Precious Metal Sector Fundamentals Stronger But Volatile

by: Emmet Kodesh

Unless you have an income stream that provides for life basics plus 10% you might prefer to avoid PMs (precious metals) or PM miners even at today's crushed valuations. As geologist, engineer and industry professional Lawrence Roulston noted May 08, in buying most miners today you get cash at a discount with PMs thrown in as value-added. That is an essential datum on which those with adequate income can act but the sector's volatility can surprise and those with conservative goals or time horizon should be cautious.

Given the YTD decline and two major plunges in the PM sector we should re-consider its fundamentals. Then we can better peruse Mr. Market's trends and consider the near and mid-term future. I will offer a thought on the long term too although our systems tend to function on short-term criteria. All the more reason to identify clearly and often review your mid and long term goals.

Here are fundamentals affecting the PM sector which as you will see conjoins economies and the global financial system:

* All major fiat currencies continue to be devalued by their CBs (Central Banks) in the self-negating exercise of easing debt service by creating debt

* Central Banks are intervening in markets by buying equities in unprecedented amounts

* Major CBs (the Fed, ECB, BoE and BoJ) are buying sovereign debt and suppressing bond yields; the bubble in bond prices is crushing fixed income investors who need safer havens

* CB buying of gold is soaring especially in Asia

* Retail investors East and West are buying record amounts of PMs as premiums rise and physical asset shortages increase: demand surges as supply slides and banks delay delivery of PM holdings. Nearly 21 million silver eagle dollars have been bought YTD

* Supply shrinks as miners seek profitability over growth

* Sentiment is very negative making PMs a value & contrarian play

* Ex-USD trade is increasing as the USD role as world reserve currency may change within a decade

* Wealthy people are exchanging dollars, paying huge sums for art, ($495 million at Christie's 5-14) & jewelry, safe havens for some

Despite these positive fundamentals, PM prices in metals and miners sagged in 1Q 2013 and after the Goldman Sachs short sell guidance April 10 (reiterated 4-16) and renewed short selling on May 16-17 crashed twice. Coincident with these last two events the USD rose, especially in the past week as it set a new 52-week highs. The DXY measures relative strength and the crash of the PM sector may push its rise as does devaluation of the yen.

Gold miner bullish sentiment, at 72.5 (on a scale of 100) seven months ago hit zero April 15 and after a 4-week rise to 7, again is near zero. CEO of Barrick Gold (NYSE:ABX) Jamie Sokalsky recently stated that "there is an anti M&A mood now" as his company (and other large mixed commodity miners like Rio Tinto [RIO] and BHP Billiton [BHP] look to divest non-core assets and difficult sites. For PMs, he says, "it's a buyer's market" and observers like Roulston, quoted above agree.

We must try to understand the break between the fundamentals and the market. The lessons touch everyone whether they are in the PM sector or not, whether they like, dislike or are indifferent to it.

Since the IMF explicitly has said that Asian governance and "economic management [has] lessons for other [world] regions" perhaps the Chinese model fusing corporations and government is being pursued in the West. "Asia's role, including the IMF [is part] of this process going forward" (Asia 21, "Leading the Way Forward") stated the brochure for an IMF July 2010 conference in South Korea. I received one as did every faculty member at a large nearby University before the event. Perhaps the Asian model is being introduced to the PM sector as well as other parts of the economy and areas of the markets.

Part of the break between the strong fundamentals for the PM sector and its price levels YTD may reflect increasing Sovereign management of economies and finance on the way to a new monetary system. In any case, large and continuing PM retail buying noted and linked above reflects not only traditional customs like India's festivals of Diwali and Ganesh but also attempts to preserve wealth and some liberty in a time of centralized governance. In an era that exalts what is transient, PMs both symbolize and contain what is enduring and genuine. They are a living history of value.

The modest recovery in PM prices that began 4-16 went to $1480 (charts here), a plateau maintained by heavy physical buying till the slide that hit markets May 13-17 leading to the second rout down to $1340. Friday May 17, a day of PM collapse there was massive sovereign buying that led to a May 20 recovery to $1420 intraday. The volatility continues and is not likely to abate despite strong demand.

