After the impressive run in precious metals last year that saw gold rise 29.6% and silver rise 83%, the question on many investors' minds is whether there is still any run left in these commodities. Our client portfolios enjoyed a 67% return in 2010, largely due to the end-of-year rally in precious metals, but we also remain keen on the issue because of our continued exposure to the space.
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Since the beginning of 2011, gold and silver have badly underperformed equities, which is a surprising trend given the high correlation between all three since August. The divergence in performance begs the question of whether investors are finally rotating assets out of precious metals (the alleged "fear trade") and into stocks.
Why Do Gold and Silver Rally?
In our opinion, precious metals such as silver and gold do not serve as fear trades, but rather trade on forward inflation expectations. The following charts show gold and silver over the past 35 years versus the Consumer Price Index Year-over-Year % Growth (including food and energy).
Regardless of popular perceptions that people buy precious metals to protect against some type of cataclysm, it is shown clearly here that the primary catalyst in precious metals prices are inflationary expectations. From both charts, it can clearly be seen that gold and silver track very well to the CPI, with the notable exception of recent years that we will discuss later.
It can be seen that both metals peaked in 1980, at the height of inflation. The spike in inflation that peaked at the beginning of the 1980s saw the CPI Index peak at almost 15% year-on-year growth, a lofty inflation figure. This peak also marked the parabolic peak in the rally in gold and silver prices that began in 1976. For those four years, gold rose 508% and silver rose an incredible 775%. The rally in silver was largely caused by the Hunt Brothers' manipulation of the metal, but the fact remains that both metals rallied incredibly in the face of quickening inflation. Also of note is that both metals quickly collapsed down to much lower levels as inflation waned quickly.
Applying this information to our present-day scenario yields a few observations. The steady ascent of both metals is not indicative of a bubble. While many consider gold and silver to be in a speculative bubble, both metals have quite a ways to go to achieve the same percentage gains witnessed 30 years ago. Also very interesting is that both metals have risen in a much more stable manner (i.e. gold at 18.3% annualized vs. 67.4% annualized) than in the late 1970s. Gold and silver would have to have a dramatic parabolic run-up, followed by an equally dramatic selloff, in order to have been considered a speculative bubble ... something that has not happened yet.
From an inflation fundamentals standpoint, it appears that inflation may have to top out before we see the end of the precious metals rally. Even though little actual inflation has yet to be witnessed in the CPI, precious metals have already seen a substantial rally. This is due to the expectation of a highly inflationary upcoming period.
Why Hasn't Inflation Been Reflected in CPI Growth -- And Why Do Precious Metals Prices Already Reflect It?
While the money supply of the U.S. has grown exponentially since the financial crisis, CPI growth has remained muted due to the low velocity of money. Simply put, the velocity of money is a measure of how fast money changes hands in an economy. If the money supply is high, but the velocity of money stays low, inflation will not happen. To make this theoretical argument more concrete, consider that most of the money the Fed "created" since the financial crisis has gone to banks balance sheets.
The banks have not turned around and lent that money, because their lending standards and underwriting processes are still extremely strict due to wound-licking left over from the credit crunch. Once the banks start lending money more freely, the effect of the hugely larger money supply will start to be felt in CPI growth. This coming CPI growth phenomenon is the event that precious metals are pricing in. There is no question as to "if" the velocity of money will increase -- only "when."
Global Rate Increases and Trichet's Aversion Towards Inflation
While banks around the world from China to Australia to Brazil are raising interest rates to tame inflation, the major currency economies (U.S., U.K., Euro, Japan) have no ability to do so and will not in the near future. The countries that have raised interest rates are the ones experiencing massive organic growth, huge capital inflows, and food-price inflation problems.
However, the major currency countries have no engines of growth, are experiencing capital outflows, and have no shot at anything but paltry GDP growth for the foreseeable future. In order to ensure their economies do not fall back into recession, these countries have engaged in competitive currency debasement (i.e. seeing who can print money the fastest) in order to make their exports look more attractive to emerging economies, as well as to each other. Printing money and creating excess liquidity also has the added bonus of inflating risk asset prices and making things look generally rosier through the glasses of inflation. As long as this situation persists, precious metals will continue to be an extremely worthwhile asset to own.
Even though ECB President Jean-Claude Trichet spoke recently about his vigilance in raising interest rates in the eurozone soon, this is nothing more than lip service. Both Greece and Ireland have already slipped back into negative year-on-year GDP growth, and many more countries risk following suit. How exactly can Trichet raise rates in a time when his economy is at risk of falling into an all-out depression?
The simple answer is he can't, but not only can he not raise interest rates, he is going to have to undertake even more inflationary policies than he has already. just to ensure the continuity of the eurozone. It remains to be seen exactly which policies the ECB will undertake, but rest assured that no rate rises are coming out of Europe any time soon, and the eurozone debt crisis is far from over. After all, Portugal has the same level of debt as Australia, yet 25% of the GDP.
This Week's CFTC Commitment of Traders Report
This week's COT report indicates that managed money net long positions fell yet again to their lowest level since November.
The gray line shows the price of silver and the green line shows managed money net long positions. As can be seen from the chart, silver has rallied each of the times the managed money longs hit this level over the past six months.
The above chart shows the same data over the last three years. As can be seen, the managed money net long position has been volatile, but continues to make higher lows since the secular bull market in silver began in late 2008. It is our view that the managed money net long position will continue to rise over time, fueling a renewed rally in silver prices as fundamentals and price movement become more bullish.
Doug Kass Gold Price Prediction for 2011
Doug Kass of Seabreeze Partners recently predicted that gold prices would fall to $1050 in 2011. Kass calling for a huge drop in gold prices is nothing new, as he called for silver prices to fall to $900 in 2010. Obviously, he was wrong then, and he will be proven wrong now. In fact, of his top 20 predictions for 2010, not a single one came true.
The fact that there are so many doubters out there like Kass is highly bullish for precious metal prices, as it indicates there is still a large amount of skepticism left towards the metal, and plenty of new buyers on the sidelines. Once we see precious metals detractors like Kass become bullish on the metals, that may signal an exit point.
We remain long silver and gold futures contracts, as well as miners through GDX and GDXJ. Additionally, we like SLW, as it provides excellent leverage to silver prices without execution risk, and it is a royalty trust. We recommend building a position in all of these securities and adding on pullbacks.