From the May 01, 2007 issue of Futures Magazine • Subscribe!

Is the end of easy money the end for metals?

In 2006, gold, up 23%, and silver, up 45%, both soundly outperformed the S&P 500 and the Dow Jones Industrial Average, which improved 13.6% and 19% respectively. In fact, despite the attention paid to last winter's record-breaking highs in the DJIA, in terms of the buying power of gold, 2006's nominally higher closes were decidedly lackluster. The market crushing finishes in the metals came in spite of a high-profile sell-off in May, and on top of outsized returns in each of the previous five years (see “Dow buys less gold,”).

The rapid gains in metals and miners have not gone unnoticed. Gold and silver were money for most of recorded history, but in the twentieth century they became relegated to the sidelines as the world’s major currencies were removed from metal-backed standards.

Aside from an inflation-driven spike in gold during the 1970s and a failed attempt in the early ’80s to monopolize the silver supply, metals were a mostly uninspiring market that paid no dividends and required costly storage and insurance.

Interest in metals seemed to undergo a renaissance as the U.S. economy came out of recession in 2002 on the heels of dramatic interest rate cuts by then Federal Reserve Chairman Alan Greenspan. After taking the real Fed funds rate negative to spur the post-911 economy, Greenspan presided during an almost 20% decline in the trade-weighted dollar index in 2002, with the dollar losing fully one-third of its value by 2005. The prices of all dollar-denominated assets, tended to inflate during this period, particularly real-estate, but because the move came concurrent with a loosening trend across the globe, precious metals appreciated against all major currencies. Greenspan’s incremental rise in interest rates in late 2005 could not keep pace, and this further contributed to the inflation dilemma faced by his successor.

Now, with the U.S. housing market foundering and bank lending tightening and inflation steadily creeping, the future of liquidity seems uncertain. When money becomes expensive, large investors are forced to overlook metals in favor of other investments, or sell metal positions to finance these other transactions. Shifts in the dynamics of the yen carry trade contributed to the sell-off in stocks in February and March, and when metals proved little safety, their role as an investment again came into question.

Precious metals became a primary beneficiary of excess liquidity for many reasons. Foremost was their long-standing association in traders’ minds as a hedge against inflation. The new buyer of precious metals, though, is not just the fanciful coin collector of old who relished the tangible qualities of bullion. Instead, a series of ETFs for gold and silver have helped open the metals markets to a new type of investor.

Hedge funds and managed futures were in their infancy during the last major gold bull market, but today the risk tolerance and massive leverage, which are the hallmark of these well-funded groups, have made precious metals more subject to Wall Street than ever before. Through the easily tradable shares of IAU, GLD, SLV and a growing host of foreign ETFs, opportunistic traders of all types can chase returns in precious metals or, quixotically, use these paper assets to diversify their mostly paper portfolios.

But, though they are not redeemable for actual metal, the ETFs do represent actual physical holdings of the market makers, and their success has taken a substantial amount of physical metal off the market. “Not only is this permanent,” says Roger Wiegand, editor of Trader Tracks, “but continuing purchases by fund managers are necessary to back those [ETF] shares.” As a result, he continues, “miners have been scrambling for new reserves.”

Any industry is subject to the forces of supply and demand. In the 1980s and 1990s, when demand for metals, and their price, was low, smaller miners were forced out of business. Even large companies that weathered the storm were forced to trim their payrolls, a factor that has contributed to the proliferation of junior miners today.

But, the same liquidity that creates inflation, which boosts gold, also finances industrialization and infrastructure development that rallies base metals. Once the explosive growth from emerging markets translated into a surge of demand that drove prices higher, miners were able to finance new exploration and keep existing mines in production. Doug Casey of Casey Research says, “Record levels of new exploration, headed by experienced pros let go by the large gold companies during the bear market, is applying the latest technology on the world’s most prospective geology.”

But all of this new development, in turn, creates the potential for excess supply reaching the market. Take the case of copper, which made rapid gains in 2005 and early 2006, only to see 15% of the value melt away as an inventory glut choked the metals exchanges later in the year (see “Copper corrects”).

Meanwhile, with copper poised for a fall, supply became so scarce for nickel that contracts in London were temporarily in default, leading to a significant rise in price. While both get short term trading cues from economic growth indicators, base metals remain particularly subject to unique supply and demand profiles.

