Playing The Surge In Precious Metals, II

by: Emmet Kodesh

The sensational rise of PM (precious metal & mining) assets in the last eight trading days continues a trend that began at the end of June. As typical of this sector, the rise has been punctuated by notable dips, e.g. August 7, just before the most recent surge. This article extends the discussion in my recent pieces on the enhanced prospects for PMs. In reviewing the issue I have in mind a reader's question. Having read my analyses of the shaky condition of traditional asset classes, he wondered if it made sense to raise PM allocation above 50%. I will address reasons for refraining from such action after examining the context for a long-term rise in PM assets.

Several factors combine to create a strongly bullish outlook on PMs. The price plunge in 2Q created a sea of value buys only slightly less inviting after an 8-day surge. Shortages of physical metal have become acute in the West such that Asian exchanges are demanding delivery of their holdings. Inflation in the US, as I discussed near the top of my previous piece, is 7-10% annually for life basics. Devaluation of the USD is being revealed in significantly rising prices that belie official numbers. Inflation makes gold worth more in USD.

Bond yields have risen with taper talk and divestment of T-bills by foreign holders of US reserves. However, 10-year Treasury yields above 2.7% still woefully lag inflation and ravage savings even as falling bond prices drain the net asset value of bond holdings. Taper talk also has damaged the indices. Having failed to hold 1709, the S&P (NYSEARCA:SPY) has broken below the May 21 intraday high of 1684: the next wrung down is the June 24 low of 1573. If accommodative talk and/or action does not ensue, the deteriorating fundamentals of the economy ("a nation of hamburger-flippers" Dan Alpert said), we may wind up testing support at the November 15, 2012 low at 1353.

This is what is at stake in the Fed's attempts to talk its way out of debt-inflated indices with prices rising at 19x earnings.

In 2Q alone, geologist and investment strategist Keith Barron notes that there was a 71% increase in gold and silver demand in India, despite increasing government gold import duties, and an 85% increase in China. The recent PM rally, Barron says, has been intensified by short covering prompted in part by Asians demanding repatriation of gold holdings. "They know the Western fractional gold system is nearing collapse," Barron adds. John Hathaway, Senior Investment Director of the Tocqueville Fund Group, comments that gold futures, options and other derivative products are 100x actual holdings of physical gold. The disjunction between paper gold contracts like Spider Gold (NYSEARCA:GLD) and physical metal (NYSEARCA:PHYS) has been used to suppress gold prices and devastate the PM mining sector. However, by depleting warehouses it is ending in a weakened paper market with greatly reduced holdings that conduce to rising demand and prices in physical metals (NYSEARCA:PSLV) and miners. The Global X Gold Explorers ETF (NYSEARCA:GLDX) I recommended July 22 is +25% since then: so too has the Market Vectors Junior Gold Mining ETF (NYSEARCA:GDXJ).

In an August 15 press release, the World Gold Council noted that 2Q global demand for gold bars and coins rose 78% Y/o/Y. In China the rise was 157% and in India +116%. If crushed gold prices were a goal of trading policy its short term success set up resumption of a secular bull in PM prices.

Dovish sounds will have to emerge from the Federal Reserve (meeting at Jackson Hole, August 22-24) to stiffen softening equity and bond prices but that may not be adequate. It has become plain to many investors that the bond market is unsteady, the housing recovery strained and equities unsupported either by earnings or increase in real incomes. Indeed, the latter are falling relative to inflation. On July 5, foreign Sovereigns dumped T-bills causing an ugly one day plunge in bond prices. It could happen again anytime. Perhaps that is why IMF Managing Director Christine Lagarde will be at Jackson Hole.

My previous piece noted several analysts with much experience and different backgrounds expecting a 6 - 20% correction in the DJIA (NYSEARCA:DIA) 3Q with some expecting this to carry through year's end. Randall Forsyth in Barron's August 17 also noted the need of the indices for QE and suggested that S&P 1700 was the ceiling for 2013. Josh Boak of Fiscal Times became the latest reporter to notice that "we are becoming a nation of part-time, low-wage workers." If taper talk persists and troubling economic basics become unmistakable, there could be retracement to S&P 1353 which would be almost a 20% drop from this year's high. A lot depends on Fed policy, itself an unhealthy situation, and the actions of other Sovereigns holding our T-bills.

In PMs the past two weeks, the best of many great plays has been the rarely mentioned Junior Silver Explorers/Miners (NYSEARCA:SILJ) that has risen 50%, from $9 to $13.53. Lightly traded (average volume is 4k shares/day), on August 16, a day of retrenchment in most of the sector, it led all issues, rising 3.44%. Sandstorm Gold (NYSEMKT:SAND), the junior gold streaming company which had lagged the sector was second, rising 2.92%. SAND is debt free, has $130 million cash on hand and enormous 78% revenue growth on revenue of $60 million. Its CEO and President Nolan Watson helped make Silver Wheaton (NYSE:SLW) the premier streaming Co. With ten streaming and five royalty agreements, SAND looks to have the most immediate upside. Enter SILJ and SAND at market: don't be certain of a dip Monday although SILJ is due for a pause: Quarter horses generally do not run marathons.

