Reviewing The Thesis For Precious Metals And Miners

by: Emmet Kodesh

As the markets surge and Gold and Silver drop we should review the thesis for Precious Metals and Miners. On April 2 the XAU index (PHLX) fell 3.94% while the main indices rose to new nominal highs. The PM sector continues to badly underperform others and this raises some basic questions: does continuing underperformance make it a strong contrarian play? Should it be limited to 5 - 10% of your holdings? Should you seek up-days to sell off your miners? Let us look at the economic and fiscal situations and the interplay of geopolitics, trade and finance for answers to these questions.

The 4.46% rise of the USD in the past year (4.09 YTD) certainly exerts downward force on precious metals and miners prices. Yet the fall in the share price of miners far exceeds the strengthening of the USD. The XAU comprises 31 miners and is down 28% in a year. The Junior Gold Miners (NYSEARCA:GDXJ) is down 42% in the past fifty-two weeks and the Gold Miners ETF (NYSEARCA:GDX) down 44%. Since the 4th Quarter of 2012 GDXJ has been making new all-time lows since inception and is 65% off its January 2011 high. In its fall the sector has become deep value and sells without a premium unlike the decade that preceded 2008. Still, one doesn't want to ride a loser for the sake of attractive prices. The decline in miners is of another order than the extended basing and range bound prices of bullion the past 22 months for silver and 18 months for gold. Even though the markets are enjoying a cyclical bull within a secular bear market, the fall in the miners is the backdrop for this review of the thesis of over-weighting PMs and PGMs (Platinum Group Metals).

Important macro-economic and geopolitical-trade dynamics in time will exert downward pressure on the Dollar. There are increasing ex-USD bilateral trade arrangements, most of them including China with nations as disparate as Japan, Australia, India, Russia, Brazil and South Africa. The BRICS nations met in Durban March 26-7 and initiated a fund to support multilateral ex-USD trading. Additionally, there are formal proposals based at OMFIF in London to establish a new world reserve system composed of the USD, Renminbi (NYSEARCA:RMB), the currencies of the BRICS nations and gold. I have discussed this plan here. The RMB's rise against the Dollar matches the current bull market and China continues its large purchases of PMs and PGMs. These developments are constructive for gold. So too is ongoing expansion of digital currency and sovereign debt in England, America, Europe and Japan.

Moreover, the shift to a multilateral world reserve system backed with gold should give a firmer basis to the global economy which now is sapped with debt and demographic decline. Strengthening of economies based on fundamentals and sounder fiscal practice rather than on debt and derivative expansion also will boost tech-industrial metals like Ag and PGMs. I reported on the integration of PGMs with economies here.

The Cyprus bank bail outs for now are boosting markets, the Dollar and US Treasuries as money leaves European banks for safer havens. Those with over 100k Euro at the Cyprus Central Bank are having 37.5% of their deposits exchanged for bank shares and 22.5% frozen for an indefinite period. Those at the second largest bank, The Popular Bank (Bank Laiki) are going to lose 80% of their funds as the bank is folded into the Central Bank. Although the Euro recovered to $1.282 from its April 1 drop to $1.277, Eurozone problems are systemic and the Euro likely will approach parity to the dollar. The official Eurozone jobless rate is above 12% and rising as UK factory orders drop. This economic decline urges holding precious metals in Euros (or Yen) but a strengthening USD will hold down PM prices/USD in the short term.

Deepening structural problems in Europe are in synergy with secular declines in American income, net worth and liquidity which lead to slowing retail sales growth which lead to market flops. While growth is up since last July's trough it is half that of early 2011 and below the rate of a decade ago. The doubling of the national debt since 2008 also raises doubts about this year's market surge. Though a notable rise in gold seems remote now, the basis of the economy is weak and in tandem with the trade, finance and reserve trends noted above will eventually produce a higher Gold/USD ratio. Looking at the ratio's chart in the 42 years since the abrogation of Bretton Woods puts the basing in precious metals prices these past 2 years in context: even with the past 4 years cyclical bull market the ratio shows USD/Au merging as was the case from 1970-9 and as recently as 1991. Indeed it shows that the signal feature of the post crash period has been the close correlation of the DOW and Gold. So the bull markets are not likely to further suppress PM prices or miners, who will rise with genuine economic growth. The metals remain in the center of their 12-year up channel, right on the trend line despite 15-20 months of basing for gold and silver respectively.

