Investing in the Precious Metals Market

Includes: GDX, GLD, SIVR, SLV
by: Jeff Nielson

Knowing that there are growing numbers of precious metals investors who are new to this sector, I've tried to provide some educational commentaries to help people learn to invest in this sector on their own. Previous commentaries have explained the “leverage” offered by precious metals miners, grouped these companies into specific categories, and provided criteria for evaluating these investments.

This time I will seek to pass along some strategic advice on how investors may want to manage their precious metals portfolio. Given that investors have different needs/goals, different levels of risk-tolerance, and different perspectives on this sector, these tips should be considered merely guidelines – rather than some rigid formula.

The place to start in planning your strategy for precious metals investments is to decide on how you wish to allocate your capital between gold and silver. I have made no secret that I consider silver to have superior supply/demand fundamentals. This is due in large part to the fact that global silver inventories have been severely depleted, with two-thirds of current inventories comprised of silver supposedly “held” by silver bullion-ETF's.

However, more conservative investors may prefer to focus their holdings on gold – given that (currently) it has superior status as both a “store of wealth” and a currency, in most markets around the world. For convenience, I will simply assume that investors have no preference for either metal, and base my advice accordingly.

Many commentators in this sector (including me) have urged investors to focus on the gold/silver price ratio to guide them in which metal to buy at any given time. As I have mentioned on several previous occasions, during the roughly 5,000 years that our species has used these metals as currencies, the average price ratio is roughly 15:1. As of this moment, the gold silver ratio is very close to 60:1. Thus, even accounting for a preference for gold over silver, this ratio is clearly skewed to favor silver.

For those who would like a very simple means of allocating their precious metals dollars, let the gold/silver ratio dictate where your dollars go, through purchasing silver in a percentage equal to the current ratio. In this case, with the ratio at 60:1, this would dictate putting 60% of new dollars into silver/silver mining stocks, and the remaining 40% into gold/gold mining stocks.

Even as someone who strongly favors silver over gold, this is approximately the ratio I'm using with my own investments. The reason for not investing even more heavily in silver (given my own preference) is that commensurate with a price ratio which values gold heavily above silver, assets in the gold sector are currently getting better valuations than in the silver sector.

Assuming that no investors are simply buying and holding everything for the long-term, this implies a desire to take profits to lock-in gains along the way. During this current rally, almost all my profit-taking has taken place with my gold mining stocks, because I'm simply not willing to sell any of my silver holdings – given their very modest valuations (in my own assessment).

Lest some critic jump to the conclusion that my “profit-taking” implies that I'm starting to “bail-out” of my own positions, I just finished re-investing two-thirds of those profits – on the brief pull-back which occurred in the “delayed reaction” to the Dubai default. At this point, I've seen no indications that the current rally is over-extended, and was happy to put more of my own money into two of my favorite miners.

Once investors decide how they wish to distribute their precious metals dollars between gold and silver, the next decision to make is in what form of precious metals holdings should they invest. As I have warned on many occasions, do not invest in the large (so-called) bullion ETF's – like GLD and SLV. There are many reasons to doubt the legitimacy of these funds, which I have detailed in several previous commentaries.

For those who are adamant about using bullion-ETF's rather than holding the “physical” metal directly, you must do your homework. Examine the prospectus carefully, and automatically shun any fund which does not hold/store all of its own bullion. Keep in mind that the “custodians” of the vast majority of ETF “bullion” are the same bullion-banks who are currently holding the largest short positions in gold and silver in history. Do you really think these bankers want to help small, retail investors enter this market (and undermine their massive “short” positions)?

Assuming investors allocate 100% of their precious metals dollars in real bullion or precious metals mining companies, the percentage to assign to those two categories is partially a function of risk-tolerance and partly an issue of time-horizon.

I can certainly understand after the events of the last year that many investors are much more concerned with maximizing the safety of their investments, rather than simply seeking to maximize profits. I would not fault any investor for choosing to invest all of their precious metals capital into bullion. This is especially true for investors only wishing to focus a small part of their portfolio into this sector. For more elderly investors with a short investment horizon, it would also be prudent to focus on bullion, itself.

For those investors who are wishing to invest 20%, or 25% (or even a greater percentage) into precious metals, I would strongly urge investors to put at least ¼ of those dollars into the stocks of quality precious metals miners. Even in the event of a complete breakdown in the global monetary system (which remains a distinct possibility), the worst-case scenario for holders of these equities is that they could become completely illiquid for an indefinite period.

