Gaming HUI Corrections 2

Adam Hamilton
Archives
Sep 23, 2006

September has been a brutal month for commodities investors. While the oil and natural gas routs have garnered most of the financial media attention, the bloodshed is much more widespread. Since September 5th gold has fallen 9.6% which has spawned a sympathetic 20.5% plunge in the HUI gold-stock index.

A freefall approaching 21% in only 11 trading days would drive phenomenal pain in any index, but the psychological damage just wrought in the HUI has been exceptional. After all, on the very eve of this carnage-laden plunge the HUI surged to 365, its highest level since its latest May interim top. But just two weeks after this bright ray of hope, this flagship gold-stock index is suddenly wallowing in the mud near 290. Riches to rags.

Many gold-stock investors who eagerly watched the HUI carve a series of sequentially higher lows in recent months are now walking around like the living dead, shell-shocked and devastated. Sentiment has fallen off a cliff to new lows. For the first time in over a year, this past week I started receiving e-mails wondering if the gold bull is over. How could a sector execute such a sudden turn-one-eight after trending higher for months?

I believe the answer to this question is simple, the HUI's correction from its stellar May top is still ongoing. A lot of gold-stock traders chose to believe that the blistering 31% decline over 23 trading days from May 10th to June 13th was the entire correction. They believed a new upleg in the HUI began in mid-June so they stopped worrying about lower HUI levels. For a variety of reasons though, this rosy thesis was problematic.

The sole purpose of corrections is to rebalance sentiment within an ongoing bull market. They exist to eradicate the greed that becomes ubiquitous and smothering near major interim tops like the one we saw in the HUI in May. Even at its deep June lows, since that plunge happened so fast no really negative sentiment had time to gain a foothold and blossom. The HUI then started rallying again so fast in mid-June that there was not enough time for fear and apathy to roll in like a fog and taint traders' gold-stock perceptions.

The one non-negotiable prerequisite for a major interim bottom to be carved is for traders to be paralyzed with fear, doubt, apathy, and even loathing for a suddenly out-of-favor sector. A great illustration is oil stocks today, suddenly investors would seemingly rather hold plague-bearing rats than oil stocks. Such depths of despair never wrapped their icy black fingers around the heart of the HUI since May, even during the June lows. Until 300 failed over this past week, fear remained conspicuous in its absence in the HUI correction.

Now it is easy today to claim that the HUI correction never ended this summer despite overwhelming enthusiasm to the contrary. It was infinitely harder to make this claim in recent months as the HUI climbed from June's 274 lows to early September's 365 highs. While this promising 33.5% run ultimately proved to be merely a suckers' rally, many if not most gold-stock investors believed it was a new upleg. It was horrendously unpopular to be neutral on the HUI, claiming it was still correcting, during this particular rally.

Yet at Zeal we steadfastly held to the correction thesis because that is what the technicals were telling us. In early August as the HUI challenged 350 I wrote the following in the August Zeal Intelligence, which explained in depth why probabilities overwhelmingly favored the HUI's correction not being over yet

"Since I bought in too early initially in each of the last two major HUI corrections, I'm not taking the potential trickiness of this one lightly. Corrections are tricky by design, full of surprises that are designed to seduce in the unscarred and obliterate their scarce capital. I'm only neutral on the HUI now because I bear so many scars, and losses, from past HUI corrections and I have not forgotten what cunning adversaries they are. Take this seriously!"

Even back on June 23rd when the HUI had already bounced sharply higher by 13.9% off of its lows of less than two weeks earlier, it was apparent the HUI correction was almost certainly not mature enough to already be over. In the original "Gaming HUI Corrections" essay back then I wrote

"Since the HUI fell so hard so fast this time around, thankfully the vast majority of its correction in percentage terms is probably behind us. Yet in the time-duration terms crucial to rebalance sentiment, it remains very young. I suspect the odds favor it meandering generally sideways to lower in a consolidation in the coming months. Upside potential is low but downside risk isn't extreme either since multiple technical approaches point to a 255ish probable bottom."

