Trading the Gold-Stock Bull

While the echo bubble in general equities booms, fueled by the blundering fools who must have slept through the hard valuation lessons of NASDAQ 2000, the stealth bull market in gold stocks continues unabated.

The HUI unhedged gold-stock index soared up to a new bull-market-to-date high this week, adding to the dazzling gains with which gold-stock investors have already been blessed in the past few years.

Even though the gold-stock bull has been galloping higher since late 2000 now, it is still running under the radars of most investors and speculators in stealth mode. I am almost certain that if you randomly surveyed a large group of American investors that less than 10% would even be aware of the massive gold-stock bull market and probably only around 1% have actually deployed capital to ride this awesome young bull.

The continuing relative obscurity of the gold-stock bull to the thundering herd is great news though, as it continues to bless us contrarians with fantastic opportunities in this long-neglected arena. Until the public leaps into the fray near the end of the gold-stock bull and shoves prices stratospheric, until CNBC is "all gold stocks all the time", vast sums of capital will be won by the diligent black-sheep contrarians.

With new bull-market-to-date highs in the HUI gloriously carved this week with practically no fanfare, contrarian investing and speculation opportunities in the unfolding gold-stock bull still abound. This week I would like to take a look at the gold-stock bull as well as offer some thoughts on a strategy my partners and I have been using to actively trade it.

First though, feast your eyes on this gorgeous chart! It strikes me as unbelievably absurd that the echo bubble in general equities, a measly 26% S&P 500 bear-market rally over 3 months, has reignited a mini-speculative mania approaching NASDAQ 2000 insanity. Meanwhile a gargantuan 335% primary bull market in gold stocks over 31 months remains widely unknown and totally ignored!

On Tuesday the HUI unhedged gold-stock index closed at 156.40, its highest closing level since September 1997! A major new interim high in a multi-year primary bull market is alwaysa big deal, and this one is no exception. Can you imagine the hype and fanfare from the financial world if a popular sector index like the SOX semiconductor index hit a new six-year high? It would be deafening!

Nevertheless, one of the perpetual curses of the markets is that the majority will always miss new primary bull markets until the very end, when they will get suckered in near the top, ignite a speculative mania, and promptly lose most of their capital in the resulting bust. This primary gold-stock bull will ultimately play out the same way, with the majority being unaware of its magnificence until right before The End.

The fact that this powerful gold-stock bull still remains generally unknown today is wonderful news for the small remnant of contrarians who would actually rather buy low and sell high instead of following the mindless short-term thrashings of the great mainstream thundering herd. As always only the rare contrarians are willing to look where the majority is not to find and ride tomorrow's Great Bull market rather than futilely chasing the decaying corpse of yesterday's Great Bull.

The primary driver of this new gold-stock bull is the rising price of gold itself. While it is exceedingly difficult for most mature companies to grow earnings rapidly, which ultimately drive stock prices, unhedged gold-mining corporations witness spectacular earnings growth during major bull markets in gold.

I explained the breathtaking leverage of gold-stock earnings to gold in detail in my "Gold Stock Investing 101" essay of last spring if this crucial concept is unfamiliar to you. In a nutshell, this earnings leverage works in two primary ways.

First, even as the price of gold rises, the costs of a given company to mine it generally stay the same. A company that can mine gold for $325 and sell it at $350 today earns $25/oz in profits for its shareholders. But when the gold price rises to $450, for example, it still only costs this company $325 to mine an ounce of gold so its profits soar to $125/oz. Profits soaring from $25 to $125/oz, a massive 400% gain, lead to much higher gold-stock prices as investors and speculators bid up the gold stocks to participate in this profits windfall.

Second, higher gold prices lead to higher production over time for many individual gold mines. Within a single mine, some gold is cheaper to chisel out of the bowels of the Earth and some is more expensive. A mine may have some deposits that cost $250/oz to mine, some at $325/oz, some at $375/oz, etc. At $350 gold it is obviously silly to spend $375 to liberate an ounce of gold from rock. But at $450 it makes a lot of sense to go after that same $375 gold for the new $75/oz profit. As the price of gold rises many gold companies can increase their production as they begin mining marginal gold that was simply unprofitable at lower gold prices.

