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With the general stock markets now due for a selloff
while gold hits new nominal all-time highs, precious-metals-stock traders
face something of a quandary. How
are their stocks likely to perform in the near future? Will they ignore general-stock
weakness to rally with gold? Will
they get sucked into a stock-market selloff even if gold remains strong?
There is no doubt that gold is the primary driver of
gold stocks’ fortunes.
Higher gold prices lead to higher profits for this industry, and
higher profits ultimately drive higher stock prices. Over the course of this sector’s
magnificent secular bull in the past decade, this core fundamental
relationship has proven itself in spades. But just because gold is gold
stocks’ dominant driver doesn’t mean it is their only one.
For the great majority of investors and speculators,
most of their buying and selling decisions are an extension of how they
happen to feel at a particular time.
When they are greedy after a powerful upleg,
they want to buy. When they are
scared after a major correction, they want to sell. These compelling emotions drown out
true fundamentals like the gold price and individual-company earnings results.
With greed and fear driving most individual trade
decisions, what drives collective greed and fear? The state of the general stock
markets, which is best represented by the level of the flagship S&P 500
stock index (SPX). Traders
everywhere feel very differently about all stocks (and indeed markets) after
a long SPX upleg than they do after a serious SPX
correction. They are eager to buy
in the former scenario, and eager to sell in the latter.
The more years I spend studying the financial
markets and speculating, the more awestruck I become by the overwhelming
power and ubiquity of the SPX’s influence on sentiment. Big SPX uplegs
and corrections usually have a near-universal impact. They affect every-single stock sector,
other stock markets around the world, currencies, commodities, bonds, and
even national economic outlooks.
Every trader looks to the state of the stock markets for trading cues,
even if they are not trading stocks!
An extreme case in point was late 2008’s
once-in-a-century stock panic.
Solely because the stock markets plummeted, the US dollar skyrocketed
while the euro plunged,
commodities including gold
entered a free-fall, Treasury bonds soared while their yields cratered, and
the great majority of investors assumed we were on the verge of a new great
depression! A stock-market event altered perceptions
universally.
Gold (and silver) stocks are certainly not immune to
the sentiment bleedover from stock-market
events. You can argue that they
should be fundamentally. Who
cares what the stock markets are doing if gold-miner profits are purely a
product of prevailing gold prices?
I’ve sure wished this was the case many times in the past
decade. But as traders, we have
to trade based on how the markets actually behave, not how we want them to
act.
If you carefully study the interaction between the
general stock markets, gold prices, and gold-stock levels over this
sector’s decade-long secular bull, a couple things quickly become
apparent. First, exactly as
traders expect gold is the primary driver of gold-stock prices over the long
term. Second, despite this core
fundamental relationship gold stocks still decouple from gold to spiral lower
with the stock markets when they suffer material selloffs.
The broad swath of psychological splash damage
spread by general-stock fear overwhelms traders’ rationality. So they sell precious-metals stocks
regardless of what gold happens to be doing if the stock markets are falling
fast enough to generate some real fear.
While this relationship extends far back into the past, the scope of
this essay is limited to the past couple years to make this analysis easier
to digest.
This chart superimposes the benchmark HUI gold-stock
index (blue) over the SPX (red).
Since we are considering the impact of material general-stock selloffs
on the HUI, these events are highlighted in red. So far in the SPX’s post-panic cyclical bull,
there have been seven material selloffs. Six have been pullbacks, selloffs of
less than 10%. And one was a
full-blown correction, a selloff greater than 10%.
Each SPX selloff is numbered, with the red
percentage representing the headline stock-market losses. The blue and yellow percentages show
what the HUI and gold did over the exact spans of these SPX pullbacks and
corrections. While gold is
certainly gold stocks’ primary driver
most of the time, during stock-market selloffs big enough to spark some
universal fear the HUI latches on to the SPX instead.
The first post-panic SPX pullback began in June
2009. Realize this was not long
after the panic lows so the background anxiety level was still very
high. The SPX slid 7.1% across a
span of just under 4 weeks. As is
usually the case during stock-market selloffs, gold was much more resilient
than the SPX with a loss of just 2.8% during this pullback. So what did the HUI do, follow gold or
the SPX?
A general rule of thumb for HUI responsiveness to
gold is 2-to-1 leverage. If gold
rallies 10%, gold stocks as a group ought to rally 20% to compensate
investors and speculators for their vastly-higher riskiness. If gold falls 5%, the HUI ought to
fall about 10%. While HUI leverage to gold can
vary radically, traders generally expect the stocks’ performance to at least double the metals’ to
make them worthwhile.
