 HUI and SPX Correlation
Adam Hamilton
Archives
April 23, 2005
With the flagship HUI unhedged
gold-stock index spending the better part of the last five weeks
plunging from 225 to 180, popular fear is mounting in this realm
and many bearish theories are flourishing.
Since it is ultimately the
bull markets in gold and silver that drive the future profits
and hence stock prices of the companies that mine these precious
metals, I remain very bullish on the HUI. Gold and silver, while
consolidating just like the HUI, remain above their 200-day moving
averages and primary bull-market support lines. Their global
supply/demand fundamentals remain very bullish as well.
If gold and silver continue
to rise in the years ahead, then the profits to be made in mining
them will also rise. The greater the profits of the precious-metals
miners multiply, the lower their valuations
will become. Eventually, when HUI valuations get low enough,
even conventional value investors will pour in to reap the low
P/Es and hefty dividend yields. As go gold and silver, ultimately
so goes the HUI.
With the probabilities apparently
in favor of another great HUI upleg erupting sooner or later
here, I have been trying to combat the usual crop of bearish
theories that grow like weeds during any consolidation. Last
week I discussed gold
futures and the week before that gold-stock
sentiment and technicals. My goal with these essays is to
expose bearish myths so prudent contrarians are not misled by
today's irrationally pessimistic sentiment.
This week I would like to take
a look at yet another fear factor weighing heavily on contrarian
hearts. It involves the correlation between the HUI and the
general US stock markets.
As has become more evident
in the past six weeks or so, the general stock markets are deteriorating.
Based on their extremely high valuations
and almost total lack of any sense of fear,
the ongoing general market weakness is no surprise at all. Valuation
mean reversions tend to run for 17
years or so and we are only about 5 years into this one so
far. Eventually the piper is always paid for speculative excess.
While this Long
Valuation Wave winter is inevitable and will fully run its
course, contrarians have no problem planning around it and thriving
in the midst of it. Great commodities
bulls tend to soar when stock valuations are mean reverting,
so capital can be diverted from bearish general stocks into various
commodities-related investment and speculation vehicles.
This is all well and good,
but what if commodities-producing stocks are sucked into the
black hole of deteriorating general markets? What if stock-market
fear spreads to commodities stocks like a virulent plague? Could
precious-metals stocks become collateral damage in a general
market selloff?
As all serious students of
the markets know, the answer to a "could" question
is always yes. Anything can happen at any time. There is never
certainty that a particular course of action will or will not
come to pass. As such, we must deal in probabilities. Ultimately
the markets are nothing but the greatest probabilities game on
the planet. The right question to ask is not "could it
happen", but instead "is it likely to happen".
In order to investigate this
alarming thesis, I examined the HUI bull market to date relative
to the S&P 500 (SPX), the best major proxy for the US stock
markets as a whole. The behavior of the HUI relative to the
S&P 500 over the past four to five years should give us an
idea of how closely related the HUI is to the general markets.
While past correlation or lack thereof is no guarantee of uniform
behavior extrapolating into the future, it does give us a basic
understanding of the probabilities involved.
The tools used in this analysis
are simple. The HUI has had 5 major uplegs and 5 major corrections/consolidations
bull to date. Using daily data we ran correlation analyses on
the HUI versus the S&P 500 in all 10 of these major intermediate
moves in the HUI. The results are quite interesting and generally
do not support the bearish thesis that stock-market downlegs
are dangerous for PM stocks.
In these charts the vertical
blue lines divide up the 10 major HUI moves. During each of
these 10 HUI uplegs or corrections, the blue number notes the
absolute percentage gain or loss in the HUI while the red number
highlights the S&P 500's performance over the same slice
of time. The yellow numbers reveal the individual correlation
coefficients for each major HUI move.