The combination of this first and second-stage gold-stock leverage to the price of gold can be breathtaking. Gold-stock profits rapidly spiral higher and higher with the rising price of gold and gold-stock prices follow. This process can last for many years in a primary gold and gold-stock bull like we are witnessing today. The chart above highlights only the very earliest stages in this virtuous circle that leads to vast riches for the contrarians willing and able to get out and ride a new bull early before their neighbors figure it out.

Unfortunately it is not as simple as just buying any old gold stock to ride the gold-stock bull though! Gold stocks can be divided into the ranks of the unhedged and hedgers. Unhedged gold companies do not use derivatives to lock in a future price for their product. Hedged gold companies, on the other hand, enter into extensive derivatives contracts to lock in the future selling price for their gold.

Since the hedgers fix their future gold sales price they cannot fully participate in a gold bull. If they contractually agree to sell their gold at $375/oz, for example, and gold soars to $450, their shareholders are out of luck. They have to honor their hedging contracts and sell gold well below the prevailing market price. The more hedges a company burdens its shareholders with, the less it will participate in a major bull market and the less attractive it becomes to investors and speculators.

The charts above and below really drive home this crucial lesson. While the blue line is the unhedged HUI index which is forging new highs today, the red line is the heavily hedged XAU gold-stock index. In general gold stocks in the HUI are unhedged, they can fully reap the higher market prices in a major gold bull. Conversely most of the gold stocks in the XAU are heavily hedged, they have bet that the gold bull won't last so they've already contractually locked in selling prices for much of their future production.

As in everything financial, the free markets are the ultimate arbiter determining the wisdom or folly of hedging. Since the gold-stock bull began in November 2000, the unhedged HUI has run up a blistering 335% trough-to-peak as its companies are not bound by derivatives contracts and can fully capitalize on the rising price of gold.

You will note above that the blue HUI line on the chart is nicely leveraging gold's run in line with its historical precedent. The last time the HUI traded in the 150s in 1997 was also the last time gold traded in the $350s. Only fully unhedged gold stocks can seize the day for their shareholders and realize vastly higher profits thanks to higher gold prices.

The heavily-hedged XAU, on the other hand, is languishing. It is not doing much better today than it was when gold broke through $300 early last year. From its ultimate low in November 2000 until this week the XAU hedged gold-stock index is "only" up 97%. Now 97% isn't a bad absolute return, especially considering the horrific Great Bear bust in general equities, but it pales in comparison to the unhedged HUI's gargantuan 335% run over the same period!

This radical bifurcation in the gold-stock market is even more apparent in a more recent chart only encompassing the gold and gold-stock bull markets. Incidentally, if you would like to see some larger and more-detailed versions of the charts in this essay, we posted some of our raw research graphs at www.zealllc.com/charts/gold.htm on the Web.

I find it extremely provocative that the heavily-hedged XAU and the unhedged HUI traded at similar index levels in the early days of the gold-stock bull market in late 2000 and early 2001. The convergence of the red and blue lines above during this time period is quite striking, as is their later divergence as the unhedged HUI flew higher with gold and left the hedge-burdened XAU choking on its dust.

Since these two indices both began the gold bull at the same general levels, I believe that the difference in price between the XAU and HUI indices today can be considered a "hedge tax". There are great gold mining companies in both the XAU and the HUI, but the XAU hedgers sold-out their shareholders' gold at lower contractually fixed prices while the unhedged HUI members' shareholders have fully participated in the bull market to date.

With the HUI up 335% as of this week and the XAU only up 97%, the total hedge tax at this point in the game is a breathtaking 238%! How would you like to miss an additional 238% gain over a few years simply because you made the mistake of betting on hedgers rather than the unhedged? For the life of me I can't understand why one single investor on Earth, either retail or institutional, wastes their time and capital betting on the heavy hedgers when their performance has been so dismal in comparison to the unhedged!

The moral of this story is, if you want to invest or speculate in gold stocks, make darned sure that the horses you bet on don't sell future production via hedging contracts today. Only place your own scarce capital at risk in totally unhedged companies. If you are not a direct investor, absolutely insist that your fund managers only buy totally unhedged companies. While hedgers will earn you money in a gold bull, ultimately their returns will only be a fraction of what the wonderfully unhedged will offer.

While the unhedged HUI's long-term, medium-term, and short-term trends shown above are all superbly bullish, the hedged XAU is stinking up the gold-stock world by trading sideways for over a year now. Do not forget this expensive lesson in hedging!

