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December 21, 2007

HUI/Gold Ratio Trends 2
by Adam Hamilton

If you are a gold-stock investor, the dark cold days surrounding the winter solstice seem exceptionally fitting this year. As the warm sunlight has largely fled the northern hemisphere, so has bullish sentiment largely fled the gold stocks. Thankfully as inevitably as sun returning to the north, gold-stock sentiment too will thaw.

Today's terrible gold-stock sentiment is really something of a paradox. The gold price is the primary long-term driver of gold miners' profits and hence their stock prices. And gold is really looking good these days. After powering over $800 nominal for the first time in a quarter century in early November, gold has since casually meandered near $800 like it was born to trade here.

Over the 33 trading days since gold's first foray over $800, it has averaged $804 on a closing basis! Gold-stock investors and speculators ought to be dancing in the streets, jumping for joy, as it is hard to imagine better news for gold miners. $800 gold seemed impossibly high for the first six years of this gold bull, but it has now become the new reality. Nevertheless, gold-stock traders are very discouraged.

Sentiment is so bad that even long-time gold-stock investors are considering moving their gold-stock capital into gold bullion. This week I saw a professional gold-stock fund manager on CNBC saying he was considering deploying all his capital in gold because he thought gold stocks' profits would wane due to operating cost increases. This is amazing to hear from a professional gold-stock investor!

I love physical gold investing and have always thought that it needs to be the foundation of every investment portfolio. But while 10% to 20% of one's portfolio should always be in gold, I think 100% is a bit extreme. Over the course of entire commodities bulls all throughout history, mining stocks far outperform their underlying commodities. Gold stocks are the classic way to leverage and multiply gold's gains.

But although stocks outperform commodities over entire bull cycles, despite inflationary cost increases, their outperformance is highly cyclical. Sometimes the underlying commodity soars, leaving the stocks in the dust for a season. Later the stocks catch a bid and blow past the commodity, far more than making up for lost ground. Stocks' outperformance of commodities is certainly not a smooth linear phenomenon.

And much like the endless greed and fear cycles in the markets, after a long period of one type of behavior (either stock outperformance or underperformance) traders naturally start to extrapolate it out into infinity. You know the thought pattern. "Well, since gold has outperformed stocks for so long now maybe they will never outperform gold again. To heck with gold stocks, I am going solely with gold."

But this is the same type of flawed logic that gets traders in trouble at major interim tops and bottoms. Remember the NASDAQ top in March 2000? "Tech stocks have gone up for a decade now so they will probably keep going up forever. We are in a New Era now." Whenever one condition lasts long enough for traders to assume it is permanent, the markets tend to quickly change and crush that flawed perception.

I suspect we are reaching a similar inflection point regarding gold and gold stocks. Gold has outperformed for a long time now so traders assume this new status quo is going to last forever. But in reality, relative performance is very cyclical. Gold outperforms for a while, then the stocks outperform for a while. After long periods of gold outperformance is actually when the stocks are the most likely to suddenly rocket higher.

This cyclical nature of outperformance is readily evident in our gold-stock bull to date. My favorite way to look at it is via the HUI/Gold Ratio. The HGR is very simple just like it sounds. The closing price of the flagship HUI unhedged gold-stock index is divided by the closing price of gold on an ongoing daily basis. Then the resulting ratio is charted over time. It creates a continuing chronicle of relative outperformance.

Since the HUI is in the numerator of this ratio, a rising HGR line means the gold stocks are outperforming gold. Conversely with gold in the denominator, a falling HGR means gold is outperforming the gold stocks. Now please realize this doesn't necessarily mean both are rising. If gold is falling at a slower pace than gold stocks in a correction, for example, gold is still "outperforming" gold stocks to the downside.

