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April 08, 2005

Trading the Gold-Stock Bull 5
by Adam Hamilton

With the flagship HUI unhedged gold-stock index languishing near 200 for the better part of a quarter now, sentiment among gold-stock investors and speculators is understandably pessimistic.

After all, it is recent price action that drives current psychology, and with gold-stock prices meandering sideways from anywhere between 3 to 18 months depending on your perspective, it is natural for enthusiasm to wane. And as goes sentiment, so follows the perpetual debate on the market.

Bull markets tend to climb walls of worry, and nothing brings out swarms of worries as effectively as stalling prices. In the HUI's case, its recent lack of performance is causing all kinds of bearish theories to gain prominence. And if the gold-stock-investing Internet forums are a valid reflection of general sentiment, there is a growing firestorm of worries tormenting gold-stock investors.

I started following Internet gold forums back in 1998, well before gold's secular bottom in early 2001, and to this day I still find them very valuable for getting a read on prevailing sentiment. As I pondered the state of the HUI this week and monitored the forums, a virtual cornucopia of bearish predictions burst forth.

The hardcore deflationists think gold stocks are doomed because they believe the gold bull is over. Per this thesis, as soon as the massive debt bubbles plaguing the US implode, prices of everything from gold to groceries are going to be sucked into a giant deflationary black hole. Why buy the HUI if the debt implosion looms?

Meanwhile the perpetually victimized feel convinced that shady big-money syndicates are actively shorting the gold stocks into oblivion, trying to break the back of the growing pro-gold outlook among small investors. Since these nameless forces allegedly have unlimited money and the gold-stock sector remains so small, why even bother fighting them?

Still others are mesmerized by the growing chorus of predictions for a mega bear-market rally in gold's arch nemesis, the mighty US dollar. Even some contrarian gurus are calling for a 25% mega-rally from the dollar's late December lows, an event which would almost certainly beat the tar out of gold. Why buy the HUI if the dollar is about to become the global currency darling again?

I find these bearish theories fascinating in the aggregate, all considered together as a single trend. They are each bricks helping build the wall of worry terrorizing would-be HUI investors and speculators. But as King Solomon wisely wrote millennia ago, there is nothing new under the sun. Negative sentiment is the expected and natural response from prices not rising fast enough to excite, and it has accompanied every gold or HUI interim low in this entire bull to date.

In late 1999 when gold ground down to just above $250 on the eve of the Washington Agreement, the forums were calling for sub-$200 gold and the Elliott Wave bears were having a field day. In late 2000 when the HUI bottomed under 36 and was just preparing to launch its mighty 614% bull, the forums were convinced central banks would never "let" the gold price rise again. At gold's secular bottom in early 2001, once again popular consensus near $260 was that gold was likely to see $200 before $300.

And each time the HUI has corrected since then, negative theories have gained prominence buttressing the wall of worries. It is natural for market players to feel negative when prices aren't rising rapidly enough, and this psychology leads to a theory-selection bias that elevates congruent bearish theories and chokes out contrary bullish ones.

But if we can rise above the tactical melee and regain the big perspective, when the majority of gold-stock players wax bearish it is a fantastic omen for contrarians. True contrarians remain neutral internally, and as Warren Buffett so eloquently stated they buy when others are afraid and sell when others are brave. It sure seems like gold-stock players are generally afraid today, a crucial clue that another interim bottom is probably being laid.

This week I would like to discuss the current state of the HUI from a variety of technical perspectives, ignoring the wall of worries and instead focusing on hard price data. From my battle-hardened perspective, the gold-stock bull continues to look healthy and indeed on the verge of its next major upleg. When prevailing technicals slice through the incessant sentiment noise, a very bullish picture emerges.

We'll look at trading the gold-stock bull from a volume perspective, examine the ongoing effects of the maturing countertrend currency reversals, and finally look at my favorite gold-stock trading indicator that has proven so incredibly profitable in this bull to date. Today's HUI correction is nothing to fear and it is probably well on its way to fully running its course and embarking on its next major upleg.

This first chart examining HUI volume is new since the last essay in this series but was described in depth in last autumn's "Trading HUI Volume". This particular indicator is really interesting since the HUI itself doesn't actually have volume! Since HUI shares don't exist, it is just a tracking index, we developed a composite HUI volume by adding up the individual daily trading volumes in all of the HUI's individual component companies.

This composite HUI volume yields important technical clues for investors and speculators wondering what is going on with gold stocks, whether now is a good time to buy or not. Contrary to the rotten prevailing sentiment, the 5-day moving average of composite HUI volume indicates that we are near a high-probability-for-success opportunity to once again throw long gold stocks in a big way.

Volume, interestingly, is tied directly to sentiment. When investors get really excited about the HUI's prospects near major tops, volume often surges as folks rush to buy as fast as they can so they don't miss the boat. Conversely, when investors are terrified volume also spikes dramatically. Thus high volume typically marks major interim tops or the sharp plunges that usually follow unsustainable near-vertical ascents.