Now that we have celebrated the HUI's awesome new bull-to-date highs and exposed the enormous hedge-tax cost of betting on the wrong horses in this race, I would like to discuss actively trading this gold-stock bull. While I do strongly believe that investors should always maintain a never-traded core position in gold stocks as long as the gold supply and demand fundamentals continue to favor this Great Bull, it can be even more profitable to actively trade a portion of one's portfolio.

Unlike the general equity markets, the gold-stock market is so small and unloved today that there are few external trading indicators to use. As such, we contrarian gold-stock speculators can't rely on sentiment indicators like the VIX and have to build our own tools. I have been working on one such gold-stock speculation indicator for many months now based on the moving-average convergence and divergence of gold itself.

This tool is very simple. It merely involves watching the relative distance between the 50-day moving average and 200-day moving average of gold itself. I explained it in more depth relative to trading gold in my recent essay "Trading the Gold Bull" and I call it the Gold 50/200 MACD (Moving Average Convergence Divergence). It is calculated by dividing the 50dma of gold by its 200dma and converting the result into a percentage.

If you closely examine the chart above, you can see the white 50dma and black 200dma of gold. Since mid-2001 or so, just like in all primary bull markets, the 50dma of gold has beenabove its 200dma. Sometimes the 50dma is relatively high above the 200dma and sometimes the two moving averages converge, but interestingly their action creates an exceptionally promising gold-stock speculation indicator.

The light blue line below on our next chart shows this Gold 50/200 MACD in percentage terms. A reading of 6%, for example, means that the 50dma of gold is 6% over gold's 200dma at that given moment in time. A negative Gold 50/200 MACD means that gold's 50dma traded under its 200dma, something that hasn't happened since very early in the unfolding gold bull market.

The relationship between the Gold 50/200 MACD and the wondrous HUI unhedged gold-stock index is quite striking. There is no more important driver of gold-stock prices than the price of gold, at least in the early pre-mania stages of a gold-stock bull, and this trading concept really capitalizes on this central truth of gold-stock speculating.

As in any bull market, gold itself goes up and down alternating between dazzling new uplegs and normal healthy bull-market corrections. As the two earlier charts in this essay clearly showed, gold stocks tend to move in lock-step with gold over the long-term. If gold is up then so are gold stocks, and if gold is weak gold stocks languish too. The interplay between gold's 50dma and 200dma tracks and smoothes these perpetual gold oscillations.

Interestingly, the Gold 50/200 MACD tends to be lower when gold stocks are poised for another upleg and higher when a pullback is due. Gold-stock speculators can use this Gold 50/200 MACD to help them gain a better understanding of when they should jump back into gold stocks full throttle and when they should ratchet up their stop-losses and prepare to be stopped out.

Since the gold-stock bull launched in late 2000, each time the Gold 50/200 MACD was moving down from an interim peak and pierced 2% proved to be an excellent time to buy gold stocks. This is our gold-stock buy signal, a Gold 50/200 MACD falling under 2% following a gold pullback. A Gold 50/200 MACD of 2% simply means that gold's 50dma is 2% higher than its 200dma on any given trading day, an easy concept to understand.

The green arrowheads mark these Gold 50/200 MACD gold-stock buy signals. There have only been three of these excellent signals flashed so far in this gold bull, so they don't tend to happen often. You will note on the chart that each time this buy signal was thrown the HUI tended to be just starting a major new upleg, quite near the ideal time to throw long to ride gold stocks for a few months or so. These buy signals didn't catch the exact troughs, but they were pretty darned close and very impressive.

In gold-stock terms, when the Gold 50/200 MACD heads back down under 2% it is time to deploy fresh gold-stock positions. All you need to do is pick a quality group of unhedged gold stocks, around a half-dozen or so, equally divide your capital into each one, and pull the trigger.

On this initial buy signal you should run trailing stop losses of around 20% or so on your gold-stock positions. I personally prefer close-only stop-losses, meaning only daily closing prices are considered, but these aren't popular outside the futures world so normal intraday trailing stop losses around 20% are also acceptable. Your initial stops can also be tailored to the volatility of individual unhedged gold stocks in your portfolio. For example, you may run a 25% trailing stop on a chaotic junior company while running 15% on a large major producer. 20% is merely a guideline.