If today's popular thesis that gold is destined to outperform gold stocks forever is correct, then the HGR will perpetually grind lower. But the reality of this bull is quite different. Since early 2001 when gold's secular bottom arrived, the HGR has been meandering higher on balance. Standard technical analysis applied to this ratio, rendered below in blue, is very illuminating. Perhaps gold stocks aren't doomed to forever linger in limbo in gold's dark shadow.

This graphical depiction of relative outperformance drives home just how cyclical it really is. While the HGR has risen nicely on balance, it has been one wild ride. This chart is extremely volatile, witnessing dazzling spikes rocketing higher followed by long periods of sideways-to-lower grinding in between. If you can internalize the relative outperformance trends so far in this bull, you'll have a much better idea of what to expect going forward.

First consider the temporal division of outperformance. This whole chart covers 28 quarter-year periods. Within this seven-year span, there have really only been four episodes of sharp HUI outperformance. They are numbered in blue above. If you count the quarters over which these massive gold-stock rallies unfolded, the number is somewhere around 10. So gold stocks have only radically outperformed gold in 10 of 28 quarters since 2001. This works out to 36% of the time, not much more than a third.

So everything else being equal, based on this bull so far we should expect gold stocks to not be radically outperforming gold almost 2/3rds of the time. In reality gold-stock traders are far less patient. If gold rises in a single trading day, but gold stocks don't dutifully leverage this gain instantly, traders get worried and start spinning bearish theories. This is very irrational from a long-term perspective though.

The 1/3rd of the time when gold stocks radically outperform gold is cyclical in nature and readily apparent in the HUI/Gold Ratio. This ratio tends to surge up to major interim highs on gold-stock outperformance. This happens when the HUI is powering higher in massive uplegs. (For reference, the raw HUI is charted above in red off the left axis.) But after these huge HUI uplegs, the HGR drifts sideways for a season. These drifts are just as important as the surges.

Whenever gold stocks rocket to new bull highs, traders get uncomfortable. They wonder if the bull is over and if such lofty prices are sustainable. So gold stocks enter high consolidations after massive HUI uplegs. This trading sideways not only bleeds off the excess greed rampant at the preceding upleg top, but it gives traders time to acclimate to new high prices. Drifts build the technical base off of which the next surge eventually launches.

This surge-drift pattern drives the HGR higher in fits and starts. The ratio surges higher on relative HUI outperformance, but then it drifts sideways for a long period of time to acclimatize. Often these sideways drifts angle lower too, which shows relative gold outperformance. Since these drifts last longer than the surges, relative gold outperformance is the norm rather than the exception. Nevertheless, the relative outperformance is highly cyclical and eventually the next HGR surge will come despite the naysayers.

As this chart shows, over time this surge-drift pattern has created a secular uptrend in the HUI/Gold Ratio. With the exception of an impressive surge above this uptrend in late 2003/early 2004, the HGR has been very comfortable within this secular support and resistance channel for six years now. This rock-solid uptrend has huge implications for gold-stock investors and speculators today.

Since early 2006 at the apex of the last major HUI upleg, the HGR has been drifting sideways to lower. On balance, gold has been outperforming the gold stocks which is increasingly discouraging traders. But this typical post-upleg drift has accomplished a great deal technically. Where the HGR was way up near its resistance after the early 2006 surge, today it is down near support thanks to the subsequent long drift.

Over the last six years, there have only been five major support approaches including today's. It is provocative that the first four couldn't remain near support for long. Whenever sentiment got bad enough to drive the HGR to such dismal lows, soon after the HUI blasted higher. Some support approaches, like 1 and 4 labeled in yellow above, simply resulted in sharp and fast HUI rallies.

But other support approaches, 2 and 3 above, resulted in some of the biggest massive uplegs seen in this entire gold-stock bull! They occurred right at the very beginnings of huge surges higher in the HGR driven by extreme gold-stock outperformance. So worst case a support approach calls for a sharp and fast HUI rally, but best case it can portend a new and highly profitable massive upleg in the gold stocks. And we are right at this ultra-bullish long-term support line again now!

