The HUI unhedged gold-stock index has been rather impressive so far this month, up 10% as of Wednesday’s close. And this move is just the latest component of a nicely developing 36% upleg that was born back in May.

With gold stocks surging again, they are attracting a lot more attention as we move into the busy autumn trading season. Just a few months ago gold stocks languished well under the radars of even most contrarian investors. Today they are moving into the spotlight as even CNBC has been reluctantly highlighting their strength this week.

As with any run higher, the HUI’s renewed vigor is generating an interesting mix of psychology. Gold-stock bulls are growing happier by the day. The higher the HUI runs the more enthusiastic they will grow, until their euphoria eventually gets out of hand and spawns an interim HUI top and subsequent correction.

Gold-stock bears, on the other hand, are busy thinking of reasons why this latest HUI upleg probably won’t be sustainable. Potential reasons advanced include deflation, central-bank selling, a persistent Wall Street bias against recommending gold stocks, and a general-market selloff hammering gold stocks. The higher the HUI runs the more pessimistic the bears will grow, building the proverbial wall of worry that all major uplegs must climb.

While I remain firmly in the bullish camp where I have been long gold stocks since their 2000 bottom, I have certainly learned to respect the bears over the past five years. All bull markets, including gold stocks’, take two steps forward before suffering a one-step retreat. Bulls generally flow higher but then inevitably ebb periodically in healthy corrections to keep sentiment balanced.

As such, it is always fair, regardless of one’s long-term bias on gold stocks, to ask if they are technically overbought or oversold at any given time. Since corrections are par for the course in even the most powerful bull market, astute investors and speculators will expect them periodically. These corrections grant enormous opportunities as they provide entry points at prices well below the usual bull-market levels.

So is the HUI overbought now after its impressive run since May? Is another correction imminent? In order to investigate these important questions I analyzed a wide variety of HUI technical indicators this week. Even though they all approached these questions from different perspectives, I was pleased to find that they unanimously indicated that this latest HUI upleg probably remains young with much room to run yet.

While unfortunately I can’t fit all of the indicator charts I analyzed into this essay, I would like to present three of the most interesting and compelling. They amply demonstrate that this premier unhedged gold-stock index is not only not looking toppy, but indeed it appears to be in the early stages of a major upleg.

The HUI/Gold Ratio, HUI Composite Volume, and Relative HUI indicators all make the case that the HUI technicals remain very bullish.

We’ll start with the HUI/Gold Ratio. It is simply calculated by dividing the HUI by the price of gold. This ratio is interesting because it expresses the relationship between the HUI and its prime driver in one data series. When this ratio is rising the HUI is outperforming gold, usually in a major gold-stock upleg. And when this ratio is falling gold is outperforming the HUI, often by not falling as fast as gold stocks during their periodic corrections.

The venerable HUI/Gold Ratio distills the sometimes chaotic tactical relationship between gold stocks and gold into one tidy technically-analyzable line. This ratio can be used to define trading signals as well using the system outlined in this chart. A buy signal triggers when the ratio breaks above its resistance while a sell signal spawns when the ratio’s 50dma fails as support.

These signals, while not particularly precise in time like other indicators, are very valuable as they tend to catch all the big swings that prudent investors and speculators want to time. The latest buy signal for this ratio just triggered in early July after a particularly vicious V-bounce in the index. This signal alerts us that probabilities are high that gold stocks will continue to outperform gold for anywhere from a quarter to over a year.

This is so exciting relative to our current HUI strength for several reasons. No major gold-stock upleg in this entire bull to date has ever occurred without one of these ratio buy signals first triggering. These ratio buy signals tend to be like official stamps of approval relatively early on in each new upleg. The mathematics governing the ratio and the technicals it carves ensure that only rallies of major proportions spawn a ratio resistance breakout.

And since this signal confirms this rally is almost certainly a new full-blown upleg, it is interesting to compare it to past major HUI uplegs. Our current upleg as of this Wednesday, the data cutoff for this essay, was up 36% over the past 84 trading days. On average, past major HUI uplegs have run 98% higher over 137 trading days. Thus our current upleg is now only 3/8ths as big as we can reasonably expect and less than 5/8ths as old. It is nowhere close to being overbought yet by bull-to-date standards.