Low volume, on the other hand, usually corresponds with waning interest in a market. When prices don't appear to be doing anything notable, like the HUI's today, gradually gold-stock investors and speculators lose interest and just don't trade much. Prices are typically lethargic without real volume. Low volume also corresponds with a grinding low-level fear very different from the sharp fear driving plunges. This low-level fear is spawned by prevailing bearish sentiment like today's scaring people into not trading gold stocks.

But if you carefully examine this chart, low-volume episodes also mark some of the best times to throw long the HUI. When the 5dma of composite HUI volume decays under 16m shares, the green bar above, the HUI is usually just finishing a major correction or consolidation and is ready to rock and roll again. Every low volume episode of the last several years is highlighted above in blue and they really do tend to mark fantastic times to buy.

Low volume also coincides with the HUI correcting back down to its linear support line. In any secular bull market, one of the highest-probability-for-success times to buy is when a price retreats back to support in a normal, healthy bull market correction. So far in 2005 the HUI has kissed support twice now, each time accompanied by the telltale low volume. Once again today the HUI composite volume threatens to fall under $16m shares on a 5dma basis.

In every previous case the HUI rallied not long after these lethargic low volume periods were registered. Some of these rallies sown in the depths of low-volume despair were relatively modest, running for a couple months. Others were truly massive primary bull-market uplegs that blasted higher for several quarters generating enormous profits for gold-stock investors.

Will this time be different and not portend an imminent HUI rally? I really doubt it. Low volume episodes are common at major interim bottoms in pretty much all secular bulls. It is natural human nature to get the most fed up with trading near major bottoms when nothing exciting seems to be happening so volume dries up right as prices are done correcting and once again ready to thrive.

Our second chart highlights what I believe is the cause of this HUI correction, the ongoing parallel currency countertrend reversals in gold and the US dollar. This is a Relativity chart, showing both currencies as a multiple of their key 200dma baselines over time. If you are not familiar with this approach it is explained in more depth in December's "The Relative Dollar and Gold 3" essay.

The only reason to own a gold stock is because gold is in a secular bull market, a subset of the Great Commodities Bull of the 00s now underway. The higher gold prices rise, the greater the profits of the unhedged gold miners multiply and the higher their stock prices ultimately run. But since gold drives gold-miner profits and hence gold-stock prices, the HUI is at the mercy of gold corrections as well.

Gold itself still sojourns in the initial stage of its three stage bull, where it still remains subject to the whims of the parallel secular bear in the US Dollar Index. Until global investment demand grows great enough to lift the gold price independent of currency machinations, gold will remain weak each time the dollar has one of its periodic bear-market rallies. And since December, as expected, the dollar has been in bear-rally mode.

Both secular bulls and bears alike tend to diverge away from their 200-day moving averages to extend their primary trend and then periodically retreat back to their 200dmas to maintain balance in sentiment. When gold is rising and the dollar is falling both currencies are diverging from their 200dmas. But when the inevitable temporary countertrend reversals arrive, like today, both currencies converge with their 200dmas.

The chart above outlines this well-established phenomenon. In December both gold and the dollar diverged relatively far away from their respective 200dmas and sentiment was waxing extreme in both cases, bullish for gold and bearish for the dollar. Since this extreme sentiment is not sustainable, soon the dollar entered bear-market rally mode and gold corrected, converging with their 200dmas represented as 1.00 in this relative chart.

The bold yellow lines above highlight the mirror-image pattern in gold and the dollar in relative terms. When the dollar is weak gold is strong and when the dollar is strong gold is weak. And of course since gold ultimately drives the gains in the HUI, the premier gold-stock index also suffers while gold is grinding through one of its periodic corrections.

The HUI's current gold-weakness-driven correction is no surprise at all for prudent investors and speculators who understand this critical relationship, indeed we have been expecting and predicting it. All bull markets flow and ebb, taking two steps forward and one step back. Corrections are natural and healthy in all bulls as they keep sentiment in balance and prevent the secular bull from maturing too quickly at too low of price.

Our Relativity trading bands that will probably signal the end of the current gold correction and dollar bear rally are marked above. Once gold falls under 0.99x its 200dma, and the US Dollar Index exceeds 1.00x its 200dma, then the threat of the correction will be largely past and investors can redeploy for the next major gold and gold-stock upleg. We are getting very close on both accounts, as a new bear-rally-to-date rDollar high was just carved this week.

If you would like to follow this rapidly approaching major long signal in gold and short signal in the dollar, our newsletter subscribers gain access to an exclusive section of our website with large charts of rGold and the rDollar updated twice a week or so. Since these relative signals have been so profitable bull to date I keep a close eye on them and use them to guide my own gold-stock trades.

