Sunday, January 31, 2010

Gold And The Amex Gold Bugs Index: A Chart Check

There are those who believe that the Amex Gold Bugs Index chart can be used as a double-check of gold itself. These people tend to hew to the Dow Theory, which uses the Dow Transport Index as a double check of the primary trend as shown by the more-familiar Industrials. Both indices have to show a pattern of higher highs and higher lows before an uptrend is deemed to be valid. If one of the indices (usually the transports) fails to confirm, then the uptrend becomes iffy. More sophisticated users of the Dow Theory use the Utility Average as a further check, believing that the utilities enter a downtrend before the other two indices do. The most venerable practitioner of the Dow Theory today is Richard Russell.

Shifting back to gold and the Gold Bugs Index (HUI), these two Stockcharts.com charts show a disquieting picture. They're, in order, the one-year daily charts for gold and the HUI:




The gold chart at the top looks disquieting in and of itself, and explains why there are so many cautious gold bulls now. The HUI chart looks worse. Gold has reached its late-December low again. The HUI has sunk well below its. Not only that, but the HUI has also sunk below its low made at the beginning of November. There's already a well-established pattern of lower highs and lower lows in the lower chart.

Using a Dow-theory takeoff leads to a doleful conclusion: the downtrending HUI is anticipating a further drop in the gold price itself.

A longer-term perspective using the weekly charts adds to the disquiet.




In late 2007, both charts showed a higher-low and higher-high pattern. Just beforehand, a new short-term low on the HUI was not confirmed by the price of bullion. Starting in February of '08, the downtrend in both started. Both made lower highs in July, and (of course) lower lows followed. After the October crisis, however, gold made a higher low that was confirmed by the HUI: see the early-November lows for both. The HUI made a new '09 high in late May which was not confirmed by gold itself. However, both made higher lows in the July downswing. I note that the HUI made a slighly lower low in the beginning of November, which gold itself did not. Both made higher highs at the end of November, and both made lower highs in early January.

This time, however, we already have a longer-term lower low in the HUI. Granted that it has yet to be confirmed by gold itself, but the longer-term perspective adds to the foreboding. As far as the gold market itself is concerned, the only reason for optimism is evident bargain-hunting buying as the price sinks. Needless to say, the strong rally in the U.S. Dollar Index does not give grounds for hope.


Finally, a pair of charts that show the daily and weekly HUI to gold ratios. That value goes up when the HUI is outpacing gold itself, and sinks when gold is outperforming the HUI. Those who believe that the HUI should show leverage with respect to gold would associate a rise in the ratio with a gold upswing, and a fall with a downswing. I should note that this belief doesn't stand up well to the '07 period.





Both charts show a deteriorating ratio of HUI to gold in recent weeks, leading to a low that hasn't been since since July. Some may argue that this downtrend means the HUI is undervalued relative to gold.

That's the trouble, in general, with using charts without having the fundamentals tucked away somewhere. A stock, or investment, that approaches bargain levels usually has a lousy chart pattern. Technical analysts tend to assume that a bargain-priced investment goes nowhere for a time once its bargain status becomes apparent.


Speaking of trouble: I should also point out that the above interpretation, although informative (I hope), doesn't translate all that well to a trading strategy. The very basis for the Dow-Theoryesque approach - overreaction on the upside and downside at the end of trends - clips its performance when used mechanically. Overreactions are followed by snapbacks, which a careful Dow Theorist would avoid because of lack of confirmation. A higher high has to be followed by a higher low in order to establish an uptrend. That requirement takes a real piece out of the performance, as does the opposite requirement of a lower high following a lower low. Because of those chunks, the Dow Theory tends to underperform a simple buy-and-hold strategy.

However, there is an argument for the Dow Theory despite that underperformance: people who use it not only miss out on some of the uptrend, but also miss out on some of the downtrend. During bear markets, they sleep better. When looked at in this light, the tranqilizing effect can be seen as a benefit which is paid for by underperformace. The Wikipedia article on the Dow Theory points out that a recent revisionist study has shown the Dow Theory lowers the volatility along with the return, to the point where its risk-adjusted performance beats buy-and-hold. However, this revisionism is still controversial.

The same criticism does apply to the Dow-Theoryesque schema above, if used mechanically.

Practitioners of the real Dow Theory who've come up with great calls, such as these four, have something extra: a sense of how the stock market acts when it bottoms and the guts (if watery) to apply that sense at bottom time. Call it intuitive bargain-hunting, or an intuitive flair for market turns.

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