THE GOLD BEAR'S RATIONALE

Over the last few months, Gold Stocks have been in decline with the widely watched XAU Index most recently hitting a low of 78.23 on May 16^th. At that point, the XAU was down 21.39% for the year and 28.60% from its November 22, 2004 peak at 110.25. Within the community of technical analysis, there are a certain contingent of “gold bears” that make the argument that Gold Stocks have slipped into a “bear market”. In my view, this argument is completely unfounded and suggests a weak grasp of the gold and gold stock market. One example of the bearish argument is that within markets, a 20% decline often defines a bear market. As noted above, gold stocks are recently down 28.60% from their November 22, 2004 high. Thus, according to the gold bears, Gold Stocks are in a bear market with the current rally described as a bear market rally.

Understanding Beta
What the bears are missing is an understanding of volatility. Where gold stocks are concerned, there is a very high “beta.” In the stock market, “beta” describes the sensitivity of an index or stock sector to broad market movements with the S&P 500 assigned a beta of 1.00. As an example, a stock sector with a beta of 0.5 will tend to participate in broad market moves, but will only gain half as much as the market overall. A portfolio or sector with a beta of 2.0 will tend to benefit or suffer from broad market moves twice as much as the market overall. Gold Stocks have a negative beta, which means they are strongly inversely correlated to the overall stock market indices. What’s more, the negative beta for the Gold Stocks is on the order of 3 to 3.50 times the volatility of the S&P 500. As a result, if the S&P 500 had an 8 to 10% decline, it would be considered a “normal correction,” while a 20% decline or more would define a bear market.

XAU Index is NOT the Same as the S&P 500 Index
For the Gold Stocks, if we use an average beta of 3.25, we can arrive at the rough equivalent in terms of gaining a handle on the “market condition.”  In this vein, a 24% to 30% decline in Gold Stocks is roughly the equivalent of an 8 to 10% correction in the S&P. For anyone who has followed Gold Stocks for any period of time, you will realize from observation that a 20% to 30% decline in Gold Stocks is fairly routine and happens at regular intervals. Why over just the last few years, the gold stocks have seen the following declines:

There is nothing unusual about a 25% to 30% XAU decline within a few months as this type of decline has happened with great frequency over the last 2 decades. Nor is there anything unusual about 25% to 50% or more gains in the XAU over a span of a few months. In just the last few years, the market gains were:

Thus “gold bears” make a great deal out of a 25% decline in Gold Stocks. They act like the gold stocks have a volatility akin to that of the S&P which is simply not the case.

200 Day Moving Average and Gold Stocks
Further, a number of these technical “gold bears” point to a downward turned 200 day moving averages, which they argue proves the gold stocks are in a bear trend. Again, nothing could be further from the truth. With a duration of 200 days, a long moving average -- such as a 200 day moving average -- will always lag behind a volatile index like the XAU or HUI. Instead of looking at the direction of a particular moving average, which is akin to looking at the rear view mirror, investors need to understand that Bull Markets move forward with three steps, and often take 2 back.

In classic Elliott Wave Theory this translates into the familiar five wave advancing pattern, followed by a three-step correction. Within Dow Theory, a typical “bull market” correction may end up retracing 50% of the prior advance with some deeper declines retracing 66% of the prior advance with the market still remaining in a bull market. Under Elliott Theory, the typical fibonacci retracements are .236%, .382%, .50% and .618%. Clearly, the .618 and .50% retracements are fairly deep corrections, but have been seen many times in many markets over the years. Among Elliott’s other retracements, a .382 correction is “shallow to normal” for a bull market correction, while a .236% correction is the “shallowest retracement” of all and is nearly always a sign of a very strong underlying market.

GOLD STOCK BULL MARKET ADVANCE

XAU Index With a Normal Correction
With that in mind, let’s look at the XAU, which began its bull market on October 25, 2000 with a low close of 42.40 and peak its first major advancing wave on January 5, 2004 at 112.90. A “normal” .382 fibonacci retracement of this advance would come in at a reading of 76.33 (the 2^nd horizontal line down from the top)

Does the above chart look like a “normal correction”? Answer: You bet it does. In fact both the May 2004 low and the May 2005 low pulled right down to that 76.30 area and promptly whipped around and rallied off that long- term support.

