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After a Rough Year for Gold Stocks, What Will Happen in 2012?

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The bottoming process in gold stocks could continue for an extended period of time if the overall stock market moves lower during the first half of 2012.

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Of the legions of investors who are welcoming a fresh start to the year after the choppy and directionless market of 2011, perhaps gold stock investors are the most eager. Gold stocks had a volatile year last year with no progress made on the upside. The HUI Gold Bugs Index was rangebound between 500 and 600 for the whole year, with three failed breakouts above 600. As if to put a cherry on top of a depressing year for gold stock investors, the HUI closed down -14.7% for the month of December, which was the worst December for the HUI since the beginning of this gold bull market.

Taking a look at the performance of the HUI this past year compared to previous years, it's interesting to note that gold stocks had only their second negative performance for the last six months of the year going all the way back to 2003. The only other time since 2003 that gold stocks didn't produce positive returns during the second half of the year was during the stock market panic in 2008. 2011 was also the first year since 2003 where gold stocks had negative returns for both the first half and second half of the year.



Gold meanwhile produced positive returns during both the first half and second half of 2011. But gold had it's third weakest performance for the second half of the year since 2003. Gold has tended to perform better in the second half of the year than the first half of the year, but 2011 was an exception.



Looking at the relative performance of the HUI versus gold, the HUI performed almost as poorly against gold last year as it did in 2008! As a result of this poor performance gold stocks are almost as cheap relative to gold as they were during the panic in 2008.



Now why did gold stocks struggle so much in 2011? Since gold stocks are still stocks, they are greatly affected by the action in the stock market. Negative action in the stock market can cause gold stocks to perform poorly against gold. When gold is rising and the stock market is falling, the stock market can act like a lead weight on gold stocks and hold them down. And when gold and the stock market are falling simultaneously, gold stocks can get crushed. On the bright side, when gold and the stock market are both rising, you can get huge upside moves in gold stocks.

The two main moments that contributed to the rangebound nature of gold stocks for 2011 was the stock market top in May 2011 and the top in gold in September 2011. The top in gold in September was particularly nasty since it coincided with a falling stock market. This caused a violent move lower in the HUI over a two-week period at the end of September where the HUI plummeted from 630 to almost 480. After that plunge, gold and the stock market both recovered in October which drove gold stocks higher, but then gold sold off starting in November and continuing into the end of the year. This drove gold stocks to close at the low end of the range in December.



For 2012 obviously the two main threats to gold stocks continue to be: 1) a falling gold price and 2) a falling stock market. A falling gold price looks to be a lesser threat to start 2012, as gold is overdue for a bounce after having a dismal December. Sentiment levels on gold are extremely bearish. The Commitment of Traders report is showing a reduced commercial net short position against gold, which typically occurs when gold gets close to a bottom. It is also showing the lowest level in open interest in more than a year, which indicates a lack of speculative activity and also coincides with a bottoming in price.



Click to enlarge

There is also a bullish falling wedge on the gold chart with a positive divergence in momentum. This is another sign gold is due for a potential short-term bounce.



Moving further into 2012, the threat of a continued bear market in stocks could keep a lid on gold stocks, even if the gold price firms. The stock market made a low volume push from the last week of November 2011 until the end of December 2011. In order for it to fight through the overhead resistance that was established in the first half of 2011, there needs to be more conviction on the buy side.



There also needs to be a rotation back out of defensive sectors and into growth stocks. Consumer staples, for instance, continued to outperform the tech sector during the last two months of the year, and that trend has been going on since February. That was one of the earlier signs of the risk-off trade that occurred during 2011 along with the early 2011 top in financials.



So the bottoming process in gold stocks could continue for an extended period of time if the overall stock market moves lower during the first half of 2012. One other thing to look for is a majority of gold stocks moving higher once a bottom is established. During 2011 the gold stock sector was fragmented during the breakout attempts, with many gold stocks continuing to move lower while other gold stocks attempted to break out. Contrast that with what happened in the second half of 2010 where the entire gold sector was lined up for a powerful breakout at the same time. When most gold stocks move higher together it adds legitimacy and sustainability to their move.

Editor's Note: This article was originally published on NextBigTrade.com.

Twitter: @nextbigtrade
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