 HUI Leverage
to Gold
Adam Hamilton
Archives
November 26, 2004
Gold-stock investors and speculators, blessed with dazzling realized
profits for years now, are growing ever-more nervous over an
increasingly obvious anomaly in the premier HUI gold-stock index.
The famous HUI leverage to gold has inexorably fizzled in the
past couple months, sowing confusion and fear in its wake.
This waning HUI leverage to
gold is particularly troubling because the sole reason to own
gold stocks is to reap their legendary leverage
to our bull
market in gold. Gold stocks, ultimately just pieces of paper,
are only valuable if they consistently provide a return massively
higher than that of gold itself. If HUI returns don't outstrip
gold's dramatically, then we are better off just holding physical
gold itself since it is far safer than paper stocks. Gold stocks
need big returns to justify their big risks!
Since the latest major interim
bottoms in the HUI and gold in May, the gold stocks are up 45%
upleg to date while gold is up 19%. While 45%+ returns in six
months are certainly nothing to ridicule in the abstract, when
considered in the context of the HUI's traditional enormous leverage
to gold they are startlingly low. If you look at the ratio of
HUI gains to gold gains in this latest upleg, the HUI leverage
to gold, the result is only 2.4x at the moment.
Bull to date, since the HUI
bottomed in late 2000 and gold in early 2001, the HUI's leverage
to gold has been a breathtaking 9.0x
or so! For every 10% gain in the price of gold over this secular
bull, the HUI has registered fantastic gains approaching 90%.
Naturally, after having reaped such magnificent gains for years
now, we are all conditioned to expect extreme HUI leverage to
gold going forward. Hence our current anemic 2.4x feels so unsettling.
I am certainly concerned about
this waning HUI leverage to gold now dominating precious-metals
thought. Not a day has gone by in the past couple weeks when
my partners and I haven't discussed it. I know our subscribers
are concerned too, as I am receiving more and more e-mails lamenting
the HUI's malaise. This week I would like to dig into this anomaly,
in the hopes of learning whether this threat is temporary or
likely to persist.
The first step to understanding
lies in quantifying the HUI leverage to gold at a tactical level.
Rather than considering this leverage strategically in terms
of 9.0x over the entire bull, we need to know how the leverage
has played out over individual major uplegs and corrections.
This distinction is very important. The key to understanding
the present in the markets lies in seeing it in context with
the past.
The HUI has only been lagging
gold since the metal finally shot above $400 in September. It's
only been in the last couple months when this HUI anomaly has
really become glaringly evident. If there have been temporary
past episodes of similar HUI underperformance, then today's episode
is probably nothing to fear. As discussed a few weeks ago in
"Trading
the HUI/Gold Ratio," sometimes the HUI outperforms gold
and sometimes it does not.
In order to understand today's
unpleasant episode in context, our first graph divides the HUI
into all of its major uplegs and corrections in this bull to
date. The HUI has already advanced higher four times since its
secular bottom in November 2000, and we are now in its fifth
major upleg. All of these uplegs are noted below with the green
numbers. As always, these uplegs are inevitably followed by healthy
bull-market corrections, the four major of which are labeled
with the red numbers below.
The actual HUI gains and losses
in all of these individual major uplegs and corrections are shown
in blue. Gold gains and losses over the same periods of time
are noted in red. Now it is important to realize that major interim
gold tops and bottoms don't usually coincide exactly with
the HUI. Thus, if this chart was divided up based on gold alone
the divisions would be slightly different. But, in general
terms, the major HUI moves coincide very well with the major
gold moves so looking at gold over specific HUI date divisions
is technically sound.
Once we have the individual
upleg and correction HUI and gold gains and losses, we can finally
investigate the tactical HUI leverage to gold. In each individual
upleg or correction, the HUI gain or loss divided by the gold
gain or loss yields the tactical HUI leverage to gold in that
particular major move. These leverage numbers are rendered below
in yellow. It is here that our quest to understand this current
anomaly starts to bear fruit.
I have to admit this chart
really surprised me. At the HUI's and gold's respective best
levels bull to date, the HUI leverage to gold is running about
9.0x as our giant
gold and gold stocks chart shows. But, as this new HUI leverage
chart reveals here, other than the first major upleg starting
in late 2000 when the HUI was coming off unbelievably dismal
lows, actual HUI leverage has consistently run well under
9.0x. In fact, the best upleg leverage after the first upleg
was "only" 7.2x in early 2002 while the worst is today's
2.4x.
