Precious Metals Paradox: Good Fundamentals Help And Hurt

by: Emmet Kodesh

PMs (precious metals) are a small sector vital to industry and monetary policy. Their extreme volatility belies the constant and increasing uses of silver and can induce jitters in those with holdings in the sector. The week of October 7 included extreme volatility in equity markets, a 3.46% swing in the S&P Wednesday to Friday. It also had two major drops in PM prices: early in the week, a sell order for 600k oz. gold crushed bullion prices and before trading Friday, a 5000 unit sell of futures on COMEX briefly stopped trading and knocked gold down from $1305 to $1267 / oz. Ironically, it is precisely strong demand that may prompt trading by big players that suppresses PM prices.

Art Cashin, 50-year market veteran and NYSE floor manager for UBS addressed recent massive shorting of gold (NYSEARCA:GLD), noted the pattern and said "there should be some further investigation and why always [naked shorting happens] at that time" (before the open in NYC). Don't expect this to occur. The Friday short sell caused the CME to halt trading briefly as noted on CNBC among other sites but reparative action like that sometimes promised by CFTC Commissioner Bart Chilton also faces headwinds. The recent Goldman Sachs and Credit Suisse downgrades of gold are in the process of being turned into fact.

I will discuss the simple but overlooked logic for this paradox, the havoc it wreaks on those trying to understand and invest (not simply trade) in the sector and consider strategies and allocation that adjust to chaotic situation likely to persist.

Silver is a commodity essential to many industries and its uses are increasing. Its unique conductivity makes it ubiquitous in circuit boards and electric switches, car, truck and jet engines, household appliances, cell phones and televisions and photo-voltaics. It resists oxidation and corrosion. Its anti-bacterial properties find increasing medical applications. It also is highly desired as a monetary metal and store of value: as I have noted in previous columns, record numbers of silver eagles and maple leafs have already been sold this year. Fiat currencies continue to be devalued with some, the Rupee, Real and Yen, suffering major deterioration and volatility. Despite these great fundamentals, the price of silver is down over 31% YTD: at $21.40 it is at its level of early October 2010. Its one year hi-low is $18.50 late in June, down from $34.20 in December 2012.

The fundamentals for gold are nearly as strong. Record levels of buying by Asian Central Banks and by retail investors world wide have not boosted prices: the opposite has occurred. Bank and retail buying has been occasioned by deteriorating currencies, enormous increases in Sovereign and individual debt, troubled demographics and movement toward a new reserve system whose details remain obscure.

Ironically, it is the very utility and appeal of gold and silver for industry, for borrowing leverage, wealth preservation and jewelry that helps suppress prices. The PBOC, Russian Central Bank, Western banks trying to restore their reserves would rather buy gold at $1200-1300 / oz. than at $1800 or $2500/oz. The surge in retail investment in coins has been sparked by falling prices as well as by well-founded concerns about the frailty of fiat currencies and intractable debt accumulation.

Investors must understand that it is not only strong hands, Sovereigns and their affiliated financial institutions that benefit from PM price drops prompted by huge sell orders at odd hours. Every car and jet manufacturer, all major appliance makers and technology giants need silver and have an interest in low PM prices. While lower supply from cutbacks in capex and E&D by PM miners that have been crushed by the price plunge eventually will push prices up, the interest of strong hands in capping bullion prices is unlikely to lessen, at least until a new monetary system is established.

Retail investors in bullion and PM mining companies must consider this context in their investment and trading strategies. It is not clear that a point will come when fundamentals trump the ability of strong hands to move the system by sophisticated trading techniques. On the plus side, it is worth noting that China is one of the world's second largest silver producers and soon will be a major or the major holder of gold. At that point, Sovereigns may countenance higher bullion prices. No one can be estimate the degree to which retail holders will be able to this price accretion.

Last month I wrote an article suggesting that investors reconsider their allocation to the sector despite it strong fundamentals. Because of its extreme volatility and the enormous and often irrational influence of strong hands, I invited those with net worth of less than $2 million to consider limiting their allocation to miners and bullion to 7-10% of their holdings. Price action in the sector makes holding it a stressful and punishing exercise. Besides the emotional wear and tear, frequent powerful downdrafts can prompt investors to sell at a loss, even a considerable loss. This never should be done in a holding with intrinsic merit except in a situation of urgent need for cash (such people should not be in PMs), but price action in the metals may drive you to it.

Therefore, many investors might consider 5-7% allocation to the sector adequate for them despite very depressed prices in great, highly profitable companies like First Majestic (NYSE:AG), Endeavour Silver (NYSE:EXK), Silver Wheaton (SLW) and McEwen (NYSE:MUX). MUX and junior miner Fortuna Silver (NYSE:FSM) with mines in Peru and Mexico have zero debt, experienced management and multiple good sites and properties. Their prices of all these companies are very low with great upside. The leader in reserves and low cost production properties, Barrick Gold (NYSE:ABX) has been cutting costs, selling higher-cost properties and non-core assets like its Canadian energy operations and has received a spate of recent upgrades. The Deutsche Bank $30 price target is 68% above Friday's close.

However, great fundamentals, cost control and good ratings do not protect PM miners against repeated hits on bullion prices or low-ball estimates from prestigious investment banks that can successfully game the trading system and thus the sector. Therefore, even when invested in the best companies one must periodically take profit. This requires a degree of vigilance that not all investors are able or willing to make. Those who invest in this small, vital and closely watched sector must accept its givens and context.

There are many great companies in other sectors whose profitability and place in the socio-economic structure is deeply rooted. I have identified some in many recent articles including here, here and here. Meanwhile, regarding PMs, forewarned is forearmed. After the latest price drops, the present is a reasonable buying time for those whose net worth and stomach can weather the situation outlined above. Remember to take some profits when they arise and don't expect logic to prevail. There is no intrinsic reason to believe that unnatural price action will cease or cease to have effect: our culture is constructed by play and gaming. Moreover and as noted, a large number of major players gain when PM prices are depressed. Some retail investors can benefit from this by identifying strong buys, entering low and holding: that may work, but be prepared for frequent unpleasant shocks and perennial assignment to the contrarian camp of "fools."

When QE ends, if it ever does, equity indices boosted by debt creation may stall out and crash. Perhaps then PM miners and bullion ETPs like Sprott Physical Silver (NYSEARCA:PSLV) will rise. In these markets, however, and in an age of interventionism, there are no guarantees outside the castle of the State. Retail investors need a defensive posture.

Disclosure: I am long ABX, AG, 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.

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