Precious Metals: Barbaric Relics Or Effective Hedges

Includes: CDE, GG, GLD, NEM, PAAS
by: The Hedged Economist


John Maynard Keynes considered gold a barbaric relic.

But he should have had some in his portfolio.

If not, he missed an important hedge.

Precious metals hedge a different risk than precious metal miners.

This is the sixth posting in a series on the overall portfolio structure implied by a focus on a dividend-growth portfolio. A previous posting, “A Dividend-Growth Portfolio Isn't A Strategy, It's A Class Of Assets" presented the plan for the entire series on the topic. This is the first posting to address alternative investments that provide a hedge to the barbell strategy discussed previously in “Enter The Barbell." The amount of assets held in each of these alternatives may not be large, but their impact can be highly significant because they are hedging particular risks that can have disastrous impacts on a portfolio.

None of the assets discussed previously provide protection in the event of a market crash or runaway inflation. Once one begins discussing alternative investments, the hedging affect becomes extremely important. Further, alternative investments are often specifically designed to hedge some very specific market development.

Precious metals and precious metal miners can be considered a form of alternative investments. Under the right circumstances, they can be a hedge against both a market crash and inflation. However, they are only an effective hedge if those conditions arise from particular causes. They are only moderately effective hedges against inflation in general. Furthermore, both the price of the stocks of precious metal miners and the value of precious metals can fall during a market decline.

Precious metals are, after all, a commodity, and commodity prices can fall with an economic decline often associated with a crash in the stock market. So, it's important to understand exactly under what conditions precious metals and precious metal miners provide a hedge against inflation and/or a market crash.

Some analysts and investors treat precious metal miners and the underlying commodities as separate asset categories. Given how strongly they are correlated, it seems appropriate to treat them as a single category within the broader category of alternative investments. However, it is legitimate to hold both. While their price movements are correlated, the circumstances under which they would diverge in performance are extremely important.

Anytime one acquires an asset with the intention of using it as a hedge, it is extremely important to be clear about exactly what it hedges. What gold hedges is widely misunderstood. In a posting on The Hedge Economist on April 5, 2010 entitled “Gold: Be sure you know what you've hedged," the topic is discussed in detail.

The most widely misconceived notion is that precious metals are inherently hedges against inflation. That's not the case, and it is easy to identify long historical periods where using precious metals as a hedge against inflation would've been a disaster. Precious metals are a hedge against financial and social chaos, or as the posting put it:

…gold is a good hedge against inflation if the inflation is associated with distrust or chaos. It is actually the real or feared chaos and counterparty distrust that gold is hedging…. that hedge would be valid with or without inflation. However, for inflation that doesn’t result from or spawn extremes, there are alternative hedges against inflation that entail less risk or lower cost. For example, absent the distrust, indexed bonds, TIPS, have a positive return and no storage costs, and, absent the financial chaos risk, the stocks of gold miners can effectively hedge inflation risk.

Consequently, with that narrow definition of what physical gold hedges, it should be clear that it does not play a large role in one's portfolio. It's a hedge against inflation only under very specific conditions, and it is primarily a hedge against a very low probability event. However, there are very few other options that hedge the specific risk that precious metals hedge. Further, it also makes clear that there are risks that are not being hedged by precious metals. One of those risks that physical precious metals don't hedge is inflation that isn't associated with counter party distrust and the financial chaos associated with such distrust.

Despite the fact that there are long historical periods when the price of gold has fallen, some people believe that the long periods of declining price are irrelevant because gold is scarce and new finds are unlikely. As has been pointed out in previous postings:

…if someone wants to increase supply, look to Fort Knox, the NY Fed, and other central banks….the individual looking for supply can also look to the stockpiles of the gold ETFs as well…. That brings up another misconception. People argue that gold, unlike fiat money, is not something governments can tamper with. True, unless they decide to release gold from their stockpiles or to increase their stockpiles. Within recent memory, prices of gold have been held down when European governments reduced their holding and then propped up when China and India …increased their stockpiles. Further, much of history shows governments pegging gold values in one way or another. Governments clearly are not passive regarding gold, and they never have been.