With this upleg confirmed with a ratio buy signal yet still small relative to past major uplegs, today’s HUI technicals remain quite bullish. Without the ratio buy signal the bears could argue that this is just another minor rally and not a real upleg. But once these signals trigger gold stocks tend to outperform gold for a considerable period of time and march a lot higher. These signals are very unambiguous.

Other technical indicators confirm this thesis, suggesting that the HUI is nowhere close to being overbought and due for a correction yet. One of these is a really interesting indicator that is not widely followed, HUI Composite Volume.

The HUI, like many sector indexes, is not actually traded. It is a pure mathematical construct designed solely to track the progress of its constituent components. As such it has no trading volume. But of course its 15 component companies do have trading volumes in their own stocks. We can add up these stocks’ individual daily volumes and use the result as a composite volume metric for the HUI as a whole.

Charted over time, this construct offers great insights into gold-stock investor psychology and HUI swing-trade timing. Since trading volume is so incredibly variable from day to day, a 5-day moving average is used here to slightly smooth out the wildest gyrations. The resulting chart forms a kind of horizontal volume-based trading band for this indicator.

The basic idea behind HUI Composite Volume is that speculators love to trade often when they are making money but when prices are languishing they get bored or discouraged and trade far less. Thus, low-volume levels tend to coincide with major HUI lows while high-volume levels cluster around major interim highs. Low volume indicates fear-laden psychology, bottoming conditions, while high volume manifests near times of short-term euphoria, topping conditions.

We are currently using a HUI volume 5dma trading range running between 16m and 38m shares per day. So far these volume bands have remained pretty constant despite higher HUI levels. Increasing stock prices don’t necessarily drive more raw share volume, but actually capital volume grows tremendously. It takes a lot more capital to trade 25m shares at $40 per share than it does to trade the same 25m at $5 per share.

If you look at the latest HUI rally since May, the entire move higher occurred on low HUI volume. It briefly flirted with 25m shares a few times, but the HUI volume has been nowhere close to the 38m+ levels that often coincide with major interim tops in the index. In volume terms enthusiasm for the HUI’s run since May has remained quite low to this day. This means it is really unlikely that the HUI is anywhere close to topping today.

Compare this low HUI volume signature of the last few months with volume signatures near the past major interim tops in the index. In each prior case the tops didn’t occur until volume soared, indicating high levels of euphoria among contrarian gold-stock investors. Since it is overly bullish sentiment that causes tops, the lack of any such sentiment today as reflected by volume means we probably yet have much room to run higher.

Like all the other technical indicators I have been painstakingly studying this week, the HUI Composite Volume now shows a pattern consistent with the early stage of a major new gold-stock upleg. This latest move was born in low volume and lack of enthusiasm and remains mired in low volume despite its price gains. So far at least, it seems like the majority of gold-stock speculators don’t believe this is the real deal worthy of riding.

Our final bullish HUI technical indicator I would like to illustrate is the Relative HUI. Computed by dividing the HUI by its own 200-day moving average, the rHUI quantifies an important bull-market phenomenon. All bull markets tend to march ahead in an upleg before pulling back in a correction. These uplegs tend to carry the bull far above its rising 200dma while the periodic corrections tend to bring it back down to its 200dma.

Thus Relativity measures the ratio distance between a bull and its crucial 200dma baseline. Major tops tend to occur when the rHUI is stretched far above its 200dma and major bottoms tend to occur when it falls to or below its 200dma. Despite the powerful HUI run so far since May, the index remains just above its 200dma and hence more technically oversold than overbought!

Unlike the HUI/Gold Ratio discussed above, the rHUI tends to provide very precise trading signals. We are currently watching a band between 1.00 and 1.50. When the HUI trades at or under 1.00, which is right at its 200dma, then it is generally a fantastic time to be long. And when the HUI rockets up to 1.50+, usually near the terminal topping stages of its major uplegs, it is time for speculators to close longs and consider adding shorts.

