span to define a trading range. And in the rHUI's case, most of its activity falls between 0.95x on the low side to 1.40x on the high side. Think of this range as a probability band. The lower in the range, the better the odds the HUI is going to rally. The higher in the range, the better the odds the HUI will soon correct.

Note that back in late July when this current HUI surge started, this index fell under its 200dma (0.982x) to approach the bottom of its relative range. This was a strong buy signal I shared with our subscribers. And despite the HUI's nice 23% run higher since late July, even at this week's record highs the rHUI still remains low in its trading range. As of Wednesday, the HUI at 531 showed an rHUI reading of only 1.185x. In other words, the HUI was trading just 18.5% over its 200dma baseline.

Compare this to past rHUI levels at major highs after massive surges or even big rallies. In June 2002 (top 1 above) the rHUI hit an astounding 1.821x! In December 2003 (2) the rHUI was running 1.554x when the HUI peaked. In May 2006 (3) the rHUI ran 1.438x as the HUI challenged 400 for the first time in history. In March 2008, even in a surge that never reached its full potential thanks to some Fed actions and the subsequent bond and stock panics, the rHUI still hit 1.302x as the HUI peaked at 515.

And then last autumn, which wasn't the end of a surge but deep into the HUI's extraordinary post-panic-recovery rally, the rHUI peaked at 1.397x in December 2009 when the HUI hit 511. At less than 20% above its 200dma today, the HUI is certainly not very overextended like it was at the ends of past major surges and rallies where it usually ran 40%+ above its 200dma. The HUI is simply not even remotely close to being overbought yet despite its new record highs!

This is wonderful news for gold-stock investors and speculators. It clears the way for this latest surge to continue powering higher in the months ahead. And it could be quite a run, ultimately peaking next spring at levels that most traders today would scoff at. In addition to gold stocks remaining far undervalued relative to prevailing gold prices today, seasonals remain very favorable on balance until May.

A lot of mainstream traders don't realize that gold is heavily influenced by seasonal demand spikes. This gold seasonality leads to strong rallies between September and May that erupt each year like clockwork. A fascinating series of income-cycle and cultural factors combine to drive much-higher-than-average gold investment demand over this span. And naturally, rising gold prices drive very similar HUI seasonality. So the stars are certainly aligned for the HUI's next big surge to continue powering higher.

At Zeal, we've spent an entire decade studying this gold-stock bull and successfully trading gold stocks through every kind of environment imaginable, including the panic. Our resulting knowledge, wisdom, and experience is second to none. And we keep relentlessly expanding our expertise. We recently finished a 3-month deep-research project that investigated all the junior gold producers trading in the US and Canada. The timing is great since elite junior gold stocks will really leverage the HUI's gains.

We published comprehensive fundamental profiles of our dozen favorites (whittled out of a starting universe of nearly 100 stocks) in a new 27-page report. It represents the fruits of several-hundred hours of expert world-class research. While these stocks are already moving, we haven't seen anything yet if the HUI indeed proves to be in its next surge cycle. For the bargain price of just $95 ($75 for Zeal subscribers), you can learn about these high-potential junior gold producers. Buy yours today!

And of course we also publish our acclaimed weekly and monthly subscription newsletters. In order to intelligently trade our own capital in high-probability-for-success scenarios, we have to continuously research and analyze the markets. All of this is distilled down into Zeal Speculator and Zeal Intelligence for our subscribers, so they can learn from and capitalize on all our hard work. If you want to know what to expect in the markets before it happens when opportunities to profit are greatest, subscribe today!

The bottom line is despite this week's record highs in the HUI, the rally in gold stocks is probably just getting started. The HUI appears to be finally embarking on the next big surge in its long series of drift-surge cycles, which will likely carry it to dazzling new record highs before it gets overextended. The technical signature today is very bullish and matches what history shows early in new surges.

As if this wasn't exciting enough, gold stocks remain deeply undervalued relative to prevailing gold prices which ought to supercharge their surge. And despite their run over the last couple of months, the HUI is nowhere close to looking overbought yet by historical standards. With such an extraordinarily bullish setup so early in gold stocks' seasonally-strong months, traders shouldn't delay in getting deployed.

 


 

Adam Hamilton

Author: Adam Hamilton

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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