first majestic silver

Gold Stocks in SPX Selloffs

CPA, Principal & Co-Founder of Zeal LLC
March 4, 2011

With the general stock markets now due for a selloff while gold hits new nominal all-time highs, precious-metals-stock traders face something of a quandary. How are their stocks likely to perform in the near future? Will they ignore general-stock weakness to rally with gold? Will they get sucked into a stock-market selloff even if gold remains strong?

There is no doubt that gold is the primary driver of gold stocks' fortunes. Higher gold prices lead to higher profits for this industry, and higher profits ultimately drive higher stock prices. Over the course of this sector's magnificent secular bull in the past decade, this core fundamental relationship has proven itself in spades. But just because gold is gold stocks' dominant driver doesn't mean it is their only one.

For the great majority of investors and speculators, most of their buying and selling decisions are an extension of how they happen to feel at a particular time. When they are greedy after a powerful upleg, they want to buy. When they are scared after a major correction, they want to sell. These compelling emotions drown out true fundamentals like the gold price and individual-company earnings results.

With greed and fear driving most individual trade decisions, what drives collective greed and fear? The state of the general stock markets, which is best represented by the level of the flagship S&P 500 stock index (SPX). Traders everywhere feel very differently about all stocks (and indeed markets) after a long SPX upleg than they do after a serious SPX correction. They are eager to buy in the former scenario, and eager to sell in the latter.

The more years I spend studying the financial markets and speculating, the more awestruck I become by the overwhelming power and ubiquity of the SPX's influence on sentiment. Big SPX uplegs and corrections usually have a near-universal impact. They affect every-single stock sector, other stock markets around the world, currencies, commodities, bonds, and even national economic outlooks. Every trader looks to the state of the stock markets for trading cues, even if they are not trading stocks!

An extreme case in point was late 2008's once-in-a-century stock panic. Solely because the stock markets plummeted, the US dollar skyrocketed while the euro plunged, commodities including gold entered a free-fall, Treasury bonds soared while their yields cratered, and the great majority of investors assumed we were on the verge of a new great depression! A stock-market event altered perceptions universally.

Gold (and silver) stocks are certainly not immune to the sentiment bleedover from stock-market events. You can argue that they should be fundamentally. Who cares what the stock markets are doing if gold-miner profits are purely a product of prevailing gold prices? I've sure wished this was the case many times in the past decade. But as traders, we have to trade based on how the markets actually behave, not how we want them to act.

If you carefully study the interaction between the general stock markets, gold prices, and gold-stock levels over this sector's decade-long secular bull, a couple things quickly become apparent. First, exactly as traders expect gold is the primary driver of gold-stock prices over the long term. Second, despite this core fundamental relationship gold stocks still decouple from gold to spiral lower with the stock markets when they suffer material selloffs.

The broad swath of psychological splash damage spread by general-stock fear overwhelms traders' rationality. So they sell precious-metals stocks regardless of what gold happens to be doing if the stock markets are falling fast enough to generate some real fear. While this relationship extends far back into the past, the scope of this essay is limited to the past couple years to make this analysis easier to digest.

This chart superimposes the benchmark HUI gold-stock index (blue) over the SPX (red). Since we are considering the impact of material general-stock selloffs on the HUI, these events are highlighted in red. So far in the SPX's post-panic cyclical bull, there have been seven material selloffs. Six have been pullbacks, selloffs of less than 10%. And one was a full-blown correction, a selloff greater than 10%.

Each SPX selloff is numbered, with the red percentage representing the headline stock-market losses. The blue and yellow percentages show what the HUI and gold did over the exact spans of these SPX pullbacks and corrections. While gold is certainly gold stocks' primary driver most of the time, during stock-market selloffs big enough to spark some universal fear the HUI latches on to the SPX instead.

The first post-panic SPX pullback began in June 2009. Realize this was not long after the panic lows so the background anxiety level was still very high. The SPX slid 7.1% across a span of just under 4 weeks. As is usually the case during stock-market selloffs, gold was much more resilient than the SPX with a loss of just 2.8% during this pullback. So what did the HUI do, follow gold or the SPX?

A general rule of thumb for HUI responsiveness to gold is 2-to-1 leverage. If gold rallies 10%, gold stocks as a group ought to rally 20% to compensate investors and speculators for their vastly-higher riskiness. If gold falls 5%, the HUI ought to fall about 10%. While HUI leverage to gold can vary radically, traders generally expect the stocks' performance to at least double the metals' to make them worthwhile.