Interestingly both major HUI
uplegs and corrections can happen during both major S&P 500
bear-market rallies and downlegs. The general stock markets
don't appear to have too big of influence at all on the HUI bull
to date. It is ultimately the prices of gold and silver that
drive the HUI, not prosperity or carnage in totally unrelated
general stocks.
There is a lot going on this
chart, so it is probably best to start with the big strategic
picture and then zoom in to the tactical details. The HUI bottomed
in November 2000 and has been powering higher in a secular bull
market ever since. This HUI bull, like all bulls, consists of
a series of powerful uplegs (numbered 1-5) punctuated by necessary
and healthy bull-market corrections to bleed off short-term excesses
of euphoria.
The S&P 500, meanwhile,
carved a more complex macro pattern. After topping in March
2000 after a spectacular bull market born way back in 1982, this
flagship index fell sharply over the subsequent three years.
This secular bear period was marked by vicious downlegs punctuated
by periodic bear-market rallies to keep fear from ballooning
to astronomical levels.
Then stocks carved a triple
bottom near 800 in July 2002, October 2002, and March 2003.
In March 2003 the spectacular war rally erupted over the exuberance
ignited when Washington's invasion of Iraq went from a nagging
uncertainty to a fait accompli. Since then the stock markets
have been in a cyclical
bull market, although momentum is rapidly fading with the
S&P 500 still trading today where it was in early 2004.
So we are running correlation
analysis of a secular HUI bull market versus a secular S&P
500 bear that gave way to a cyclical bull. If you are not familiar
with these terms, secular generally means a primary trend running
for three years or more. Cyclical means a primary trend running
for more than one year but less than three years. Naturally
the HUI bull should have higher correlations with the recent
bullish stock-market years than the preceding wickedly bearish
ones.
Since 2000, the whole enchilada,
the HUI and S&P 500 have run a weak negative correlation
of -0.44. This means there is a tendency, although not particularly
strong, for gold stocks to be up over time when the general stock
markets are down. This big picture view alone definitely refutes
the bearish notion gaining currency today suggesting that HUI
stocks are going to get sucked down along with the general markets.
As far as individual major-HUI-move
correlations, they are all over the map. As you can see above
they ran from -0.72, a fairly moderate negative correlation,
to 0.88, a strong positive correlation. Interestingly if you
average the individual major-HUI-move correlations, all the yellow
numbers above, the result is an amazing 0.05. This means that,
on average, major HUI uplegs and corrections have no correlation
whatsoever with the general stock markets.
A correlation of 1.00 means
that the HUI would always move in lockstep with the general stocks,
rising when they rise and falling when they fall. A -1.00 reading
indicates that the HUI would always move in perfect opposition
with the general stocks, rising when they fall and falling when
they rise. But a reading of 0.00, of course, indicates no correlation
at all. Regardless of general-stock action, the HUI is equally
likely to be up or down or flat. Averaging all the major move
correlations showed this to indeed be the case.
Another thing to consider when
pondering correlations is the r-square value. When a correlation
coefficient is multiplied by itself, the r-square is the result.
It explains how predictable one set of data is likely to be
given the changes in the other set. A rudimentary understanding
of this additional step to correlation analysis is necessary
to comprehend just how weak these HUI/SPX correlation numbers
really are.
If the HUI and SPX were perfectly
correlated, they would have a correlation of 1.00 and an r-square
of 100%. But as the actual correlation drops, the r-square falls
exponentially. In market analysis I consider a 0.90 correlation
to be very strong, yielding an r-square of 81%. This suggests
that 81% of the price variability in one stock, index, or commodity
can be explained by the variation in the other. Such high levels
can be quite useful for timing trading.
But if the correlation merely
falls to 0.80, the r-square plunges to 64%, a moderate relationship.
0.70 yields 49%, 0.60 yields 36%, and 0.50 yields a paltry 25%.
