 Trading the HUI/Gold
Ratio
Adam Hamilton
Archives
November 6, 2004
With gold pushing shiny new 16-year highs this week, contrarian
investors and speculators continue to earn dazzling profits in
this young
bull market. But even though gold's mainstream notoriety
continues to gradually increase during exciting weeks like these,
it remains a very small sector in the grand scheme of the markets.
As I discussed
a couple weeks ago, actively trading an up-and-coming sector
can be quite challenging. Young bull markets in traditionally
overlooked sectors lack the amazing array of highly specialized
trading indicators which the mainstream stock markets take for
granted. As such, contrarians are constantly striving to create
innovative tools to aid their trading decisions.
In response to my thoughts on designing custom HUI-specific indicators
carefully tailored for today's gold-stock bull, I have been blessed
with some fantastic feedback. I am very grateful as generous
speculators, investors, and analysts from around the world have
shared some outstanding ideas with me. I have learned a great
deal so far thanks to these people graciously helping me expand
my perspectives on trading indicators.
One gentleman sent me a neat idea last weekend that led to this
essay. He developed an innovative and elegant way to cull crystal-clear
major intermediate trading signals out of analyzing the ongoing
relationship between the HUI and gold. This really caught my
attention since ratio
analysis is becoming increasingly popular among contrarians
these days.
A ratio, which in market terms is one price series divided by
another, provides an excellent way to precisely quantify the
relative performance between two different market prices. When
a ratio is created with price A as the numerator and price B
as the denominator, the interrelationship between A and B is
far easier to understand. The single A/B ratio graph is vastly
more intuitive and easier to assimilate than the challenging
exercise of trying to mentally combine two separate graphs of
A and B to understand their relationship.
With this A/B ratio example, if A is outperforming B the ratio
will rise. But if A is lagging B, the ratio will fall. Thus the
ratio distills and illustrates the relative performance differences
over time between two separate price series. Ratios can reveal
subtle trends in relationships that are difficult to detect when
comparing two conventional price charts.
The popularity of ratio analysis has exploded in the past five
years or so. I suspect a key factor in this development is the
emergence of powerful websites like www.StockCharts.com
that enable traders to instantly and effortlessly create any
kind of ratio they wish. By entering any two financial symbols
in StockCharts.com separated by a colon, new ratios can be created
as fast as one can think them up.
One particular ratio that has long intrigued contrarians is the
ratio of gold stocks to gold itself. During any major bull market
in gold, there are times when gold stocks radically outperform
gold during uplegs. Naturally these are the very times when investors
and speculators want to be heavily long gold stocks. Conversely,
there are also inevitably times when gold outperforms the gold
stocks. While this can be due to gold rising faster than stocks,
more often than not it is the result of gold stocks correcting
far faster than gold. These are not good times to be long.
Since today's premier unhedged gold-stock index is the HUI, the
gold-stock-to-gold ratio of choice today is the HUI/gold ratio.
This is easy to pull up at StockCharts by typing in the symbol
$HUI:$GOLD
. While this ratio is discussed and debated almost constantly
on Internet gold forums, I hadn't yet seen a comprehensive and
elegant way to trade it for major intermediate trends until last
weekend.
My friend and fellow analyst/financial commentator, Matthew Frailey,
graciously shared a simple and brilliant approach to trading
the HUI/gold ratio with me. Mr. Frailey runs www.BreakPointTrades.net
where he shares comprehensive technical analysis and speculation
signals with his subscribers. He publishes a weekly newsletter
covering many sectors including gold as well as periodically
contributes essays to gold portals. In addition, as a technician's
technician he is an adept chartist ranked high in the StockCharts.com
Hall
of Fame. If you love charts as much as I do, you owe it to
yourself to check out his website.
While pondering how to help his clients ride the same major intermediate
trends in gold stocks that we chase, Mr. Frailey pointed out
the following to me. "Rather than analyzing a chart of the
HUI, I think a ratio between the HUI and gold metal is far more
useful. Gold stocks tend to outperform or underperform gold metal
at various times. Obviously, it is the times when gold stocks
outperform the metal when you want to own gold stocks."