If one needs evidence that it is distrust that gold hedges, developments in Europe in 2010 illustrate the point. During 2010, Europe experienced a period that raised the prospect of deflation if governments tightened budgets. That drove the price of gold up. Note it was the distrust of government, fiat money, the economy, banks and most other European institutions that drove the price up. That occurred despite the fear of deflation, not inflation.

Under the circumstances where one would want the hedge provided by precious metals, it is too late to start looking for alternatives. Furthermore, the chaos and distrust argument for precious metals says nothing about timing. Since the kind of chaos and distrust precious metals hedge is highly unpredictable, precious metals are best considered a permanent hedge. They function a lot like an insurance policy. Like any insurance, it is important to keep the cost low and not over insure for a very low probability risk.

As mentioned in the quote above, “absent the financial chaos risk, the stocks of gold miners can effectively hedge inflation risk.” That precious metal miners can act as a hedge against inflation is very similar to stating that oil companies can act as a hedge against inflation. Granted, it's quite legitimate to discuss precious metal miners as nothing more than a hedge. That is generally recognized as true with respect to the actual commodity while the stocks of miners are sometimes approached and evaluated just like any other stock. In many respects, that is a legitimate approach.

While the metal can hedge against distrust, the mining stocks only have value as long as there is a certain amount of trust in equities and equity markets. Consequently, a productive approach to viewing miners is to focus on whether the stock of a particular miner dampens or accentuates the fluctuations in the underlying commodity price. One relies upon the fluctuations in the underlying commodity for some hedging affects.

That said, another legitimate reason to evaluate the stock in the same way one would evaluate a base metal miner, or for that matter an oil company, is that a good evaluation and timely purchase can reduce the cost of the hedge. Further, just as different oil companies have different cost structures, different precious metal miners have different cost structures.

Those cost structures, to some extent, determine the sensitivity of the precious metal miner to the price of the metals. However, those cost structures also have implications regarding the potential for growth in output. Growing output, in turn, has implications for growth in revenue, and thus the potential for growth in profitability.

What is highly unusual about analyzing precious metal miners is that the industry itself does not determine supply. That is a very big difference from oil companies or any other base metal miner. A substantial amount of the supply of precious metals, mainly gold, is dependent upon how existing inventories are being managed. The same durability that is frequently cited as a reason precious metals are valuable means that the existing inventory is not dissipated over time from consumption. That's very true of gold and, to a lesser extent, of silver.

Consumption takes the form not of eliminating precious metals, but, rather, consumption takes the form of stockpiling. Consequently, consumption does not permanently remove any of the existing supply. So, forecasting the supply of precious metals requires more than just an analysis of the industry. The industry is only one source of supply. The existing inventory is the other source of supply.

However, as demand increases, the amount of that existing inventory that will be offered for sale is temporarily depressed. Remember, demand is an increase in the desire to hold stockpiles. That relationship between demand and supply is a reason that the miners and metal are highly sensitive to forecasts of future inflation and the risk of distrust and chaos.

During inflation, the demand for precious metals can actually increase with the increase in the price. That occurs well before the distrust and chaos that the metal hedges surfaces. It only takes the fear of the potential of distrust and chaos for the price of the commodity to rise. Under those circumstances, there is a desire to add more precious metals to the inventories of those who wish to hedge that chaos and distrust. Rising demand benefits the commodities, but it also benefits the miners. The benefit to miners is significant because they now become the swing source of supply. Existing inventories cease to be a source of supply.

Further, the benefit to the miners can take the form of additions to capacity. Increases in capacity can have long-run impacts on profitability even after the price of the commodity falls. Developing the capacity has high upfront fixed costs, but once capacity is in place, the ongoing production costs can be much lower. Analysts will talk about the “all in cost” versus the production costs. They're referring to whether they are including the capital costs.

