Time to Sell the Dollar & Buy Gold & Silver

After twelve years of continued price appreciation, precious metals have taken a bit of a bath this year, and to the despair of many…

In a year during which the US government raised its debt ceiling, surpassing $16 trillion, and with the US Federal Reserve becoming even more aggressive with their quantitative easing program and expanding its balance sheet to over $3 trillion, it is somewhat strange and challenging for many to understand the weakness presently being experienced by precious metals. Many say this is the beginning of a bubble being burst as the gold price rose almost 400% during this twelve year run. But, if we look at either US debt or at the money supply we see the first rose 200% and the second more than 400% and which, per economic monetary theory, can justify the current price of gold (take a look here at page 8 to learn more about the Gold Standard and it’s effect – http://issuu.com/spreadbetmagazine/docs/spreadbet_magazine_v17_generic)

Looking back through history, we quickly understand that the printing of dollars has a massive effect on the value of fiat currency relative to precious metals. From 1840 until 1971, gold’s price changed from $20 per troy ounce to just $35/oz. The existence of full convertibility between paper currency and gold simply didn’t facilitate any massive printing and thus the value of precious metals in terms of US dollars was relatively stable.

All changed in 1971 however, with Richard Nixon removing full convertibility (the gold standard) permanently. The price of gold boomed to $600/oz in the 80s. Then, following a period of monetary contraction under Paul Volcker to fight against the malign effects of inflation, gold dropped to near $300 at the beginning of the new millennium. Since then, it resumed its bull trend to hit the current $1,400 level (although off highs just over $1900/oz in 2011).

Silver has followed a similar path. Until 1970, the price of silver actually moved within a limited band. After the gold standard was abandoned however, the price also boomed. Trading at less than $2 in 1970, it hit more than $49 in the 80s. It then suffered with the gold price right up until 2000 falling to less than $5 until taking off and hitting a high of nearly $50/oz in 2011. At the current price of $23 we can see that it has fallen proportionately much more than gold and is now back towards, what we believe to be, long term support levels.

With the current aggressive monetary easing programs, coming not only from the FED but also from the BOE and BOJ, precious metals will almost certainly resume their uptrend. In fact the currency war, which Japan is presently winning hands down, is likely to generate late cycle inflation sometime within the next 18 months – 2 years. Precious metals will be  a mjaor hedge against it and of course, with the market being a discounting mechanism, we think the time is getting near for a sharp rally in silver in particular.

What has weighed on prices this year has been the strong dollar and the possibility of QE3 ending – something we flagged at the beginning of the year to those who read our 2013 outlook (see Trading Guides page). Ben Bernanke knows he is creating a bubble. Stocks are at all-time highs even though the unemployment rate is still at (relative to recent years) pretty unhealthy levels and economic activity is not properly robust. With government bonds yielding less than 2%, even though the US government owes more than $16 trillion, the penny has finally dropped with “Main St” that stocks are the only game in town. But, Bernanke is unsure about what to do next and, on balance, will most likely continue with QE3 or, at most, drop hints of its ending for a while but then resurrect it at the first negative sign of economic activity – he is in fact a hostage to his own fortune now and, as many economic commentators have relayed, has painted himself into a box. For now, the prospects of premature end for QE3 are hurting metals but, we expect them to recover in the near future and probably explode next year.

Our scenario is built on 2 outcomes – first, end QE and the stock market will likely take a sharp tumble – there will be the usual run to safety and so gold and silver will probably rise. Scenario two is continue QE, even on a watered down basis, and inflation picks up 2013-2014. With gold and silver in its paper form now oversold and bull sentiment all but washed out en bloc, this sets up the typical recipe for a rally.

If the case for gold is good, as John Paulson believes, the case for silver may however be even better. Demand for physical silver has been rising substantially and buyers currently outpace sellers by a 50-to-1 ratio. If we look at the US mint, sales of American silver eagle coins clearly corroborate this demand trend. The first four months of 2013 show a substantial increase in demand when compared with the same period last year.

Bullion dealers are in fact paying a premium of 25% on the American eagle coins over silver spot prices while waiting six weeks for delivery. This increase in silver demand may be an earlier indicator of a squeeze in the silver market that may result in a great trading opportunity. Remember the point about their being a preponderance of bear sentiment and negative positioning when looking at COT analysis? All we need now is John Piper to pipe up (‘scuse the pun) and say Sell and we have a slam dunk long set up!

While the demand for silver has been rising, the supply has been relatively stable. Miners are however facing increasing extraction costs. These costs have risen 9% since January 2012 while silver prices have dropped 20%.  In fact, when considering the dollar debasement over the last four years compared to the currencies of silver-production countries, mining costs have in fact quadrupled. Miners have seen their margins squeezed and are currently trading at very low valuations. But, prices will have to increase to meet the demand and adjust to a reducing supply profile.

We believe here at SBM that we have a classic set up to buy precious metals on the current dip with gold now down 17.7% YTD and silver down 26.4%. The continuing and intensifying currency war between central banks makes, in our opinion, all precious metal attractive as an asset class. With the current historic low valuations in the mining sector, both senior and junior miners are very attractive to us (see our guide below for a concise PDF of our top picks). Should the price of either metals fall much further then supply will very likely be materially reduced as some of the weaker players cease production from various mines and/or consolidation occurs. It seems a heads you win, tails you win picture with consolidation possibilities and a natural brake on further sharp price declines in the mining sector through reduces supply, QE game theory pointing to rising prices irrespective of the next move by Bernanke, heavy short positioning in the futures markets and materially rising demand for the physicals.

We are pleased to report that we expect to have the final approval from the FCA for our unique spread betting fund management service – Titan and will be launching out Natural Resources fund in which we have our own capital to the retail marketplace in June and in which the gold and silver miners will have a good representation. Email us at info@titanip.co.uk quoting “Natural Resources” to register your interest ahead of the launch.