Thus, though it is counter-intuitive, historical price movement shows that PMs will track market strength and when economic or fiscal problems undermine nominal index highs, metals prices will regain their status as a hedge to fiat valuations. Because miners are rooted in business-economic matrices they will be volatile when equities decline. They certainly are shunned now but that is a bullish epitome: "buy when there's blood in the streets," as Buffet says: "buy panic" as Jim Rogers remarks. Having reached capitulation - like selling amid growing ex-USD trade that previews a new world reserve system, miners too will share in the rise of metals. Major producers now grossly undervalued will lead this expansion and acquisitions will resume.

It is becoming legitimate to favor gold and silver and criticize Keynesian experiments. In the New York Times, David Stockman blasted the "warfare-welfare" state and the wrecking of the economy that ensued when the State usurped gold as the definer of value. Reinforcing my view on the dangerous and growing chasm between the markets and economy, Stockman lashed a government being run for the 1% while disguising its imperial character with populist rhetoric. So the collapse or "sundown in America" as he termed it and its link to fiat currency is now in the mainstream. This discourse will lift knowledge about fiscal - currency basics and support metals' prices.

Similarly regarding gold, on the Willis Report on Fox Business April 1, analysts Steve Crowley and David McAlvaney stated that the best investment at this juncture is gold. Crowley added "the entire Canadian Resource Sector" is today's best value play. The segment is not yet on the web but the prominent place given to these suggestions speaks to sentiment for precious metals and miners as premier value plays in today's rush to the indices.

As noted in my previous piece, insider buying at GDX listed companies in March reached 7 - 1 level usually seen at a market trough. The Toronto Globe & Mail online for March 25 wrote

"Insiders are typically contrarian investors... Right now it appears many of them think [mining] stocks are going for fire-sale prices. They are usually early, too. Historically, insider transactions often foreshadow market moves... it's interesting to see insiders display this level of confidence in a sector that the broader investment community has been fleeing." The macro backdrop that drove the 2011 peaks has not changed but only deepened. Insider buying accelerated last December and supports the thesis being examined in this article that despite the dismay about this badly lagging sector a base is being prepared from which "fortunes will be made" as Rick Rule commented. He added his own version of the Rogers, Templeton, Buffet rule: "sell when you're feeling brilliant: buy when you're feeling terrible." Rule shares my view on upcoming growth in PGMs as articulated here. He has just bought $280 Mn in PGM miners based on increasing demand and limited supply. Basic principles like supply and demand and buying panic ("buy low, sell high") help re-focus the mind when sector under-performance sickens the heart.

In a March 27 interview with au report, Peter Krauth notes that average commodity bull is 17 years, not 12, and suggests, as I have done that energy, agriculture and precious metals are the best areas for growth. I have mentioned the merits of Sprott Natural Resources (OTCPK:SCPZF) that combines these areas in its holdings. Also note that the current equities market is a cyclical bull within a larger secular bear market that began in 2000 and that it rests unsteadily on the inflation of fiat-debt currencies. Continuing electronic creation of debt builds bank balance sheets, receiving credits at 0.0% interest and loaning it out at 3-5% (or selling Treasuries for MBS repos and playing the market), but even with this no-risk profit margin the loan/deposit ratio is shrinking as the major banks vote 'NO' on the economy. Against this backdrop, the descending wedge for both silver and gold has solidified as recent dips have stayed above strong support at $26.50/oz and $1555/oz respectively: "The larger gold miners have become extremely cheap, with very compelling valuations" Krauth comments. Among juniors, I again mention Reservoir Minerals (OTCPK:RVRLF) with its huge, high-grade mine in Serbia. In the past month it out-performed not only its sector but even Consumer Staples, rising 55%. Amid the April 2 sell down in the miners it rose 6.01%.

