HUI Irrational
Pessimism
Adam Hamilton
Archives
Jun 15, 2007
In a December 1996 speech,
former Federal Reserve Chairman Alan Greenspan uttered one of
the most famous catch phrases in modern market history. Buried
deep in a typically Greenspanian sentence of great length and
grammatical complexity, the words "irrational exuberance"
cut through his usual obfuscation to rise to immortality.
Greenspan was trying to gently
communicate that the US stock markets might be getting
a little frothy at the time, so when world stock markets slumped
right after his speech the financial media looked to Greenspan's
cryptic warning with awe. The notion of irrational exuberance
was widely discussed and grew into something of a slogan for
the great stock bull of the late 1990s.
But much like the yin and yang
of ancient Chinese philosophy, the financial markets are a showcase
of dualism. The markets are a battlefield witnessing an endless
war waged between greed and fear. Neither driving emotion can
dominate at extremes for long, as the markets are inherently
self-balancing. With this dualistic nature, if there is irrational
exuberance on the greed side then there has to be a corresponding
irrational pessimism on the fear side.
Such irrational pessimism has
manifested itself today in gold stocks. Dark sentiment in this
tiny sector is like a photographic negative of the euphoric sentiment
in the tech sector in early 2000. In today's depressed gold-stock
world, all news is bad news. Traders cower in fear waiting for
the other shoe to drop. This is the yin (literally "shady
place") to Greenspan's yang (literally "sunny place").
I don't think any gold-stock
investor or speculator can deny that sentiment is pretty darned
pessimistic today. Despite high gold prices in historical context,
a surprising number of gold stocks are trading near multi-year
lows. And the information flow regarding gold and its
miners is overwhelmingly negative. Countless theories articulating
why gold stocks are certainly doomed vie for traders' attention.
While there is little doubt
the gold stocks, and their flagship HUI index, are bathed in
black fear today, whether it is rational or not is debatable.
Fear when a market is highly likely to plunge lower is totally
rational. But due to human nature fear tends to peak when things
look the worst, near major interim bottoms. And of course harboring
fear when prices are highly likely to rise is totally irrational.
I am definitely on the irrational
side of this debate today. After actively trading gold stocks
for their entire bull market which started way back in November
2000, I have seen plenty of dark times in this bull. Sometimes
technicals justify fear, like when a sector just starts to crash
but hasn't bottomed yet. But today's fears seem totally irrational
and unjustified. This essay will explore why this is the case.
The most critical core fundamental
element for a gold-stock bull is a rising gold price. The higher
the gold price rises, the more profitable it becomes to mine
gold. And for any stock, the greater its profits grow the higher
its stock price will ultimately rise. Over the long term, operating
profits are what drive stock prices. Everything else is fleeting
noise. So for gold stocks, gold alone holds the key to their
future secular performance.
With HUI sentiment so pessimistic
today, one could make the assumption that gold must really
be beaten down. A plunging gold price would render the gold-stock
antipathy and depression logical. If gold was falling, then the
profits for mining it would look less attractive in the future
and gold stocks would be sold off to reflect this new reality.
Curiously though, this certainly isn't the case today.
It is true, gold has shown
some weakness over the last couple weeks and indeed the last
couple months. This has been a major contributor to the HUI pessimism.
The tyranny of the present is strong in the markets, as traders
collectively have very short-term memories. They tend to subconsciously
extrapolate what has happened in the last few days out into infinity.
Yet this natural human tendency is myopic and flawed.
Even if we just zoom out a
little as this chart does, the strategic context framing gold's
recent weakness becomes much clearer. Perspective is everything.
Gold has actually been rising in a beautiful uptrend since early
October. It has carved a series of higher lows and higher highs
since, and they have been consistent enough to form solid support
and resistance lines. Gold's on-balance strength is dragging
its 200-day moving average higher too, an arrow which runs parallel
with a price's primary trend. In gold's case this is up.