While surprising at first,
this does make sense in hindsight. Speculators have long gamed
the law of small numbers, the truism that speculations starting
from a low base have a higher probability of seeing huge percentage
gains than ones starting from a high base. An unloved $1 gold
stock only has to be bid to $2 to double, which is almost always
far easier than bidding a more popular gold stock from $20 to
$40 to get a similar 100% gain. The greatest leverage in the
HUI, 14.7x, was naturally seen as it advanced from its horrifically
low sub-36 Great Bear base in November 2000.
The higher the HUI base gets
as its bull marches on, the exponentially greater the capital
requirements grow to bid it up fast enough to maintain truly
extreme leverage to gold. Upleg leverage in sequence from the
low HUI days to the present ran 14.7x, 7.2x, 2.9x, and 5.5x,
so even before today's lackluster 2.4x the prevailing trend was
generally down. Naturally if this trend continues, we should
expect lower leverage going forward.
A simple graph of 14.7x, 7.2x,
and 5.5x shows a descending parabolic shape going asymptotic
at some point as it approaches the horizontal axis. As this parabola
falls from very steep initial leverage in the early days on the
left to stable ongoing leverage on the right, perhaps the curve
will stabilize at 4x to 5x HUI leverage to gold. This leverage
absolutely has to flatten out at the asymptote, probably 4x to
5x, rather than going below 1x for a few critical reasons.
First, the operating
leverage of gold mines mathematically assures their profits
will grow far faster than the price of gold rises, and their
stock prices must eventually follow their profits. Second, as
more and more investors grow interested in gold and gold stocks,
their capital will deluge in driving up prices proportionately.
The global gold supply at $450
is probably worth $2170b today (assuming 150,000 tonnes of gold
mined in world history). In contrast just a month ago the market
capitalization of the entire HUI blue-chip unhedged gold-stock
index was only $54b
or so and it is probably not above $60b today thanks to the HUI's
pathetic recent performance.
Thus, the physical gold market
is roughly 36x as large as the premier gold-stock index so capital
flooding into gold stocks is virtually assured to push them up
far faster than gold since they start from such a relatively
small capitalization. This gross capital-footprint misbalance
will ensure the HUI leverage to gold remains favorable.
Finally, gold-stock investing
is fraught with countless perils while holding physical gold
in your own immediate physical possession is the safest and surest
investment in world history. The HUI gains will have to come
faster than gold gains in the future, ensuring positive leverage,
in order to compensate investors for the significant additional
risk of owning paper stocks. If the ratio ever dropped under
2 to 1 or so, then there would be little or no reason to even
bother with stocks as people could buy the far safer gold for
the same returns.
In light of these and other
reasons, I suspect that HUI leverage to gold of 4x to 5x is probably
the lower long-term limit. Sure, we can have periodic episodes
like today's 2.4x where the HUI leverage really lags, but over
all uplegs the average should be far higher and ultimately very
profitable for gold-stock investors and speculators. From this
perspective, our current low HUI leverage to gold can be considered
a temporary anomaly likely to mean revert back above 5x in future
uplegs.
While we developed some new
tools to consider HUI leverage to gold in context, before we
get into our next graphs there are a couple more items of interest
above. First, note the dismal 2.9x HUI leverage to gold in the
late 2002 HUI upleg, number 3. This is on par with today's 2.4x
levels and provides comfort since the HUI's leverage promptly
returned to a far more profitable 5.5x in its next upleg, 4.
Thus we can see historically that HUI leverage naturally fluctuates
from upleg to upleg so today's relative weakness is not completely
unprecedented.
It is also interesting to compare
the average HUI leverage in uplegs, 6.5x, with its average leverage
in corrections, 4.4x. This asymmetry heavily favors the bulls
since it shows that gold-stock speculators can reap outsized
gains in major uplegs on average but in the inevitable pullbacks
that follow they get to keep a larger proportion of these gains
than gold investors. This is another interesting virtue to add
to the already impressive list of attractive gold-stock attributes.