After you buy your unhedged gold-stock speculations on the Gold 50/200 MACD buy signal, all you have to do is sit back and wait and watch the gold stocks run higher. Long-term gold-stock investors can also add to their core positions on this signal, as it tends to catch the gold-stock troughs in the HUI rather well.

While there aren't Gold 50/200 MACD sell signals per se, there are neutral signals marked above by the yellow arrowheads. These neutral signals occur when the Gold 50/200 MACD heads back above 5% as a gold/gold-stock upleg continues to unfold. The purpose of these neutral signals is to warn speculators to be on their guard that a particular gold upleg is growing long in the tooth. You don't need to sell outright here, as a bull market can always surprise on the upside, but you do need to consider ratcheting up your trailing stops in anticipation of being stopped out.

Once this 5% Gold 50/200 MACD threshold is crossed, immediately raise all your trailing stops on gold-stock positions to at least 10%, and maybe even a really tight 5% if the run-up has been particularly sharp. The idea of ratcheting up trailing stops rather than selling outright is designed to enable you to stay in a gold-stock upleg as long as possible, until the upleg itself noses over. Yes, you may get stopped-out early on a particularly strong head-fake that blitzes your stops, but nevertheless you will consistently earn excellent profits while minimizing your risk.

For example, Rally 1 above using this speculation methodology yielded HUI gains of 114%, very impressive. The more recent Rally 2 launched late last year managed a respectable 17% gain. These gains are computed using 5% trailing stops on the HUI. If looser 10% trailing stops triggered on the neutral signal were used, the gains dropped modestly to 102% and 11%, still nothing to scoff at.

It is also possible to beat the HUI gains by carefully picking elite unhedged gold stocks with the best prospects. As a real-world example, in our Zeal Intelligence newsletter we were blessed to ride Rally 2 to an actual realized gold-stock portfolio gain of 31% on our picks, even though the HUI only managed a 17% rally during this period. As in any bull market, the base index gains can be multiplied by careful stock picking.

During Rally 1 last year we were very blessed to have one of our Zeal Intelligence gold stocks run up to a 372% realized gain and another to +158% realized. The HUI index results are a great baseline for performance, but are certainly not a limit. The idea of the Gold 50/200 MACD signals helps gold-stock speculators buy near the right time and ratchet-up their stops near the right time and the realized gains can be dramatic.

The latest Gold 50/200 MACD buy signal occurred in early May. Since then this flagship unhedged gold-stock index is up 20%, a very impressive number in such a short period of time. Yet again at the very moment when many were predicting a plunge in gold and gold stocks after Washington's annexation of Iraq, the Gold 50/200 MACD buy signal proved correct and contrarians who heeded it have been well rewarded.

In our new anytime Zeal Speculator alert/update service, our current unrealized gold-stock portfolio gains in this Rally 3 so far were sitting at +33% as of June 19th, which isn't too bad at all. In our monthly Zeal Intelligence newsletter, which is limited to buying and selling on month ends due to its fixed publication schedule, our current Rally 3 gold-stock picks were up 20% as of June 19th. We will certainly continue tracking and trading gold stocks based on these signals for our Zeal Speculator and Zeal Intelligence subscribers.

If you are a contrarian investor or speculator and you are interested in gold stocks, you ought to consider honoring us with a subscription! In our current June issue of our acclaimed Zeal Intelligence monthly, I discussed the coming Gold Exchange-Traded Fund in depth, an immensely important development for the gold and gold-stock markets. The coming gold ETF could light a rocket under gold stocks and gold! We will fire out a complimentary copy of this current June issue to all new e-mail subscribers to ZI.

As contrarians today we are very blessed to be riding the awesome gold-stock bull. Unlike the current sentiment-driven mini-mania in general equities, the gold and gold-stock fundamentals are sound and the foundation of the bull market is strong. Long after the Great Bear eviscerates today's thick-skulled fools buying tech stocks at NASDAQ-2000-like bubble valuations, the powerful gold-stock bull market will still be running higher.

The new bull-to-date HUI high this week was wonderful to see! Gold-stock investors and speculators staying away from the hedgers have already reaped great gains and will see their capital multiply many times over before this gold-stock bull fully runs its course.

You can ride this gold bull for the long haul, or you can trade it, or you can do both! Whatever you do though, don't let this next Great Bull market pass you by!

Adam Hamilton, CPA

 

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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 [email protected]. 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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