Gold And Silver: Bulls, Bears, And Common Ground

May.22.13 | About: ProShares UltraShort (ZSL)

Gold and silver have been taking a pretty good beating of late. In fact, over the last 1 month, 3 months, and 6 months IAU/GLD is down 8%, 11%, and 14% respectively, while over the same time horizons SLV is down 15%, 23% and 25% respectively.

In the midst of this ongoing collapse in the precious metals market, there is a lot of contradictory analysis between precious metals bulls and bears taking place. Nonetheless, despite the debates there is a fair amount of common ground between the bulls and bears. In this article we will consider three of the most salient points of the discussion. Finally, we will conclude by looking at a related investment idea regarding the leverage ETF, Proshares Ultrashort Silver (NYSEARCA:ZSL):

Paper v Physical

While the demand for "paper" precious metals is very weak, the demand for physical precious metals is at record levels. In the bull camp, the disconnect between the paper and physical markets is seen as an unsustainable state which must correct itself. In particular, the paper market must eventually follow the physical market. On the other hand, in the bear camp, the amount of physical gold being traded in a year is negligible to the amount of paper gold being traded every day, thus making the increase in physical gold irrelevant.

It should be noted that among the more extremist factions in the bull camp this phenomenon of price discrepancy between paper and physical metals is the basis for some outlandish conspiracy type arguments.

Production costs vs price

The mining companies are in bad shape! In fact, they are in even worse shape than the metals themselves. For example, while IAU, which tracks daily performance of gold bullion, is down about 20% over the last 6 months, GDX an ETF index of gold miners, is down over 40% in the same time frame. See the chart below.

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The reason why miners are being hit so hard is that they are subject to a "double whammy" of increasing costs and lower prices. Specifically, their mining costs are increasing as the "easy to mine" resources are used up leaving only the harder to obtain stuff. Meanwhile, the value of the precious metals being mined is decreasing with the plunging market value for precious metals.

It should be remarked that precious metals is the only industry where this kind of doubly bad situation can persist on the scale of an entire industry. Elementary economics dictates that as production costs increase the cost of the product will increase as well. In fact, this is precisely the bullish argument regarding this situation. On the other hand, bears argue that because precious metals are never "used up" but instead stored, their production cost is not relevant to their value. Specifically, since there is already a ton of gold sitting around, the cost of gold is not affected by the cost of ongoing production of additional gold. In fact, the amount of gold being produced pales in comparison to the amount of gold already available. See here for a fellow SA author who makes this case quite compellingly.

Short vs Long term

The short term picture remains grim, and in fact this is increasingly being admitted by even the bulls as the carnage continues. On the other hand, even the bears are admitting that the long term picture remains positive, seemingly because the short term horizon has been overly devastating. In fact, Goldman Sachs who in early April issued a statement to short gold, has recently reversed its stance due to the fact that they believed the correction which occurred was already more than expected.

The debate here between bulls and bears is really over the definition of what amount of time is meant by the words short or long. Is the grim short term just the summer (as bulls argue), or instead through the end of the year, or even beyond that until some time years from now when inflation finally pops its head up again (as bears contend).

A Risky Metals Play

While I am currently long the precious metals, given the current state of chaos in conjunction with the aforementioned arguments, I recently have been looking for a more out of the box play on the precious metals. Specifically, rather than either add to my position right now and risk further loss, or sell my position at a time that I believe will in retrospect will have looked even more foolish, I am looking for some alternative and related kind of investments with better prospects. In particular, my searching has brought Proshares Ultrashort Silver to my attention. ZSL is an inverse leveraged ETF which aims to provide daily investment results of -200% the performance of silver bullion.

First look at a long term chart for ZSL. It's pretty horrendous!

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So why is ZSL so awful? On the one hand, silver has done pretty well in the same time frame, going up roughly 70% - see the chart below. But this is not the whole story. First of all, ZSL has a management fee of .95% and an expense ratio of 2.69%. Compare this with SLV's management fee of .5% and expense ratio of .5%. Moreover, in addition to the high fees, ZSL also suffers from a well documented problem of being an ultra ETF, namely the stated goal of doubling daily performance while roughly accurate (modulo leverage costs) in the short term is highly inaccurate and very ill-advised in the long term.

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Being a precious metals bull, I have always been especially skeptical of ZSL. Nonetheless, during the recent bear market for silver, ZSL has been on a tear, up almost 100% over the last 6 months. In fact, it may be very hard to believe, but the following chart for ZSL is a 6 month chart for the very same stock whose long term chart above looks devastatingly bad.

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Given ZSL's history and poor prognosis as a long term investment, the current run up makes it a seemingly nice candidate for a short sale. That said, shorting ZSL must be performed with a lot of caution (in particular, only do so with a small portion of a well diversified portfolio), as ZSL is a leveraged ETF thus making it extremely volatile. Moreover, this is not the kind of short sale one would ever want to be margin called on, as our hypothesis is that ZSL will perform poorly in the long run, which implies one can actually wait out this current bear market for SLV. Another more sophisticated investment along the same hypothesis is to buy long out of the money put options for ZSL. In particular, I am considering the Jan 14 and Jan 15 puts for ZSL with a strike of 50.


The precious metals bulls and bears are involved in a pretty nasty fight, but even in this fight there does seem to be some common ground including the fact that the precious metals have some things going for them: (1) increased demand even if only on a physical level, (2) limited supply even if only in terms of what is being produced currently, and (3) favorable long term prospects. All of these things, coupled with ZSL's high management fees and nature as an inverse leveraged ETF, make ZSL a common short candidate (especially in a long-term time frame) for silver bulls and bears alike. Usually an enemy's enemy is a friend, but perhaps even enemies can have common friends.

Disclosure: I am long IAU, SLV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Long ZSL put options.