In order to better understand
the flowing and ebbing of the HUI leverage to gold in context,
I have been trying to figure out how to quantify it over time
in some way that facilitates easier direct comparisons between
present and past. One potential solution involves indexing each
individual major upleg and correction in the HUI and gold.
The graph below shows the result of individually indexing all
the major moves over their same respective time frames from the
first chart.
In order to individually index
each major upleg and correction, a base value is set at 100 on
the first day of each major move. If the HUI doubled in an upleg,
that specific index would go up 100% from 100 to 200. If the
HUI fell by 20% in a correction, then that index would fall to
from 100 to 80. The neat thing about these individual upleg/correction
indexes is that they can all be graphed over time and form perfectly
comparable percentage charts tracking the absolute fluctuations
in the HUI relative to gold.
These indexes are rendered
on our next chart superimposed over the usual HUI. The HUI indexed
gains and losses are drawn in red while the gold indexed gains
and losses are drawn in yellow, with all indexed numbers slaved
to the right axis. All kinds of interesting observations jump
out of this indexed chart.
One of the most provocative
observations emerging from this strange chart is the possibility
that there may be two distinct types of HUI uplegs in
this bull market. The first type, the true HUI uplegs we have
grown to love and respect, are the massive runs up that witness
gold stocks double or more, heading up above 200 indexed. Uplegs
1, 2, and 4 exemplify these model uplegs. Everyone lamenting
the HUI's lackluster performance today including me was expecting
one of these true uplegs. There is nothing on earth that breeds
disappointment faster than unmet expectations.
The curious case of upleg 3
however, in late 2002, provides a clue that not all HUI uplegs
witness 100%+ gains over a couple quarters or so. The third major
upleg in the HUI, while it did witness respectable 60%+ gains,
looks more like a consolidation on this chart. Gold stocks
had exploded up extremely rapidly in the preceding upleg 2 and
were probably bid up far ahead of gold. During upleg 3 they more
or less ground sideways and waited for gold to catch up to justify
their lofty
valuations.
If you look at the underlying
blue HUI line, the grand chart pattern running from upleg 2 to
correction 2 to upleg 3 looks an awful lot like today's upleg
4 to correction 4 to upleg 5 pattern at a smaller scale. This
shouldn't surprise us since the markets are generally fractal
in nature, similar price patterns appear at all scales. This
general pattern involves a massive HUI upleg that far outpaces
gold, a sharp and fast correction, and then a subsequent consolidation-type
upleg with far more modest HUI gains while stocks wait for gold
to catch up.
This leads to a theory that
gold stocks advanced higher in 2003's mega rally than they ought
to have based on the positive fundamentals spawned by the rise
in gold alone. For example, while gold topped in January 2004
near $425 maybe the HUI's earlier December 2003 top had
discounted $475 gold into gold-stock prices and future cashflow
and profits projections at the time. Thus, gold stocks could
have advanced too far relative to gold.
If this is indeed the case,
and I have no way of knowing either way for sure, then today's
abnormally low HUI leverage to gold could merely be the
result of gold-stock buyers curtailing their new purchases as
they wait for gold to catch up and justify high HUI levels. Just
as during upleg 3 however, this is not a threat but an opportunity.
While upleg 3 didn't double, it did go up 60% which is similar
in magnitude to today's 45%ish gains upleg to date. If this thesis
proves correct, upleg 6 ought to be stupendous after this modest
consolidation upleg 5 and its subsequent correction!
Another far more attractive
idea suggests that the HUI is lagging gold only because it is
early in this particular upleg. If true, the HUI could surge
parabolically in the weeks ahead and catch up with gold before
this upleg tops. I am heavily long gold, gold stocks,
and gold-stock call options so I really want to believe that
this is the case, but for a variety of reasons I have to unfortunately
conclude that our current upleg is closer to mature than immature
at this point in the game.
Note above how the HUI uplegs
tend to have regularity in terms of time. The uplegs erupt periodically
like sawteeth and run for two or maybe three quarters before
they give up their ghosts and correct. Our current specimen has
been running since early May so it is already more than two quarters
old. In pure timing terms, upleg 5 has already lasted
as long as we had the right to prudently expect based on history.
An even bigger problem with
the seductive idea that a massive HUI catch-up surge is imminent
in this upleg is found in the yellow gold indexed line.
