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Precious metals exposure is always something of an adventure, but it seems to be the case more now than usual.

Last week, my weekly ETF Pullback strategy (see Appendix below for explanation and performance data), went almost full out with metals (four silver ETFs and one metal-and-mining ETF which had significant exposure to precious metals miners). Until yesterday, the weekly performance was dreadful, as we see in Figure 1, a screen shot from the FolioInvesting.com account I use to trade the model. (For more on my evaluation of these results, click here.)

Figure 1

Click to enlarge

Interestingly, though, when I re-ran the model for the week ahead, the four silver ETFs remained in place. The only change was the general metal-and-mining ETF, which was swapped for a networking sector ETF.

Here’s the current list:

  • PowerShares DB Silver Fund (NYSEARCA:DBS)
  • Global X Silver Miners (NYSEARCA:SIL)
  • ETFS Silver Trust (NYSEARCA:SIVR)
  • iShares Silver Trust (NYSEARCA:SLV)
  • PowerShares Dynamic Networking (NYSEARCA:PXQ)

This was last week’s list:

  • PowerShares DB Silver Fund (DBS)
  • Global X Silver Miners (SIL)
  • ETFS Silver Trust (SIVR)
  • iShares Silver Trust (SLV)
  • SPDR S&P Metals and Mining (NYSEARCA:XME)

As to what to expect in the week ahead, this in a way, reminds me of law school, when it was equally important to be able to argue a case from the perspectives of both the plaintiff and defendant. I can just as easily argue the bull and bear cases for precious metals.

Arguing for the bulls, I have to start with inflation. It’s becoming quite apparent that the U.S. Federal Reserve is doing all it can to stimulate economic activity, and considering its role as a central bank, that pretty much boils down to a continuing effort to keep the economy liquid, apparently by keeping interest rates at breathtakingly low levels and potentially more rounds of quantitative easing which, in effect, amounts to printing more money.

Speaking for myself, I don’t see potential inflation rates in the U.S. as likely to go high enough to sabotage the economy. But today’s investment and political communities have become a bit spoiled when it comes to thinking about inflation, and would, I suspect, go into crisis mode even if inflation here amounted to, say, 3%. When it comes to precious metals, actual inflation is relevant, but emotions about inflation may be even more important, and in this regard, it’s easy to be bullish.

We also need to remember that it’s not just U.S. inflation that warrants attention. We need to be concerned with Western Europe, where some less-fiscally-disciplined Euro members warrant continuing concern. We also have to watch China, where we’re seeing that even a strong authoritarian government is finding it hard to impose its will (i.e. its desire for moderating growth and inflation) on economic reality (nobody ever promised that incorporating capitalism would be easy). We also have to watch Brazil, where we’ll soon discover how much of its economic miracle (decent growth and tolerable inflation) owed to the personal popularity of magnetism of former President Lula and how much of it was based on sustainable structural improvement.

We also have to remember that precious metals are not strictly for inflation-phobic hoarding. There is also industrial usage, more so for silver (which is where my current ETF exposure is) than gold. The U.S. economy, especially the electronic portions thereof, is looking better. China’s continuing petulantly-strong levels of growth are relevant here too.

Constructive harmony in Washington would arguably be bad for precious metals if it means we’re likely to foster public sector-private sector harmony and get control over our budget deficits, thereby diminishing concerns over inflation. The Obama Administration does seem now to be trying to paint precisely this sort of picture. But for now, this could just as easily be a collection of photo ops and sound bites, as opposed to substantive reality.

On the bearish side, we start with the notion of correction. Precious metals have had an incredible run. Fundamentals aside, nothing can rise in price indefinitely. Economists like to present pretty supply and demand charts intersecting at a point known as equilibrium, which purports to depict the market’s verdict as to correct levels of production and pricing. Equilibrium appears to be a fixed point, implying stability once the correct levels of production and pricing are achieved. That, however, probably reflects the absence of coursework in graphic animation in economics curriculums rather than reality. In fact, as we can easily observe from keeping our eyes open, we never really achieve equilibrium; we always bounce around it, overshooting, undershooting, overshooting again, undershooting again, etc., etc., etc. Lately, it looks like the precious metals markets finished an overshooting phase and now seem to be correcting their way toward undershooting, a process we’ll probably recognize as having been completed a month or so after it reverses course.

We also have to consider interest rates. Increases in interest rates exert downward prices on commodities in general, which, obviously, includes precious metals. (Rising rates mean higher holding costs for those who take physical delivery of commodities thereby leading to offsetting price declines.) This doesn’t seem to be a big risk factor in the U.S. at this moment, but it will continue to lurk in the shadows as long as the Fed remains determined to continue pumping liquidity into the economy (the hope is that new money will translate to higher levels of economic activity; the fear is that the new money will translate to higher interest rates). We also need to watch China and that government’s apparent willingness to keep raising rates in order to achieve its desire to tame its economy. This factor that may have been the one that was most responsible for the model’s poor performance last week.

So where are we?

For much of the past week, the bears won out. If forced to make a long term (say three to five year) call, I’d probably lean toward the bulls. As to the week ahead, which is what’s most important to me given the nature of this strategy, I think back a few decades to a comic film entitled “Oh God,” specifically the scene in which the deity is asked if he can predict the future. His answer: “Yes, I can predict the future ... as soon as it becomes the past.”

APPENDIX

To create this model, I started with a very broad-based ETF screen I created in StockScreen123.com.

  • Eliminate ETFs for which volume averaged less than 10,000 shares over the past five trading days
  • Eliminate HOLDRs (I don't want to be bothered with the need to trade in multiples of 100 shares)
  • Eliminate leveraged and short ETFs (I think of these as hedging tools rather than standard ETF investments of even trading vehicles)

Then I sorted the results and selected the top 5 ETFs based on the StockScreen123 ETF Rotation - Basic ranking system, which is based on the following factors:

  • 120-day share price percent change - higher is better (15%)
  • 1-Year Sharpe Ratio - higher is better (15%)
  • 5-day share price percent change - lower is better (70%)

The idea of using weakness as a bullish indicator is certainly not new. But often, it's an add-on to other factors that, on the whole, emphasize strength. Here, the weakness factor is dominant, with a 70% weighting.

This model is designed to be re-run every week with the list being refreshed accordingly. I trade through FolioInvesting.com, where I pay a flat annual fee rather than a per-trade commission, so I don't care about the fact that turnover form week to week is often 80%-100%. If you want to follow an approach like this but do have to worry about commissions, the strategy tests reasonably well with three ETFs, or even with one. (Cutting the number of ETFs is far preferable to extending the holding period.)

Figure 2 shows the result of a StockScreen123 backtest of the strategy from 3/31/01 through 12/30/10.

Figure 2

Click to enlarge


Figure 3 covers the past five years, a very challenging market environment that witnessed the fizzling of many strategies that had succeeded for a long time.

Figure 3

Click to enlarge


Source: Quo Vadis Silver?: ETF Pullback Choices for This Week