In the parlance of an economist, the distinction is between the average cost versus the marginal cost. Further, since the marginal cost is lower than the average cost, increasing production reduces the average cost. Put differently, they benefit from volume in the form of reduced cost. At a higher volume, they can be profitable for the life of the capacity at a lower price.

A very interesting aspect of that dynamic is that not only does the development of new resources involve high fixed costs, it also doesn't occur instantaneously. Developing a new mining resource can take years. It can take years just to get through the permitting process and environmental approvals, much less setting up the actual production.

Consequently, capacity comes on with a lag. Monitoring the aggregate capacity additions can be used to time purchases of mining shares in a manner that is totally analogous to investing in any other extractive industry. There are a number of miners who seem to have diligently tried to work off excess capacity. Some of those that were less diligent have been forced to either sell or close down planned operations.

Interestingly, there was an article in BARON’S on 1/6/2018 entitled “Gold's Recent Rally Could Be Just the Start". It pointed out that gold has moved up 6% in the last four weeks. That sort of move gets the attention of writers. What's interesting is that the article noted the hedging effect of gold. In fact, the subtitle pointed out that gold could move up as the dollar declines and inflation perks up. However, the article also noted one of the deficiencies in gold as a hedge against inflation.

If the inflation is accompanied by tightening by the Fed, the higher interest rates raise the opportunity cost of holding gold. Of the three gold miners highlighted in the article, two have been referenced in previous postings: Goldcorp (GG) and Newmont Mining (NEM).

Goldcorp fell 6% last year, but it got new management in 2016. The new management recognizes that the company needs to cut cost and increase production growth. Traditionally, Goldcorp’s stock was priced at a premium over other gold producers. However, its current financials would indicate the premium has fallen due to its underperformance. Its production growth has remained muted for the last two years, and its costs have trended higher.

The bull case, which I am not endorsing, is that Goldcorp’s production, costs, and reserves are expected to improve significantly over the years going forward. Its balance sheet is also in a deleveraging mode. Due to its lower capital intensity going forward, it’s expected to generate significant free cash flow. If it can improve performance, it would justify a higher stock price even if the premium does not return to previous levels. If they can again command that premium, the stock price could increase even more.

Newmont Mining’s stock price rose 9.4% last year. Newmont Mining is one of the larger gold miners and offers the benefits, or risks, associated with geographically diverse operations. The company has been a high-cost producer. However, it is focused on bringing down costs. The bull case, which again I am not endorsing, is that they can bring down costs even though the company operates some older, higher cost sites. Either way, the company has done a great job of keeping long-term debt low.

It's also worth noting that it is the only gold miner that benefits from investments in the S&P 500 index. It also raised its dividend 50% last year, but the dividend has to be put in perspective, it is less than 1%. However, the company has a history of returning profits to investors through dividends and has an explicit dividend policy tied to the price of gold.

For less optimistic discussions of Goldcorp and Newmont Mining, see: “Goldcorp: Is It Time To Buy?" and "Why Newmont Mining Is Not A Buy." For a more thorough description of the bull case, see: “Goldcorp Is A Great Buy In Anticipation Of Gold's Next Run" and “Newmont Mining - Clear Sailing, Not Much To Complain About." Each investor has to decide whether one or both are appropriate in their portfolio. My decisions are described in this posting.

The primary difference between precious metals and base metals is the volatility introduced by the relationship between demand for precious metals and the availability of existing inventories as a source of supply. The volatility of price introduced as a result of that interaction has no theoretical reason for being at all correlated to stock market moves. However, empirical data would indicate that it tends to be negatively (i.e., inversely) correlated to the stock market.

That inverse correlation makes precious metal miners an effective hedge even if there's no theoretical reason for its existence. Put differently, fear and greed have the opposite effect on the price of most stocks versus the stocks of precious metals miners. There's no reason why they should, but they often do. Further, even if the inverse relationship broke down, it is likely that precious metal miners’ stocks would represent an uncorrelated asset when compared to the rest of the stock market. Viewed from that perspective, some holdings as a diversifier are justified.