However, with gold and silver as the best “stores of value” of any asset-class, clearly the companies that produce these hard assets would be favored above any other class of equity – and would thus be first to regain their value as markets returned to normal.

For more aggressive investors, or those with a longer investment horizon, I would suggest that at least 50% of their precious metals dollars be invested in the miners – since they will always outperform bullion over the course of any bull market in precious metals. As I have detailed previously, it is the “junior” miners (and especially junior producers) who provide the best risk/reward profiles amongst the mining companies.

Of course, placing your investments in this sector is literally only half of the task of managing your precious metals portfolio. Regular profit-taking is an essential part of any long-term investment strategy, so deciding how/when to take profits is a critical determinant in the long-term performance of your investments. As a firm believer in the KISS principle (“keep it simple, stupid”), again I would suggest a very basic strategy: do not sell any of your bullion holdings.

Given that the mining companies offer superior performance to bullion, itself, trading and profit-taking exclusively through buying and selling these shares provides ample opportunities to lock-in gains – with the greater volatility of the mining shares giving investors the best opportunities to re-invest their profits on the inevitable dips which occur in even the strongest sectors.

As for when to take profits, in this case precious metals are no different than any other asset class. Many investors strongly favor selling half their positions on a “double” (a 100% gain), so that your remaining investment represents “free shares” - already fully paid-for through profit-taking. Personally, I don't like to be that rigid with my own buying and selling.

With my favorite holdings, I rarely sell more than ¼ at any time. On the other hand, with companies which I don't regard quite as highly, I'm quite happy to sell 100% on any short-term spike – as there are no shortage of quality, under-valued companies to pick from. For those who are investing in the junior miners, do not allow yourself to “fall in love” with any of these companies.

Seeing some of the spectacular gains which these companies have achieved just in this current rally, the temptation for novices to this sector is to look for a “home run” - and put most/all of their precious metals capital into one or two companies which they see as “can't miss” prospects. Never forget that there is always risk with these companies, no matter how competent or conservative is the management team.

Accidents occur, governments change, and there are always the dreaded “Acts of God”. You must distribute your dollars into a basket of these companies. As I suggested earlier, for those only wanting to put a small portion of their capital into this sector, you are much better off to stick with buying bullion, rather than placing a “bet” on just one or two mining companies.

I personally have more than ¾ of my own portfolio concentrated in this sector – with that ratio having risen substantially due to the outperformance of this sector. I am fully conscious of the conventional wisdom of “diversifying” into many sectors/asset-classes under normal conditions. However, if I have accomplished nothing else with my own writing, hopefully I have made it clear to people that “this time it is different”.

The last forty years is the first time in history that the entire, global financial system has been completely detached from a gold-standard. In every individual instance of purely “fiat” currencies (i.e. money backed by nothing), this banker-driven adventure has ended badly. Now, for the first time, the current system is facing the imminent risk of collapse.

As is always the case, the cause of this instability is the grossly excessive (and extremely unstable) mountains of debt (created by the bankers), combined with recklessly “easy” monetary policies (also courtesy of the bankers) which are fueling a rapid expansion of these mountains of debt. Unless an investor truly believes that you can “put out a fire with gasoline”, there is only one way this recklessness can end.

This doesn't mean that everyone should put 100% of their investments into precious metals (or even close to it). What it does mean is that investors must be focused first and foremost on protecting their wealth – and only once that is accomplished do we have the luxury of seeking to maximize returns.

Other classes of “hard assets” are also valid alternatives, however, real estate is (currently) not one of the hard assets which investors can use to protect themselves. The “easy money” supplied by the bankers means that real estate markets around the world have been flooded with new housing inventories – and despite the massive supplies in most markets, real estate valuations remain inflated.

The precious metals sector is not the only place for people to make their investments, it's simply the best sector. No other category of investment offers the combination of wealth preservation with superior up-side, investment potential. However, this does not mean that those investing in this sector can afford to be lazy or complacent.

The generational shifts taking place in our societies, economies, and markets means that we will see unprecedented volatility – and no shortage of “shocks” to markets. Because there are so many major stresses at work in the global economy (mostly derived from excessive debt/leverage), there are a near-infinite number of possible calamities ahead.

Focusing a significant portion of one's portfolio into the precious metals sector provides a realistic strategy for small investors to protect themselves – versus the option of leaping from sector-to-sector as various crises unfold in the years ahead. As with all investment cycles, those who engage in such preparation first will be amongst those who benefit most from this strategy.

Disclosure: I hold no position in SLV or GLD