A Hard To Call Bottom In Gold And Miners: Strategy Going Forward

by: Emmet Kodesh

This article considers the price action and prospects of PMs (precious metals) and PM miners. As a preface to investing strategy and sector outlook it reviews the opinion of an experienced financial professional on the process that adds to PM sector volatility and risk. Although valuations there now are compelling it is difficult to call a bottom based on fundamentals. Price action on Friday May 17 is a context for the following discussion. I hope this piece will help investors avoid big losses and panic selling.

Some people contend that the gold market is manipulated by major banks in a way similar to the rigging of LIBOR (London Interbank Offer Rate that sets interest rates worldwide) that earlier this year elicited billions of dollars in fines. By gaming daily spot prices, so goes one argument, some major players profit in ways that disorder markets and patterns of supply and demand. It is important to consider this process whether or not you own a single ounce of gold or silver or a single share of a precious metal miner. PM prices do not simply follow supply and demand. As Kafka wrote in The Trial, force matters more than truth in certain spheres of life in certain periods of history. That is "a melancholy truth."

There again has been capitulation selling in the PM sector. The rise of the DXY USD index which made a 52-week high of 84.355 at 9:58 EDT Friday is part of the PM drop but it is a relative measure. Despite $346 billion of margin debt in America, almost as high as the July 2007 record level, the markets surged so we should consider the problems of PMs from various perspectives.

William Kaye, founder and chief investment officer of the Pacific Group in Hong Kong used to work on arbitrage for Paine Webber and for Goldman Sachs on M & A. He contends that the five major banks in London that twice-daily set precious metal prices work with New York Bank Mellon, custodian for the Gold ETF (NYSEARCA:GLD), and about a dozen other banks that are "too important" to prosecute as the A.G. recently testified (reported in the NY Times) to press prices lower so "strong hands" can buy and then sell at a premium into surging Asian markets. Fundamentals of supply and demand seem overwhelmed by this process and all investors in the sector should consider it. One must expect extreme volatility and consider most PM assets as trading vehicles. Set aside a portion on which you can be patient.

As I mentioned in my piece "Precious Metals Piracy & the Daily Fix," and as reported recently by The Guardian, linked above, the twice-daily setting of the gold price is being investigated. Whether that will bring fines and operational changes as in LIBOR remains unknown. What happens at present is that if at the opening a major bullion bank places a huge sell order, say 100 tons of gold the lack of buyers at that level depresses the price at the opening in New York five hours later. After shorting COMEX futures in London, Kaye argues, major banks buy GLD low in NYC. When prices rise they sell gold at a premium into the surging Asian markets ("the strongest waves of gold buying in thirty years") at the next day's open. It sounds plausible and Kaye is an experienced professional whose fund returned 195% from 2001-12. His viewpoint is not uncommon among those active in the sector that often speak about the use of short selling to push price action. In any case, it makes problems for retail investors whose holdings are buffeted.

May 16-17 were an example: millions of retail investors panic-sold their PM and mining shares at a loss. The Junior Gold Miners ETF (NYSEARCA:GDXJ) made another low-since-inception at $10.42. Prices again swung giddily despite surging retail buying (in America, too) and significant industrial demand. Sentiment becomes extremely negative and the process can become a rinse-and-repeat cycle whose end is difficult to predict. As Dave Kranzler wrote on SA, gold selling has become "plain silly." It is noteworthy that while George Soros recently pruned his GLD holdings he increased his fund's share of the Gold Miners (NYSEARCA:GDX) and GDXJ to 2.67% of his holdings. This also is a significant datum: perhaps the bottom of the current trough is near.

Heavy buying of PMs in Asia has been boosted by commerce through China's own gold exchange in Shanghai. With volume there rising 24% y/o/y by March it becomes increasingly useful to evaluate reasons for sudden plunges in PM-related prices and to expect that there is continuing buying pressure as well as gamesmanship by some big players.

The action to take in response to this situation depends on your time horizon and the portion of investable cash in your total holdings. It is possible that the PM sell-off prompted by the April 10 Goldman Sachs guidance to short-sell gold is not over. As of May 17 we seemed to be in a follow up phase to elicit complete capitulation. This could be part of the policies urging investors out of bonds and other asset classes into the main equities indices which are flying on QE and claims of economic recovery. As Lawrence Fuller recently noted:"the real economy is horrid for the vast majority of Americans." Unless market makers can change the laws of nature the outcome cannot be good for the indices either. That is "the ugly news" to use Fuller's phrase, a point I often have made in urging cautious participation in equities.

Takeaways: Reason says that if you have investable cash, the mining sector has become the ultimate value play. If you already are allocated more than 10% to PMs however, you must have a good income stream or total conviction to add in the current conditions. If you do add, consider that palladium (NYSEARCA:PALL) has performed and likely will perform best of the PMs: Sprott physical platinum and palladium trust (NYSEARCA:SPPP) is a good holding that will rise if China makes even small moves to control its particulate emissions.

Among major mixed commodity producers, BHP Billiton (NYSE:BHP), Rio Tinto (NYSE:RIO), Goldcorp (NYSE:GG), Freeport McMoRan (NYSE:FCX) and Barrick Gold (NYSE:ABX) should out-perform. ABX has large Copper reserves (14 billion pounds) as well as Au and Ag (140 million and 1.05 billion oz respectively). In the PM space, beaten-down mid-tier producers with ample proven and probable reserves like Kinross (NYSE:KGC), Eldorado (NYSE:EGO) and major streamer Silver Wheaton (SLW) offer the best value. Amid continuing sector decline May 16, SLW, KGC and EGO did well only to droop again on May 17 when the USD peaked. So allocate half your PM position to near-mid term trading and depending on your situation don't hesitate to take profit. To be in the sector one must be able to tolerate volatility and the apparent failure of fundamentals. If you cannot do so, or your situation cannot sustain it you should avoid the sector.

When a sustained economic decline or a crisis hits the indices, Mega Caps will hold up best. In recent weeks, Chevron (NYSE:CVX), DuPont (DD), Halliburton (NYSE:HAL), FCX and Kubota (KUB) have performed best on my list of producers and makers of basic materials: May 17 they surged ahead of the indices as people bought the promise of economic recovery. However, it is difficult to see much structural improvement as opposed to market fizz and fizzle this year or next. The demographic disaster of the late 20th century is exacting its costs. We will not emerge from its shadow for at least another generation. "The ability of the global economy to grow organically is "almost at zero" says John Embry, Sprott Asset's chief Investment Officer. Mr. Fuller, quoted and linked above wrote that "rates of growth in nearly every economic indicator aside from housing are either slowing dramatically or turning negative."

If you think the indices accurately reflect the economy go 80-90% equities and the rest in short-term bonds. But in my view and that of many others the pleasurable surge YTD is unsustainable.

Regarding acquisition of PM and miners, indeed any equities there is a caveat based on the fragility of the system. Thus I urge you to continue cautiously to participate in the indices but to have stops in place and an idea of when you need to shift to short term investment grade ETFs. If you can, buy some land. This strategy has worked before as a back-up to turbulent socio-economic conditions.

It is likely that precious Metals will continue to be a roller coaster and the markets filled with "croupiers" (John Bogle's term) near an abyss. Play the PM sector for value and trading but be mindful of sector volatility and divergence from fundamentals of supply and demand. As Spengler wrote, "through money, democracy becomes its own destroyer," perhaps a comment for our times.

Disclosure: I am long SLW. 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.