Understanding the current relationship between gold and the dollar is crucial for protecting yourself from getting caught up in the prevailing bearish sentiment. As long as gold remains in the initial currency-driven stage of its bull market, it will correct when the dollar periodically rallies. And during these healthy gold corrections the HUI will be weak, consolidating or correcting, since it is the gold price that ultimately drives the stocks of the companies that mine gold.

Thus everything we have witnessed so far in 2005 is merely par for the course. There is nothing special, scary, or anomalous about the latest HUI weakness compared to its bull-to-date behavior. With the root cause of the HUI correction understood, our final chart gets back into trading the gold-stocks directly. It is also a Relativity chart, with the rHUI line showing where the HUI has traded as a multiple of its key 200dma support over time.

Since all bull markets flow above their 200dmas and then ebb back down to them periodically, the best time to enter any bull market on the long side is when it has converged with its 200dma. The HUI has already converged with its 200dma twice in 2005, a critical technical event that has proved immensely profitable in previous uplegs for intrepid contrarian investors and speculators who bought near the 200dma.

Today the HUI is once again just under its 200dma, represented by the red rHUI line now trading at less than 1.00x the HUI's 200dma. Previous sub-200dma periods where the HUI fell under its key trailing support line are highlighted in blue. Notice above in every previous case that the HUI started climbing soon after it fell under its 200dma. Today is not likely to prove any different.

Prevailing sentiment, as discussed initially above, is a direct consequence of recent price action. Investors are generally bearish on the HUI today since it has been weak, no other reason. Conversely investors are usually bullish near major interim tops, when the HUI soars more than 50% above its 200dma. Just as contrarian theory predicts, the majority of investors are always wrong at the turning points. They are bullish when they should be bearish and bearish when they should be bullish.

A key example that shines light on today's probably irrationally pessimistic HUI sentiment is March 2003. Look at the chart above and imagine there is no data after March 2003 and you are trying to game the index in real-time two years ago.

At that time, the HUI was struggling under 125 and popular predictions of a sub-100 HUI abounded. Washington was about to invade Iraq and most people thought gold had only rallied due to war fears. So, the popular reasoning went, once the war was launched and uncertainty evaporated gold would collapse and drag the HUI down with it. Even most gold bulls considered you crazy to be bullish then, as I remember well as I was writing bullish essays at that interim bottom.

Like many of the bearish arguments today, the gold-war-rally argument of March 2003 seemed logical and sound at the time. Yet, regardless of how appealing it was intellectually, it overlooked two key factors that are also being ignored today in the growing hysteria of HUI pessimism.

The secular gold bull is driving the gold-stock bull. As long as gold continues higher for global supply/demand reasons gold stocks will march higher right along with it. Yes, gold will correct periodically and weigh on gold stocks, but all corrections in a secular bull market are temporary. Was gold in a secular bull market in early 2003? Yes. Is it still in a secular bull today? Absolutely.

And if gold is in a secular bull, then its prices will rise over time on average. And unhedged gold stocks will rise as well as their profits multiply due to a higher gold price. So if gold is still rising and gold stocks are trading at their linear support, and under their key 200dma, then there is no better time to aggressively throw long. These very bullish technical conditions were met in March 2003 before one of the greatest HUI uplegs in history and they are once again met today.

The bottom line is the recent HUI correction that has spawned so much consternation is totally normal technically and was expected in advance. Gold remains hostage to the dollar's capricious whims in Stage One and the dollar was simply due for one of its periodic bear rallies to blow off some steam. And as the dollar rallied since December gold fell and the HUI was dragged down with it.

In the midst of all this despair though, gold remains in a secular bull. And if gold continues to rise in the years ahead, gold stocks will follow. And if gold stocks will follow, there is no better time to buy technically than in conditions just like today's where HUI volume is anemic, the HUI is hovering at its linear support, and the HUI is meandering just under its key 200dma.

If you are wondering how we are playing this probable coming HUI upleg, please consider subscribing to our acclaimed monthly Zeal Intelligence newsletter.

The latest issue, just published a week ago, outlines ten open gold and silver stock trades that we have been layering in preparing for the next upleg. Like the HUI all of these companies remain technically weak today, but they are likely to thrive or even soar along with the HUI when its next upleg erupts. We will continue to add more trades as appropriate in future issues. Please subscribe today and buy cheap before the HUI runs and leaves you behind!

Our subscribers also gain exclusive Web access to the same private charts that we use to make our trading decisions, including larger more detailed versions of the composite HUI volume chart, rGold, rDollar, and the rHUI among many others. We update these charts a couple times a week or so enabling our subscribers to follow all these exciting technical developments and signals as they transpire.

Today's widespread pessimism on the HUI is par for the course for major interim bottoms in gold stocks, nothing new under the sun. But if you can dig down to the core issue, gold's secular bull, and consider the very bullish HUI technicals, then the long-side opportunities in gold stocks today look vast.

Adam Hamilton, CPA
Zeal LLC.com

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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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