Such a new massive upleg today would carry the HGR up to its upper resistance. Since these take a couple quarters to unfold, HGR resistance would probably be near 0.70 by the time this happened. Where would the gold price climb to drive such a massive gold-stock upleg? Probably at least to $900 to $1000. At $900 gold, a 0.70 HGR yields a HUI target of 630. At $1000 this jumps to 700. Incidentally these HGR-HUI targets are right in line with the HUI upleg cycle targets of 580 to 700 for the HUI in this upleg.

So just because the HGR has been drifting for some time now doesn't mean it is permanent. HGR drifts are more common than surges, but the surges always erupt late in the drifts when most traders have largely given up hope. In both time and technical terms, we are now overdue for a surge where gold stocks radically outperform gold for a couple quarters and the HUI surges to incredible new highs.

Before we move on, I want to address one more aspect of this long-term HGR chart. The HGR hit its bull high in late 2003, and wasn't able to exceed it in early 2006. So measured from a top basis, the case can be made that gold stocks haven't outperformed gold since late 2003. While technically true, this is misleading. As I discussed last week in reference to euro gold, extreme outlying highs are not the optimal measure from which to consider a bull's progress.

At highs, euphoria reigns supreme. Unbelievable greed can drive mind-blowing prices, but they just aren't sustainable. As soon as the greed abates, prices plunge. So over the long term, interim lows far better reflect sustainable fundamental realities than interim highs. At major interim lows, euphoria is nonexistent. Most traders have abandoned a sector temporarily, and the remaining ones are quite discouraged. So interim lows offer a superior fundamental picture (not greed-tainted) of true sustainable price levels.

Much like euro gold's support was rising on balance for years yet traders ignored it in favor of a few outlying highs, the HUI/Gold Ratio's support has also been rising for years. This means that even at the worst of times sentimentally, fundamentals supported a rising HGR. On balance gold stocks have outperformed gold for years. This is confirmed by the HGR's rising-on-balance 200-day moving average. And if you drew a mathematical best-fit line into this chart, it would rise at a strong slope to the right.

So I wouldn't get hung up on the late 2003 HGR high. No it hasn't been exceeded yet, but it was an extreme extra-trend outlier. I strongly suspect that either in this gold-stock upleg or the next the HGR will climb over 0.65, achieve new bull highs, and hit its rising resistance. Due to the nature of secular gold bulls, I am almost certain that we will see higher HGR levels to come. It is only a matter of time.

This next chart zooms in a bit to focus on our current HGR drift since early 2006. While this tactical perspective isn't as important as the strategic perspective above, it still offers some additional insights. Once again the raw HUI is rendered in red behind the blue HGR for easy comparison.

As the down-sloping initial drift resistance shows, gold was really outperforming the HUI on balance for most of this drift. This trend started to change back in July, when the HGR made an upside breakout above this drift resistance line. Since then, the HGR has showed a lot more strength indicating that this drift is maturing. It is the worst possible time for traders to extrapolate gold outperformance out into infinity.

The HGR's drift support line was also trending lower, but only slightly. Almost like clockwork, every two or three months in this drift the HGR would hit this support line and bounce. But several times, including today, the HGR suddenly knifed under its drift support. These sub-support episodes were very short-lived though. Whenever they happened, a sharp HUI rally soon ensued to yank the HGR back up into more normal territory.

With sharp HUI rallies occurring in both June 2006 and August 2007 after the last deep sub-support HGR episodes, I suspect we can reasonably expect another sharp HUI rally today out of our latest sub-support episode. And as late as we are in this drift, as irrational as fear and pessimism surrounding gold stocks have become, a massive upleg is just as likely as a simple rally. We are sure overdue for one!

