HUI Leverage to Gold

By: Adam Hamilton | Fri, Nov 26, 2004
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Gold-stock investors and speculators, blessed with dazzling realized profits for years now, are growing ever-more nervous over an increasingly obvious anomaly in the premier HUI gold-stock index. The famous HUI leverage to gold has inexorably fizzled in the past couple months, sowing confusion and fear in its wake.

This waning HUI leverage to gold is particularly troubling because the sole reason to own gold stocks is to reap their legendary leverage to our bull market in gold. Gold stocks, ultimately just pieces of paper, are only valuable if they consistently provide a return massively higher than that of gold itself. If HUI returns don't outstrip gold's dramatically, then we are better off just holding physical gold itself since it is far safer than paper stocks. Gold stocks need big returns to justify their big risks!

Since the latest major interim bottoms in the HUI and gold in May, the gold stocks are up 45% upleg to date while gold is up 19%. While 45%+ returns in six months are certainly nothing to ridicule in the abstract, when considered in the context of the HUI's traditional enormous leverage to gold they are startlingly low. If you look at the ratio of HUI gains to gold gains in this latest upleg, the HUI leverage to gold, the result is only 2.4x at the moment.

Bull to date, since the HUI bottomed in late 2000 and gold in early 2001, the HUI's leverage to gold has been a breathtaking 9.0x or so! For every 10% gain in the price of gold over this secular bull, the HUI has registered fantastic gains approaching 90%. Naturally, after having reaped such magnificent gains for years now, we are all conditioned to expect extreme HUI leverage to gold going forward. Hence our current anemic 2.4x feels so unsettling.

I am certainly concerned about this waning HUI leverage to gold now dominating precious-metals thought. Not a day has gone by in the past couple weeks when my partners and I haven't discussed it. I know our subscribers are concerned too, as I am receiving more and more e-mails lamenting the HUI's malaise. This week I would like to dig into this anomaly, in the hopes of learning whether this threat is temporary or likely to persist.

The first step to understanding lies in quantifying the HUI leverage to gold at a tactical level. Rather than considering this leverage strategically in terms of 9.0x over the entire bull, we need to know how the leverage has played out over individual major uplegs and corrections. This distinction is very important. The key to understanding the present in the markets lies in seeing it in context with the past.

The HUI has only been lagging gold since the metal finally shot above $400 in September. It's only been in the last couple months when this HUI anomaly has really become glaringly evident. If there have been temporary past episodes of similar HUI underperformance, then today's episode is probably nothing to fear. As discussed a few weeks ago in "Trading the HUI/Gold Ratio, sometimes the HUI outperforms gold and sometimes it does not.

In order to understand today's unpleasant episode in context, our first graph divides the HUI into all of its major uplegs and corrections in this bull to date. The HUI has already advanced higher four times since its secular bottom in November 2000, and we are now in its fifth major upleg. All of these uplegs are noted below with the green numbers. As always, these uplegs are inevitably followed by healthy bull-market corrections, the four major of which are labeled with the red numbers below.

The actual HUI gains and losses in all of these individual major uplegs and corrections are shown in blue. Gold gains and losses over the same periods of time are noted in red. Now it is important to realize that major interim gold tops and bottoms don't usually coincide exactly with the HUI. Thus, if this chart was divided up based on gold alone the divisions would be slightly different. But, in general terms, the major HUI moves coincide very well with the major gold moves so looking at gold over specific HUI date divisions is technically sound.

Once we have the individual upleg and correction HUI and gold gains and losses, we can finally investigate the tactical HUI leverage to gold. In each individual upleg or correction, the HUI gain or loss divided by the gold gain or loss yields the tactical HUI leverage to gold in that particular major move. These leverage numbers are rendered below in yellow. It is here that our quest to understand this current anomaly starts to bear fruit.

I have to admit this chart really surprised me. At the HUI's and gold's respective best levels bull to date, the HUI leverage to gold is running about 9.0x as our giant gold and gold stocks chart shows. But, as this new HUI leverage chart reveals here, other than the first major upleg starting in late 2000 when the HUI was coming off unbelievably dismal lows, actual HUI leverage has consistently run well under 9.0x. In fact, the best upleg leverage after the first upleg was "only" 7.2x in early 2002 while the worst is today's 2.4x.