All these technicals, when
considered together, only allow a single conclusion. Gold is
in a full-blown upleg! Since its latest major interim lows in
October, it has already risen 23% at best in April and was still
up 15% even at its lows this past week. Over these same periods
of time respectively, the flagship S&P 500 stock index was
only up 9% and 12%. Thus gold has handily beaten even the benchmark
stock-market performance!
Is this bearish? Is gold outperforming
a widely-respected stock-market rally a bad thing? You'd certainly
think so when listening to gold-stock traders lament gold's performance
of late. Yet all the Ancient Metal of Kings has done is make
an orderly retreat within its uptrend from upper resistance
to lower support over the last couple months. This is totally
normal behavior as all uplegs flow and ebb, taking two steps
forward then one step back to rebalance sentiment.
Since the gold price is the
final result of all buying and selling on the planet, regardless
of motivation or source, a strong technical uptrend alone is
more than enough evidence for me to believe that gold is thriving.
With gold climbing higher on balance, why worry? Yet gold-stock
traders still remain very scared. Fundamental factors that act
as headwinds to gold's progress are being blown way out of proportion
in popular discourse, fanning fears.
I drew some of these headwind
factors on this chart to illustrate their timing. The red lines
under each show the precise period of time over which each was
active. Since October, the European Central Bank has sold 60
tonnes of gold. Between March and May, all known central bank
gold sales exceeded 170 tonnes! Other researchers who follow
these sales closely are saying this is a record-high 3-month-sales
tally for this gold bull. Now with all these CB sales gold must
have plummeted, right? Nope, it rose on balance.
Back in 2000 and 2001 when
gold threatened to fall under $250, I understood why central
banks were feared. Around a quarter of the world's above-ground
gold was held in their vaults so they collectively wielded tremendous
power. They could sell at anytime and theoretically cap the gold
price. The ongoing threat of CB sales was the most-feared fundamental
attribute of the gold market for years.
But today it is a whole different
ball game. Despite heavy central-bank gold selling since 1999,
the gold price has soared 181% higher at best in dollar terms.
If gold was still able to nearly triple under an onslaught
of intense CB selling between 2001 and 2006, then world investment
demand easily digested all the gold the CBs wanted to offer for
sale. It has always been thus during bull markets. Awakening
investment demand always trumps CB selling. Collectively
investors control vastly more capital than CBs.
And every tonne of gold the
CBs sell weakens their collective "market share", or
the proportion of world gold they hold. If the CBs' own numbers
are to be believed, today their share of gold has fallen to well
less than a fifth of global above-ground gold. And if GATA's
assertions that CBs really have far less gold than they are reporting
prove true, then total CB market share is probably closer to
a tenth. Either way, the era of CB dominance of gold prices
is over. Investors collectively run the gold show today.
The more gold the central banks
sell today the less they have left to sell in the future which
reduces their potential ability to adversely impact the gold
market. Last year the total gold held by central banks and other
government organizations fell to its lowest level since 1948!
And the last several months really illustrate CBs' growing impotence.
Despite heavy CB gold sales, a record 3-month period, gold climbed
for the first two months and is still higher today than when
these sales started. Is this bearish?
Gold also faced other headwind
factors in recent months. The mammoth flagship American gold
exchange-traded fund, GLD, dumped 37 tonnes in just six weeks!
ETFs are forced
to sell when investors sell their ETF shares at a faster
pace than the ETF's underlying assets are falling. This keeps
the ETF tracking its underlying price and prevents discounts
from growing extreme. These forced GLD ETF sales reflect today's
poor sentiment. Stock traders were freaking out and selling GLD
faster than gold was falling.
As if this is not enough headwind
pressure, the US Dollar Index has rallied about 2% over the last
six weeks or so. While the era
of dollar dominance of the gold price is over, many traders
still hold to the old paradigm and look to sell gold when the
dollar strengthens. Together the amount of pressure these four
factors alone put on gold is considerable, 207+ tonnes of gold
hitting the markets in the last few months while the dollar surged.
Yet did gold crumble and crash like gold-stock traders expected?
Not so you'd notice.