In order to discern these times when gold stocks are due to outperform
gold in a major upleg, Mr. Frailey developed a great system that
parses the undulating HUI/gold ratio to ferret out key buy and
sell signals to ride major intermediate trends. By deftly combining
linear resistance breakouts with 50-day moving average failures,
his system throws out very clear signals that are unambiguous
and easy to interpret. As an added bonus, these signals are easy
to watch for in the future on a StockCharts.com $HUI:$GOLD
ratio chart.
Our three charts below detail this trading system, beginning
with a bull-to-date HUI/gold ratio strategic view to outline
the general thesis. After this, we zoom into the latest major
upleg and correction in gold stocks in additional graphs to observe
how the most recent HUI/gold ratio trading signals unfolded on
a tactical level.
Before we delve into how to
trade it, the HUI/gold ratio itself is quite interesting. Notice
above how this ratio systematically marches higher during our
current secular bull market in gold and gold stocks. Powerful
uplegs unfold as the HUI outperforms gold stocks. After these
uplegs when the HUI and gold inevitably correct to take a healthy
breather though, the ratio tends to consolidate, either grinding
sideways or retreating. If you compare this ratio graph with
a conventional HUI-only
graph, of course the ratio uplegs precisely match the HUI
uplegs' timing.
Now since this ratio reveals the relative performance
of the HUI compared to gold, it offers deeper clarity in some
senses than a HUI chart alone. While a HUI-only chart shows an
effect, gold stocks leveraging a gold bull, this ratio chart
illustrates the relationship between the cause (gold bull) and
effect (gold-stock bull). This ends up filtering out some of
the incessant noise that plagues HUI charts.
For example, during every major post-upleg consolidation to date,
late 2001, late 2002, and late 2003, the HUI appeared to carve
double tops which spooked some players. Double tops tend to be
bearish, since the standard interpretation is that a price is
hitting major bull-to-date resistance for a second time but remains
woefully unable to punch through.
In the ratio chart shown above though, the HUI interim highs
of mid-2001, mid-2002, and late 2003 are very unambiguous. The
ratio topped and headed lower into the necessary correction without
any technical lollygagging. No ratio double tops formed.
Many intriguing comparisons like these become evident if you
compare a HUI/gold ratio graph to a HUI-only graph. The ratio
expressing the cause and effect as one seems to act as a filter
to helpfully moderate the high noise levels inherent in the pure
HUI data.
Matthew Frailey's elegant HUI/gold ratio trading system is drawn
in above. A combination of the blue top resistance lines during
consolidations and the white 50-day moving average during uplegs
is used to define major buy and sell signals. If you look at
the actual green and red buy and sell signals drawn on this chart,
it is readily apparent that buy signals flash right as major
uplegs launch while sell signals sound soon after these uplegs
top. This system's timing for gaming intermediate gold-stock
trends is quite good.
In order to define a HUI/gold ratio buy signal, the ratio must
first decisively break out above its latest consolidation's
upper resistance line. In the past four years there have been
three major consolidations with three resistance lines, all drawn
above in blue. These resistance lines connect the latest bull-to-date
ratio high with the inevitable subsequent descending highs as
gold stocks correct after a major upleg.
For months after a major interim top, the HUI/gold ratio struggles
but continues to fail near the consolidation resistance. But,
eventually, sooner or later sentiment waxes too negative so a
major new upleg is due to erupt. The actual advent of this upleg,
and the end of the preceding correction, is announced when the
ratio finally musters the strength to blast up through and shatter
the consolidation resistance lines.
Such buy signals flashed in early 2002 and mid-2003 right on
the door step of the two most powerful gold-stock uplegs in this
bull to date. Investors and speculators alike would have done
very well to throw long quality unhedged gold stocks as these
buy signals triggered. Incidentally, the latest buy signal just
flashed in August and suggests we are already in the early months
of the next major gold-stock upleg today.
Mr. Frailey defines sell signals as times in major uplegs where
the HUI/gold ratio collapses back down below its 50-day
moving average. During the uplegs the ratio's 50dma tends to
act as strong support until the upleg reaches maturity.