Consider the day when investors digested the most recent comments on QE by the Fed. Wednesday May 22, the Gold ETF (NYSEARCA:GLD) was down .78% while the junior gold miners ETF (NYSEARCA:GDXJ) was up 1.66% after being up 3.14% at 1 EDT. Both ETFs slid with the USD in the afternoon. There was strength throughout the PM mining sector from small caps like McEwen (NYSE:MUX), up 6.39% to mid-tier producers like Eldorado (NYSE:EGO), up 3.01% to Goldcorp (NYSE:GG), up 2.03%. The bounce may reflect strong hands buying miners as well as other investors who see extreme value in depressed mining prices. Wednesday's action was another sign that the inverse correlation of the USD to PMs has become, like other market metrics uncertain. As the miners were surging Wednesday so did the DXY to a new 52-week high of 84.22. After hours, at the start of trading in East Asia it hit 84.498. It then rose to 84.498 before subsiding a bit Thursday.

Other significant developments included Mr. Bernanke telling the JECC (Joint Economic Committee of Congress) that "premature tightening of monetary policy…would risk slowing or risking the economic recovery" which might have been expected to drop the USD. It is not clear what this "recovery" is but he hinted at deflationary depression which is plausible in a structurally impaired economy with demographic problems. Continuing debt creation should make PMs more appealing to all investors. Lastly, the sharp divergence of GLD from the miners and, to a lesser extent from spot bullion suggests that the paper market may be breaking down. Some observers believe that the warning of a downgrade of US credit status by Moody's helped boost the PM sector as the S&P downgrade did in 3Q 2011. Certainly comments by a rating agency about downgrades stir desire for safe havens. The basics say that despite volatility the PM sector retains this function.

For takeaways consider the situation: buying by Central Banks and retail investors is increasing. PM supply has been and is being strained by powerful demand. Premiums have risen while shortages and delayed delivery of physical assets extend. The downturn in prices since the silver and gold nominal tops in 2Q and 3Q 2011 respectively has elicited cost cutting and slowed E & D by miners and increased retail interest. This is all constructive for prices though still masked by negative sentiment.

Investors entering the space after April 15 are in good shape. While it is impossible to rule out further volatility reflecting large orders before the open at the daily price settings in London, major players are buying the sector. Moreover, as Eric Parnell recently noted, the greatest bubble in markets today is not equities or bond prices but the explosive increase in short positions in gold. Buying pressure from CBs and hundreds of millions of retail investors continues. Asian buying is unconcerned with action in the miner ETFs (NYSEARCA:GDX) or GDXJ or PM proxies like the gold and silver (NYSEARCA:SLV) ETFs. Burgeoning business via the Shanghai gold exchange will displace and likely moderate sector distortion that occurs in Western exchanges. Buying of physical gold has been so heavy since April 26 that deliveries "have dropped nearly to zero" (see previous link to the Shanghai exchange) from an average of 8 tons/day delivered. The Asians, and many American buyers of bullion understand that it is good to "buy panic."

Those holding PM mining shares bought before this year should hold unless they need to raise cash: nearly all estimates for PMs and for most miners for 4Q 2013 going forward are significantly above, often double today's prices. For example, despite a spate of downgrades in the past 8 months (and an April 12 upgrade by Mackie Research from "Hold" to "Buy") reflecting negative events already priced in, Barrick Gold has an estimate of $46.83 (135% above current price) and Silver Wheaton (SLW) a "Buy" rating on market watch with an average price target of $40.37 for this year, 86% above today's price.

If your income stream permits, add some miners for value and the likelihood of significant growth later this year and next: you must be able to tolerate volatility in the interim. Mining is a dirty and dangerous business and accidents and resource nationalism will remain factors that affect prices. The other macro monetary and economic issues noted at the outset suggest a rewarding future for investors in the sector.

Meantime, the indices have hesitated in their flight to the empyrean. Take profits: as Jeffrey Saut, Chief Investment Strategist at Raymond James expects a significant 3Q correction after the YTD "buying stampede." Most years have a 5-8% correction and the current run of bulls over a gasping economy is not likely to prove an exception.

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.