There is a very low probability risk that physical precious metals hedge: financial chaos. However, they are very effective as a hedge of that risk. That justifies a small exposure to precious metals. Both precious metals and precious metal miners provide a less effective hedge, and one without a theoretical justification, against a higher probability risk. Consequently, the small holding of precious metal miners can be justified as a hedge.

There is considerable benefit to timing when the hedges against that higher probability risk are put in place. Basically, one wants to keep the cost of the hedges as low as possible. As stated, it acts as insurance, and, like any insurance, it makes no sense to over insure. It's worth noting that the dividends on precious metal miners are currently comparable to the interest earned on cash. Nevertheless, neither the dividends earned on the stock of precious miners nor interest earned on cash can justify them as investments. Owning the precious metals themselves results in no earnings. They have to be justified by their value as a hedge.

Given the comment about the importance of keeping the cost of hedges as low as possible, some discussion of timing regarding precious metal or precious metal miner purchases is warranted. Much of the analysis of precious metals and miners focuses on technical analysis. Since that's not my forte, I'll just provide some references.

Please, don't take the discussion of the technical analysis as a criticism. Technical analysis plays a role in timing purchases, and the references below are to postings that provide the kind of guidance technical analysis can provide. In other words, don't take what follows is a criticism of technical analysis or as a criticism of the particular postings.

It's simply a discussion of where you can find what types of technical analysis. After the discussion of the technical analysis, there will be some analysis of fundamentals and their implications. Most of the technical analyses cited below are bullish. Perhaps a reader can provide a reference to technical analysts who've reached a different conclusion.

If you would like an illustration of the extent to which technical analysis dominates the discussion of precious metal mining stocks, consider an article like “Is Silver Ready For Takeoff?". Based upon a key takeaway, one might think the article is focused on fundamental analysis. However, it spends a good deal of the posting discussing technical analysis of the market for gold. Even when it says, "as we take a look at the supply and demand factors,” it actually focuses on technical analysis.

That is where it mentions the dollar’s downtrend, the bitcoin phenomena and the silver/gold ratio. In terms of actual supply and demand forces, the only comment is “silver is greatly undervalued given its wide range of uses and possible new use in thinner, more flexible touch screens.”

For an example that explicitly focuses on gold rather than silver, one can consider, “Industrial Commodities Support Higher Gold Prices". It does begin with a discussion of factors that influence supply and demand, specifically mentioning inflation, international tension, and the weak dollar.

How it handles the weak dollar is telling. It focuses on the impact of the weak dollar on the price of gold. However, it then focuses on strong prices for industrial commodities without noting that the price phenomena being noted for industrial commodities is not a separate indicator when it comes to analyzing gold. The industrial commodities are also priced in dollars, and their price behavior, like that of gold, is a reflection of the weak dollar. Further, once the article shifts from providing general background information to focusing on specific recommendations, it refers back to recommendations based upon technical analysis.

A recent posting that more directly focuses upon the hedging value of precious metals was entitled, “Stock Selloffs Great For Gold". The article makes a general thesis that gold can be a hedge against a stock market collapse. As discussed in this posting, that clearly can be the case, but only under very specific conditions. The article itself spends a lot of time on the thesis that the market is about to collapse, and, therefore, now is the time to purchase gold.

Once it gets to the issue of how effectively gold can work as a hedge against market collapses, the article presents some very interesting, but largely antidotal, data. Consequently, the article comes up short in terms of describing the limitations on gold as a hedge.

One point the article makes is extremely important to the decision as to whether to hedge by holding the metal or the gold ETF (GLD). The article points out:

In Q4'15 when gold was largely forgotten and despised, GLD's holdings fell 45.0 metric tons or 6.6%. But in Q1'16 after stock markets corrected sharply, GLD's holdings soared 176.9t or 27.5% higher! Gold investment demand turned on a dime, and the trigger was the last stock market correction. Stock selloffs driving surging gold buying is nothing new, so gold will certainly rally again in and after the next SPX correction.