Regarding rising taxes and royalty rates on miners, Krauth says "We expect to see this everywhere. Governments are hungry for income." Nevertheless he foresees profitability. Because of the strong fundamentals for precious metals, Central Bank and investor buying and, for silver and PGMs expanding industrial applications "this rise in taxes will have only a temporary dampening effect; it will not hurt the bull market in any way" Krauth concludes. Combine his view with the thesis I presented in "NGOs Thwart Miners, Skew Sector Outlook."

John Hathaway of Tocqueville Gold (MUTF:TGLDX) continues to see precious metals as optimal value plays. Caesar Bryan, Manager of Gabelli Gold Fund (MUTF:GOLDX) emphasizes that increasing governmental direction of fiscal policy distorts markets, increases debt and deadens economic growth. In Europe there is negative growth and in Japan inflation posturing as growth. Today miners trade at discounted valuations whereas from 1997-2007 they traded at 100% premium.

The Cyprus crisis exposes counterparty risk in simple checking and savings accounts. The ugly fact is that via derivatives banks are insolvent and this is why they are hoarding cash and blaming the consumers whose money is their collateral. So even cash now is a risk asset. "Bank deposits and even cash itself must now be considered as investments with severe downside risk in the event that the Cyprus template spreads to other countries. This is a huge change..." notes Robert Fitzwilson of the Portola Group. So the Cyprus crisis bolsters the thesis for owning precious metals which at current prices qualify as strong value and contrarian plays aside from their intrinsic merits in technology-industry and as currency. Fitzwilson concludes:

"Doubts about the safety of bank accounts and sovereign debt could trigger a rare confluence of fear and greed. The impact on the prices of real assets, particularly gold and silver, would be great." Recall that the FDIC only has funds to back .04 of the bank deposits it supposedly secures. The banking sector of Cyprus was 7.1 x GDP. UK Banks are 5.1 x GDP. In Switzerland the ratio is 4.8 x 1. America at .8>1 is clean by this measure and the flow of money into the "safe haven" of US Treasuries masks the positive fundamentals for PMs.

Note that Tuesday's sell down in PM miners did not show that royalty or streaming companies do better than miners. Franco Nevada (FNC), Silver Wheaton (NYSE:SLW), Sandstorm Gold (NYSEMKT:SAND) and Royal Gold (NASDAQ:RGLD) were down 1.51% (NYSE:FNV) to 3.93% despite analysts retaining a strong buy on Silver Wheaton with an average target price of $49, 65% above its current level. Its revenue, income, income to revenue ratio, dividends all are increasing. Its trading performance typifies the rupture between perception and value on the precious metals and mining sector.

To sum up the main points of the precious metals thesis: they are powerful value and contrarian plays. Government debt and currency devaluation increases their merits though this presently is masked by a stronger USD and investment in US bonds. Massive buying of PMs continues by Asian banks and citizens and the BRICS nations are establishing a $100 Bn reserve fund to trade in their own currencies. These developments bolster BRICS currencies and PMs which are part of their trade arrangements. Silver and the PGMs retain the benefits of expanding industrial - technological uses that will persist even when the world sags into recession. The debt in major economies is finessed with creation of more debt and derivatives which almost insures a depression. But even if the markets soar, the history in the charts referenced and linked above indicate that PMs and miners will rise from current depressed levels.

Thus, rather than capitulate on metals, trim if your allocation feels unsustainable but try to avoid locking in a loss. Check top-ranked funds to support your own research on the best companies to hold or add. Remain in the 10-20% range for bullion and miners combined. Wait for a spring pullback before nibbling more on the indices. This will be a memorable year.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SLW over the next 72 hours. 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.

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