Trading the Gold-Stock Bull 2

By: Adam Hamilton | Fri, Aug 8, 2003
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The stock markets, and more specifically the collective behavior of their countless participants, never cease to utterly amaze me.

While most folks agonize over yesterday's dead bubble and waste away longing for the past days of tech glory, an immensely powerful bull market in gold stocks continues to relentlessly power higher. Just this week the little-known HUI unhedged gold-stock index blasted up to a new bull-market-to-date closing high above 169!

Since its long-term secular bottom carved in November 2000, the HUI has rocketed up a phenomenal 371% in almost three years! This magnitude of raw gains in a sector index is breathtaking and would do any bull market proud! The far-sighted contrarian investors who have saddled up this young gold-stock bull in recent years are rapidly growing wealthy from its enormous gains.

Amazingly however, I doubt that even 1 in 20 investors even has a clue that the magnificent bull market in gold stocks soared to new highs this week. While few are aware of this awesome stealth bull market, even fewer are willing to put some capital on the table and play it. I would be extremely surprised if even 1 in 50 investors currently own a single share of stock in any gold or silver mining company in their portfolios.

This current vast disconnect between stellar gold-stock performance and popular gold-stock awareness is quite provocative. In history all of the Great Bull markets start out stealthily, initially marching higher with relatively few participants early on. The general investors, the great thundering herd, are notoriously late to the Great Bull parties and usually only catch the final mania blow-off stage in any major bull market. Only the prudent contrarians arrive early and ride 80% or more of an entire long-term bull-market move.

Remember the tech stocks way back in the early 1990s, during the recession in the States and George Bush the Elder's Gulf War? Probably not. The number of investors and speculators playing the initial few years of the tech-stock Great Bull of the 1990s was trivial, a tiny fraction of the total number who would later flock to the enormous gains for a piece of the action near the top. Yet, as always, the legendary gains were only reaped by those fearless contrarians who leapt in early well before technology became a global speculation obsession.

While the parallels between all young Great Bulls are many, I am not writing this essay to try and convince you or anyone about the reality of the secular bull market in gold and gold stocks. I have been doing that for over three years now, and the time to wonder if this is really a bull market or not is past. The debate is over and the gold bulls won.

While back in the early days you had to be a true contrarian to see gold's potential, today the evidence on the price charts for the new bull markets in gold and gold stocks is crystal clear and irrefutable. In light of the already existing strong multi-year bull-market uptrends in both the Ancient Metal of Kings and the companies that painstakingly chisel it out of the bowels of the Earth, all ambiguity has been effectively eliminated.

Gold and gold stocks are in a secular bull market by any definition and must be respected, analyzed, and traded in light of this earned status. In honor of this week's exciting new HUI highs, we updated our large reference Gold and Gold-Stock Charts and I humbly offer this latest essay contemplating the gold-stock bull and what may be approaching next for gold-stock investors and speculators.

Since the bull-market-or-not question has been laid to rest, our usual long-term charts like the ones presented in the original "Trading the Gold-Stock Bull" have been condensed down to only include the past year and a half or so in order to grant us a higher-resolution perspective on recent trading action. If a mammoth 371% gain over almost three years is not enough to convince any skeptic of the reality and power of this gold-stock bull, then I suspect that no long-term graph ever would either.

Zooming in, it is hard to believe the fantastic gains with which we have already been blessed as gold-stock investors just since the beginning of 2002! The HUI is up 160% in the past 19 months or so while the S&P 500 has fallen 16% over the same period and crushed countless mainstream investors who have steadfastly refused to investigate gold and gold stocks in recent years.

Wow! What a gorgeous bull-market chart! If you were playing this game a few years ago you certainly remember the dark days of despair when gold approached $255 and the HUI fell below 40. Back then it seemed difficult to fathom that a new bull market was being born before our very eyes, but what a wonderful difference a few years makes!

The blue line above is the beautiful belle of the ball, the awesome HUI unhedged gold-stock index. Its newest bull-market-to-date high this week marked the latest in a long series of higher highs that started way back in late 2000 after the ultimate bottom. In a secular bull market, each new higher high achieved is very important because it confirms that the bull is still alive and healthy. The HUI graciously flashed this welcome double thumbs-up signal to gold-stock investors this week.

The index's higher highs have been carved within the context of a rock-solid bullish uptrend, which is bound on the bottom by a narrow strong support zone. The trend channel shown above is parallel with this support zone, and offers an interesting insight. Even in light of the HUI's excellent action this week, the index remains nowhere near its upper resistance line and still has plenty of room left to advance technically over the short-term before challenging its uptrend resistance.

This is great news for gold-stock investors! Not only has a fresh new bull-to-date high just been achieved, but odds are that additional higher highs are rapidly approaching since the index isn't yet crowding its short-term trend-channel resistance. From a pure technical perspective, pretty much everything about this HUI bull-market uptrend remains textbook perfect.