When stock investors want gold exposure fast, they naturally turn to GLD. This gold ETF acts as conduit for the vast pools of stock market capital to slosh into and out of gold. GLD's mission is to track the gold price. So when stock investors buy GLD shares at faster rates than gold is rising, this ETF's price will soon decouple to the upside and fail its mission. GLD's managers prevent this by shunting that buying into gold.

Clearly, using the ETF involves a level of trust that conflicts with the underlying reason for holding the physical metal. It involves trusting the functioning of the exchange market and the ETF manager’s ability to maintain parity. It makes it quite apparent that the ETF is far more important as a speculative vehicle then as a hedging vehicle.

The article also provides quantitative data relevant to a point discussed above. The price behavior of the metals and the price of the stocks of the metal miners are correlated, but, as mentioned, they differ in terms of the size of their quantitative moves. This has important implications regarding how effective each asset would be as a hedge. The article points out:

…when gold rallies significantly, the greatest gains are won in the gold miners' stocks. Their profits are really leveraged to prevailing gold prices, so their stocks tend to amplify gold gains by 2x to 3x.

An excellent discussion of how and when gold works as a hedge can be found in “Gold Confounds Skeptics With Rate-Driven Rally," and many of the comments on that article. Gold provides a hedge against a market decline if the market decline is associated with inflation and high interest rates. The key, as one of the commenters points out, is that gold responds to the market's assessment of the difference between the nominal interest rate and real interest rate, and how that relates to the rate of inflation.

When people perceive that the Fed is raising rates in response to inflation threats, rather than in anticipation of heading off inflation, the price of gold will go up. That will be associated with a market collapse only when the rate of inflation and the high interest rates begin to threaten corporate profitability. Consequently, gold and the market can both move up together for a long time before inflation reaches the point of threatening corporate profitability. However, as argued above, once it reaches that point, the cost of hedging by purchasing miners’ shares will be too high to be justified.

It's worth noting that all of this discussion of timing has, thus far, focused on demand. Given how demand interacts with supply by encouraging additions to inventories being held by investors, demand is a good starting point. However, it would be naïve to ignore supply.

Many precious metal miners have spent the last few years managing capacity. The stock price of some of the miners has gone down because of a market assessment that their failure to add capacity represents a permanently lower growth rate for the profits of the company. It's a silly conclusion to reach, but that's the way the market works. In some cases the analysis is probably accurate, but in many cases it's just a knee-jerk reaction.

Any analysis of gold supply has a huge margin of error because of the extent to which inventory can be dumped onto the market, especially by unpredictable sovereigns. Silver is also supplied from existing inventories, but the influence is much smaller. The situation is often characterized by the statement that silver is both a precious metal and an industrial metal.

Because of the dual role silver plays, it is easier to find fundamental analyses of silver than gold. Using data from an article entitled “Global Silver Demand WAY Outstrips Supply", it's easy to see that the market for silver is quite different from the market for gold.

Generally, silver miners supply about 85% of the silver supplied. The balance of the supply is generally covered by scrap recovery of silver. There are potential inventory swings related to financial derivatives based upon silver prices such as ETFs. However, the demand or supply accounted for by those derivatives is usually about 5%, and it has recently been a net contributor to demand rather than supply.

Another major difference regarding the production of silver is that a substantial portion of the silver that is mined is mined as a byproduct of the mining of gold and base metals. So, for example, The Silver Institute’s World Silver Survey 2017 shows reduced production of silver in 2016, and it attributes the decline in silver output to a reduction in the mining of base metals (e.g., lead and zinc). The Institute estimates 70% of silver output is generated as a byproduct of mining for other metals. Primary silver producers actually managed a 1% increase.