I offer up my earlier analyses to prove that there were actually contrarian students of the markets out there who have been warning continuously since June that the odds were very high that the HUI correction was not yet over. As detailed in our Zeal essays, newsletters, and alerts published since then, the HUI technicals never looked right for a major interim bottom since the May highs. Major bottoms have specific technical signatures which we simply had not witnessed yet this time around.

But today, thanks to the sharp HUI plunge in September, things are finally looking up. Rather than traders seeing dollar signs when they think of gold stocks, now they are getting scared. They are questioning the entire premise of this bull, they are extrapolating the recent downtrend to much lower lows than we've just seen, and they are getting scared. In the movie Wall Street, Gordon Gekko was wrong, it is fear that is good, not greed. It is fear that marks the very best buying opportunities in any ongoing secular bull market.

The primary reason I held fast to the notion that the HUI's latest correction did not end in June despite the summer strength in the index was its bull-to-date precedent. Over time bull markets tend to establish rhythms. Greed drives major uplegs to dazzling new highs, but by the time those highs are reached sentiment is way out of balance. So corrections subsequently ensue to bleed off the greed and restore balance. Once the sentiment pendulum swings the other way and fear takes the place of greed at major interim lows, the way is clear for the next major upleg to start powering higher.

This latest update of the HUI bull-to-date rhythm chart illustrates how this sentiment mechanic has unfolded in the HUI since its enormous 996% bull market was born almost six years ago. I believe this is one of the single most important charts for gold-stock investors and speculators to internalize. It does wonders in setting realistic expectations about probable HUI behavior in both major uplegs and corrections to come.

So far in its amazing bull market, the HUI has had six major uplegs and six major corrections. In secular bull markets both of these primary phases of market activity are equally important. The periodic single steps back in corrections are absolutely and completely necessary in order for the next double steps forward to occur in uplegs. No bull market ever rises in a straight line and neither does the HUI. To expect anything less than periodic corrections is totally irrational and will lead to losses.

The HUI's six major uplegs so far have yielded an average absolute gain of 104% each over 156 trading days! To the best of my knowledge no other sector has even come close to seeing such recurring 100%+ gains over the past six years. These breathtaking upleg gains illustrate why the gold stocks remain the most popular commodities-stock sector among investors and speculators. Gold stocks have really walked the walk.

While everyone loves to wax ecstatic about the magnificent gains with which we have been blessed in the HUI uplegs, few like to talk about the other side of the coin. Major corrections have happened after every single major HUI upleg without exception. Corrections after uplegs are as inevitable as night following day. But just as night never lingers eternal, neither do corrections. The five major HUI corrections before our current one have averaged 30% absolute losses each over 88 trading days.

It was this particular metric that made me wary in June when I wrote my original essay in this series. HUI upleg 6, which just ended in May, was the second largest witnessed in this entire bull market. After big uplegs usually come big corrections, there tends to be some symmetry between greed and fear in a particular upleg/correction cycle. The only other uplegs comparable to 6 in magnitude were 2 and 4. I consider all three of these to be "massive" uplegs.

It is intriguing that the HUI uplegs have carved a binary pattern since 2001. There will be a massive upleg, with gains between 125% to 145%, followed by a particularly ugly correction. This massive upleg will drive the HUI way up into new territory to radical new bull-to-date highs. But after these dazzling new highs are achieved, traders aren't quite comfortable with them yet. In the next uplegs after massive uplegs, the HUI usually fails around the previous massive upleg's top. I call these in-between uplegs "consolidation" uplegs.

Although market patterns can always change at any time, over the past five years the HUI's uplegs have run in a massive-consolidation pattern. Uplegs 2, 4, and 6 were massive uplegs while uplegs 3 and 5 were consolidation uplegs with gains less than half of the massives' gains. Back in June I realized that the corrections following massive uplegs 2 and 4 averaged 35% losses. This made me wary of correction 6's relative lack of progress at that time.

From May to June, the HUI fell 31% in 23 trading days in major correction 6. But after the second biggest upleg of this entire bull market, 31% seemed a bit light compared to the 35% average after the first two massive uplegs. While this was somewhat problematic, I could live with it and even concede that in depth terms correction 6 had pretty much hit expectations. After all, the average loss in all five major corrections before it was 30%.