Back when this latest rally started in May, the HUI was tremendously oversold and languishing well below its 200dma baseline. Since then it has powered from the abyssal depths of 0.80 relative up to 1.10 relative this week. This rally from 0.8x to 1.1x the HUI’s 200dma may feel like a big move to some, but it really isn’t at all within the context of major HUI uplegs.

Most start under 1.00 and ultimately soar above 1.50 before they give up their ghosts. With the HUI still near its lower green long band near 1.00 today, it is actually almost technically oversold. Enthusiasm among contrarian investors and speculators regarding gold stocks has remained so low that the index isn’t even out of its general buy zone yet.

The HUI’s current low position relative to its foundational 200dma offers another perspective on the tremendously bullish HUI technicals prevailing at the moment despite its recent run. It shows, just like virtually any other technical tool you want to use, that the HUI does not look like it is near a major interim top yet. These major bull-market uplegs take some time to unfold and they tend to double the HUI, on average, before they fully run their courses and yield to periodic corrections.

Interestingly if we apply the average 98% gain achieved over the past major bull-to-date HUI uplegs to the latest major interim low near 166 on May 16th, it yields a current HUI upleg target of just under 330. This represents another 47% rally higher from today’s levels! While only time will tell if this particular HUI upleg will evolve in line with its past averages, it is crystal clear that we ought to be able to expect a lot more from this one than what we have already witnessed.

The HUI, like all bull markets, is being driven by long-term fundamentals but battered about over the short-term by investor psychology. In fundamental terms, the higher the price of gold runs the more the profits of the world’s elite unhedged gold miners multiply. The higher the profits earned by the miners, the more their stock prices will ultimately be bid up. And profit growth is not linear with gold’s price gains, but leveraged almost exponentially.

While these fundamental forces are driving the long-term HUI bull, it is greed and fear that are responsible for its major uplegs and corrections. As an upleg evolves investors eventually get too greedy and bid prices up to temporarily unsustainable levels. A correction ensues which bleeds off the greed and even spawns fear. When this fear grows deep enough, a major interim bottom is carved and this cycle begins anew.

All technical indicators, including the ones discussed here today, concentrate on price patterns. While not identical over time, price movements are driven by human investor psychology which is quite predictable. As long as prices don’t indicate short-term euphoria, then odds are we are some ways away yet from witnessing the next major interim top in the HUI. Without rampant greed it simply cannot be seriously overbought.

If you are interested in following these and other technical indicators as this upleg continues to evolve, we update large high-resolution versions of these charts on our website each week exclusively for our newsletter subscribers. As this upleg marches closer to the red topping zones, you can monitor these technical developments as they happen to help you make superior trading decisisons. Well-designed charts offer crucial strategic perspectives that minimize the temptation to trade on dangerous emotions instead of cold hard market realities.

In order to profit from this latest HUI upleg we have been layering in positions in elite unhedged gold and silver miners for the past six months or so. Unrealized gains in our dozen or so equity positions are now running as high as 40%+ despite this HUI rally still looking quite young. Our synthetic HUI options positions are showing unrealized gains up to 125% so far.

If this upleg merely unfolds along bull-to-date averages, these gains will grow dramatically in the coming months. While the easy bottom-picking may be behind us this time around, it is not too late to buy in for potentially fantastic gains if this upleg proceeds as expected. You can check out all our stock and options picks and ongoing trades and the logic behind them in our acclaimed Zeal Intelligence monthly newsletter. Subscribe today!

The bottom line is the HUI technicals, despite its strong run since May, still remain very bullish. The index is definitely not overbought yet in light of past bull-to-date precedent and indeed it remains nearly oversold still by some measures. Major bull-market uplegs take some time to unfold and our current specimen continues to look technically young.

Against this bullish technical backdrop the core fundamentals driving this powerful gold-stock bull remain strong. Gold prices are rising around the world which will continue to increase profits for the best of the unhedged gold miners. And ultimately gold-stock prices will follow the miners’ growing profits.

Adam Hamilton, CPA

September 16, 2005

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