That has major implications for how silver prices respond to general inflation. If the general inflation is driven by an increase in the price of basic materials, like base metals, the inflation can increase the supply of silver. Consequently, inflation has offsetting impacts. The inflation tends to increase the demand for silver, but it is also influencing the supply. Historically, the swings in supply due to higher prices for base metals have been more than offset by increased demand for silver. That can be expected to continue to be the case.

One of the reasons that increases in the demand for base metals is associated with increases in the demand for silver is that both are dependent upon the same phenomena. More than 50% of silver output is used for industrial purposes. The industrial demand for silver has broken down roughly as follows for the last few years:

Electrical & electronic = 42%

Brazing alloys = 10%

Photography = 8%

Photovoltaic = 12%

Ethylene oxide = 2%

Other = 26%

Two things are worth noting about that demand. First, photography, which once was important and declining rapidly, is now a minor use. Second, by contrast, electrical and electronics, and photovoltaic are growing sources of demand. Absent a phenomenal growth in some of the developing countries, one would expect the demand for silver to grow faster than demand for many base metals.

The remaining uses for jewelry (about 20%), coins and bars (about 23%), and silverware (about 6%) are very much consumer driven, and, clearly, should be classified as consumer discretionary expenditures. They can be highly volatile and price-sensitive.

However, especially jewelry, but, to some extent, all of those categories are international markets. Consequently, a weak dollar can actually offset a price increase in the primary consuming markets. For example, demand in Asia is far more important than demand in the US. When the price of the metal increases in dollars due to a weak dollar, the price in the Asian currencies may actually go down.

Consequently, even without speculative increases in demand for inventories, the demand for silver looks quite healthy. Further, the analysis of the sources of supply shows a key role for miners. In particular, it's worth noting that the primary silver miners are actually increasing output. If the relative implications of price increases for base metals are accurate, primarily silver miners will be the swing suppliers.

A logical conclusion is that while the argument for gold as a hedge is highly dependent upon market reactions to gold prices and inflation, silver is subject to the same forces, but it is also influenced by fundamental supply and demand conditions. The nature of supply and demand may make it a particularly timely hedge. Further, market characteristics would also seem to indicate that the magnitude of price fluctuations in the miners will be significantly greater than in the metals themselves. Further, the miners are an effective hedge for the risk being targeted.

As discussed in “Year-End Portfolio Summary: Keepers Carry The Portfolio)" Newmont Mining was added to the portfolio toward the end of last year as a supplement to a position in Goldcorp.

In silver, Pan American Silver (PAAS) has been held for some time. Recently, a position in Coeur Mining (CDE) was added as an additional hedge. For a description of why I continue to hold Pan American Silver, see: “Pan American Silver: What Now?", and, for a description of why I purchased Coeur Mining, see: “Why Coeur Mining Could Bounce Back After Slumping 17.5% in 2017."

All of the positions are small; in fact, under most conditions, they are actually immaterial. However, they are held, and have been supplemented recently, because, while irrelevant under most conditions, they will be disproportionately relevant under very specific conditions that they are designed to hedge.

One way to look at the timeliness, is to assess the relative cost of the small purchases of additional precious metal miners versus the amount of additional cash that would have to be held in order to get the same hedging effect. Thus, they were purchased in order to keep down the costs of hedges that seem prudent given current market conditions. Precious metals hedge distrust and chaos, while the stocks of precious metal miners hedge inflation and market crashes under certain specific conditions. Consequently, they both have a role.

Disclosure: I am/we are long CDE, PAAS, GG, NEM.

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.

Additional disclosure: Certain market conditions can literally cream a dividend-growth portfolio even if it is supplemented with significant cash holdings. Each type of market condition can be hedged in different ways. This posting discusses potential ways to hedge against certain risks. Whether these hedges are appropriate depends upon an investor’s assessment of the likelihood and impact of the particular risks discussed in the posting. Each investor has to do his or her own due diligence, but that due diligence is nowhere more important than when assessing the likelihood of risks that can totally short-circuit even a well-designed strategy. This posting describes some steps I've taken, but does not constitute a recommendation that the same steps would be appropriate for all investors.

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