Precious Metals In A Tough Situation

| About: SPDR Gold (GLD)
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As we have recommended for weeks (here), we are no fans of precious metals at these prices. The past couple of days and weeks since February 29th have been rough for gold (GLD), and consequently for all precious metals, and we expect more of the same to continue.

The market is finally waking up to the fact that the Fed has no options on the table. With economic optimism already extremely high, and some data points confirming, the Fed has no scope to ease policy whatsoever.

At the same time, given the still-depressed nature of housing and employment, the Fed also has no ability to tighten. The Fed is hamstrung at the present time, and until such time as a drastic downward move in asset prices or a dramatic upward move in the Main Street economy, Fed action will be little more than verbal rhetoric. Given that the size of the Fed balance sheet calls for only around a $1,500/ounce price of gold, and the fact that downward momentum is significant, we believe gold could see at least 10% more downside, if not more. Shown below is a chart of gold against the Fed balance sheet.

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As can be seen, gold skyrocketed after QE2 as the market anticipated QE3. But when it never came, gold entered a choppy downtrend in which it is currently situated. In order for gold to return to its trend, it would have to decline to ~$1,500/ounce. As we said earlier, given the large negative momentum behind gold combined with the extremely wide ownership of the metal, prices can and should overshoot to the downside. If our general thesis regarding risk assets and the economy is correct as well, gold could easily correct to $1,300/ounce before receiving fundamental support in the form of QE3. Such a phenomenon would most likely be accompanied by a stock market that has fallen by a similar or greater magnitude as well.

Perhaps even more striking than how poorly the precious metals complex has performed has been the miners. Posted below are charts of GDX and GDXJ.

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Both charts look nothing short of train wrecks, with both senior and junior miners sustaining year-long downtrends despite gold having performed admirably during this period. In our opinion, gold miners are huge value traps. The reason why is because the price of gold six months, one year or five years out is completely unpredictable. Unlike oil and energy producers, gold and silver are not necessary industrial commodities, and as such their prices are determined by trader psychology.

As we know, determining trader psychology, even for the next 24 hours, let alone for the next year, is a tricky proposition. Because there can be no certainty about the price of gold over any kind of long-term time period, the argument that "gold in the ground" via buying mining equities is cheaper than bullion is completely null and void. By the time these miners pull that gold out of the ground, the price of gold could easily be 30% higher or 30% lower than where it currently is. The lack of certainty renders the miners an especially poor investment.

To make matters worse, the junior miners are an investors' worst nightmare. Many of the junior miners in the GDXJ have yet to actually pull a single ounce of gold out of the ground, and some do not have a single dollar of revenue. This doesn't even take into account that many of the reserves are in politically unstable areas, or extremely difficult to mine deposits.

The love affair of commodity investors over the past few years for junior miners with "reserves" is highly reminiscent of companies attaching .com to their name and IPO'ing in the tech bubble heyday. When your company can sell a huge slug of stock with no revenue and only essentially a story, you know the sector is overheated. The fact that investors have plowed billions into what should be penny stocks in the hopes of hitting it big with a junior miner that can actually deliver on its promises is indicative of an industry that has lost its fundamental mooring to reality.

Absent another round of quantitative easing, gold has no fundamental reason to rise, and with its loss of momentum over the past six months, it has no technical, or trend-following, reason to rise either. Shown below is a chart of gold.

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As can be seen over the past five weeks, gold has shown an uncanny inability to rise above the 200 day moving average. The inability of gold to sustain any type of rally due to fundamental investors utilizing rallies as selling opportunities, as well as technical traders capping its upside at the 200 day moving average, makes gold an exceptional short.

In other precious metals, platinum may be an even better short than gold. Shown below is a chart of platinum.

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Platinum today broke below critical support at $1,600/ounce, which it had tested three times over the past two months. Given the quick move from 1,400-1,600, and the steady "lower highs" trend since February, prices returning to the 1,400 level would not be inconceivable. In addition to the technical weakness, auto sales in the U.S. came in below estimates for the month of March. Given the heavy use of platinum group metals in catalytic converters, negative factors for auto production both in the U.S. and abroad are highly negative for platinum prices. Combined with the general malaise in precious metals and industrial metals, auto production slowing could be the final nail in the coffin for the rally in platinum.

Trade Recommendation

We recommend traders stay in short gold positions, adding to positions on any type of strength, and using the 200 day moving average as a stop-loss (presently at 1,686). Traders can do the same in platinum, shorting platinum at a price of $1,601 or better and using the 200 day moving average (1,644) as a stop-loss.

Detailed information on trade recommendations here.

Disclosure: I am short GLD, SLV.