Precious Metals And Market Outlook: Opportunity And Dangers

by: Emmet Kodesh

The markets are 15 days into the rocky period I have suggested would arise when debate began regarding the continuing budget resolution (passed 10 days ago without the health care mandate) and raising the debt ceiling. Since the Fed's September 18 rejection of tapering T-bill purchases sparked a sharp 2-hour pop to S&P 1726, the markets have remembered macro issues and have shed 2.72%. This past Monday and Thursday, September 30 and October 3 were particularly unpleasant: between the close Wednesday at 1693 and noon Thursday the S&P shed 23 points, down 1.41% in 3 trading hours. This was predictable and likely will get worse before calmer seas emerge.

This article briefly examines the situation for PMs (precious metals) and the markets as illuminated by October 3 action. Good opportunities are emerging in the context of significant dangers some of which will subside in the short term (3 weeks) but will linger at the edges and in the guts of the socio-economic picture throughout next year. They likely will bear heavily by 2015.

PMs again have demonstrated my view that they are the prime risk-off trade when things get dicey for the indices. Rather than the inverse correlation that some commodities show in times of distress (wheat (NYSEARCA:WEAT), grains (NYSEARCA:JJG), aluminum (NYSEARCA:JJU) and Pure Funds Precious Gems (NYSEARCA:GEMS) rose Thursday), the PM sector saw carnage: great companies with prices already depressed like First Majestic (NYSE:AG) -2.42%, Yamana (NYSE:AUY) -2.04% and Silver Wheaton (NYSE:SLW) -1.48% took more casualties. In the backwash of a Deutsche Bank (DB) assessment that at current bullion prices Silver Standard Resources (NASDAQ:SSRI) would not be able to bring its world class site, Pitarilla in Durango, Mexico, into production, the company again was hammered, -3.57% and is pennies from a new 52-week low.

PM prices invite buying but those who follow the sector should weigh whether it is a case, given price action, sentiment and the power of strong hands, of throwing good money after bad or an opportunity to lower one's cost basis and wait for a rebound based on slowing supply and increasing demand. This is true especially for silver, a tech-industrial metal essential to electronics, solar energies (the solar ETF (NYSEARCA:TAN) is surging this year), industry and medicine.

My view is that buying this sector depends on one's current allocation to PMs and ability to ride out volatile price action and the possibility that things will get worse and for months remain worse before they get significantly better. Those who initiated positions in late April, late June or very recently might well choose to add a bit or, depending on their circumstances and temperament, simply hold and be glad that their cost basis is very low. Depending on their net worth, time horizon and income stream, others may decide that the frequent infliction of pain and failure of fundamentals to determine price action means looking for occasional surges to trim positions and increase allocation to other asset classes. Note that bond prices are unsteady and that the USD is falling. Buying when there is "blood in the streets" is a truism that may soon give investors occasion to test their mettle.

Many experienced observers of the sector, like Dr. Stephen Leeb, an expert hi-tech software that interfaces with markets and commodities, believes that the case for PMs, especially silver has grown stronger. Many believe that the drawdown of physical metal in Western depositories as gold continues to be bought massively in Asia will exert irresistible upward pressure on bullion prices, and thus on PM mining companies traded in Western markets. This is a reasonable thesis but it is unclear that such expectations remain rational as culture subsides into a din of tendentious but omnipresent narratives and increasing management by media and government of markets, buying habits, consumer expectations and social relations. These are "interesting times" and the new normal is abnormal: one must accept it.

To put it plainly, one cannot expect that fundamentals will apply to action in PMs or in the markets going forward except insofar as deepening troubles in the socio-economic and demographic structure of most nations are a growing danger not only to investment but living conditions. This premise, based on decades of depth study of history, geopolitics, philosophy, literature and cultural principles and dynamics argues for maintaining a significant cash position and, as the current disorder continues, to add to equities on particularly bad days.

By Halloween, a stretch of smoother sailing and optimism that boosts equities are likely to arrive. It will be punctuated with atrocities and the resulting risk-off atmosphere. The economic drag of the Health Care Mandate likely will be substantial (see this article in the Wall St Cheat Sheet) as will actual inflation in the 6-10% range and weak and slipping workforce participation. One must bear these factors in mind when one invests and adjusts allocation to major asset classes and sectors.

PMs remain an extremely undervalued sector with enormous upside, more for silver than for gold. A core role for gold in a new global reserve and exchange system is plausible and quite possible but one should not make investment decisions on this basis. The people who decide such matters are concerned not with fundamentals but with management of a world system. The case for silver as a vital tech-industrial commodity is stronger but its price action, and the viability of silver miners is linked to gold.

Takeaways: Based on this macro view, Health Care and bio-tech remain the sturdiest sectors for long term holdings. Consumer-related companies should excel for at least another year. Major media-entertainment companies like Time Warner (NYSE:TWX), Disney (NYSE:DIS), CBS (NYSE:CBS) and Comcast (NASDAQ:CMCSA) which owns NBC Universal films and its TV networks should be stalwart.

In the PM space, the best companies are AG, Endeavour Silver (NYSE:EXK), McEwen Mining (NYSE:MUX) and SLW. For a margin of safety amid the great volatility of the sector and this month, many investors should buy 10-15% below current prices. The greatest value plays may be mid-tier producers AUY and IamGold (NYSE:IAG) which are avoiding debt, controlling costs (at the expense of growth) and have multiple sites. Barrick Gold (NYSE:ABX) has the greatest reserves, lowest cost production and a price greatly depressed by debt and negative growth from impairment charges. It has received several recent upgrades and for those with patience, which the sector requires, it may produce solid gains. It closed at $18.10 Thursday but the new Deutsche Bank target is $30.

Based on revenue and cash flow / debt ratios, revenue growth and ROE (return on equity) here are some companies that are compelling buys on down days like October 3: TJX (NYSE:TJX), Whole Food Markets (NASDAQ:WFM), Home Depot (NYSE:HD), Starbucks (NASDAQ:SBUX), British Petroleum (NYSE:BP) and, despite the debt that fuels its rapid growth, Dunkin' Brands (NASDAQ:DNKN). I have profiled all these companies in recent articles here and here. Aerospace-defense has several companies distinguished by profitability, earnings and ROE: Northrop-Grumman (NYSE:NOC), Boeing (NYSE:BA) and Lockheed-Martin (NYSE:LMT) are in good position and like the best of the media-entertainment and consumer-identity sectors should outlast good times. A mix of the best companies and low-cost ETFs like Vanguard's Health Care (NYSEARCA:VHT), Consumer Discretionary (NYSEARCA:VCR), High Dividend Yield (NYSEARCA:VYM) and Industrials (NYSEARCA:VIS) is a defensive way to invest in the rise of core areas of strength.

PS: Consider positions in two highly uncorrelated and consistently performing assets I have commended: Vanguard Natural Resources (NYSE:VNR) yields 9.2% annualized (paid monthly), well below its five-year average dividend of 12.9%. Additionally, for preservation of capital GEMS looks attractive: in the sea of red October 3 it rose 4.06% and is a bit above its YTD trading range. Take care.

Disclosure: I am long AG, BP, DIS, DNKN. 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.