So with gold only down 2.8% during that initial SPX
correction, based on it alone it would be reasonable to expect a 6%ish
selloff in the HUI. But the
actual came in at 10.2%, considerably worse than the SPX’s loss and
3.6x downside leverage to gold!
And note above that the HUI’s pair of sharp selloffs during this
SPX pullback span corresponded exactly
with the SPX’s own sharp selloffs.
This relationship holds true through most of the other SPX selloffs as
well.
The leading gold-stock index not only fared worse
than general stocks, but vastly worse than gold! Why? Gold and silver stocks are risky. When the stock markets are falling,
their bearish sentiment bleeds into everything else. Traders’ appetites for volatile
assets wanes and their desire to hold cash grows more compelling. So they sell all risky trades
(including all commodities stocks) when the SPX is weak.
The SPX’s second pullback was born in
September 2009, a milder 4.3% over less than 2 weeks. Gold weathered this weakness like a
champ, down just 1.2%. So did the
HUI only fall 2.4% to reflect gold’s price action? Nope. It plunged 7.7%, far exceeding both
the SPX and gold declines. This
downside leverage was actually a pretty-scary 6.3x gold! SPX selloffs scare the dickens out of
PM-stock traders.
The SPX’s third pullback erupted the following
month, October 2009. During its
5.6% retreat in just under 2 weeks, gold only fell
1.7%. Yet the HUI plunged a
ridiculous 12.9% over this short timeframe! And as you can see above, its sharp
selloff perfectly mirrored the SPX’s. Instead of doubling gold’s
decline as it ought to, the fear splash damage from this stock-market event
led to the HUI leveraging gold’s downside by a massive 7.8x! See the pattern emerging here?
The SPX’s fourth pullback starting in January
2010 was exceptional. It was the
stock markets’ biggest pullback (less than 10%) so far in this cyclical
bull. Look at what was going on
in the HUI before that. The HUI
had rallied rapidly to new post-panic highs in December, but plunged sharply
(as usual) when gold entered a healthy yet steep correction. Before
the SPX launched its own selloff, gold and the HUI had already bounced and
started rallying again.
This should ring a bell, because it is exactly what
is happening today. Gold and the HUI topped in early
December 2010, consolidated a month, and then entered their own corrections
in January. Then gold bounced in
late January the first day the Middle East riots really started scaring the
stock markets. Naturally its
miners followed it higher. Today
the vast majority of PM-stock traders are arguing the SPX action is
irrelevant because the HUI is going to follow gold, and geopolitics will
drive gold higher.
Last year I bought into a similar argument. I knew well that the overbought
levitating SPX was overdue for a major selloff. Yet since the HUI had already corrected sharply, I figured
that its downside risk would be minimal when the SPX sold off. I wasn’t expecting gold and
silver stocks to rally through an SPX selloff, but I figured they would hold
their own so we might as well start adding PM-stock positions at that seasonally-favorable time
(early January). Boy was that a
mistake!
The moment the overdue SPX selloff finally started
in mid-January 2010, the already-weak HUI plunged in perfect parallel with
the SPX. The fact that weak hands
already should have been wrung out of the gold stocks didn’t matter a
bit. By the time this necessary
SPX retreat ran its course to rebalance sentiment, it had fallen 8.1% in less
than 3 weeks. Meanwhile gold didn’t
weather that sentiment storm well, plunging 6.6% over this short span. And the HUI, despite having just
corrected, lost another 15.4%!
One of the keys to successful trading is learning
how the markets react in certain scenarios so you can trade accordingly in
the future. And last January the
hard (and crystal-clear) lesson was that PM-stock traders as a group could
not withstand the sentiment splash damage unleashed by a material
stock-market selloff. They rushed
for the exits then and I suspect they will do the same thing in this upcoming
SPX correction today.
The SPX’s fifth selloff of this cyclical bull
emerging in April 2010 was its only full-blown correction (greater than
10%). Over an exceptionally-long
span approaching 10 weeks, the SPX gave back 16.0%. Yet gold was very strong within this
particular SPX correction, surging 4.8% and achieving almost a half-dozen new
all-time-record nominal highs in the process. Surely with gold up so big, the PM
stocks could ignore the SPX weakness right? Kind of.
Instead of rallying almost 10% to double
gold’s big gains, the HUI merely crept 2.7% higher over this
SPX-correction span. Sure, the
PM-stock gains were a heck of a lot better than the SPX’s losses in
this particular scenario. But
their upside leverage to gold was a pathetic 0.6x! Since gold stocks bear all kinds of
mining-specific risks that don’t affect gold, it’s unacceptable
when they underperform it.
Obviously PM-stock traders were torn between following the strong gold
rally and the weak stock markets.