While surprising at first, this does make sense in hindsight. Speculators have long gamed the law of small numbers, the truism that speculations starting from a low base have a higher probability of seeing huge percentage gains than ones starting from a high base. An unloved $1 gold stock only has to be bid to $2 to double, which is almost always far easier than bidding a more popular gold stock from $20 to $40 to get a similar 100% gain. The greatest leverage in the HUI, 14.7x, was naturally seen as it advanced from its horrifically low sub-36 Great Bear base in November 2000.

The higher the HUI base gets as its bull marches on, the exponentially greater the capital requirements grow to bid it up fast enough to maintain truly extreme leverage to gold. Upleg leverage in sequence from the low HUI days to the present ran 14.7x, 7.2x, 2.9x, and 5.5x, so even before today's lackluster 2.4x the prevailing trend was generally down. Naturally if this trend continues, we should expect lower leverage going forward.

A simple graph of 14.7x, 7.2x, and 5.5x shows a descending parabolic shape going asymptotic at some point as it approaches the horizontal axis. As this parabola falls from very steep initial leverage in the early days on the left to stable ongoing leverage on the right, perhaps the curve will stabilize at 4x to 5x HUI leverage to gold. This leverage absolutely has to flatten out at the asymptote, probably 4x to 5x, rather than going below 1x for a few critical reasons.

First, the operating leverage of gold mines mathematically assures their profits will grow far faster than the price of gold rises, and their stock prices must eventually follow their profits. Second, as more and more investors grow interested in gold and gold stocks, their capital will deluge in driving up prices proportionately.

The global gold supply at $450 is probably worth $2170b today (assuming 150,000 tonnes of gold mined in world history). In contrast just a month ago the market capitalization of the entire HUI blue-chip unhedged gold-stock index was only $54b or so and it is probably not above $60b today thanks to the HUI's pathetic recent performance.

Thus, the physical gold market is roughly 36x as large as the premier gold-stock index so capital flooding into gold stocks is virtually assured to push them up far faster than gold since they start from such a relatively small capitalization. This gross capital-footprint misbalance will ensure the HUI leverage to gold remains favorable.

Finally, gold-stock investing is fraught with countless perils while holding physical gold in your own immediate physical possession is the safest and surest investment in world history. The HUI gains will have to come faster than gold gains in the future, ensuring positive leverage, in order to compensate investors for the significant additional risk of owning paper stocks. If the ratio ever dropped under 2 to 1 or so, then there would be little or no reason to even bother with stocks as people could buy the far safer gold for the same returns.

In light of these and other reasons, I suspect that HUI leverage to gold of 4x to 5x is probably the lower long-term limit. Sure, we can have periodic episodes like today's 2.4x where the HUI leverage really lags, but over all uplegs the average should be far higher and ultimately very profitable for gold-stock investors and speculators. From this perspective, our current low HUI leverage to gold can be considered a temporary anomaly likely to mean revert back above 5x in future uplegs.

While we developed some new tools to consider HUI leverage to gold in context, before we get into our next graphs there are a couple more items of interest above. First, note the dismal 2.9x HUI leverage to gold in the late 2002 HUI upleg, number 3. This is on par with today's 2.4x levels and provides comfort since the HUI's leverage promptly returned to a far more profitable 5.5x in its next upleg, 4. Thus we can see historically that HUI leverage naturally fluctuates from upleg to upleg so today's relative weakness is not completely unprecedented.

It is also interesting to compare the average HUI leverage in uplegs, 6.5x, with its average leverage in corrections, 4.4x. This asymmetry heavily favors the bulls since it shows that gold-stock speculators can reap outsized gains in major uplegs on average but in the inevitable pullbacks that follow they get to keep a larger proportion of these gains than gold investors. This is another interesting virtue to add to the already impressive list of attractive gold-stock attributes.