Gold, the ultimate driver of the HUI bull, has been far more
reliable than the HUI. It has advanced up three times in a row
now (uplegs 2, 3, and 4) with nearly perfect precision before
topping near an index level of 120 every time.
For whatever reason, each major
gold upleg so far has only tended to run 20%ish higher and then
correct like clockwork, dragging the HUI down in its correction.
Ominously gold is already 18.6% higher in our current upleg since
May, very mature in historical terms. If today's gold upleg continues
to conform to the nearly perfect sawtooth pattern of the previous
3, then gold is likely almost out of gas. And if gold enters
a healthy bull-market correction, you better believe the HUI
is going to correct right along with it.
I fully realize this analysis
throws a monkey wrench in tactical trading strategy and I intend
to directly address these concerns for our subscribers in the
upcoming December issue of our acclaimed Zeal
Intelligence newsletter.
I am now carefully analyzing
gold, the dollar, the euro, and gold stocks in reference to our
outstanding trades and formulating strategies this weekend. Despite
the holiday distractions, the December newsletter remains on
track to be published December 1st for our subscribers. It will
address the pressing "so what do we do now?" questions
plaguing HUI investors and speculators today, so please sign
up now if you don't want to miss it!
We built one final chart based
on the indexed chart above. Our third graph divides the HUI Indexed
by Gold Indexed lines above to form a ratio. Please realize this
HUI Indexed/Gold Indexed ratio is not the same as the
raw HUI/Gold
Ratio I discussed a few weeks ago, but an entirely different
concept. This provides one final perspective on the HUI leverage
to gold and really emphasizes just how sick the HUI looks in
this current upleg in leverage terms.
If my alternating true HUI
upleg followed by a lesser consolidation HUI upleg theory proves
correct, then the ratio of the HUI indexed and gold indexed should
be proportional between its last occurrence across uplegs 2 and
3 and today's occurrence between uplegs 4 and 5. This chart simultaneously
shows similarities and differences across these two episodes,
rather ambiguously neither confirming nor refuting the thesis.
Uplegs 2 and 4 were indeed
similar in magnitude and shape, with indexed HUI gains ultimately
outpacing indexed gold gains by 1.8x+ in both cases. Uplegs 3
and 5 also look similar, but the current performance of upleg
5 today remains far inferior to even the consolidation upleg
3 in late 2002. Upleg 4 in 2003 had the lowest HUI leverage to
gold of any true upleg to date and today's upleg 5 has
followed that performance with the lowest HUI leverage to gold
in all uplegs to date, period.
Even if the HUI leverage to
gold has to gradually decay as the base HUI rises higher and
higher in each subsequent upleg/correction and makes like percentage
gains harder and harder to achieve in the future, the HUI's underperformance
today is even worse than such a model would suggest. Put bluntly,
the HUI has looked more and more sick in recent months and the
hard numbers confirm this increasingly uneasy feeling that has
plagued gold-stock players.
While these charts don't lie,
and they certainly call the longevity and ultimate gains of our
current HUI upleg into serious question, they don't feel
long-term threatening to me. Even if today's HUI upleg is nearing
maturity now, even if it "only" runs up 50%ish instead
of 100%+, this is certainly not the end of the world.
Gold stocks' prices are ultimately
driven by gold stocks' profits, which are directly driven by
the price of gold. As long as this secular gold bull remains
in force, the profits of the unhedged HUI miners will continue
to rise. As profits rise, valuations of gold stocks will drop
until they inevitably get too cheap and attractive. At that point,
investors will flood in to chase the windfall gold-mining profits
whether they are predisposed to PM investing or not.
In addition, over time the
HUI leverage to gold will almost certainly be restored. Like
every other market phenomenon from valuations to sentiment, it
is natural that HUI leverage gradually fluctuates around a mean.
Sometimes we will witness gloriously high HUI leverage to gold,
other times it will be frustratingly anemic like today, but over
the long-term it will probably average out to exceed 4x to 5x.
And this is just fine with
me, as the HUI registering gains 4x to 5x those of gold will
ultimately lead to great riches for today's gold investors and
speculators!
November 26, 2004
Adam Hamilton, CPA
email:
zelotes@zealllc.com
Archives
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