Consider another perspective on this mid-2010 SPX
correction. Fully 6/7ths of this
event’s total losses in the SPX occurred by early June, as the
secondary early-July low was a short-lived anomaly driven by a China scare. Up to the original June bottom of that
SPX selloff, it had lost 13.7% in 6 weeks. Meanwhile gold had surged 7.4% higher,
hitting a new all-time closing high of $1242 the very day the SPX bottomed. Yet how did the HUI do? Only up 3.6%, less than 0.5x leverage
to gold’s big run!
The SPX’s sixth material selloff of this
cyclical bull started last August, a 7.1% pullback over less than 3
weeks. Gold was actually strong
over this span too, heading into its usual big surge of Asian seasonal
buying. It rallied 3.0%. Yet the HUI, even heading into one of
its strongest times of the year while gold was bumping along over $1200 near
all-time highs, only rallied 4.2%.
1.4x leverage to gold is very poor, evidence that the HUI was again
vacillating between following the SPX or following
gold.
The SPX’s final and mildest pullback of this
bull so far emerged in November, when it lost just 3.9% in a little over a
week. Gold was pretty weak during
this span, falling 3.7%. Despite
this, the HUI only lost 3.7% as well.
This was definitely an impressive show of strength given the weak
stock markets and gold prices.
But realize such a shallow and short pullback didn’t have enough
time to spark any real fear in the stock markets. And without that necessary fear
infecting PM-stock traders, they held strong.
So far we’ve seen seven material SPX selloffs
in this cyclical bull in which to examine HUI performance. In the first four, the HUI plunged
farther than the SPX and far more than gold. Gold and silver stocks were
exceptionally weak, hammered very hard by bearish general-stock
psychology. And this held true
whether the PM stocks were near post-panic highs or even if they had already
corrected!
In the next two selloffs, the HUI managed to defy
the SPX and climb due to strong gold rallies running concurrent with the SPX
selling. But despite gold’s
big gains and new record highs, these HUI rallies were very weak. Their leverage to gold was pathetic as
PM-stock traders were torn between selling their positions in line with the
SPX selloff or buying more to try to ride the gold
rally. And in that final and
shallowest SPX selloff, even though the HUI didn’t leverage
gold’s downside it was still pretty weak.
Every material selling event in this cyclical bull,
every general-stock pullback and correction, has affected gold-and-silver-stock
performance adversely. The HUI’s downside leverage to
gold during these selloffs has run as high as 7.8x, a scary number. Would you be happy losing 8% in your
gold stocks for every 1% gold fell?
And the very-best performance of the HUI during an SPX selloff when
gold was very strong was unacceptable 1.4x upside leverage. This isn’t enough to compensate
traders for PM stocks’ big
risks.
In light of this precedent, which extends back many
years beyond the couple I’ve highlighted here, why take the risk of
owning short-term PM-stock speculations if the probabilities favor an
imminent general-stock selloff?
For a variety of technical and sentimental reasons, a major SPX correction looms
today. It may have already
started! As a speculator I want
high-probability-for-success trades, and the evidence is crystal-clear that no matter what gold does the PM stocks
don’t fare very well during SPX selloffs.
At Zeal we are trading accordingly. We’ve realized the great
majority of our massive gains from this huge SPX upleg
since September. We’re
mostly in cash, the best way to weather a major SPX selling episode which
will hammer down all commodities stocks like usual. And then when the dust settles as the
SPX selloff matures, we’ll be ready to buy the resulting magnificent
bargains. Why rush to buy high
when a little patience ought to yield high odds of being able to buy low?
We can’t wait to aggressively buy the gold and
silver stocks beaten down by the SPX selloff! We’ve painstakingly spent the
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The bottom line is precious-metals stocks follow the
general stock markets during material selloffs. Even though gold is their primary
driver most of the time, they decouple from this metal and glom on to the
stock markets during pullbacks and corrections. If both the stock markets and gold are
weak, the PM stocks plunge far more than either. And even if gold is strong, PM stocks
are torn and seriously underperform.
The bearish psychology sparked by stock-market
selloffs is so powerful that it permeates all markets, including PM
stocks. I’m not thrilled
with this correlation, but it is well-established hard reality. PM-stock traders have proven over and
over again that they can’t ignore a stock-market selloff even when gold
is strong. So traders really need
to be wary of gold stocks when the stock markets face an imminent selloff.
Adam Hamilton,
CPA
Zealllc.com
So how can you
profit from this information? We publish an acclaimed monthly
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Questions for
Adam? I would be more than happy to address them through my
private consulting business. Please visit www.zealllc.com/adam.htm for
more information.
Thoughts,
comments, or flames? 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!
Copyright 2000
- 2006 Zeal Research (www.ZealLLC.com)
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