Will Precious Metals Remain Dangerous? How To Play

by: Emmet Kodesh

My previous article discussed the nature of price action in PM (precious metals) and its frequent and extreme divergence from basics like profitability and supply and demand. The article suggested trading strategies that adapt to this reality and identified the best companies in the sector. I want to address a more fundamental question today: can one expect that fiddling with PMs ever will end. I will contextualize discussion of this issue by quoting CFTC Commissioner Bart Chilton.

At a speech in Mackinac, Michigan September 14 two days after PM prices were crushed, Mr. Chilton followed several paragraphs of jocular opening remarks by noting that our markets and especially his purview, commodity markets behave like a dangerous form of reality TV. In fact, he said, like dangerous animals:

"High-frequency cheetah traders…now remind me of World's Scariest Animal Attacks [a "reality TV" show]. The cheetahs are a problem issue much larger than ever imagined," Chilton said.

The pun on "cheaters" was adroit and typified the fierce wit that pervaded his speech which aptly was titled, "The Brutality of Reality." Until late in the address, he deflected attention from specific players with humorous references to DC power events from the White House Correspondents Dinner ("a confluence of journalism, Hollywood and politics") to Miss America pageantry. He avoided, until late in the speech specifying firms responsible for predatory practices, "it isn't prudent for us to get into details on increased concerns about the cheetahs" and their "humongous number of potentially illegal trades, heaven forbid," he said initially. His reticence itself is notable.

The next sections of his remarks, "the Brutality of Reality," "Shark Tank" and "Mythbusters" suggested that what has been occurring in our commodity markets is like the LIBOR fixing scandal that to date has prompted $billions in fines. He stated that "the list of banks getting a pass are names we all recognize, Citigroup, UBS, Barclays, JPM" and he listed about ten more of what he termed, "an elite crowd." Before concluding his remarks by saying that the government should get banks out of commodity trading and "back to banking," he singled out Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) as "two special large banks" that have received "extraordinary treatment."

The critical remarks are interesting as is the out-of-the-way location and predictable lack of major coverage. In any case, political action of any kind is uncertain and the problems facing retail investors remain: the markets have become, as Mr. Chilton said, a "Shark Tank" and it is unclear that absent a high-profile law suit vigorously pressed by the government (don't hold your breath) "naked shorting" or other forms of diddling with markets will cease. Life did not become "virtual reality" by accident. Disinformation and distraction are staples of this period in culture as Orwell foresaw, "the lie became truth."

Investors must note that after last week's crushing of PM prices, Goldman Sachs commodities chief Jeff Currie announced a 12-month gold price target of $1050. Firms like his have the ability to create reality, to forge "truth." Readers should review my piece written ten weeks ago, "Gold may touch $1050 before rallying." In mid April there was the initial GS short sell guidance and then a follow-up hit six days later. It is quite possible that this may recur. On May 8th I wrote, "Married by Fiat: PM Collapse Precedes Markets" and two weeks later the markets began what became a 5.75% drop. In any case, the crushing of PMs, barring major government legal action, could continue periodically despite supply - demand basics or the profitability of the best miners.

The strategy remains as I described in my previous piece: nearly any major issue, a bullion ETP like Sprott Physical Silver (NYSEARCA:PSLV), Swiss Gold Trust (NYSEARCA:SGOL) or indeed the familiar paper contract vehicles Spider Gold (NYSEARCA:GLD) and iShares Silver (NYSEARCA:SLV), or most miners can be used for trading. But one needs to be nimble as well as strong going in and out because there may be follow-up shorting by strong hands. Do not hesitate to take profit. In some ways, GLD and SLV are best for this although by playing them you enhance the ability of those who short the markets so it is better to use other vehicles. One also can use the mining ETFs for Gold Juniors (NYSEARCA:GDXJ), Silver (NYSEARCA:SIL), the more volatile but thinly traded silver juniors (NYSEARCA:SILJ) and Gold Explorers (GLDX) for trading.

However, I believe that for the most part you should buy and, when necessary, trade the best of the sector, entering at major drops and retaining some of your holdings when you take profit. The great companies in time will out-perform and there are many buyers for their products, especially the silver miners. It is possible that in the mid to long-term they even may become quasi-governmental entities for the commodity is essential to industry. Trends in governance suggest this as one of the paths evolving from the present.

In closing, here again are the best PM miners ranked by low to zero-debt and profitability (revenue and cash flow / debt ratios, multiple producing high-quality sites and experienced geologists, miners and prospectors on the Board): First Majestic Silver (NYSE:AG), Endeavour Silver (NYSE:EXK), Eldorado Gold (NYSE:EGO), McEwen Mining (NYSE:MUX), Fortuna Silver (NYSE:FSM), Yamana Gold (NYSE:AUY), New Gold (NYSEMKT:NGD) and Silver Standard Resources (NASDAQ:SSRI). In the first six especially one should consider retaining a portion when cashing gains. Larger mid-tiers Kinross (NYSE:KGC) and IamGold (NYSE:IAG) have revenues 2.2 x debt though KGC has negative cash flow. I would avoid it though IAG is good for trading and yields a hefty 4.7% on a moderate 32% payout.

In addition to these mid-tier and small cap companies, among the majors, Barrick Gold (NYSE:ABX) remains the deep value and long term recovery play. Its North and South American holdings, 60% of its production even without Pascua Lama remain the lowest cost sites and it is divesting higher-cost assets. Enter below $18 for a large margin of safety. TD Securities and Merrill Lynch recently have made ABX a Buy with a 2013 target of $25. Andrew Bary in Barron's also termed ABX the best buy among major producers and it closed Friday at $17.72. You may review my most recent Focus piece on ABX here and an earlier discussion of outlook here.

Note that Merrill Lynch (previous link) also singled out as buys Freeport McMoRan (NYSE:FCX), calling it "significantly undervalued" which has been my thesis in several focus pieces. ML also cited KGC as a "buy."

Among PM streaming and royalty companies, Silver Wheaton (SLW) and Franco Nevada (NYSE:FNV) are best with SLW a very strong buy below $22. FNV has led the sector since its June 26 bottom and rebounded 3.57% September 13. Still, like other issues in this sector, these two great companies with coverage ratios off-the-charts and FNV debt-free, one must consider them at least in part as trading vehicles. See my initial article, linked above on this strategy for the sector, do your due diligence in learning price history and action, follow company news and prosper. Keep an eye on the "shark tank" and do not assume the sector will hit a string of green days after the Sept. 12 plunge. Several nations, including China celebrate an autumn festival Sept. 19-20 and that may be a time of sector weakness as east Asian buying pauses.

FCX is an exception to these rules. Now a mixed commodity miner and energy giant, it retains significant non-correlated and out-performance qualities. See this piece for a discussion of these merits. Take care.

Disclosure: I am long AG, EXK, FSM, 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.