The reason gold stocks are in a bull market is because gold itself is also in a powerful secular bull. The venerable Ancient Metal of Kings has been relentlessly rising for over two years now and shows no signs of slowing down. Gold's technical uptrend is very evident above, with its strong bottom support zone drawn in on the graph. As long as the gold bull continues to run higher, the gold-stock bull will gallop right along with it!

Gold's uptrend, like all major bull markets, is roughly parallel with its 200-day moving average. In bull markets the 200dma often provides major technical support for the bull and this particular specimen is no exception. Since the gold bull launched in early 2001, its 200dma has steadfastly held as major support. Occasionally the 200dma is challenged, as it was earlier this year, but for the most part the best time to buy gold and hence gold stocks is when the yellow metal approaches its 200dma.

It is really exciting right now to note above that gold is still hovering near its 200dma today! This suggests that probabilities strongly favor a continued gold move higher in the coming months, potentially even a major new gold upleg. Gold stocks often move up before gold as investors and speculators anticipate the coming gold upleg and try to buy in ahead of it. We are probably witnessing this same phenomenon today, heralding a surge in gold itself.

While each of the steep ascents of the gold stocks shown above is often initially driven more by speculators than investors, the rise in the gold price is very important because it provides the key fundamental foundation to support the higher gold-stock prices. As the price of gold rises the profits of gold-mining companies soar dramatically due to their amazing profits leverage to the gold price.

The costs of mining a particular body of gold-laden ore are essentially fixed. For example, it might cost a gold company $300 to chisel an ounce of gold out of tons of rock. If the gold price is $350, this gold company can sell its gold at a $50/oz profit. But if the gold price goes up 20% to $420, now the same gold company can still mine gold for $300 but is now able to sell it at $420 for a $120/oz profit. A modest 20% rise in the gold price leads to a massive 140% increase in a gold company's profits in this example, which illustrates the incredible profits leverage of gold stocks!

So the higher gold prices are what ultimately drive higher gold-stock prices. As long as the secular gold bull market continues to gallop, gold-mining companies can dramatically increase their profits which fundamentally supports the far-higher stock prices that the speculators bid into existence. Since the gold bull shows no signs of abating, neither does the gold-stock bull that has already so richly rewarded investors and speculators in recent years.

While almost all gold stocks go up with the rising tide of gold, they are not all created equal. Some gold-mining companies choose to hedge their bets, or decide today to lock in future prices for the gold they are planning on selling. The red line above shows the XAU gold-stock index which is heavily dominated by these hedgers at the moment, although thankfully a couple more non-hedgers are being added this month.

While the HUI unhedged index has soared, the heavy-hedger-laden XAU has essentially traded sideways in recent years. It is really important to realize that gold-stock investors can be right on the major bull trend but still not reap the rewards if they pick the wrong stocks. Companies that hedge their production by locking in prices today are the wrong stocks to bet on in a secular bull market in gold.

For example, if a company can mine gold at a $300/oz cost and locks in a contract to sell it at $375 in the future, the deal seems favorable if gold is only trading at $350 today. But as soon as gold goes over $375, the hedging contract starts to cost the shareholders huge amounts of lost potential profits. As gold soars to $400, $500, and even far beyond, the hedged company is contractually obligated to sell at $375 in this example regardless of what the prevailing price of gold at the time happens to be. Needless to say this destroys profits leverage!

Because of their hedging contracts, hedged gold miners cannot fully participate in a gold bull market. They have effectively sold off their profits leverage to the counterparties on the opposite side of the hedging contracts. Because hedging severely limits the growth of gold-mining profits in a major gold bull, investors and speculators ought to carefully avoid the hedgers. These sound fundamental arguments are vividly illustrated by the price chart above, which reveals the devastating opportunity costs of hedging during a gold bull in comparative stock-price terms.

Since the key to gold-stock rallies is the price of gold, I have been carefully watching the gold price for clues and signals that we can actually use in real-time to successfully trade gold stocks. One technical tool that has served us particularly well this year involves watching the convergence and divergence of gold's 50-day and 200-day moving averages. You can see these lines drawn in white and black on the graph above.

If you are not familiar with the Gold 50/200 MACD, I explained it in depth in my original "Trading the Gold-Stock Bull" essay published in June. Basically it involves buying gold and gold stocks when the gold 50dma and 200dma converge and ratcheting up stops and preparing to get stopped out after rallies when these two moving averages diverge. We look for sub-2% convergences to buy and 5%+ divergences to raise our stops.

Like the HUI technical resistance and the price of gold itself, the Gold 50/200 MACD indicator also suggests that there is certainly plenty more room available to run yet in this particular gold and gold-stock upleg. This is a wonderful omen for today's gold-stock investors and speculators!