But the far more troublesome component was correction 6's trivial duration at the time. Major corrections exist to destroy greed and they do so over two dimensions, depth and duration. The most effective corrections attack greed simultaneously on both fronts, falling substantially to eviscerate enthusiasm and then grinding sideways to new lows over many months to utterly destroy hope among the deployed and create apathy among the undeployed. Correction 6 had no duration element, it had only lasted for 23 short trading days.

How short is 23 days relative to the HUI's bull-to-date precedent? Ridiculously short! The average duration of the first five major corrections was 88 trading days. Back in June the HUI's correction was only about one-quarter of the way to the point in time where its correction was expected to mature to in duration terms. Correction 2's 36% decline over 37 trading days made the young correction 6 look even more suspect. Even though it occurred after the biggest and most powerful upleg of this bull it still took 60% longer than the young correction 6.

With correction 6 back in June failing to even remotely parallel the HUI's bull-to-date correction precedent, the only technical conclusion to reach was that it was almost certainly not yet over despite the sharp rally. This unpopular view was bolstered by the fact that it was so detested, that virtually everyone wanted to believe that a new HUI upleg had erupted in June. There was no fear. At real fear-laden bottoms traders get so beaten down that they cease to even look for a bottom. But back in June it was universally believed to be the bottom.

If correction 6 was to at least make a semblance of following its predecessors, then the only prudent course of action to take back in June was to be neutral on the HUI and expect a further consolidation and correction. So that is exactly what we did at Zeal. While this stance was extremely unpopular and generated an unbelievable amount of flak for us this past summer, we were vindicated in the last couple weeks. Corrections take time to unfold because greedy sentiment cannot be eradicated overnight.

This brings us to today. For the first time since summer 2005, the technicals for the HUI are actually starting to look really bullish again thanks to the early-September carnage! The correction that was only 23 days old in June is now a mature consolidation that has been running for 92 trading days, actually above the 88-day correction average. Fear is finally returning to the HUI, a very bullish development, because correction 6 has finally lingered long enough to start shaking the faiths of even longsuffering gold-stock investors.

With correction 6's duration finally mature, in pure duration terms this correction can now end anytime having nearly accomplished its sentiment-rebalancing goal. This is wonderful news and very exciting. The one remaining loose end is depth. While the depth dimension of this correction certainly could be done, there are several technical perspectives that suggest we may have a little further to go yet.

With an average correction falling down 30%, correction 6's 31% decline as of mid-June is sufficient to slightly exceed average. This is the key piece of rhythm evidence suggesting that June's 274ish HUI lows might just hold here. While this may prove to be the case, it is important to consider the contrary evidence as well. It all points to a slightly lower major interim low in the HUI than the levels we saw in June.

First, our latest upleg 6 was massive. After massive uplegs 2 and 4, the only comparables to 6, the HUI corrected 35% on average. If correction 6 follows the precedent of post-massive-upleg corrections 2 and 4, then we could very well see another 35% May peak to whenever trough decline. This yields a 255ish bottoming target for the HUI. Lest you think this is new spur-of-the-moment thinking, I said the exact same thing in June, "A 35% HUI correction off the early May highs would drag this index down to 255ish."

Second, during each of its last two major corrections, 4 and 5 above, the HUI fell to levels just under 0.80x its 200-day moving average. You can see the blue HUI line cross well under its black 200dma line above in corrections 4 and 5. As of this week, the lowest the HUI has traveled relative to its 200dma in correction 6 was only 0.90x. At today's 200dma, the HUI would again have to see 255ish if it fell fast to 0.80x relative. This concept isn't new either, I discussed the 0.80x rHUI bottoming levels in the June 2006 Zeal Intelligence.

Third, there is a fascinating Fibonacci retracement tendency in corrections after massive HUI uplegs, which I again discussed in my original essay back in June. Here is an updated version of that earlier chart.