So once correlations fall under 0.80 or so, there is probably
no readily definable tradable interrelationship. At 0.70 or
less, or 49% r-square, you may as well just flip a coin to decide
if price A is likely to predict price B at any given moment in
time or not. Below 0.70 in the markets, with scarce capital
on the line, is seldom worth getting excited about.
Using this 0.70 correlation
threshold, 8 of the 10 major HUI moves above had no level of
useful correlation with the S&P 500. Neither did the entire
dataset from 2000 nor the average of all 10 major moves. Of
the 2 exceptions to this rule that did show individual major-move
correlations above 0.70, together they illustrate that the HUI
can do whatever it wants regardless of general stock market pressure.
Back in early 2002, the HUI
rallied a massive 145% in its single greatest upleg to date.
During this very short period of time, just a couple quarters,
the S&P 500 fell an ugly 9% in the initial third or so of
its steepest bear-to-date downleg. This peculiar period of time
had the strongest negative correlation of all, -0.72. Yet still
the r-square was only 52%, there were only even odds that the
HUI action would be predictable by the SPX action. Even when
stocks started freefalling, the HUI remained strong.
A year later in 2003, the HUI
rallied again, up 125% in its second largest upleg to date.
But during this time the general markets soared by 23% over the
resolution of the Iraq invasion uncertainty. This resulted in
the strongest correlation witnessed so far, a high 0.88 between
the HUI and SPX. This yields a high r-square of 77%, indicating
that 77% of the daily moves in the HUI were predictable by the
general markets. This parallel rally ran about 3 quarters in
duration.
Thus, out of about 18 quarters
in the HUI's bull to date, there have been just 3 where the gold
stocks and general stocks have had a high positive correlation.
2 more of those quarters witnessed a fairly moderate negative
correlation. This leaves 13 of 18 quarters where the correlation
between the HUI and S&P 500 was so low that it had no trading
significance. General-market action, bullish or bearish, is
generally not a useful predictor of HUI fortunes over any given
intermediate-term time horizon.
And while we are considering
the two greatest HUI uplegs in this bull to date, 2 and 4 above,
it is fascinating to note that they occurred in very different
general-market seasons. The massive HUI upleg 2 erupted when
the SPX was topping and then gradually starting to fall into
a parabolic vertical tailspin into its worst downleg. But upleg
4 blasted higher when stocks were rising in their biggest rally
since 2000. The HUI is demonstrably capable of strong uplegs
in both bull and bear general-market conditions!
Before we delve into our final
chart, there is one more point of interest here. It deals directly
with today's theory that any steep stock-market selloff is likely
to hammer the HUI stocks inflicting heavy collateral damage on
contrarians. The bull-to-date record really doesn't support
this assertion to any material degree. Sharp general-market
selloffs can happen without hammering the HUI and the HUI can
also plunge just fine on its own accord without the stock markets
encouraging it.
Starting way back in 2001,
the two wickedly ugly V-bounces in the S&P 500 that year
didn't seem to affect the HUI to any significant degree. The
HUI just continued climbing higher when it was in an upleg and
grinding sideways when it was consolidating, oblivious to the
general-market fires burning around it.
In 2002, the HUI held near
bull-to-date highs for all but the very last weeks of the SPX's
devastating freefall. But this damage wasn't particularly bad,
as the HUI was due for a correction at the time anyway and merely
fell to a higher interim low at its crucial 200-day moving average
support line. The HUI showed some moderate weakness near the
second V-bounce of late 2002 and the final one of early 2003,
but the actual correlation numbers are so low as to be useless.
Meanwhile in spring 2004, the
HUI entered a vicious freefall of its own, slicing through its
key 200dma like a bullet through cardboard. The wailing and
gnashing of teeth in precious-metals land a year ago was extraordinary
as folks fled for the hills in terror. Note, however, that the
general markets barely moved at all while the bottom temporarily
fell out of the HUI.