In order to better understand the flowing and ebbing of the HUI leverage to gold in context, I have been trying to figure out how to quantify it over time in some way that facilitates easier direct comparisons between present and past. One potential solution involves indexing each individual major upleg and correction in the HUI and gold. The graph below shows the result of individually indexing all the major moves over their same respective time frames from the first chart.

In order to individually index each major upleg and correction, a base value is set at 100 on the first day of each major move. If the HUI doubled in an upleg, that specific index would go up 100% from 100 to 200. If the HUI fell by 20% in a correction, then that index would fall to from 100 to 80. The neat thing about these individual upleg/correction indexes is that they can all be graphed over time and form perfectly comparable percentage charts tracking the absolute fluctuations in the HUI relative to gold.

These indexes are rendered on our next chart superimposed over the usual HUI. The HUI indexed gains and losses are drawn in red while the gold indexed gains and losses are drawn in yellow, with all indexed numbers slaved to the right axis. All kinds of interesting observations jump out of this indexed chart.

One of the most provocative observations emerging from this strange chart is the possibility that there may be two distinct types of HUI uplegs in this bull market. The first type, the true HUI uplegs we have grown to love and respect, are the massive runs up that witness gold stocks double or more, heading up above 200 indexed. Uplegs 1, 2, and 4 exemplify these model uplegs. Everyone lamenting the HUI's lackluster performance today including me was expecting one of these true uplegs. There is nothing on earth that breeds disappointment faster than unmet expectations.

The curious case of upleg 3 however, in late 2002, provides a clue that not all HUI uplegs witness 100%+ gains over a couple quarters or so. The third major upleg in the HUI, while it did witness respectable 60%+ gains, looks more like a consolidation on this chart. Gold stocks had exploded up extremely rapidly in the preceding upleg 2 and were probably bid up far ahead of gold. During upleg 3 they more or less ground sideways and waited for gold to catch up to justify their lofty valuations.

If you look at the underlying blue HUI line, the grand chart pattern running from upleg 2 to correction 2 to upleg 3 looks an awful lot like today's upleg 4 to correction 4 to upleg 5 pattern at a smaller scale. This shouldn't surprise us since the markets are generally fractal in nature, similar price patterns appear at all scales. This general pattern involves a massive HUI upleg that far outpaces gold, a sharp and fast correction, and then a subsequent consolidation-type upleg with far more modest HUI gains while stocks wait for gold to catch up.

This leads to a theory that gold stocks advanced higher in 2003's mega rally than they ought to have based on the positive fundamentals spawned by the rise in gold alone. For example, while gold topped in January 2004 near $425 maybe the HUI's earlier December 2003 top had discounted $475 gold into gold-stock prices and future cashflow and profits projections at the time. Thus, gold stocks could have advanced too far relative to gold.

If this is indeed the case, and I have no way of knowing either way for sure, then today's abnormally low HUI leverage to gold could merely be the result of gold-stock buyers curtailing their new purchases as they wait for gold to catch up and justify high HUI levels. Just as during upleg 3 however, this is not a threat but an opportunity. While upleg 3 didn't double, it did go up 60% which is similar in magnitude to today's 45%ish gains upleg to date. If this thesis proves correct, upleg 6 ought to be stupendous after this modest consolidation upleg 5 and its subsequent correction!

Another far more attractive idea suggests that the HUI is lagging gold only because it is early in this particular upleg. If true, the HUI could surge parabolically in the weeks ahead and catch up with gold before this upleg tops. I am heavily long gold, gold stocks, and gold-stock call options so I really want to believe that this is the case, but for a variety of reasons I have to unfortunately conclude that our current upleg is closer to mature than immature at this point in the game.

Note above how the HUI uplegs tend to have regularity in terms of time. The uplegs erupt periodically like sawteeth and run for two or maybe three quarters before they give up their ghosts and correct. Our current specimen has been running since early May so it is already more than two quarters old. In pure timing terms, upleg 5 has already lasted as long as we had the right to prudently expect based on history.