And this is certainly not even
close to being an exhaustive list of factors weighing on gold
lately. Yet despite all of this, gold is still powering higher
on balance within its newest uptrend channel. This is really
a tremendously bullish omen. If global gold investment
demand is so high, and mined supply is so pinched, that gold
prices can still rise despite strong headwinds then imagine how
gold will soar once these headwinds inevitably fade. After all,
CBs' gold hoards are finite and dwindling rapidly.
Instead of gold-stock investors
trembling in fear, I think we should be celebrating the fact
that gold is near $650 today. Even two summers ago, when
gold languished near $425, today's levels seemed impossibly high
and optimistic. Yet today, in this Twilight-Zone-like sentiment
wasteland, $650 is curiously seen as a negative. Boy let me tell
you, after suffering through sub-$300 gold in the early years,
as a long-term investor I feel like the luckiest guy alive to
see the physical gold I own at such awesome levels. It confounds
me that most of my peers don't hold $650 in awe too.
With gold performing so well
in a beautiful textbook uptrend despite heavy CB selling, the
pessimism permeating the HUI looks increasingly irrational. Over
the long term, profits drive stock prices. For gold stocks, gold
prices drive their profits. So higher gold prices lead to higher
gold-stock profits which lead to higher gold-stock prices. This
logic is simple, proven throughout history, and unassailable.
Yet gold-stock traders generally
don't believe this today. They've forgotten that gold
drives gold-stock fortunes. They've sold and sold, their collective
fears dragging the HUI down into a kind of limp consolidation
sideways. They've even ignored the fundamentals. $650 gold is
already working wonders on gold-stock profitability and driving
their valuations down. The cheaper gold stocks become relative
to their earnings, the more desirable they become as investments
and speculations.
In this next chart, the gold
price is rendered in red underneath the HUI in blue. Note how
tightly the HUI clings to the gold price on a daily basis. Even
with sentiment clouded in this emotional haze of fear, gold still
runs the show. I particularly point this out for those of you
who fear that gold stocks are just another highly-correlated
sector to the general stock markets rather than a classic
alternative investment.
In addition to the HUI's technicals,
I drew in its monthly market-capitalization-weighted-average
price-to-earnings ratios so far this year. While the HUI certainly
isn't cheap yet in an absolute fundamental sense, it is now the
cheapest it has been in this bull by far. It is ironic that a
year ago when everyone was scrambling to buy gold stocks they
were trading
at valuations nearly three times higher than today's. Yet
today they languish unwanted.
In fact, every single month
of this year the HUI has been fundamentally cheaper than the
NASDAQ 100! While the flagship tech-stock index has been trading
between 31x to 35x earnings, the HUI has been running between
24x and 29x! $650 gold, a level sadly taken for granted by today's
irrational HUI pessimists, has already proven very profitable
for gold miners. It amazes me that gold stocks are held in contempt
at their lowest valuations, and hence best fundamental
buy points, of this entire bull.
Now as you drink in this HUI
chart, look at the blue gold stocks relative to the red gold
line underneath. Early on in this new gold upleg, gold stocks
responded well. But increasingly in recent months, despite gold's
relatively strong performance, gold-stock traders have grown
ever more discouraged. The HUI is climbing on balance, but only
modestly. It is carving marginally higher lows and marginally
higher highs while it tries to grind higher in the face of the
overwhelming irrational pessimism.
The HUI has been so unloved
in recent weeks that it is back at its tactical support line
and even under its 200-day moving average. The highest-probability-for-success
time in technical terms to buy any stock in a long-term secular
bull is when it periodically
retreats back under its 200dma. Yet in an environment like
today where all news is interpreted as bad news and bulls are
going extinct, few care anymore.
With gold rising and gold stocks
looking just fine technically and fundamentally, clearly the
HUI's problem is sentiment. Across all financial markets, there
are a couple really critical attributes of sentiment that must
be understood. First, it is price action that drives sentiment
and never the other way around. Second, sentiment extremes can
never persist. Both of these truths have huge implications for
the gold stocks.