With its five producing mines, First Majestic (NYSE:AG) remains in my view the best silver miner. Endeavor Silver (NYSE:EXK) has three producing mines, 7 development properties and a team of directors who are geologists with decades of experience in mining. The future of Silver Standard Resources (NASDAQ:SSRI), whose current production comes from its Penasquito site in northern Argentina's Andes, are based largely on its immensely rich site at Pitarilla in Durango State, Mexico: Pitarilla's probable reserves now are estimated at 479 million oz. silver (plus a million lbs of lead and 2.7 million lbs zinc). By comparison, Tahoe Resources' (NYSE:TAHO) site at Escobal, Guatemala has 367 million oz. proven and probable reserves silver set for production 1Q 2014 and Barrick Gold's (NYSE:ABX) Pascua Lama project has 676 million oz. silver. These are the great sites in the world along with Fresnillo's (OTCPK:FNLPF) holdings in Zacatecas State, Mexico.

Note that silver's spot price is rising steadily toward its previous base at $26.50. FNLPF in six weeks has retraced nearly half its decline, $31.60 to $10.35, from the high plateau of 4Q 2012. It closed Friday at $18.25, up 30% in ten days. Silver is a strong buy.

While the entire sector has appreciated mightily and quickly, keep in mind that the rise follows a terrible quarter whose price declines were prompted by targeted and strategic selling which triggered algorithmic and then panic-selling. PM prices are returning to an organic level but the ground rules have changed. Their fundamentals are much stronger in a macro situation in which other primary asset classes, equities, bonds and real estate face seemingly intractable problems given the reluctance or inability of governments to repair socio-economic basics. Moreover, gold's price drops of 1975-6, after the IMF sold massive amounts of gold into the markets, and 1980-2 under the tight money regime of Paul Volcker, were 65% and 46% respectively. From 3Q 2011 - 2Q 2013, gold declined 36%. Thus, while 2Q was the worse quarter since 1971, the sell off was not enough to drop PM prices further given macro-economic conditions far more difficult for currencies and Sovereigns than in past decades. Instead there was massive buying by retail investors and Sovereigns. We are at an inflection point for societies as well as markets and PMs.

Why not then allocate 50 - 75% of one's holdings to the sector? Ironically it is for reasons similar to those that make the bullish case for substantial PM appreciation, up to $90/oz. silver by end 2014 as I explained here. The main reason is that Sovereign responses to crises in currencies, markets, economies and demographics are difficult to predict. There may be harsh consequences for citizen-consumers. The effects may include increased geopolitical tensions and financial, monetary and military conflict. On the national level, they might include new kinds of taxes and financial regulations not conducive to heavily over-weighted PM allocation, however good it may look relative to other asset classes. Major economic disorder will affect miners, too. Streaming companies like SLW, SAND and Franco Nevada (NYSE:FNV) will be affected less. Incremental allocation weighting seems to me more prudent.

I suggest that the times increasingly encourage increased weighting of PMs, cash and short term corporate bonds. One might wait until after the Jackson Hole meeting to re-structure allocation in a major way. Those with means certainly can add PMs: the basics are in place and the values remain strong relative to other investments. I again suggest the greatly depressed price of Wheat (NYSEARCA:WEAT) and Uranium (NYSEARCA:URA) as additional options. There is a large ongoing increase in nuclear energy building and refurbishment world wide.

I do not believe that analysts are keeping up with the changing macro situation in their evaluation of the upside for PMs. The top buys in the PM sector in my view are SAND, ABX, Goldcorp (NYSE:GG), Yamana Gold (NYSE:AUY), TAHO, SILJ and SLW. The top performer since the June 26 bottom has been FNV, a gold and energy royalty company with no debt and $900 million cash and equivalents. They can fund distressed miners and then sell their inexpensive gold into a rising market. They have excellent management and are a top pick. and should be strong going forward, as should Eldorado Gold (NYSE:EGO) which has producing sites in Turkey and China and sites nearing production in Greece and Romania. Like them, SSRI and IAG remain good choices to buy on a dip with limit orders. I have discussed them often and focus pieces on AG and EGO may be found in my archive.

Increasing PM holdings is fundamentally sound as is trimming and shortening bonds and equities. Unless your assets exceed $2.5 million I would limit PM allocation to 33%. This is likely to be a rocky quarter and coming years will see socio-economic and political changes that may compel re-thinking of many truisms about value and investment.

Disclosure: I am long TAHO, SILJ, WEAT. 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: I own precious metal companies in funds and individually.