The sharp HUI run starting in mid-August out of the last sub-support HGR episode is also interesting to consider. While the HUI itself soared to easily break out of its long consolidation, the HGR did not. Before the HUI rally even got halfway to its early November interim high, the HGR stalled. After that the HUI was merely pacing gold, not outperforming it. While this discouraged a lot of traders, I think its interpretation is actually bullish.

In these giant HGR surge-drift cycles, the surges are solely defined by massive outperformance of gold by the gold stocks. Clearly this didn't happen between mid-August and early November per the HGR. This means that the sharp HUI rally we saw recently was not the one that this mature HGR drift is calling for! In pure HGR terms, this recent rally was irrelevant. The expected massive surge upleg is still entirely yet to come.

Now I know there are legions of bearish theories surrounding gold stocks today, as there always are prior to massive uplegs when traders are discouraged from the preceding long consolidations. Many of these theories focus on problems gold miners are having mining gold. While gold mining is indeed very challenging, it is important to realize that near-term profits growth is not the only driver of gold-stock prices.

Like every other price on the planet, gold-stock prices are set by supply and demand. If traders want to buy more shares than are offered for sale over any given span of time, a stock price has to rise. The rising price retards demand and entices out more supply to create a new market-clearing price where all traders who want to trade are able to do so. While profits help drive long-term stock demand, they are irrelevant over this pure short-term share supply/demand perspective.

A couple weeks ago I did a study on the GDX Gold Miners ETF. Its 34 component companies represent the lion's share of the entire gold-stock world in market-capitalization terms. Back in early December, prior to this week's HUI carnage, all 34 GDX component companies added together only had a market capitalization of $163b. This compared to $220b for Google alone and $13,369b for the S&P 500. Gold stocks remain an exceedingly small sector. There aren't many shares available to meet demand surges.

So as gold travels higher as it ought to due to the US dollar woes and endless fiat-paper creation by the central banks, will mainstream stock investors get interested? Will $900 or $1000 gold get their attention? I bet it will. Like all investors, mainstreamers want to chase momentum. Some will buy GLD, the gold bullion ETF, for exposure. But I am sure the more speculative-bent will look to leverage gold's gains through gold stocks, just as we contrarians have done for over six years now.

With today's entire tiny gold-stock sector probably in the neighborhood of $175b in market capitalization, it won't take a lot of bidding to drive stock prices up fast. This is just a trivial amount of capital in general stock-market terms. New mainstreamers flooding in won't be worried about long-term profits growth, but short-term stock-price gains. If they are willing to own GOOG at 55x earnings, they aren't going to be the least bit worried about gold-stock P/E ratios.

So despite rising operating costs and profit pressures on gold miners, the speculators who will rush in to drive a surge in gold stocks won't care one bit. They will be looking for short-term capital gains and have zero interest in the long-term viability of gold miners. Massive HUI uplegs have always been far more sentimental than fundamental in nature. It is greed, not underlying stock profits growth, that drives them.

At Zeal we have been battered and bruised since early November like the rest of the gold-stock traders. Nevertheless, we focus on the long-term picture and don't believe the fear-drenched status quo will last forever. So we have been buying elite gold stocks in our subscription newsletters lately and preparing for the next upleg. It is never easy buying when sentiment is rotten, yet this is when the most favorable buying prices arrive. Join us today to ride this coming massive surge upleg!

The bottom line is gold has been outperforming the HUI since early 2006. But contrary to trader fears, this isn't going to last forever. Relative outperformance is highly cyclical. Gold outperforms about 2/3rds of the time during HUI/Gold Ratio drifts. But when the HUI outperforms the other 1/3rd of the time during surges, watch out! Truly legendary gains can be won during these massive gold-stock uplegs.

The longer that any given market condition has persisted, the harder it is to believe that it could actually change. Yet change always happens. The markets abhor all extremes and they are never sustainable. Based on market history, there is almost zero chance that we have entered a New Era where suddenly gold is going to outperform gold stocks forever. Gold stocks will have their day in the sun again.

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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