Gold Stock Recovery

One year ago this week, I wrote about the end of the gold-stock panic.  As measured by its flagship HUI gold-stock index, this sector plummeted an unbelievable 52% in a matter of weeks in October 2008.  It was an epic catastrophe and its aftermath is still reverberating through gold stocks to this day.  All of 2009 has been defined by gold stocks’ recovery from this unprecedented panic anomaly.

And despite last year’s legions of naysayers wondering if the gold-stock bull was mortally wounded, recover the gold stocks have.  After hitting an unbelievable panic nadir near 152 in late October 2008, the HUI quickly doubled to finish last year around 302.  And a couple weeks ago the HUI closed near 511, representing an outstanding 69% year-to-date gain in 2009.  This tripled the S&P 500’s 23%, impressive!

Still, the gold stocks continue to climb the proverbial wall of worries.  Even though a couple weeks ago the HUI closed within 1% of its all-time high from March 2008, investors and speculators are concerned because gold rose 22% over this same span.  Why hasn’t the HUI kept pace with gold’s awesome rally of late?  And the last couple weeks haven’t helped either, with the HUI sharply down by 14% over a short span of time where the general stock markets were dead flat.

Considered in isolation, some of these gold-stock developments can certainly appear ominous.  But when they are all placed into context like the pieces of a puzzle, the resulting picture tells an entirely different story.  All of 2009’s ups and downs, triumphs and disappointments, coalesce into a coherent whole when considered together.  And it paints the picture of a healthy ongoing gold-stock recovery.

Gold stocks’ progress is primarily measured through their stock prices, and the resulting abstraction known as the HUI index.  And a 48% year-to-date gain as of this week on top of and following the stunning 100% gain in the final 9 weeks of 2008 is certainly excellent progress by any standard.  But perhaps a more illuminating measure, one that offers more insights, is the HUI’s progress relative to the price of gold.

This relationship is best distilled in the HUI/Gold Ratio, or HGR.  It is simply the daily HUI close divided by the daily gold close, charted over time.  Since the HGR is such a critical metric for this gold-stock recovery, I’ve discussed it in most of the gold-stock essays I’ve written over this past year.  Our subscribers have earned huge realized and unrealized gains this year betting on the mean reversion of the HGR.

Studying the HGR in context not only offers a critical perspective on the gold-stock recovery far beyond the raw HUI’s, it has a calming effect on traders’ perpetually over-excitable emotions.  We’ve all seen those days in recent months where gold rallied strongly but the gold stocks lethargically refused to leverage its gains.  Dwelling on those days to the exclusion of the broader trend quickly discourages.

This broader post-panic HGR trend is crystal-clear in showing that the HUI is recovering relative to gold.  While there are times when gold surges ahead of the HUI (like in November), on balance the gold stocks are regaining ground relative to gold.  This is readily evident in this chart, which renders the HGR in blue (right axis) on top of the raw HUI in red (left axis).  The HGR’s uptrend is critical to keep in perspective.

The whole purpose of ratio analysis is to reveal relative performance.  If the HUI had merely paced gold in 2009, had the same percentage gains as the metal these companies mine, the HGR would be a smooth flat line.  But when the HGR is rising, the HUI is rallying faster than gold and outperforming it.  And as you can see, not only has the HGR been rising over this past year but it has formed a well-defined uptrend.

When the HUI rockets higher much faster than gold, the most-fun times to own gold stocks, the HGR shoots up towards the upper resistance of its uptrend.  And when gold rallies faster than the HUI (or is more often the case falls slower than the HUI during precious-metals pullbacks), the HGR sinks back down towards its lower support.  Within the past year, there have been no fewer than 3 resistance and 4 support approaches.  These extremes precisely bound the beautiful uptrend we see above.

Whether you’re an investor or speculator, the best times to add new gold-stock positions are when the HGR is down low near support.  Whenever the HUI is weak enough relative to gold to drag the HGR down to the bottom of its uptrend, odds are those conditions won’t persist.  They almost always occur after gold has fallen significantly and sentiment in the precious-metals world feels really dejected.  Buy into the fear.

And speculators can also capitalize on the opposite end of this HGR uptrend, when HUI outperformance has lifted this ratio up near resistance.  When the HUI is strong enough relative to gold to drive an HGR resistance approach, gold stocks are getting overbought.  Traders are too excited about their near-term prospects so a pullback or correction is necessary to rebalance sentiment.  Sell into the greed.

Gold stocks’ strong recovery in 2009 drove the HGR into a meandering path between these two extremes.  Near resistance, traders naturally felt pretty excited about gold stocks.  And near support, they naturally felt pretty discouraged.  While it is easy to get caught up in these emotions when they happen to be prevailing, perspective is the key to neutralizing them in your own trading.  And this perspective shows the HUI has continued to rise relative to gold on balance since last year’s brutal stock panic.

