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July 15, 2005

Trading the HUI/Gold Ratio 2
by Adam Hamilton

The longer that today's awesome secular gold bull remains in force, the more innovative trading tools are developed by speculators to help better time this bull's periodic flowings and ebbings.

One of these technical tools that is winning increasing popularity is the HUI/gold ratio. By taking the world's premier unhedged gold-stock index and dividing it by the price of gold, the HUI/gold ratio deftly expresses the relative strength or weakness of gold stocks compared to gold.

We've been diligently following the HUI/gold ratio at Zeal for about 8 months now, since I first wrote about it back in early November. Since then the ratio really hasn't been too exciting, as it gave a sell signal soon after and the HUI spent the next half year or so correcting. But just this week, for the first time in almost a year, the HUI/gold ratio is finally flashing a new buy signal! It's time to take another look.

The core ideas underlying all ratio analysis in the financial markets revolve around ratios' unique benefits. Ratios take two independent data series and distill them down into one hybrid data series that is much easier to analyze technically. Rather than examining two separate series independently and trying to combine the often conflicting results coherently, the ratio enables students of the markets to concentrate on a single composite series.

The ratio dataset also perfectly visually quantifies the relative strength or weakness between the two sets of parent data. If you look at separate gold-stock and gold charts for example, it is very difficult to determine exactly when gold stocks are outperforming gold and vice versa. Often relative performance can be subtle and turbulently changing, and our brains have a hard time mentally combining two complex visual series.

But relative performance trends are easily recognizable in a ratio chart. When the ratio is rising it means the numerator is outperforming, and when the ratio is falling the denominator is shining. In terms of the HUI/gold ratio, the numerator of course is the HUI while the denominator is gold. A rising HUI/gold ratio shows when gold stocks are outperforming gold while a falling ratio signals that gold is outperforming the stocks.

This concept of relative outperformance is not limited to the upside as it logically seems, but is symmetrical to both upside and downside moves. If the HUI is rising faster than gold is rising in an upleg, the ratio will rise. But if the HUI is falling slower than gold is falling in a correction, the ratio will also rise. Thus, outperformance is possible in both flowing and ebbing markets, although only probable in rising markets.

For speculators, the HUI/gold ratio is very valuable in helping us decide how much exposure we want in gold stocks. If the ratio itself is in an upleg, then it is the best time to own gold stocks since they are rising faster than gold and exhibiting excellent outperformance. But if the ratio itself is correcting, then speculators would be better off being in gold since it would either rise faster or correct less than the stocks of the companies that painstakingly wrest it from the bowels of the earth.

And the HUI/gold ratio, even though it is a hybrid composite, carves its own chart trends that are very conducive to standard technical analysis. Support and resistance zones can be defined, trendlines can be drawn, and even very specific and unambiguous buy and sell signals can be defined. Speculators would do well to pay attention to all these signals while investors can benefit greatly by limiting their major gold-stock purchases to times near ratio buy signals.

The HUI/gold ratio also trends like non-hybrid financial assets. Once the ratio starts rising, which often happens during a major gold-stock upleg, it tends to run for several months to several quarters before the next intermediate trend change. The same thing happens when it starts falling, usually during a major gold-stock correction, warning speculators that gold stocks face some tough sailing in the coming months.

With clear technical buy and sell signals happening fairly early in these periods of relative over- or underperformance, the signals grant speculators ample time to ride the intermediate trends to completion. As such, the HUI/gold ratio is really a valuable addition to any speculator's toolbox. If you would like some more background information on it, please check out my original essay.

My partners and I have been watching this ratio with increasing anticipation since the HUI started rallying again after its mid-May interim low. It was closing in on flashing its first major buy signal in about a year. That signal would alert us that a major new gold-stock upleg was highly probable so we should be finishing up layering in new gold-stock positions in anticipation. I am thrilled to report that this long-awaited buy signal emerged this week!

Visually this ratio chart really doesn't look too exotic. It looks a lot like the HUI's or some random individual gold stock. But conceptually the visual representation of relative strength and weakness is really quite profound. When the ratio is rising gold stocks are outperforming gold and vice versa when it is falling. It offers a totally unique perspective on gold-stock speculating.

Before we delve into the actual trading signals, a peripheral technical line caught my attention while building these charts. A long-term ratio support line is rendered in light gray above. This line is intriguing because it witnessed bounces off sharp ratio corrections in 2002, 2003, and now again in 2005. It is fascinating that the sharp gold-stock correction since late last year just happened to bounce at levels relative to gold exactly in line with where it had in two previous years. The often subtle technical serendipity of the markets is endlessly captivating.

