Precious Metals Drop: Blood In The Streets

by: Hebba Investments

Investors in gold, silver, and the precious metals ETFs (GLD and SLV) are reeling from months of losses even as stock markets gain - a vicious combination. Sentiment is decidedly negative and investment banks are rushing to drop gold price forecasts. Nouriel Roubini predicts gold dropping under $1000 and investors who have never owned an ounce of gold and silver are jumping to short as many as much as they can.

Is the precious metals bull market done? Is it time for investors to abandon ship and hope to find some poor sap to relieve them of their nightmarish gold and silver investments?

It is absolutely not the time to sell. In fact, we think quite the opposite and that the current ongoing smack down is the best time to buy for a number of reasons.

1. Physical Demand is Still Very Strong - Even as mining shares and paper gold prices drop, physical demand is surging. U.S. investor demand for bullion coins is on pace for its best year ever in both gold and silver. While India's central bank continues its war on gold, buyers are flocking to buy on any downturn and even today's drop (6/26/13) was met by demand that outstripped supply in India. "We are unable to give supplies though there is demand we give deliveries after 2-3 days," said Harshad Ajmera, proprietor of wholesaler JJ Gold House in Kolkata.

COMEX warehouse inventories and ETF gold holdings have been dropping as gold is removed and moves elsewhere (possibly to satisfy Asian gold demand), which means that if paper investors change sentiment and turn bullish on gold - they may not find physical gold anywhere close to current prices to fill back these inventory at these institutions.

Additionally, according to the latest U.S. census report, U.S. net exports of gold have risen dramatically and are close to 50 tonnes a month. This number is net of imports, which means that every month a net 50 tonnes of physical gold leaves U.S. shores. We will address and analyze this issue in a future article, but this is clearly institutional selling of investment gold vehicles that is being sent to meet international gold demand. If there was weak physical demand, we would not expect such a large spike in gold exports, but instead this confirms that international investors are demanding physical gold to such an extreme that it is sucking U.S. gold resources to foreign shores.

2. Spot Prices for Gold and Silver are Significantly Below Miner All-in costs - We have documented this in prior pieces, but as a reminder, gold all-in costs for 2012 were close to $1300 per ounce and were rising as of Q1FY12. Silver production costs were even higher as a percentage of current spot, with Q1FY12 all-in costs well above $20 per ounce. This situation is just not sustainable long-term - supplies of precious metals will plummet if prices stay anywhere near current levels. Even Fresnillo, the largest primary silver producer in the world, cannot produce silver profitably at current prices without significantly cutting supply.

Finally, gold production of the miners we analyzed, which incorporates 30% of annual world gold supply, actually dropped in 2012 from 2011 - even as gold prices averaged close to $1700 per ounce. With prices 25% lower than in 2012, we expect gold production to drop significantly, and since mine production satisfies more than 50% of annual world physical demand, this will be a major supply cut for buyers of physical gold.

3. Monetary Bases of Central Banks Continue to Grow - Central banks continue to print money at astonishing rates. The Federal Reserve, Bank of Japan, Bank of England, and even the European Central Bank are all increasing their monetary bases at rates that dwarf anything done in history. The Fed continues to pump $85 billion per month into the financial system - which is 50% of annual gold mine supply (around $110 billion per year at current prices) and more than 500% of annual silver mine supply (around $15 billion per year at current prices). That means that in the span of two months the Federal Reserve adds enough dollars to the monetary supply to purchase every single newly mined ounce of gold and silver.

Simply put, dollars are being created much faster than metals are being mined and eventually the laws of economics will force the price of commodities and precious metals higher. This doesn't even include the actions of the other central banks.

4. The Dollar Based System is Gradually Being Replaced - Central banks have continued to buy gold at an increasing rate even as prices fall. This is a sign that central banks feel that they want more of their reserves in gold and less in fiat currencies - which is something investors need to pay attention to because these are the ones who manage our financial systems. Why would central banks buy gold, and asset that generates no returns, unless they believed it provided a better option than currencies, bonds, and the dollar?

Not only are they buying gold, but they are also increasing U.S. Treasury sales and the latest data indicates that in April they sold the most treasuries since 2008 - not quite the display of confidence in the dollar that a recovering economy would suggest. Gold and silver would benefit greatly from any change in the structure of the financial system, especially if the dollar starts to lose its status as the world's reserve currency.

5. The Correlation with Other Asset Classes is Dropping - Gold and silver's correlation with other assets has dropped significantly. This is a classic sign that an asset is either very overbought or very oversold, depending on recent directions. Whether stock and bond markets rise or fall, gold and silver have shown significant weakness - which at this point means investors are looking at gold as a sure bet to fall and have been making significant money doing so. But as the strategy starts to fail, this lack of correlation can quickly become a very bullish factor because it can also lead precious metals to rise regardless of the performance of other asset classes - which may provide powerful reason for investors to diversify into gold and silver.

The fact is that there are plenty of fundamentals that still support precious metals prices. But investors and hedge funds have been selling and shorting precious metals to the point that they are way oversold, but since the trade has worked they continue to do it and only the strongest hands are really left in the gold market. As the factors above drive the physical gold world into accumulating more gold, this bearish sentiment will turn as shorts and buyers find fewer sellers willing to be relieved of their gold and silver at current prices.

Conclusion for Investors

Investors should take this drop in precious metals as a huge buying opportunity to acquire out-of-favor assets that have strong fundamentals. I realize it is tough to buy when prices do nothing but drop, but this is precisely the best time to buy. Gold and silver have risen over the last decade for reasons that have not changed - these reasons still exist and are more relevant than ever. Physical gold and silver should be accumulated as part of any long-term wealth management strategy, and the ETFs (GLD, SLV, PSLV, CEF, and PHYS) can also be used as a liquid part of portfolio diversification.

The financial world is very bearish on precious metals and are all on one side of the boat on this trade. Savvy investors should consider taking a contrarian position here remembering that boats always tip on the side with the most people. Soon enough shorts and gold buyers will not be able to find sellers of physical gold to meet demand.

That change in market psyche will cause quite a large rally as shorts are forced to cover on an asset they thought was a sure loser, while precious metals and investors will find that the bull market is still quite alive.

Disclosure: I am long PSLV, SIVR, SGOL. 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.