Consider the last few months’ gold-stock action within this paradigm.  Between its interim highs in mid-September and early December, the HUI only rose 15%.  This would be well and good, but gold blasted 19% higher over this very span.  Since gold stocks are far more risky than owning gold itself, there is no reason to own them if they can’t outperform gold.  While gold only has price risk driven by its own supply and demand, gold stocks add geopolitical risks, geological risks, operational risks, and many others.

Gold stocks need to ultimately leverage and multiply gold’s returns to justify their enormous additional risks.  While their leverage to gold has varied considerably in different uplegs in this bull, a long-term line in the sand is probably 2.0x.  If gold stocks can’t at least double the underlying gains in gold, then investors are probably better off selling the gold stocks and using the proceeds to add to their foundational physical-gold holdings.

Between mid-September and early December, the HUI could only manage to leverage the awesome surge in gold by a horrendously bad 0.8x.  This pathetic episode has understandably once again called the ongoing viability of the gold-stock recovery into question.  There is no doubt that gold stocks have been seriously lagging gold’s advance of late, and this underperformance is unacceptable.

But considered within the context of the HGR uptrend, the seeming urgency of today’s gold-stock problems quickly fades.  We’ve seen many similar episodes.  Between the end of last year and early March, the HGR ground lower.  Gold stocks were underperforming gold so similar fears to today’s erupted.  Yet once the HGR slumped low enough to challenge support, the gold stocks rocketed higher again.  In the last few weeks of March, the HUI soared 32%!

Following that surge, the HUI again started underperforming gold in April and drove the HGR lower.  But once this key metric hit support, it was off to the races again for gold stocks.  In May, the HUI shot another 33% higher!  Then in June, July, and August, the HGR drifted sideways as the HUI couldn’t leverage gold’s gains at all.  Again this looked really ominous in isolation, like a big structural gold-stock problem.  But right after that drift, the HUI blasted 27% higher in the first couple weeks of September.

See the pattern here?  Gold stocks are highly-speculative and have always moved in fits and starts.  There are longer periods of consolidation or retreat relative to gold that are immediately followed by hard and fast periods of advance.  Most of the time gold stocks don’t do much at all, but when they start moving they move.  And the net result of all this ebbing and flowing is very clear in this chart, on balance the HUI continues to gain ground relative to gold.

Interestingly, this latest ebbing of the HUI’s fortunes has dragged the HGR back near support today.  If this HGR uptrend holds, this implies that we will soon be due for another sharp gold-stock rally.  I suspect this next one will drive the HGR back up to its resistance line and a new post-panic high.  While not quite here yet, this coming HGR support approach should prove to be a fantastic buying opportunity.

We warned our subscribers that gold was very overbought before this latest retreat, including selling a couple of gold-stock trades at 130% and 118% realized gains in our weekly Zeal Speculator newsletter the very day the HUI topped in early December.  They knew a pullback was coming, and were ready.  And today we are preparing our subscribers to once again buy gold stocks aggressively when various buy signals including this HGR support approach are triggered in the coming weeks.  It is an exciting time for gold-stock traders.

The HGR’s textbook-perfect uptrend that has defined this gold-stock recovery since the panic ended is all well and good.  But will it persist?  Is there any reason why gold stocks should continue to gain ground relative to gold?  Actually there are a couple, an airtight fundamental argument leading into a powerful technical case for the HGR to continue its post-panic recovery.

In the stock markets, any stock’s long-term price is ultimately driven by the profits earned by the underlying company.  If a company can grow its profits, its stock price will rise over the long term.  Investors buying stocks are really purchasing fractional rights in the future profits streams of the companies they own.  The greater those profits streams, the higher the companies’ stocks will be bid up by investors competing to own them.

Gold miners’ long-term profits are driven almost exclusively by the price of gold.  The higher the prevailing gold price, the greater their profit margins on their existing operations.  If a company can mine gold at a total cost of $600 per ounce, and this metal is selling for $900, it makes a $300 profit.  But if gold only rises 33% to $1200, this company’s profits double to $600 per ounce.  The earnings leverage inherent in producing commodities for relatively fixed prices leads to enormous profits growth in higher-price environments.  In some cases gold-mining profits grow exponentially with the gold price!

In addition, higher prevailing gold prices make previously uneconomical ore deposits economical to mine.  So gold miners can also increase their production at higher prices, further expanding their profits.  If this secular gold bull continues, and its fundamentals strongly argue it will, then gold mining is going to get a lot more profitable.  And higher profits always ultimately lead to higher stock prices, this is an immutable long-term law in the stock markets.  Thus fundamentally, gold stocks have to continue higher.

And technically, they remain way too cheap relative to gold today.  This next chart expands the HGR to a secular time frame since 2003.  Prior to the once-in-a-lifetime discontinuity caused by the stock panic, the HGR traded in a well-defined secular range.  As I pointed out a year ago as we emerged out of the panic, there is no reason why today’s gold-stock recovery won’t return the HGR to its pre-panic secular range.