On the trading signals I am indebted to my friend Matthew Frailey at www.BreakPointTrades.com for sharing this neat system with me last year. By combining crystal-clear technical events such as intermediate resistance breakouts and failures below a key moving average, Mr. Frailey deftly created a HUI/gold ratio trading system that is intuitive and easy to follow. All credit for its elegance goes to him alone.

This particular HUI/gold ratio trading system is designed to signal profitable intermediate-term trends, such as major gold-stock uplegs and the major corrections that inevitably follow major uplegs. I like it so much because it mirrors our approach at Zeal of entering trades with expected time horizons of six to nine months or so. These time horizons are long enough to filter out daily randomness and yield big profits yet short enough to minimize exposure to periodic corrections.

Starting on the sell-signal side of the equation, a HUI/gold ratio sell signal for gold-stock positions occurs when the ratio decisively breaks below its key 50-day moving average. Such a 50dma failure tends to happen after a major interim gold-stock top and warns astute speculators that gold stocks are likely to underperform gold for the coming months as a healthy periodic correction rebalances over-enthusiastic HUI sentiment.

Since 2001 there have been four major HUI/gold ratio sell signals, all rendered above, and each has tripped just after a major upleg topped. If you want to compare these ratio signals to an actual HUI chart, please check out the first chart at this link. In each case gold stocks significantly underperformed gold, usually by falling faster than the metal, in the subsequent two or three quarters after these sell signals.

If you are a gold-stock speculator and the HUI/gold ratio lights up one of these sell signals, it is wise to lighten up your exposure and take some profits. At the very least mechanical trailing stops can be tightened up to run more closely behind your positions so you don't leave as many profits on the table when the correction arrives. Also, all gold-stock call options should be sold and cashed out whenever a ratio sell rears its ugly head.

After one of these sell signals, the ratio declines as gold metal outperforms gold stocks. Gold of course is nowhere near as volatile as the mining stocks so it tends to correct much more modestly than the HUI. After the last ratio sell signal late last year for example, the HUI plunged by 32% peak to trough while gold only bled off 9%. Gold therefore "outperformed" the HUI during this correction.

Now long-term investors have little choice but to weather these periodic capital storms. Speculators, however, do have a choice. If a period of ratio decline is probable, which it always is after a sell signal, it is best to temporarily get out of gold stocks and move your capital to gold. Or, probably even better yet, just pull your speculative capital out of the gold arena entirely for a couple quarters or so while the correction runs its course. After the gold-stock and gold correction matures, capital can be redeployed for the buy signal.

Buy signals are defined as ratio resistance breakouts in this trading system. When the ratio tops, it tends to fall sharply initially then have one or more reaction rallies back up even though its trend is generally lower. If a best-fit upper resistance line is drawn through this series of subsequent short-term ratio tops it forms a downward-sloping resistance line.

The buy signal occurs when the ratio decisively breaks out above this resistance a few months or quarters later. All three previous buy signals in this ratio led to major and extremely profitable HUI rallies. Even Upleg 4 above, the one in the second half of last year, still witnessed a 45% gain in the HUI in just a couple quarters. While not quite as impressive as Upleg 3's 125% HUI gain and Upleg 2's 145%, 45% in about six months is still excellent in absolute terms over such a short period of time.

And buy signals are indeed what led to this essay, as just this week the HUI/gold ratio certainly appears to have flashed its fourth major buy signal of this bull. The latest resistance line on the right that has survived several previous attempts to break out finally looks like it is decisively breaking. Is a major new HUI upleg upon us? The past-year chart area shaded in blue above is blown up in our next chart below.

Starting last August, a HUI/gold ratio buy signal occurred heralding the 45% HUI rally that would culminate in mid-November. Within a week after that top a ratio sell signal flashed and the HUI spent the next six months grinding out a grueling 32% correction. Over those six months the ratio made two or three attempts to break above its resistance, but it failed every time until this week.

The ratio came closest to breaking out in March, when the HUI index finished a rather impressive month-long 17% reaction rally after its initial correction grind lower. That early-year rally proved particularly vexing for speculators starting to layer in positions in anticipation of another upleg. The 17% run higher raised trailing stops considerably, and then these new higher stops were hit when the HUI continued lower in April.

The reaction-rally stopping out earlier this year on initial gold-stock layers reveals an important limitation in the HUI/gold ratio signals' trading efficacy. Why would we or other speculators start layering in positions early before the HUI/gold ratio buy signal triggered? Why not just wait for this week's signal? The answer is readily evident above. These HUI/gold ratio signals are slow-moving and they can be offset a considerable temporal distance from actual interim tops and bottoms in gold stocks.

