Monday 11 May 2015

Gold and the miners: identifying the bear market logic

Irrespective whether the latest precious metal recovery sets off a miners rally or is just another dead cat bounce, it 's important recognizing the underlying logic in the trends of gold miners (the HUI index) relative to gold.

Brutal awakening as the fairy tale ends ...

During the early years of the secular gold bull in the previous decade, gold miners have been outperforming the metal by a more than decent margin. In its second phase, gold rose almost in lock-step with the miners, when approximating those using the ARCA index of unhedged gold miners (HUI). The narrow range of the HUI relative to bullion has been used as a trading rule, successfully... until it failed as all ' trading rules' did in the 2008 financial crisis.

A first glance on these gold bull years will tell more than words describe:
Gold (red, left scale in USD/Oz) and HUI (blue, right scale) - click to enlarge
As the HUI bottomed by the end of the gold bear market, the yellow metal was quoting around $270. The gold recovery, however timid, was picked up by miners recovering from their all time lows. Miners outperformed gold and the blue curve of the HUI miners index approaches the red one of gold bullion and breaks above near the end of the 2003 miners rally. This marks the end of the first phase of the gold miners rally: the only lengthy period of miners outperforming gold bullion.  Going forward, the HUI index (in points) is to approximate about half the gold price (in USD/Oz). That statistical coincidence is going to get turned into a linear trading rule which will hold until spring 2008, when gold first breaks above $1000/Oz in March 2008.
The old trading rule sounds easy: selling miners to purchase bullion as the blue curve gets ahead of the red one, the other way around as the blue curve lags the red gold bullion curve. It results in accumulating small profits while sweeping on to the major catastrophe...

The full picture

Gold (red, left scale in USD/Oz) and HUI (blue, right scale) - click to enlarge

The above graph gives you the full picture. It has been discussed in more detail in previous articles. Some observations:
  • During  the decline of the HUI index from its start in June 1996 to the very bottom in November 2000, the index fell to 17.3% of its intial value.
  • That initial decline was worse than the recent one experienced since the HUI topped and what it is like now: we now are down to 27.7% of the top closing value (635.04) reached on Sept 8, 2011. Even at the bottom of the current bear market trough on Dec 16, 2014, the HUI was down to 23.1% of its top value, which still is less bad than the initial decline from the 1996 value to the bear market trough in Nov-2000.
  • The current level of the HUI index (175.06 on May 8) is but 84.4% of its starting level in June 1996, despite gold having risen over threefold from $389.7 to $1187.5
  • During the 1998-2000 gold bear trough, the HUI/Gold ratio bottomed at 0.1354. So far the actual gold miner bear market has seen lower readings for HUI/Gold on exactly 13 occasions.
I won't try to explain why the current bear market is this severe. It has been discussed previously in more detail:
  1. Decades of underperformance (Feb 2011)
  2. Miners relative to precious metals: a tactical approach; (July 2, 2012)
  3. Miners relative to precious metals: An update on 2012; (Jan 13, 2013)
  4. Anatomy of a gold miner bear market (Dec 30, 2013)
  5. Gold miners: three decades for naught (Jan 2015)
It also is a good idea to listen to what seasoned geologists as Brent Cook or mining investors as Rick Rule comment on this issue... and focus on the explanation of how and why it went wrong, not on the current perspective: this may work out but don't ask for a time frame.

Identifying the bear market logic

Gold (red, left scale in USD/Oz) and HUI (blue, right scale) - click to enlarge
A disclaimer to start with: Investor beware, curve fitting often works well over an extended period... until some paradigm shift makes your theory break down dramatically: remember the HUI = 1/2 Gold of the 2003-2008 period ?

By end 2009, HUI/Gold stalled at around 0.42 and it soon became clear that the 2003-08 trading logic was not going to get re-established.  Instead the HUI gold miners index failed to catch up with gold prices progressing and rallying to their August 2011 absolute high.

The oscillatory down trend of the HUI/Gold ratio ever since 2011 implies that a proportional logic is not holding any longer. On the above graph, HUI on the right scale seems to match well the Gold price on the left scale. The time scale extends from July 2013, as gold started recovering after its major slide since April 2013 till the present day. There still is a match of about 25 points on the HUI index to a $50 variation on the gold price. One very important difference though: the 'zero level' on the HUI would match to a reading of $850/Oz for gold. The fresh rule then is:

HUI = 0.5 * (Gold price - $850)

This essentially makes the relationship non-proportional and implicitly assumes that a gold price of $850/oz would imply the gold miners to go out of business. The disclaimer at the start is not there without any reason: there is no such clear 'cut-off' gold price for the mining industry. The level of the USD-index affects mining costs for gold producers. Moreover, gold producers have vastly different margins and most probably also high margin differences among their individual gold mining sites.
Yet a rule with only two parameters is most elegant ... while the bear market logic holds.

* * *

Notes: 1) The above equation was derived graphically and parameters were rounded to make major divisions on the left (Gold) and right (HUI) axis coïncide. A (least square) regression analysis provides you with mathematically exact values. However, any time interval necessarily yields a slightly different set of parameters.  Using data from May 1, 2012 till July 23, 2015 the slope and intercept are 0.574 and $902, with a 0.968 correlation coefficient, turning the HUI dependency on gold into:

HUI = 0.574 * (Gold Price - $ 902)

2) The regression made is y-values: Gold price on x-values : Hui index. It provides the intercept on the gold price axis and the inverse value of the slope of HUI relative to gold.  Inverting y's and x's yields a different regression line.  Its negative intercept on the HUI axis is however meaningless.

3) Checking the validity of the above equation for a more extended period requires little effort. A regression line with excellent correlation is obtained when extending the time interval used back to September 2012 (with gold over $1700) and with a good correlation even to Sept 1 of 2011, when gold made its all time high. The correlation dramatically drops off when incorporating much earlier data.

Follow-up article: The Bear Market Logic for Gold Miners: Continuation and Analysis
(July 24, 2015)
Last posted article on this subject: Regression between the gold price and the HUI miners index (26-04-2017)

1 comment:

  1. very interesting information from development of gold metal you give
    I hope you give the article is always beneficial for us