So with gold only down 2.8% during that initial SPX correction, based on it alone it would be reasonable to expect a 6%ish selloff in the HUI. But the actual came in at 10.2%, considerably worse than the SPX's loss and 3.6x downside leverage to gold! And note above that the HUI's pair of sharp selloffs during this SPX pullback span corresponded exactly with the SPX's own sharp selloffs. This relationship holds true through most of the other SPX selloffs as well.

The leading gold-stock index not only fared worse than general stocks, but vastly worse than gold! Why? Gold and silver stocks are risky. When the stock markets are falling, their bearish sentiment bleeds into everything else. Traders' appetites for volatile assets wanes and their desire to hold cash grows more compelling. So they sell all risky trades (including all commodities stocks) when the SPX is weak.

The SPX's second pullback was born in September 2009, a milder 4.3% over less than 2 weeks. Gold weathered this weakness like a champ, down just 1.2%. So did the HUI only fall 2.4% to reflect gold's price action? Nope. It plunged 7.7%, far exceeding both the SPX and gold declines. This downside leverage was actually a pretty-scary 6.3x gold! SPX selloffs scare the dickens out of PM-stock traders.

The SPX's third pullback erupted the following month, October 2009. During its 5.6% retreat in just under 2 weeks, gold only fell 1.7%. Yet the HUI plunged a ridiculous 12.9% over this short timeframe! And as you can see above, its sharp selloff perfectly mirrored the SPX's. Instead of doubling gold's decline as it ought to, the fear splash damage from this stock-market event led to the HUI leveraging gold's downside by a massive 7.8x! See the pattern emerging here?

The SPX's fourth pullback starting in January 2010 was exceptional. It was the stock markets' biggest pullback (less than 10%) so far in this cyclical bull. Look at what was going on in the HUI before that. The HUI had rallied rapidly to new post-panic highs in December, but plunged sharply (as usual) when gold entered a healthy yet steep correction. Before the SPX launched its own selloff, gold and the HUI had already bounced and started rallying again.

This should ring a bell, because it is exactly what is happening today. Gold and the HUI topped in early December 2010, consolidated a month, and then entered their own corrections in January. Then gold bounced in late January the first day the Middle East riots really started scaring the stock markets. Naturally its miners followed it higher. Today the vast majority of PM-stock traders are arguing the SPX action is irrelevant because the HUI is going to follow gold, and geopolitics will drive gold higher.

Last year I bought into a similar argument. I knew well that the overbought levitating SPX was overdue for a major selloff. Yet since the HUI had already corrected sharply, I figured that its downside risk would be minimal when the SPX sold off. I wasn't expecting gold and silver stocks to rally through an SPX selloff, but I figured they would hold their own so we might as well start adding PM-stock positions at that seasonally-favorable time (early January). Boy was that a mistake!

The moment the overdue SPX selloff finally started in mid-January 2010, the already-weak HUI plunged in perfect parallel with the SPX. The fact that weak hands already should have been wrung out of the gold stocks didn't matter a bit. By the time this necessary SPX retreat ran its course to rebalance sentiment, it had fallen 8.1% in less than 3 weeks. Meanwhile gold didn't weather that sentiment storm well, plunging 6.6% over this short span. And the HUI, despite having just corrected, lost another 15.4%!

One of the keys to successful trading is learning how the markets react in certain scenarios so you can trade accordingly in the future. And last January the hard (and crystal-clear) lesson was that PM-stock traders as a group could not withstand the sentiment splash damage unleashed by a material stock-market selloff. They rushed for the exits then and I suspect they will do the same thing in this upcoming SPX correction today.

The SPX's fifth selloff of this cyclical bull emerging in April 2010 was its only full-blown correction (greater than 10%). Over an exceptionally-long span approaching 10 weeks, the SPX gave back 16.0%. Yet gold was very strong within this particular SPX correction, surging 4.8% and achieving almost a half-dozen new all-time-record nominal highs in the process. Surely with gold up so big, the PM stocks could ignore the SPX weakness right? Kind of.

Instead of rallying almost 10% to double gold's big gains, the HUI merely crept 2.7% higher over this SPX-correction span. Sure, the PM-stock gains were a heck of a lot better than the SPX's losses in this particular scenario. But their upside leverage to gold was a pathetic 0.6x! Since gold stocks bear all kinds of mining-specific risks that don't affect gold, it's unacceptable when they underperform it. Obviously PM-stock traders were torn between following the strong gold rally and the weak stock markets.

Consider another perspective on this mid-2010 SPX correction. Fully 6/7ths of this event's total losses in the SPX occurred by early June, as the secondary early-July low was a short-lived anomaly driven by a China scare. Up to the original June bottom of that SPX selloff, it had lost 13.7% in 6 weeks. Meanwhile gold had surged 7.4% higher, hitting a new all-time closing high of $1242 the very day the SPX bottomed. Yet how did the HUI do? Only up 3.6%, less than 0.5x leverage to gold's big run!