The HUI's latest interim bottom was the abyss of the sharp V-bounce of May, where the ratio intersected its long-term support for a third year. But the actual buy signal in ratio terms did not flash until this week, almost two months later. And during these past two months the HUI has already rallied by 20%. Thus waiting for the signal before buying any gold stocks would have cost speculators a hefty chunk of the expected HUI upleg.

While the HUI/gold ratio is a valuable tool, it is important to realize that it tends to lag. Sell signals aren't too bad, usually occurring within weeks of a major interim top in the HUI. But buy signals can refuse to trigger until significantly after major interim bottoms. The degree of this lag is dependent on the downslope of the top resistance line.

If the initial reaction rallies in a correction are strong, the downslope of the resistance line drawn through their peaks will be more moderate. If you take another look at our first chart above, you will note that the slopes of resistance lines during periods of ratio weakness vary considerably. In general the steeper the downslope, in other words the less powerful the initial reaction rallies that define this key technical line, the less lag the HUI/gold ratio buy signal is likely to produce. A sharper down angle makes for a faster signal.

This characteristic of this particular HUI/gold ratio trading system is not only a liability though. Slower triggering signals have a far lower probability of yielding false positives, where a signal triggers but the timing is way too early relative to intermediate trend changes. If a speculator had not bought any gold stocks near the February low because the ratio buy hadn't triggered yet, he would have been spared the stopping outs of April. So conservatism reduces both risk as well as potential rewards.

Gaming the HUI/gold ratio buys runs a gamut from investor conservatism to speculator aggressiveness. True long-term investors are probably better off waiting for buy signals to flash before deploying. Any opportunity costs of missing the initial surge in an upleg are usually immaterial over a multi-year time horizon.

But speculators, with risk coursing through our veins, often choose to attempt to anticipate a major buy signal before it happens. When the season starts looking favorable speculators gradually start adding positions in gold stocks, layering in new ones over several months in an attempt to straddle the bottom. While certainly riskier, the ultimate potential returns for this strategy are much higher. Speculators look to the HUI/gold ratio buy signals not as a primary indicator, but as a secondary confirmation.

And this is exactly how we use the HUI/gold ratio signals at Zeal. On the sell side, when the ratio falls under its 50dma I don't sell stocks outright but instead I ratchet up their trailing stops, maybe from 20% to 10%. This hedging strategy enables us to save more of our profits if a real correction is brewing while at the same time keeping us deployed until the last possible moment in case the HUI goes a bit higher first.

On the buy side, we consider the HUI/gold ratio buy signals as secondary confirmations, not primary indicators. Thus we watch other more temporally-precise tools like the Relative HUI for our primary buy alerts and start layering in new gold-stock campaigns on those. While the risk of getting stopped on the earlier layers is larger, overall the expected upleg portfolio gains are much greater. If you are interested in the foundational portfolio mathematics behind this strategy, I discussed them some depth in our May Zeal Intelligence newsletter.

Anyway, regardless of whether you consider the HUI/gold ratio signals as primary or secondary indicators, this ratio is a very valuable technical tool to follow. Distilling the relative strength or weakness of unhedged gold stocks versus gold into one easily analyzable data series offers unique insights that are difficult or impossible to glean from manually comparing separate HUI and gold charts. It is a very elegant way to visually express a sometimes chaotic relationship.

For our newsletter subscribers, we have a private chart section on our website with large HUI/gold ratio charts updated weekly. While at a higher resolution to better discern intricate chart patterns, they have the same signals and technical analysis discussed in this essay. So if you have honored us with your business, you can check up on this key ratio as often as I do.

And today's new buy signal, even though it is already 20% into what looks like the HUI's next major upleg, still marks an outstanding time to buy elite unhedged gold stocks. Each previous HUI/gold ratio buy signal, while not being at the exact bottom either, triggered when the great majority of its subsequent upleg was still left to run yet. We are still likely very early on in this one too.

The current July issue of our acclaimed monthly newsletter details eight elite mining companies that are ideally positioned to thrive in the next major gold-stock upleg. All remain great bargains to this day in a secular gold bull. If the exciting new HUI/gold ratio buy signal this week proves true to historical form, then the next six months or so ought to be extremely profitable. Please join us today for the next ride up!

The bottom line is the HUI/gold ratio just flashed a major buy signal this week, only the fourth in this powerful bull to date. Each of the previous buy signals has heralded a major new upleg in gold stocks. In addition, the conservative lagging nature of these buy signals has always manifested itself in the past with them triggering after a major interim bottom was carved, probably the ugly May lows this time around.

Probabilities now strongly suggest that gold stocks ought to continue to outperform gold in the months ahead, and I am really excited to see how this all plays out.

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.

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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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