An even bigger problem with the seductive idea that a massive HUI catch-up surge is imminent in this upleg is found in the yellow gold indexed line. Gold, the ultimate driver of the HUI bull, has been far more reliable than the HUI. It has advanced up three times in a row now (uplegs 2, 3, and 4) with nearly perfect precision before topping near an index level of 120 every time.

For whatever reason, each major gold upleg so far has only tended to run 20%ish higher and then correct like clockwork, dragging the HUI down in its correction. Ominously gold is already 18.6% higher in our current upleg since May, very mature in historical terms. If today's gold upleg continues to conform to the nearly perfect sawtooth pattern of the previous 3, then gold is likely almost out of gas. And if gold enters a healthy bull-market correction, you better believe the HUI is going to correct right along with it.

I fully realize this analysis throws a monkey wrench in tactical trading strategy and I intend to directly address these concerns for our subscribers in the upcoming December issue of our acclaimed Zeal Intelligence newsletter.

I am now carefully analyzing gold, the dollar, the euro, and gold stocks in reference to our outstanding trades and formulating strategies this weekend. Despite the holiday distractions, the December newsletter remains on track to be published December 1st for our subscribers. It will address the pressing "so what do we do now?" questions plaguing HUI investors and speculators today, so please sign up now if you don't want to miss it!

We built one final chart based on the indexed chart above. Our third graph divides the HUI Indexed by Gold Indexed lines above to form a ratio. Please realize this HUI Indexed/Gold Indexed ratio is not the same as the raw HUI/Gold Ratio I discussed a few weeks ago, but an entirely different concept. This provides one final perspective on the HUI leverage to gold and really emphasizes just how sick the HUI looks in this current upleg in leverage terms.

If my alternating true HUI upleg followed by a lesser consolidation HUI upleg theory proves correct, then the ratio of the HUI indexed and gold indexed should be proportional between its last occurrence across uplegs 2 and 3 and today's occurrence between uplegs 4 and 5. This chart simultaneously shows similarities and differences across these two episodes, rather ambiguously neither confirming nor refuting the thesis.

Uplegs 2 and 4 were indeed similar in magnitude and shape, with indexed HUI gains ultimately outpacing indexed gold gains by 1.8x+ in both cases. Uplegs 3 and 5 also look similar, but the current performance of upleg 5 today remains far inferior to even the consolidation upleg 3 in late 2002. Upleg 4 in 2003 had the lowest HUI leverage to gold of any true upleg to date and today's upleg 5 has followed that performance with the lowest HUI leverage to gold in all uplegs to date, period.

Even if the HUI leverage to gold has to gradually decay as the base HUI rises higher and higher in each subsequent upleg/correction and makes like percentage gains harder and harder to achieve in the future, the HUI's underperformance today is even worse than such a model would suggest. Put bluntly, the HUI has looked more and more sick in recent months and the hard numbers confirm this increasingly uneasy feeling that has plagued gold-stock players.

While these charts don't lie, and they certainly call the longevity and ultimate gains of our current HUI upleg into serious question, they don't feel long-term threatening to me. Even if today's HUI upleg is nearing maturity now, even if it "only" runs up 50%ish instead of 100%+, this is certainly not the end of the world.

Gold stocks' prices are ultimately driven by gold stocks' profits, which are directly driven by the price of gold. As long as this secular gold bull remains in force, the profits of the unhedged HUI miners will continue to rise. As profits rise, valuations of gold stocks will drop until they inevitably get too cheap and attractive. At that point, investors will flood in to chase the windfall gold-mining profits whether they are predisposed to PM investing or not.

In addition, over time the HUI leverage to gold will almost certainly be restored. Like every other market phenomenon from valuations to sentiment, it is natural that HUI leverage gradually fluctuates around a mean. Sometimes we will witness gloriously high HUI leverage to gold, other times it will be frustratingly anemic like today, but over the long-term it will probably average out to exceed 4x to 5x.

And this is just fine with me, as the HUI registering gains 4x to 5x those of gold will ultimately lead to great riches for today's gold investors and speculators!


Adam Hamilton

Author: Adam Hamilton

Adam Hamilton, CPA

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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 for more information, for a free sample, and to subscribe.

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Source: The Contrarian Take