Gold stock breakout targets new levels

Analyzing the HUI

Gold stocks just surged to a major technical breakout, a very bullish omen. Investors are actually starting to redeploy capital in this battered sector, catapulting gold stocks into the early lead as 2014’s best performers! This year is shaping up to be the polar opposite of last year’s epic carnage, with gold stocks mean reverting back up to fundamentally-reasonable levels. The vast majority of the buying is still yet to come.

Exiting last year, gold stocks were inarguably the most hated sector in all the stock markets. And it is easy to understand why. In a stupendous year when the benchmark S&P 500 stock index blasted 29.6% higher, the flagship HUI gold-stock index collapsed 55.5% lower! It is hard to imagine a greater performance gap, which led investors to flee as gold stocks were crushed with gold. It was a total disaster.

But naturally such brutal losses drove sentiment to hyper-bearish extremes. Virtually everyone assumed gold stocks were doomed, never to rise again. They were wholesale abandoned, there was truly blood in the streets. Plagued by peak despair, gold-stock prices plummeted to levels that were fundamentally-absurd. Many elite gold stocks were trading at trailing P/E ratios under 10x, radically undervalued by any standard.

In late December, the leading HUI gold-stock index slumped to 190. As I was pounding the table about at the time, those levels were fundamentally absurd. The first time the HUI traded at 190 in this secular gold bull was over a decade earlier in August 2003. But back then gold, the dominating driver of gold-mining profits and hence gold-stock prices, was merely around $365! In December 2014 it was $1200.

With gold almost 3.3x higher, did it make any sense at all for gold stocks to trade at decade-earlier prices? Were the widespread single-digit P/Es justified? Hell no! Gold stocks weren’t ridiculously cheap because there was any fundamental justification for those prices, but because investors had capitulated on this sector and abandoned it. But extreme bearishness, fear, and despair can never persist for long.

All anomalous sentiment extremes soon burn themselves out. Once everyone who is susceptible to being scared into selling low has already dumped their shares, only buyers remain. Then fundamentally-cheap abandoned sectors start rallying out of the ashes. That’s what has happened so far this year in gold stocks. As of its latest interim high this past Tuesday, the HUI has powered 18.8% higher in 2014.

This compares to the S&P 500 down 1.5%, and gold itself only up 7.1%. Gold stocks as measured by the HUI have leveraged gold by over 2.6x in this young new year! And the smaller high-potential gold and silver miners we prefer have seen gains far outpace the HUI’s. Once this phenomenon of gold-stock outperformance starts, it rarely stops until gold stocks soar radically higher as investors flock back in.

Just this week, the HUI enjoyed a major upside technical breakout. This is a very bullish harbinger of much more to come. This first chart looks at this flagship gold-stock index over the past year or so, superimposed over a trading construct called the Relative HUI. Relativity trading looks at prices as multiples of their 200-day moving averages. They tend to form horizontal trading ranges that help time entries and exits.

2013 was catastrophically bad for gold stocks, there’s no doubt. The HUI started falling right out of the gates, dragged down by gold. Gold got hit due to epic record mass liquidations from the flagship GLD gold ETF. This flood of supply was the result of stock traders dumping their GLD shares to redeploy that capital into the Fed-driven stock-market levitation. So gold stocks just plummeted, it was nauseating.

The worst of this carnage came in two specific episodes. Last April, gold plummeted 13.8% in just 2 trading days in a panic-like selloff. When heavy differential GLD selling pressure pushed gold under key long-term support at $1550, futures speculators were forced to dump their longs in a massive forced liquidation. That wildly-anomalous event drove a quarter of the HUI’s 2013 losses in just 4 trading days.

And then in mid-June, gold plunged again after Fed chairman Ben Bernanke outlined the Fed’s best-case timeline for tapering its QE3 debt monetizations following an FOMC meeting. Over the subsequent week, the HUI suffered another fifth of its full-year losses. Together these massive April and June selloffs, along with early-year selling, conspired to force the HUI into the free-fall downtrend rendered above.

In 2013’s first half, this index had plummeted 54.1%! That was essentially where it ended the year, so all the losses were front-loaded. The bearishness and despair in gold and gold stocks in late June was just insanely high. There were only a handful of hardcore contrarians bullish on this loathed sector, with the vast majority of analysts and investors predicting big additional losses. This consensus proved dead wrong.

In July just when all hoped seemed lost, the HUI surged dramatically. It soon broke out of early 2013’s free-fall downtrend on a sharp short-covering rally. While this trend change was very welcome, like all short-covering rallies the buying was short-lived. Short sellers buy fast and then they are all done, so if investors don’t return that momentum soon peters out. And indeed the gold stocks started drifting lower again.

Investors didn’t return because gold continued to experience pressure from heavy differential GLD selling thanks to the Fed-driven stock-market levitation. And without gold advancing, the gold stocks can almost never rally materially. The HUI settled into a new and much-shallower consolidation downtrend. The additional selling was marginal compared to the first half of 2013’s, but it was still relentless.

The HUI finally bottomed in late December, just 2 trading days after the Fed’s surprise decision to start tapering its QE3 bond monetizations at that month’s FOMC meeting. This was very interesting. After both gold and gold stocks plummeted in June on the mere threat of the QE3 taper, they weren’t too much lower when the actual event arrived. Gold only fell another 0.8%, and the HUI was 8.1% lower at worst.

All year long the groupthink-blinded gold bears argued that gold and therefore the entire precious-metals complex would just be crushed when the Fed started slowing QE3. A full-blown QE3-taper hysteria arose surrounding gold, it was crazy. But once the taper arrived and gold didn’t collapse on cue, buyers started to return. And that tentative rally has grown into the great gold-stock strength in 2014.

The HUI is up 23.6% in the past 1.7 months, which is the longest it has rallied in 17 months! This new buying is gradual and sustained, the kind of advance seen when real investment capital starts returning to a sector. This is a big contrast to the sharp short-covering rallies last summer and autumn, which quickly burned themselves out. Slow and steady wins the race, as it gradually entices in more and more buyers.

The reason I’m writing this essay this week is a major technical breakout. Note above that just in this past week, the HUI broke out decisively above its consolidation downtrend’s upper resistance line! This zone had trapped the HUI for several weeks, but the gold stocks finally powered through. And shortly after, this flagship gold-stock index regained its 200dma for the first time since the first trading day of 2013.

Next page: A very bullish sign

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