CEF: Reasons To Consider This Gold And Silver Trust

Summary

• Stimulus, inflation, and a rising money supply all support gold and silver, as well as other precious metals.
• Equity markets seem extremely calm, with low volatility and low trading volume. Under these circumstances, planning for rougher days ahead makes sense.
• CEF holds both gold and silver, which offers some diversification compared to the gold-only fund I own. Further, CEF trades at an attractive discount to NAV.
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Main Thesis / Background

The purpose of this article is to discuss the Sprott Physical Gold and Silver Trust (NYSEARCA:CEF) as an investment option at its current market price. As my readers know, gold has long been a recommended hedge of mine, which worked out well in 2020. However, as the risk-on mode has gotten underway, gold has suffered. While I have been reluctant to add up to this point in the new year, I now find it may be advantageous to do so. However, I wanted to get more creative with my metals holding, rather than just add to my iShares Gold Trust ETF (IAU) position, which was my preferred vehicle. Simply, I want more diversified exposure, and CEF offers that, as it also offers exposure to silver, as well as gold. As a result, I am looking to build a stake in this product, for a couple of key reasons.

One, there are headwinds for gold on the horizon, so diversifying my position a bit (through silver), seems a reasonable take. Two, CEF has unique tax advantages because of its structure, which IAU and other precious metals ETFs do not have. Three, I believe the equity market is getting too complacent at the moment, as evidenced by low volatility and declining sales volume. This backdrop tells me I should begin planning ahead for a bumpier ride, and the time to do that is when people do not expect it.

Why Now? Equity Markets Seem Too Calm

To begin, I want to focus on a few reasons why investors may want to branch out into physical metals right now - whether it is gold, silver, or any number of different options. Specifically, this relates to the state of equity markets, which have been on an incredible run over the past year. Despite a global pandemic, investors began to look past that headwind only a few months after the outbreak. Since then, the focus has been on "re-openings", vaccine distributions, future economic growth, and stimulus. While there has been some hiccups along the way, the story of 2021 has been entirely bullish, with equities hitting new highs on what seems like almost a daily basis.

In fact, the market seems overwhelmingly complacent. The S&P hit a fresh record at the end of last week's close, while trading volume sits near an annual low:

Source: Yahoo Finance

Now, this is not inherently "bad", but it does unnerve me a little bit. Of course, equities have bullish momentum, so there is the very real possibility they could head higher still. In that is the case, diversifying away from them will not be a profitable move.

But there are a couple reasons why I find it makes sense to do so, whether in precious metals or other hedges. Simply, I view this as a bit of a contrarian indicator. Markets are calm, and all seems well. That is the time to take some profit, shift resources, or buy hedges. I do not want to wait until things turn around, and then panic sell, as many often do. The time to prepare for the down days is during the good days, not once the bad days are here.

Another reason is that, as equities rise, they dominate my portfolio. As hedges like gold/silver, munis, and others fall or stay flat, but equities rise, equities became a larger part of one's portfolio. Again, this is an overall positive if equities are rising. Equities are, and will remain, the bulk of my portfolio, so this environment is a profitable one. But a rising equity market also puts my portfolio balance a bit out of whack. When stocks go up at a faster clip than the rest of my portfolio, the spread between what I have allocated to different sectors, in terms of percentages, gets wider. I want to bring that back into balance, so adding to metals at the expense of equities makes sense.

Furthermore, precious metals often shine the most during volatile time periods. However, the time to buy into that sector is before things get volatile and metals start to rise. In today's environment, volatility is at a year-to-date low, as shown in the following graphic:

Source: Bloomberg (via YouTube)

My point is this tells me to start to plan for more volatile days ahead, as volatility may be bottoming out. With stock markets very complacent and sitting at all-time highs, accompanied by dropping volatility measures, it seems a perfect time to start buying up some hedges on the cheap.

Investor Interest In Gold Is Down - Buy Low

To expand on the above point, let us take a look at the gold market, and why I find this area in particular to be an attractive spot. As CEF's title indicates, the fund owns both gold and silver, but gold is its primary holding. In fact, the fund holds gold at a roughly 2-1 ratio over silver, so the outlook for bullion is extremely important for investors in this fund.

With this in mind, how has gold been faring? Since the year started, not very well. Investors have been moving out of gold as economic re-openings and global recoveries have removed some of the uncertainty gold often benefits from. In fact, there has been a consistent outflow from gold ETFs this year, even as the spot price of gold has stabilized, as shown below:

Source: Bloomberg

This illustration again points to a contrarian move. While equities are in favor, gold is not, so a move in to gold may end up being timely. While the slide in price this year is not very bullish, the recent consolidation in price tells me the worst may be over for the immediate term. Further, the drop is price has somewhat of a correcting effect.

What I mean is, for retail demand, a lower price in gold may spur more demand for jewelry and/or physical gold. This is important because gold, as well as other metals, is not just purchased by the investor class. In many markets around the world, gold is purchased as a luxury good, through jewelry and other products. However, this demand can be stifled when prices get too high, because these buyers are not necessarily looking at it from an investment perspective, but as a discretionary product. When prices rise, demand may fall.