But once a major upleg crests, soon after the event its 50dma
fails as support. It is these very moments when the HUI/gold
ratio decisively pierces through its 50dma to the downside when
speculators should consider selling their gold stocks to ride
out the coming correction.
Three of these HUI/gold ratio sell signals are drawn in the graph
above, each of which occurred after one of the major bull-to-date
uplegs in the HUI. Any speculator who heeded these signals could
have avoided 80% or so of the subsequent corrections following
the major uplegs. Naturally this would put speculators way ahead
in the capital game, since they could ride the uplegs but then
deftly pull out their capital early in the corrections so they
don't suffer serious losses. Then this prudently preserved capital
can be plowed right back in when the next buy signal triggers.
So a HUI/gold ratio buy signal is triggered whenever the ratio
decisively breaks out from a descending resistance line during
a consolidation/correction. The subsequent sell signal then triggers
when the ratio's 50dma fails as primary support following a major
upleg. Definitely simple, yet elegant and very effective so far
in this gold bull to date!
Now that you have seen the big strategic picture, these signals
become even more clear when considered from a tactical perspective.
In order to illustrate this, we zoomed in to consider last year's
massive upleg to show a buy signal and this year's ugly correction
to highlight a sell signal. The blue dashed squares in the strategic
chart above show the zoomed in areas from which our next two
tactical charts have sprung.
Calendar 2003 was a phenomenal
year for contrarians invested in gold stocks, and this ratio
certainly shows it. Between March and early December, the HUI
took off and vastly outperformed gold. This period of relative
strength does a fantastic job of illustrating how to combine
HUI/gold ratio buy and sell signals to ride a major upleg in
gold stocks.
The whole process begins during a consolidation following the
last major upleg. During this time gold stocks, since they are
leveraged paper, tend to fall farther and faster than gold. The
relative underperformance of the gold stocks creates a downtrend
in the HUI/gold ratio. This ratio grinds lower within the confines
of this trend, periodically rallying but usually failing to break
back above its descending resistance line. Until the ratio resistance
breakout actually occurs, investors and speculators can bide
their time while the correction fully runs its course.
In March 2003 gold stocks bottomed as Washington prepared to
invade Iraq. The HUI/gold ratio started trending higher from
that point but didn't break out until the beginning of June.
While the HUI did rise between March and June, one thing I really
like about this particular trading tool is it demands conservatism.
Trying to catch falling knives, picking the exact HUI bottom,
can be hazardous. Speculators can use other
tools to attempt this if they wish, but investors don't need
to trouble themselves with this exercise.
By patiently waiting for the HUI/gold ratio buy signal of the
resistance breakout, investors increase their probabilities dramatically
that they are not buying in until a major new upleg is already
underway. Most of the false buy signals are weeded out waiting
for the breakout so the gains should accrue fairly steadily if
a buy is made once the signal is flashed. It probably won't deliver
an entire upleg into your lap, but the ratio will certainly alert
you to the strongest 80% of one!
After throwing long gold stocks at the buy signal, all investors
have to do is watch the HUI/gold ratio relative to its major
50dma support. As shown in white above, the ratio tends to bounce
at its 50dma during all minor pullbacks until the HUI
upleg has reached maturity. Shortly after the intermediate top,
the 50dma fails as the ratio plunges down through this support
line. Once the 50dma is decisively broken, it is time to sell
and wait for the next HUI/gold ratio buy signal.
Now this sell signal will not be triggered at an exact top either,
but this too is a very conservative approach. By waiting until
the 50dma is decisively pierced, investors vastly decrease their
odds of being whipsawed out early by a minor pullback within
an ongoing upleg. Instead, a true 50dma support failure probably
won't transpire until a major correction is already underway.
This sell signal helps investors and speculators stay in as long
as possible during a major upleg, but then gets them out while
a major correction remains young and mild. Avoiding 80% of major
corrections is a great way to multiply capital!
On a tactical level these signals are as easy to understand and
apply as they sound. Buy on a ratio resistance breakout during
a consolidation and sell on a ratio 50dma failure after a major
upleg. Our final graph, covering October 2003 to September 2004,
shows how well this elegant system works during major corrections.