Remember back in early 2000
when the New Era was upon us? All news was good news. Companies
could do no wrong, investors wanted more of everything, and the
mania was in full swing. The same thing is happening today in
the Chinese stock markets. In both cases because prices were
rising fast and people were excited, they selectively ignored
any potentially bad news and instead trumpeted and reinforced
any good news. Prevailing price action drives theories to rationalize
why it is occurring and why it must continue.
The opposite is the case in
the HUI today. All news is bad news. Companies can do no right,
investors are fed up after the HUI has effectively consolidated
since May 2006, and pessimism reigns. Gold-stock traders, seeing
price action they are not happy with, are naturally gravitating
to bearish theories that rationalize it. They are following the
natural human instinct to extrapolate the present out into the
infinite future, so they want reasons to explain why the HUI
is doomed and why they were right to sell out.
I have traded through every
single bottom of this gold-stock bull and have seen this all
before. The only time bearish theories ever gain traction in
a bull market is when prices are beat up and traders have reason
to seek bearish rationalization. The particular bearish theories
in vogue change and evolve from bottom to bottom, but the ugly
sentiment stays the same.
This time is a little stranger
than most though, as technically and fundamentally gold and the
HUI are doing just fine yet sentiment is still incredibly negative.
Believe it or not, I am even seeing evidence of capitulation.
I am having people write to me who have been trading gold and
silver stocks for years who are flat-out giving up and surrendering.
Capitulation is rare and it only happens at the most dark and
ugly interim bottoms. It is a great sign that prices can't go
much lower when even long-time advocates abandon the sector.
While I could devote entire
separate essays to exploring each of the leading bearish theories
on the HUI today, the key point to realize is that these theories
are only popular because prices aren't high. Back in May
2006 at the latest highs, bears were extremely rare, bearish
theories ridiculed, and bullish theories dominated discourse.
Once prices inevitably start recovering, today's seemingly urgent
bearish news will rapidly be forgotten too.
And since the markets perpetually
oscillate between greed and fear in their endless sentiment wars,
the only sure bet to make is that excessive fear won't last forever.
Just as irrational exuberance is an extreme and anomalous state
without staying power, so is irrational pessimism. So when no
one wants to buy gold stocks, when everyone thinks they are doomed,
when you don't feel like buying, this is the time to buy.
The hardcore contrarians who'll buy when blood flows in the streets
inevitably reap the biggest profits.
With gold
fundamentals strong as evidenced by the market's ability
to easily absorb record central-bank gold sales and still climb,
gold's secular bull is very much alive and well. As gold prices
climb higher, gold mining will become more profitable. As profits
rise, gold stocks will be bid higher. Thus there is good fundamental
reason why today's irrational pessimism cannot and will not persist.
Eventually fear gets so deep
that no more sellers are left. All the weak hands with fragile
levels of conviction are shaken out of a market and only the
long-term fundamental believers remain. With no one left to sell
at fear-laden troughs, prices can only go higher. Once this happens,
all the scary bearish theories today will quickly be forgotten
just like their ancestors were soon after past bottoms.
At Zeal we always strive to
view the markets rationally. Since there are no major fundamental
or technical reasons to fear gold and gold stocks, we have been
buying the latter, as well as silver stocks, aggressively lately.
Irrational pessimism and the wild fear that drives it offer rare
opportunities to back up the truck and load up on great stocks
at fire-sale prices. Subscribe today to our monthly
or weekly letters
if you have the contrarian fortitude to buy when others are afraid.
Odds are prices will soar once this fear storm passes.
The bottom line is gold looks
fine technically and fundamentally. It continues to climb higher
on balance despite record central-bank gold sales. And gold prices
are the primary driver of gold stocks, not the general stock
markets. With gold really faring pretty well it makes no sense
for traders to fear the gold stocks. Thus the incredibly negative
sentiment gripping gold stocks today has to be irrational since
it has no basis in gold.
The key thing about irrational
pessimism, excessive levels of fear, is that it can never persist.
The markets truly abhor extremes and are naturally self-balancing.
Just when things look the worst and fear is reaching a fever
pitch, a major rally comes along and prices rocket higher and
obliterate the fear. All financial markets work this way and
the HUI will not be an exception.
Adam Hamilton, CPA
June 15, 2007
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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