In the last 19 months or so there have been two major Gold 50/200 MACD buy signals and two major neutral signals. The buy signals, when the Gold 50/200 MACD fell under 2%, were triggered last December and this May. Each buy signal presaged a major upleg in gold and gold stocks that was certainly very profitable to trade.

The two neutral signals, when the Gold 50/200 MACD climbed above 5%, came to pass in May 2002 and January 2003. Both times proved to be nearly ideal for raising the trailing stops on gold stocks allowing speculators to be stopped out with healthy profits when the inevitable gold pullbacks arrived. The historical performance of the Gold 50/200 MACD as a gold-stock trading indicator was explained in much more detail in the original "Trading the Gold-Stock Bull" essay if you would like more background.

What captured my attention this week was the sharp recent downturn in the Gold 50/200 MACD on the lethargic gold trading action of this summer. While this indicator had been climbing rapidly from its lows in May, in July it ran out of steam and nosed over to head south. This type of behavior hasn't happened since 2001 (not shown above) when it marked a powerful base-building period for gold that eventually led to the biggest upleg in gold stocks in the entire bull market to date, the first half of 2002.

Both of these sub-5% premature downturns in the Gold 50/200 MACD in 2001 and 2003 share similar characteristics. Both downturns coincided with periods of time of sideways-trading gold action and moderate volatility in gold. The 2001 4% Gold 50/200 MACD downturn happened just before gold and gold stocks began to soar for many months. Since the technical action today is remarkably similar, I can't help but suspect that we are in for a major gold rally, and probably significantly more gold-stock rallying too, in the months that lie ahead.

While speculators can certainly buy in now, if the Gold 50/200 MACD continues its downtrend and actually crosses 2%, that will be the ideal time to load up on gold and gold stocks if recent history proves to be a valid guide for future gold behavior. With this indicator today roughly in the mid-range between the 2% buy and 5% neutral levels now, it could head either way in the coming weeks. As long as it stays under 5% however, odds are that neither gold nor gold-stocks are yet overbought and that continuing short-term upleg rallying action can be expected.

Gold and gold-stock investors and speculators definitely have a lot to be excited about right now! Even with the HUI hitting new highs that would suggest to some that this upleg is peaking, several powerful technical factors suggest that may not be the case yet this time around.

The HUI is not yet close to its upper resistance line, which grants the market technicians room to breathe and increases their likelihood of buying in for more speculation. Gold itself is hovering near its 200dma, the most powerful primary support line in any major secular bull market. The Ancient Metal of Kings' downside risk is minimal near its 200dma while its upside potential is enormous. It is wonderful to see gold stocks carving new highs while gold is poised to leap up and fundamentally justify them!

Finally, the impressive Gold 50/200 MACD has turned south, towards the full-on buy signal and away from the raise-stops-caution zone. This is a third foundational piece of evidence leading me to believe that we haven't yet witnessed the final days of this current gold-stock upleg. In fact the best is probably still yet to come!

In addition to the bullish technical picture presented above, gold is now entering its strongest season of the year, a great omen. On average, over the last few decades the greatest gains in gold have been achieved between late August and early October. The seasonally weak period for gold also ends in August, which may help explain why the revered yellow metal is still scraping along near its 200dma and not running higher yet. As the seasonally strong period arrives though, odds are the futures players will wax more bullish on gold and bid up its price to try and earn some seasonal trading profits.

There are other bullish factors now lining up nicely for gold and gold stocks too. As the dollar continues to fall on stupendous monetary inflation and unbridled Welfare State government growth in the States, gold is the primary beneficiary of the dollar's continuing abuse.

In addition, the general stock-market action has been really heavy and looked toppy in recent weeks. If the stock markets finally roll over into their long-anticipated new downleg soon, the demand for gold and gold stocks will inevitably rise as flight capital vacates burning general equities and seeks safe havens like the gold complex.

The bottom line is that the gold-stock rally of recent months has certainly been nice, but odds are it still has plenty of room left to stretch its legs and run. Investors and speculators who remain long quality unhedged gold stocks are likely to continue to do quite well in the months that lie ahead.

If you seek guidance on specific gold and silver stocks to buy and when to sell them, we maintain active gold/silver-stock trading portfolios in both our Zeal Intelligence monthly newsletter and Zeal Speculator trading alert/update service. In the actual gold/silver stocks we purchased earlier this year near the last Gold 50/200 MACD buy signal and the gold lows specifically to ride this current upleg, we have been blessed with some excellent unrealized portfolio gains now running +35% and +48% respectively. Not too shabby for a little over four months!

Please consider joining us today!

Since these awesome gold and gold-stock bulls are long-term secular phenomena, it still isn't too late to start investing in gold and gold stocks. We probably have years left yet before the public floods in and turns gold stocks into a mania, so the pickings are still excellent!


 

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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