What About the HUI Index?
Now a cynic might say, “Well, what about the more volatile Amex Gold Bugs Index (HUI), that was just down 33.50% from its November high? I bet that has retraced more than .382%?” Answer: Wrong again.

In fact the HUI, which is an even more volatile basket of unhedged gold stocks (shares containing more leverage to rising gold prices), gained +627.01% in its first bull market advance from the low of November 15, 2000 (35.31) to the high of 256.71 seen on December 2, 2003. A .382 fibonacci correction for the HUI would have meant a retracement back down to 134.13. Well, guess what? The recent lows over the last two years for the HUI have held ABOVE 163.00. What’s more, the “shallow” bull market correction threshold of .236% actually came in at a reading of 163.50 for the HUI. On May 10, 2004 the low close was 169.01 and on May 16, 2005 the low close was 166.47. For only 1 hour, (back on May 10, 2004) did the HUI even approach its .236 minimum retracement zone at 163.50 with a low of 163.81.

HUI Index Outperforms XAU Index
Put another way, not only is the HUI in a clear-cut longer range bull market, but over the last few years, after running up nearly 600% in three years, the “give back” has been a “mild” .236 fibonacci retracement. This is incredibly bullish in that the HUI represents leveraged exposure to gold and it has held up even better than the XAU. I also might add that several of the “gold bears” are of the Elliott Wave persuasion and somehow manage to not see the clear-cut 5 wave advance followed by three wave decline (a-b-c) evident on the HUI.

Attention All Gold Bears …
SEE ABOVE CHART

THIS is what a bull market looks like.
Note especially the MILD percentage retracement
following the huge and sustained advance.

PRIMARY WAVE 3 IS COMING

I have outlined in prior pieces the longer-term Elliott outlook for Gold Stocks. The even bigger picture outlook for mining shares—going back the balance of the last 100 years—strongly argues that what we have seen over the last few years has just the first Two waves of an even larger Five wave advance getting under way. The next rally sequence—Primary Wave 3—will bring all gold stock indices to decisive new all time highs and should be even more dramatic than the advance seen between 2000 and 2003.

And Still They Will Not Believe
Still other arguments come from the Elliott camp that the “wave structure of the XAU” was NOT a clean-cut “5 Wave” advance between 2001 and 2003. Answer: I agree. In the case of the XAU, the wave count is not as clean as the Elliott count on the HUI. However, the reason for the XAU’s lagged performance and poor five wave structure is the fact that during the early portion of the 2000 to 2003 bull market, the XAU contained heavy weightings of Phelps Dodge PD – a high cap COPPER stock and Freeport McMoran (FCX), a copper/gold producer. The weightings of these stocks in the index held back the index and undermined what would have been a clean-five wave pattern had they NOT been added to the index.

Try The GST Unweighted Gold Index on For Size
For those who doubt the integrity of the gold stock bull market wave structure, if the HUI isn’t enough proof, I would point to my own GST Unweighted Index, which is over 25 gold stocks. As an unweighted index, all stocks count the same in the index, which traced out a picture perfect “five wave” advance between late 2000 and mid-2002.

GST Unweighted Gold Index June 2000 - Present

Above: GST Unweighted Gold Index --- “Gold Bears” take note again. Note the 5 wave advance followed by a Three Step correction. This is classic bull market action with Wave 2 giving back virtually nothing of the prior bull market advance.

THE LARGER TREND FOR GOLD STOCKS

Finally, I want to close the technical argument regarding the larger trend for Gold Stocks with an observation on the XAU. This index has been the lagging index among gold indices. Note that over the last 18 months of correction, the XAU has traded from its upper 50 week bollinger band down to the lower 50 week bollinger band, which is still in a rising configuration. In fact, as I pointed out 6 months ago, this lower band was overdue to be “tagged” by the index.

That contact point came on May 13^th of this year. Since then, the XAU has rallied strongly OFF the rising 50 week lower band. IF and when we ever see a decline below 76 and by default, below the 50 week lower Bollinger Band, I will turn bearish on Gold Stocks and agree that a bear market is in force. However, given the fact that the gold stocks just saw historic oversold readings accompany the low seen on May 13, I have a feeling that an XAU close below 76 is one event none of us will see ever again.