Not so precious Metal

Perceived as a safe investment, the price of gold and silver has surged but the trend might not continue for much longer

There is almost unanimity on the precious metals among market participants. Almost every analyst, every brokerage house, and all speculative type players have their eyes glued to gold and silver. There has also been a drag effect from other markets, such as oil and copper, and since historically, they tend to move in tandem, the commodity boom has been eye-popping. The backdrop for the rise in metals has been near perfect in terms of rationale. The fans of precious metals base most of their argumentation on the global financial excesses, the looseness of central bank policies which weaken currencies and their gloomy outlook on the world in general, from a geopolitical perspective. More recently, the advent of China on to the scene as a large buyer of metals, especially copper, has added yet another compelling layer of positivism on to the view. Precious metals are seen by many as a unique store of value in a turbulent world, and given the performance of gold and silver in the last four years, it is a tempting argument.

Since 2001, silver is up nearly three fold, (300%) and gold about 250%, since the beginning of 2006, they have risen nearly 20%, dwarfing all other asset classes. So the purchasing power of silver and gold has gone up significantly faster than inflation and paper assets. So it is understandable that some are getting excited, especially that some of the fundamental arguments in favor of investment in precious metals are compelling. So is it time to take the plunge, or at least to consider precious metals in your overall asset allocation decision? The excess excitement, media hype and the technical backdrop, paint, for the contrarian investor, a different picture though, one of caution ahead.

Need to diversify

Although precious metals have attracted a lot of attention on their own merits, namely that they are perceived as a hedge against inflation and protected in case of outbreak of war and terror, perhaps the super spike in oil has played a part in their rise. Central banks, having spent most of the 1990s selling their inventory of gold are now scurrying to buy back as they look to diversify their assets away from the monolithic US Dollar. The reasons or pretexts behind the comeback of precious metals vary from one country to another, but on a global basis, most central banks have spent the last decade injecting liquidity into the system. So this rise in money supply across the globe, averaging nearly 8%, certainly helped, and with interest rates unusually low from a historic perspective, there was little to hinder the move up, and demand for physical gold in Asia added fuel to the nascent fire. There are even some sound and well formulated arguments that given the irresponsibility of central banks and the FIAT system of currencies, gold (and to a lesser extend silver) will end up replacing paper currencies completely.

They argue, somewhat correctly, that the fragility of the global financial system and the trend toward competitive currency devaluation, i.e. countries loosening their monetary reigns in order to compete in trade, will lead to a systemic breakdown and gold’s function as a store of value will take on a new dimension. It is true that central banks have been on a reckless money printing binge, and the money supply figures worldwide paint a picture of a mad rush to maintain liquidity high and avert a global recession. While we may agree that in the medium to long term, there are many imbalances in the global financial system, some large overvaluation in equity markets, and an excessive debt and real estate bubble, and that gold will be possible many times more expensive in a few years, it is unlikely to continue rising from current levels due to a multitude of reasons, the main ones being the overstretched technical condition.

The decline on the dollar, the rise in demand for commodities from China, and the concern over geopolitical risks (Iraq, Iran, and risk of terrorism) may have all constituted facilitating factors for precious metals revival and most portfolio managers and fund players are now looking at precious metals as an integral portion of their assets. The managers that had included metals in their portfolios have seen a positive impact from the rise on their overall returns, and the presence of gold (and oil) is a must in any portfolio, but the timing of such inclusion is crucial. While these asset classes serve to cushion the portfolio in times of crises, as gold and silver tend to be negatively correlated with traditional asset classes, they are not always safe to own. Currently, the technical analysis of metals, and to a lesser extent oil, points to lower prices ahead.

Bubble?

Analyzing the technical position of any commodity is a two step approach: first we look at the chart patterns, and next we look at the level of commitment of traders report. As can be seen in the charts here, the charts are painting a picture of excess. The pattern of the rise is almost vertical in its latest rise and this, coupled with a high degree of excitement on the part of the media and the public is a warning sign. This kind of action reveals a bubble-type environment, where the attitude seems to be, “get in before it’s too late”, a notion often associated with major tops, not healthy trends. This may seem like anecdotal evidence, but this type of enthusiasm for any market belies a simple fact: everyone involved is expecting a similar outcome: a rise in prices.

Another key factor in looking at commodities is the distribution of contracts in the futures market, is the Commitment of Traders Report, which shows which type of trader is holding and selling. There are two broad categories of traders: the commercials, i.e. traders involved in the commodity on a production level, and the speculators, which are mainly punters of the stuff. For a market to rise in healthy and balanced manner, demand must stem mainly from the commercials that use the futures market to hedge their production, and the speculators must on aggregate be selling. This is where you have a healthy balance between “genuine” and speculative demand.

At the time of writing, both silver and gold are in a position where speculators are aggressively buying and the commercials are selling, this is very frequently the nail in the coffin of the bull market. Silver will hit major resistance near $15 and gold will find it difficult to move much above the $650 area. In all likelihood, investors looking to add these assets to their portfolios must wait for lower prices and a more balanced set-up of players in the futures market. Due to the advent of Exchange Traded Funds, small investors no longer need to buy futures or physical commodities to participate, they can use the Barclays GLD and soon SLV actively traded on Amex to buy and sell. Again, this timeframe will probably mark the highest point in the precious metals and technically the charts point to at least a 25% drop before they are safe to own again.
 

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