Gold Stocks vs. S&P 500

It has been an interesting market in the precious metals since 2006 began. We have witnessed gold outperform the large gold stocks, yet the large silver stocks have outperformed silver. As a whole, the junior sector has taken leadership and outperformed both the larger stocks and the metals.

We like to use the HUI Index as our proxy for gold stocks. The HUI has traded sideways from 280 to 360, for almost a year since topping at 401. Twice the gold market has tricked traders into thinking a new uptrend had began. First it occurred in September of last year, when the HUI broke above 360 but then fell about 30% in a month. More recently, we noted that since May of 05, Gold was leading the stocks. Gold recently broke above key resistance at $655 and the stocks lagged. The HUI reached 360 but Tuesday's sell off prevented any chance of a breakout.

Throughout this consolidation period, there has been a stronger than usual correlation between the S&P 500 and the HUI. (Though since gold's peak, the S&P 500 has slightly outperformed the HUI). Any weakness in the stock market (as evidenced by last week) has led to weakness in the HUI. Does this mean that the stock market has to be strong in order for the HUI to break above 360 for good?

Let's take a look at a chart that compares the HUI, S&P 500 and the ratio between the two.

A constant has been that in order for gold stocks to stage a solid run, gold stocks had to "breakout" against the stock market. The chart shows that in each of the four legs up, gold stocks strongly outperformed the market. Also, note how the gold stocks performed the best during the general bear market from 2001-2002.

Where does this leave us going forward?

For the HUI to successfully break above 360, the HUI will also have to stage a breakout against the S&P 500. (See bottom for a short-term look at the HUI/SPX chart). A catalyst for the HUI would be the S&P 500 going into a bear market (as long as the price of gold remained strong). Judging from the chart and general market history, gold and gold stocks perform best when the stock market is in bear mode. In looking at both charts, the HUI/SPX ratio could breakout (or breakdown) in the next three to seven weeks.

A breakout in that ratio would dovetail with our fundamental outlook, which I explained in the last email. Cracks in the US economy are starting to show and the Fed will have to act quickly and "reflate" before the cracks extend. Over the past two years M3 money supply growth (annualized) has increased from 5% to 12%. Economagic.com's data (which goes back to 1959) shows the highest rates of M3 growth as 17% in 1971 and 14% in 2001. The Fed's reflation likely will exceed those levels!

The Fed's impending reflation will help support the US market but the actions of foreigners are doubly important. Remember, foreigners heavily sold US assets in December. US economic weakness should instigate some kind of reduction of foreign buying of US stocks. The fundamental conclusion here is that the Fed will reflate aggressively (good for gold, helps stock market) and foreign buying of US assets will soften, as foreigners look more towards commodities and Asia (good for gold, bad for stock market).

Yes, that would bode very well for a big breakout in the HUI/SPX ratio and would finally get the next upleg in the PM's confirmed and moving. In the meantime we will be watching that chart (below) and waiting for a confirmed breakout or breakdown.