Echoes of 2008 Suggest Caution for Precious Metals Investors

This year has been very frustrating for precious metals equity investors with gold having risen 10% from the beginning of the year to its high in May while gold stocks (as measured by the Gold BUGS Index, HUI) have risen only 5% from the start of the year to their April high, underperforming gold by more than 20% year-to-date. The last time gold equities frustrated investors to this degree was back in 2008 when the subprime crisis was just picking up steam. This leaves investors with a very important question: Is the current slide in precious metals equities a buying opportunity or a foretelling sign of further weakness?

Gold Stocks Deeply Oversold

Since its peak in December of last year, the Philadelphia Gold & Silver Index (XAU) is down more than 19% with the Gold BUGS Index (HUI) similarly down 19% from its April 2011 high. My gold stock indicator is in the buy zone associated with significant bottoms and implies that the present condition is a great buying opportunity. However, taking a broader survey of the markets would suggest otherwise.

The overall investing climate for precious metals investors is far more precarious than even during the early route in 2010. During last year’s first half correction in which gold stocks sold off and became as oversold as they are now, gold bullion was also oversold as it too corrected. Not so this time. Given bullion has held up so well during the market's correction, my gold indicator (below) is closely approaching 1.0, which is a significantly overbought condition in which a top is likely forming rather than being near -0.50 which often catches significant lows like the bottom in early 2010. Thus, while gold stocks are significantly oversold and due for a bounce, any corrective bounce may prove short lived as gold bullion is at risk of forming a top. If gold does in fact roll over then gold equities are likely in store for even more pain. If they can’t rally when gold does, how are they going to stay afloat if gold declines?

Major Inflection Point at Hand

Precious metals stocks often lead gold bullion at key turning points, bottoming before gold does at major lows and peaking before gold does at major tops. In hindsight, it looks like April was one of those key turning points for precious metals. Shown below is the Gold BUGS Index (top) along with gold bullion (middle) and the USD Index (bottom). The highlighted red band shows the Gold Bugs Index declining while gold rallied and the USD Index fell as gold equities appeared to be discounting a significant low in the USD. Since May gold has essentially traded flat while the USD Index has rallied and the Gold BUGS Index has been bludgeoned by the market. The Gold BUGS Index is deeply oversold and testing its January 2011 lows, so a market bounce should be expected. However, given gold stocks significant underperformance of gold bullion, should investors be buying the current dip or selling into an ensuing rally?

Echoes of 2008 Suggest Caution for Precious Metal Investors

There are times in which gold bullion has significantly outperformed gold equities with the last three occurrences coming during periods of elevated financial stress. This can be seen below in which the gold bullion to gold equities (Gold BUGS Index) ratio is shown on top with the Bloomberg US Financial Conditions Index on the bottom. As seen in the figure, gold significantly outperformed gold equities during the Long Term Capital Management (LTCM) crisis in 1998, the tech bubble burst of 2000, and the subprime crisis in 2008. As seen in the top panel below, the recent outperformance of gold bullion over gold equities is more than noticeable and may be foreshadowing another period of elevated financial stress ahead. As such, gold investors may want to take a “wait-and-see” approach before diving in head long to buy beat up gold stocks.

The last time gold bullion significantly outperformed gold equities was during the 2008 financial crisis and the overall price movement of the Gold BUGS Index (HUI) is eerily similar to its 2008 path. The present backdrop for the HUI looks to be equivalent to its early May 2008 low in which the HUI staged a weak oversold bounce before plunging in the fall. The HUI fell more than 25% from its March 2008 high to its May 2009 low, a decline similar in magnitude to the present. The HUI then rallied nearly 25% into July 2008 and broke above its key 50 day and 200 day moving averages, though it failed to break above its mid April 2008 peak to signal a change in trend from bearish to bullish.

Given the HUI is in close proximity to its January low and deeply oversold, a bounce should be expected in the weeks ahead, but the strength and quality of any bounce will speak volumes as to whether the present case is yet another great buying opportunity to pick up precious metal equities, or a prelude into something more onerous around the corner. For the “all clear” to be given for gold equities, I think we need to see the HUI rise above its key 50 day and 200 day moving averages AND exceed its late May peak near 556.70 at a minimum. If the HUI fails to do so then there is a high probability that the bull market for the gold stocks is over and we are in the early stages of a bear market. Because gold equities are greatly underperforming bullion as they do during financial crises and since various credit spreads are beginning to rise, a “wait-and-see” approach appears the best course of action for precious metals investors. The burden of proof is clearly on the bull’s shoulders at this point.

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Chief Investment Officer
chris [dot] puplava [at] financialsense [dot] com ()