The SPX's sixth material selloff of this cyclical bull started last August, a 7.1% pullback over less than 3 weeks. Gold was actually strong over this span too, heading into its usual big surge of Asian seasonal buying. It rallied 3.0%. Yet the HUI, even heading into one of its strongest times of the year while gold was bumping along over $1200 near all-time highs, only rallied 4.2%. 1.4x leverage to gold is very poor, evidence that the HUI was again vacillating between following the SPX or following gold.

The SPX's final and mildest pullback of this bull so far emerged in November, when it lost just 3.9% in a little over a week. Gold was pretty weak during this span, falling 3.7%. Despite this, the HUI only lost 3.7% as well. This was definitely an impressive show of strength given the weak stock markets and gold prices. But realize such a shallow and short pullback didn't have enough time to spark any real fear in the stock markets. And without that necessary fear infecting PM-stock traders, they held strong.

So far we've seen seven material SPX selloffs in this cyclical bull in which to examine HUI performance. In the first four, the HUI plunged farther than the SPX and far more than gold. Gold and silver stocks were exceptionally weak, hammered very hard by bearish general-stock psychology. And this held true whether the PM stocks were near post-panic highs or even if they had already corrected!

In the next two selloffs, the HUI managed to defy the SPX and climb due to strong gold rallies running concurrent with the SPX selling. But despite gold's big gains and new record highs, these HUI rallies were very weak. Their leverage to gold was pathetic as PM-stock traders were torn between selling their positions in line with the SPX selloff or buying more to try to ride the gold rally. And in that final and shallowest SPX selloff, even though the HUI didn't leverage gold's downside it was still pretty weak.

Every material selling event in this cyclical bull, every general-stock pullback and correction, has affected gold-and-silver-stock performance adversely. The HUI's downside leverage to gold during these selloffs has run as high as 7.8x, a scary number. Would you be happy losing 8% in your gold stocks for every 1% gold fell? And the very-best performance of the HUI during an SPX selloff when gold was very strong was unacceptable 1.4x upside leverage. This isn't enough to compensate traders for PM stocks' big risks.

In light of this precedent, which extends back many years beyond the couple I've highlighted here, why take the risk of owning short-term PM-stock speculations if the probabilities favor an imminent general-stock selloff? For a variety of technical and sentimental reasons, a major SPX correction looms today. It may have already started! As a speculator I want high-probability-for-success trades, and the evidence is crystal-clear that no matter what gold does the PM stocks don't fare very well during SPX selloffs.

At Zeal we are trading accordingly. We've realized the great majority of our massive gains from this huge SPX upleg since September. We're mostly in cash, the best way to weather a major SPX selling episode which will hammer down all commodities stocks like usual. And then when the dust settles as the SPX selloff matures, we'll be ready to buy the resulting magnificent bargains. Why rush to buy high when a little patience ought to yield high odds of being able to buy low?

We can't wait to aggressively buy the gold and silver stocks beaten down by the SPX selloff! We've painstakingly spent the past year researching the entire population of publicly-traded junior-gold and silver stocks to find the most fundamentally-promising. Our favorites are detailed in 25+ page comprehensive reports, available from just $35 to $75 per dozen stocks. These are crazy deals for the fruits of hundreds of hours of world-class research!

Subscribe today to our acclaimed weekly or monthly newsletters to stay abreast of what the markets are doing, why, and how to trade them. We've been actively trading commodities stocks, with great success and full public accountability, for over a decade now. All 235 stock trades made in our flagship monthly newsletter since 2001 have averaged annualized realized gains of +52.4%! There's no reason you shouldn't share in our hard work and success to rapidly multiply your own fortune.

The bottom line is precious-metals stocks follow the general stock markets during material selloffs. Even though gold is their primary driver most of the time, they decouple from this metal and glom on to the stock markets during pullbacks and corrections. If both the stock markets and gold are weak, the PM stocks plunge far more than either. And even if gold is strong, PM stocks are torn and seriously underperform.

The bearish psychology sparked by stock-market selloffs is so powerful that it permeates all markets, including PM stocks. I'm not thrilled with this correlation, but it is well-established hard reality. PM-stock traders have proven over and over again that they can't ignore a stock-market selloff even when gold is strong. So traders really need to be wary of gold stocks when the stock markets face an imminent selloff.

Adam Hamilton, CPA

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Adam Hamilton, CPA, is a principal of Zeal LLC, which he co-founded in early 2000 as a pro-free market, pro-capitalism, and pro-laissez faire contrarian investing and speculating Information Age financial-services company. Hamilton is a lifelong contrarian student of the markets who lives for studying and trading them.

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