It indexes each of the three massive uplegs in the HUI individually with 0 being their starting points and 100 being their tops. Then the duration of each upleg in trading days running before and after each top is rendered on the X-axis. The tops are synchronized to the day, at day zero, so each massive upleg/correction can be analyzed relative to its peers. The goal of this hybrid chart is to consider each massive upleg and subsequent correction in perfectly comparable terms.

The blue line below is our latest massive upleg and correction indexed. Back in June's essay I drew in the shaded blue area which I thought was the probable consolidation range. While the shape of the range wasn't too far off, the consolidation started higher than I'd expected since the HUI kept rallying into July. Nevertheless, today we find ourselves right back in this probable consolidation range and still above the precedent floor.

Rather than starting trading sideways in late June as I'd expected at the time, the HUI instead continued rallying sharply higher and then entered a high consolidation. High consolidations are especially deadly as they create the most false hope. With the HUI running between 310 to 350 or so most of this summer, which wasn't all that far below the 394 May highs, it was really hard for traders to believe that we were still in a young correction. Yet hope in a correction is always dashed on the rocks by the time it fully runs it course.

Interestingly this past summer's high consolidation mirrors, almost perfectly over the month or so prior to the HUI's early September highs, the high consolidation of massive upleg 4, the red one. Back in early 2004 correction 4 started out rather slowly and just grinded sideways, convincing many people including me unfortunately that the worst was behind us. Then at the very end of this correction it fell off a cliff and shredded anyone who bought in too early. Correction 4 really hurt a lot, believe me!

Now today correction 6 is mirroring correction 4 incredibly well. The HUI hit 365 and created its last hurrah of false hope on the 81st trading day of our current correction. Back in correction 4, the HUI's last minor high was achieved on the 83rd day. And then after that the bottoms fell out of both corrections and they started plummeting. While I don't know if this uncanny symmetry will continue, I'd be hesitant to bet against it.

Why? Correction 2 and correction 4 both ended at the same indexed level, just above 38. For you mystics, this 38.2 potential major-HUI-correction floor is a classic Fibonacci number as I discussed in depth in June. It is pretty extraordinary that the two very different major corrections following massive uplegs 2 and 4 both ended right near 38.2% of the way from the bottom to the top of their respective preceding uplegs. Only time will tell, but there is certainly a possibility that our current correction 6 will be drawn to this 61.8% retracement as well.

So what is the HUI level 61.8% of massive upleg 6's height below its top and 38.2% of its height above its bottom? 255ish! Obviously 255 continues to crop up all over the place from varying technical perspectives which should really cause us to take notice.

As a mere mortal who cannot see the future, I certainly do not know when and where the HUI will bottom. But since its latest major correction has finally reached a mature duration, the when could be anytime in the coming month or two. Based on the analysis above, the where could be any level between around 275 down to 255 or so. Neither is very far away from here!

This is very exciting as it means we are finally getting close to our next major buying point to add new long positions ahead of the next major gold-stock upleg. At Zeal we have been patiently preparing for this crucial inflection point all year. Back in May after many months of fundamental research we wrote and published a comprehensive report detailing our favorite 20 gold stocks for the next upleg, the coming upleg 7.

And we will be carefully watching gold and HUI technicals in the coming months and launching new gold-stock trades in highly-promising elite stocks as appropriate. If HUI precedent holds and its secular bull continues, we are on the verge of one of the best buying opportunities of this entire bull. Please subscribe today to our acclaimed monthly Zeal Intelligence newsletter so you don't miss our coming gold-stock trades!

The bottom line is the HUI, after many months of creating false hope this past summer, is finally nearing the point where its next major interim low is probable. Just as this past June when no one was scared was the time to be wary, today when everyone is scared is the time to get excited. If the secular gold and HUI bulls are still on course to power higher, then the interim low ahead of major upleg 7 is probably rapidly approaching.

All bull markets flow and ebb, follow rhythms established over time and driven by sentiment. It is very exciting to once again be reaching the moment in time in the HUI when its current ebb is likely to bottom out. For all of you prudently and patiently waiting for the first great buying opportunity in gold stocks since summer 2005, it looks like your patience is finally going to pay off. Congratulations!

Adam Hamilton, CPA

September 22, 2006

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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