gistfile1.xml

<ul>
  <xsl:apply-templates select="/data/categories/entry[not(parent)]" />
</ul>

<xsl:template match="categories/entry">
  <xsl:param name="path" select="''" />

  <li id="{title/@handle}">
    <a href="{$root}{$path}{title/@handle}/">
      <xsl:value-of select="title" />
    </a>
    <xsl:if test="/data/categories/entry[parent/item/@handle = current()/title/@handle]">
      <ul>
      	<!-- recursively call all elements with parent-nodes pointing to current node -->
      	<xsl:apply-templates select="../entry[parent/item/@id = current()/@id]">
          <xsl:with-param name="path" select="concat($path,'/',title/@handle)" />
        </xsl:apply-templates>
      </ul>
    </xsl:if>
  </li>
</xsl:template>