This was indeed the case in 2020. As gold rose in value throughout the year, demand for gold jewelry products fell to a decade low, as illustrated below:

Source: Yahoo Finance

My takeaway here is, now that gold's price has fallen quite a bit, demand in the retail sector should increase. Given the drop-off in demand last year, there is probably a lot of pent-up demand for the metal, and lower prices will make it easier for these buyers to jump back in. If this demand does rise, it will provide a bit of a basement for prices, which may be one of the reasons gold is consolidating now. After all, no matter how out of favor a product is, once the price gets attractive enough, people will buy.

Silver - Beneficiary Of Infrastructure Plan

I now want to turn to silver, as this asset makes up one-thirdof CEF's holdings. Importantly, I see some bullishness for silver going forward, as an equity and inflation hedge similar to gold, but also because of its practical applications.

Silver, aside from being a store of value, is used in industries such as electronics and solar panels. While electronics and other industrial items could demand more silver as economies re-open, the solar panel aspect has me particularly interested. The reason being, this sector could get a boost from President Biden's infrastructure plan, which has outlined tax incentives to install solar panels and other green energy projects, as reported by the Wall Street Journal.

I like this application, primarily because I see it as having a very realistic chance of making an impact. Solar is already being adopted in the U.S. at rising rates, which means consumers are already warming up to it (sorry for the pun). In fact, solar power installations have been rising consistently for years, as shown below:

Source: S&P Global

My takeaway is that demand for these panels is likely to keep on growing this year, and beyond. With tax incentives and a public already adopting this technology, the demand for silver could rise to accommodate more panels. While solar panels are getting a bit less reliant on silver, an overall increase in development should counter-act that reality. Therefore, I think legislation out of Washington may give this metal a boost in the second half of the year.

CEF Offers A Nice Discount To NAV

My next positive point looks at CEF's valuation, which I find attractive. As a closed-end trust, the market price will often trade at a different level than its NAV. This is another differentiator to IAU and GLD, as those are passive ETF instruments that rarely stray far from their NAV. By contrast, CEF has a discounted price right now, meaning investors can buy into the gold and silver markets for less than their underlying value:

Source: Sprott

Ultimately, this supports new positions at current levels. With many markets, whether in equities, bonds, or Bitcoin, looking expensive, CEF tracks metals that have seen some short-term weakness and it trades at a discount. This makes me comfortable putting some cash to work here, given what I see as relative value.

Rising Yields A Problem - Could Derail Outlook

I now want to balance out this review a bit, with a look at what could impede CEF's potential move higher. Clearly, I have taken a positive view of this product, but I want to emphasize this is not a risk-free investment. Readers only need to look at gold and silver's spot price in 2021, as well as CEF's year-to-date move, to see that this theme has not been working out.

Of course, the recent weakness is part of the reason why I like buying in, because prices are not elevated. However, there are valid reasons for this weakness, such as improvement in global economies and growth expectations. This makes demand for "safe haven" assets as less relevant. Further, rising treasury yields have also dented gold's appeal. This is because gold is a non-income producing asset, so rising yields hurt its attractiveness.

In fact, there is a clear negative correlation between yields and gold, as shown below:

Source: St. Louis Fed

My takeaway here is that rising yields have been uniquely negative for gold. If they continue to rise, which will happen if growth beats expectations and/or governments pass more stimulus measures, gold will remain under pressure. Readers should evaluate this potential against their risk appetite for gold.

Traders May Prefer The Tax Advantage

My final point looks at a tax advantage for CEF, over some alternative ETF options that are popular in this space. This is particularly relevant for those in higher tax brackets, or for traders who are going to be triggering more tax gains than the average investor.

Of note, Sprott Physical Bullion Trusts, including CEF and others, are classified as Passive Foreign Investment Corporations by the IRS. This allows a U.S. non-corporate holder to reduce the taxes owed, compared to other ETF options. As long as the investor fills out the required paperwork, capital gains will be taxed at a lower rate than the collectibles rate. Sprott illustrates this quite clearly, and the following is an excerpt from their website:

Source: Sprott

For clarity, this distinction exists because gold and other metals are considered “collectibles”, according to the IRS. Importantly, the IRS treats investment in a precious metals ETF the same as an investment in the metal itself. This means an investment in funds like IAU or SPDR Gold Trust ETF (GLD), two very popular options, would be considered an investment in collectibles. Obviously, the rate of tax depends on one's overall income, but readers should note the maximum long-term capital gains rate on collectibles is higher than the top capital gains rate for CEF, or equity ETFs for that matter. This makes CEF an attractive choice, if one is concerned about tax obligations.

Bottom-line

As I look to maintain some balance in an increasingly overweight equities portfolio, CEF has hit my radar screen. While I have invested in gold through IAU for some time, I like CEF's holdings of both gold and silver. I see positive catalysts for both, and CEF is a one-stop shop to own them. Further, the fund has a discount to NAV, offering some value in a market that is lacking it. Finally, CEF has distinct tax advantages over my IAU position, which will come in handy if gold does rally and I want to take some profit. Therefore, I am looking to initiate a position in CEF, and I would encourage readers to give this idea some thought at this time.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CEF over the next 72 hours. 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.

I am long IAU