Precious metals tend to trade as a group, but they too have supply and demand factors underpinning their bull markets. Until relatively recently, most of the gold and silver mined throughout history could potentially return to the market. Revolutions in technology, however, have created industrial uses for the metals in which they are permanently consumed, unlike jewelry or silverware, which can be melted or resold.

For example, very little of the platinum group metals used to reduce automobile emissions is ever recovered.

Similarly, gold and silver in electronic devices, such as computers and cell phones, tends to be permanently lost. In addition to the stunning new volumes of investment demand funneled through the metal ETFs, these new industrial uses have contributed to a structural supply deficit in precious metals, meaning more is consumed each year than produced.

This structural deficit may become particularly significant for silver. A highly conductive metal for electronic applications, silver also has antibiotic properties that have opened an array of additional uses. Silver-lined bandages are already aiding U.S. troops in Iraq. Other products that could become consumer staples include silver storage bags, which keep food fresh longer, and silver threaded clothing that resists odor-causing bacteria.

The current and potential supply deficit in silver has been a particular focus of independent analyst Ted Butler, who says, “Of all the industrial or precious metals, or resources in general, the one that has the absolute best chance to explode to unprecedented price levels is silver.”

A ground-breaking voice in challenging the price-suppressing effect of naked short positions as reported in the Commitment of Traders reports, Butler says the growing gap between silver production and consumption will create an explosive spike in silver when naked short positions are ultimately forced to cover.

“The world has never witnessed an actual physical shortage of a precious metal with such a large and documented short position,” Butler says. “Bottom-line, the one commodity with the potential to shock and awe and make people rich is silver.”

Price targets for an ounce of silver vary depending on time frame, but generally span a wide range, from $5 per ounce to $500. But, Roland Watson, author of The Silver Analyst, says about $30 would be a good point to start. According to Watson, gold and silver trade in an inverse relationship to the dollar. Foreign reserve diversification could be a powerful force weighing down the dollar, but probably not in the next year.

“Expect one more blow off stage before silver and gold take a protracted rest and the dollar begins a mini revival,” says Watson. There is technical support for his position. “Silver lining,” (above) shows silver entering a fifth wave in the early 1990s, in which three waves up have been completed. A fourth wave, perhaps corresponding to strength in the yen, is yet to manifest, after which the fifth could produce highs not seen in decades. If Butler’s short squeeze occurs, the next top in silver could be significantly higher.

No market goes up in a straight line, and until supply dwindles away to nothing, metals will be no exception. Though substantial profits can still be made trading metals futures, it is unrealistic to expect 20% to 40% returns every year through buying and holding.

Though some of the forces that kept metals prices low in previous decades, like central bank sales, are no longer a significant factor today, there is no clear indication metals will continue to outperform other markets without a period of consolidation.

But while metals remain in a corrective pattern, the long term bull market is intact, supported by strong global growth and inflation. Even if U.S. rates do not move lower, foreign central banks in London, Frankfurt, Tokyo and Mumbai have pushed rates higher, and expect additional firming.

For the remainder of this year expect gold to test resistance at the 2006 highs, above $720, before reversing and correcting. Strong support lies just below $550 and a successful test will lead to new all-time highs in 2008. Silver is liquid and more volatile, but will take a path similar to gold. A move to new highs above $15 should reverse and retest support near $11. Copper is not necessarily done correcting. Don’t expect new highs in the red metal, instead look for support at the previous low around $2.40 or, failing that, $1.75.

But globally, liquidity concerns become significant when interest rates outrun growth. China, the world’s growth leader, will continue to consume increasing supplies of metal. The potential disaster for metals would be a sudden collapse in Asia, but the interconnected region’s new regulations are working to prevent this.

Despite the huge returns in recent years, there are still compelling reasons to believe it’s still early enough to find profits in the metals at all risk levels. But, while in recent years it’s been relatively easy to profit in metals, and the long term outlook is still resoundingly bullish, the short term outlook suggests timing and strategy will be a growing requirement for realizing outsized gains.

Joe Nicholson is an independent analyst and the resident metals specialist at Trading the Charts (www.tradingthecharts.com).

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