So bull to date we have had
about a half-dozen fear-driven major V-bounces in the general
stock markets but perhaps only one, and that is debatable, managed
to taint HUI sentiment in the summer of 2002. Meanwhile the
HUI was perfectly capable of plunging by itself regardless of
stock-market action last spring. This supports my assertions
that it is not general stocks that drive the HUI, but the prices
of gold and silver.
Our final chart zooms in on
just the recent cyclical bull years in the general stock markets.
While we should expect higher correlations between a secular-bull
HUI and a cyclical-bull SPX than during the SPX's secular bear,
the results are still unimpressive. Regardless of popular fears,
in general the HUI is just not correlated with the stock markets
to any significant degree.
Now over this entire time frame
the HUI/SPX correlation ran 0.81, seemingly high. Yet, with
both the HUI and S&P 500 in bull-market mode, we should really
expect strategic correlations to be decent. But once again if
we delve into the tactical realm where trades are actually made,
the individual major-move correlations, with one exception, remain
very weak.
The HUI upleg 4, running at
0.88, was the only high-correlation major move during the parallel
HUI and SPX bulls of recent years. It alone is probably responsible
for most of the HUI/SPX correlation since 2003. If we actually
average the correlations shown above for all five major HUI moves,
the result is a paltry 0.28. Taken to the r-square level, this
means, on average, that only 8% of the HUI's daily action during
this period could be explainable by the S&P 500.
After this one spectacular
upleg, the relationship broke down considerably. In early 2004
the HUI was grinding lower while the S&P 500 was still reaching
a new interim high. By spring last year the HUI was plummeting
like a meteor while the general markets continued grinding blissfully
sideways in their low-volatility no-fear consolidation. After
this sharp HUI correction though, it entered its fifth major
upleg, almost all of which happened while the general markets
continued grinding lower until the US presidential elections.
Since then the SPX has hit
three subsequent cyclical-bull-to-date highs in late 2004 and
early 2005 while the HUI entered a very pronounced downtrend.
Even over periods of time when both the HUI and stock markets
are rising in bull markets, they are just not that correlated.
It isn't the general markets that drive the HUI, but the underlying
bull markets in gold and silver.
Regardless of popular perceptions
today and bearish fears spawned by the HUI weakness, the reality
of the hard data is that the HUI and general stock markets are
really not correlated at all. There may be rare exceptions when
a correlation does arise, but in the vast lion's share of the
time the HUI seems to move completely independently of the stock
markets.
In light of this analysis,
I would assign a low probability to the HUI getting sucked into
a major general-stock selloff. Sure, it could happen, just like
the NASDAQ could jump to 4000 tomorrow if enough capital bid
on it, but it probably won't. And investing and speculating
is all about betting on high-probability outcomes, not fretting
about low-probability threats.
And if a stock-market selloff
does spark a HUI selloff, then the only ones contrarians will
have to blame is ourselves. Over the short-term it is psychology
and sentiment that drives markets, and if HUI players allow themselves
to be spooked by a general-market selloff they may start selling
anyway regardless of what history shows. But if we as a contrarian
herd heed history and ignore a stock selloff, odds are the HUI
will weather it beautifully.
At Zeal we have been ignoring
the irrational pessimism surrounding the HUI lately and have
been layering in elite gold and silver stocks in the past months,
both majors and juniors. It is these very times when investors
are scared that have been the greatest moments to buy historically.
Please subscribe
to our acclaimed Zeal
Intelligence monthly newsletter today to see what stocks
we are buying, when we are buying them, and why.
The bottom line is the hard
correlations between the HUI and general stock markets in this
bull to date are very low, mathematically uncorrelated for the
most part. The HUI can rise or fall anytime the gold and silver
prices drive it to, regardless if the general stock markets happen
to be rising, falling, or grinding sideways.
Personally I am not concerned
about a stock selloff igniting a dire HUI plunge. Sure, it could
happen, but it probably won't.
Adam Hamilton, CPA
April 22, 2005
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!
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