After topping in late 2003,
the HUI entered a brutal correction in early 2004. The HUI/gold
ratio declined because gold outperformed the HUI in the initial
months of this correction and then gold sunk far less rapidly
than the HUI in the correction's late capitulation stages last
spring. This traumatic event is recent enough to remain seared
in the memories of contrarians, so it is perfect to illustrate
the HUI/gold ratio signals during a major correction.
After a major interim top is carved, at some point in the subsequent
weeks or months the HUI/gold ratio's 50dma fails as support.
This failure, which happened in December 2003, acts as a sell
signal to warn speculators of an impending correction. In this
latest example, the HUI was trading near 240 when this alarm
signaled but only 170 at its May bottom, so heeding the sell
in December would have saved speculators 29% in additional losses,
not bad at all!
After the 50dma-failure sell signal triggers, the ratio starts
grinding lower in general although this decline is punctuated
with periodic relief rallies. After a couple of these relief
rallies are burned into the charts, traders can start plotting
a ratio resistance line like the one shown above. As this line
is gradually defined over the correction months, it creates a
reference point from which traders can watch for the first decisive
breakout.
As long as this resistance line holds, no buy signal is triggered
and odds are the HUI remains in consolidation/correction mode.
As you can see above, the resistance tends to repel the periodic
ratio advances and keeps the downtrend intact. But once a decisive
breakout occurs, as in August 2004, then a buy signal is triggered
and it is time to throw long again in anticipation of a major
new gold-stock upleg.
Once again the conservative nature of this indicator really shines
through. Using relativity
tools, I went long our current upleg in April
and May, which really was the interim bottom. Yet, even though
the absolute bottom was indeed in May, the HUI still sputtered
along and consolidated for several more months. This summer,
which was psychologically grating for gold-stock investors and
speculators, could have been avoided all together with this ratio
indicator.
Conservatively this ratio breakout didn't occur until August,
after the entire consolidation had fully run its course.
While its buy signal wasn't triggered at the exact bottom near
HUI 170, it did trigger around HUI 185 in August and therefore
would have saved folks from enduring this summer's long demoralizing
sideways grind. Once again, especially for risk-averse investors,
it pays to err on the side of caution and wait until a new upleg
is already underway rather than trying to catch falling knives.
The bottom line is Matthew Frailey's simple and elegant technical
system to wring clear buy and sell signals out of the HUI/gold
ratio is an excellent addition to any investor's or speculator's
trading toolbox. Whether you use it as a conservative primary
indicator as an investor or a secondary confirmation indicator
as a speculator, it helps filter out the HUI noise to identify
major intermediate trend changes early.
I am looking forward to observing this indicator myself as this
awesome gold and gold-stock bull continues to unfold in the future.
We will use it at Zeal to illuminate the HUI from a different
perspective and provide confirmation for our other technical
tools. It ought to help us continue to recommend superior gold
stock and gold-stock options trades for our newsletter subscribers.
The better we can use technicals to illuminate the prevailing
trends, the higher the probability we can detect major tradable
trend changes early when they are still highly profitable to
trade. As Mr. Frailey pointed out to me, the best time to own
gold stocks is when they are due to far outperform gold in a
major upleg.
Since the HUI/gold ratio quantifies the relative performance
of gold stocks to gold, it provides vital clues of newly developing
intermediate trends not readily evident in the HUI alone. And
this neat HUI/gold ratio technical trading system defines simple
rules to help capitalize on these new trends while they still
remain young and promising.
November 5, 2004
Adam Hamilton, CPA
email:
zelotes@zealllc.com
Archives
 So how can you profit
from this information? We publish an acclaimed monthly newsletter,
Zeal
Intelligence,
that details exactly what we are doing in terms of actual stock
and options trading based on all the lessons we have learned
in our market research. Please consider joining us each month
for tactical trading details and more in our premium Zeal
Intelligence service.
Questions for Adam? I would be more than happy to address them
through my private consulting business. Please visit www.zealllc.com/financial.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 ©2000-2004
Zeal Research All Rights Reserved (www.ZealLLC.com)
321gold Inc
|
