Entering Into 2013 - Part 3

In this series of articles called "Entering Into 2013", so far I've covered my view on the US equity market, and highlighted scepticism towards the continuation of the bull market and the economic expansion. Let us now turn our attention to other asset classes and specifically focus on Precious Metals in this post. I will leave the fundamentals out of the current article, as they have been discussed many times in previous posts.

For long term investors like myself, the main goal is to participate in rising markets which will be making new highs as they progress forward. This means that I personally favour the secular bull markets in precious metals (and other commodities) relative to the sideways secular bear markets in equities. It is because of this view, and many other fundamental reasons, that I continue to believe in the precious metals story and anticipate substantial gains in the future quarters and years ahead.

Chart 1: During secular equity bear markets, Gold performs well

Source: Short Side Of Long

If we consider the chart above, we can see that Gold did remarkably well during the 1970s secular bear market in equities. Furthermore, even though equities went sideways from 1966 to 1982, during those 16 years, inflation was rampant eating away real inflation adjusted returns on capital. In other words, someone who bought the Dow Jones in 1960s around 800 points and sold in 1980 around 800 points did not break even in inflation adjusted terms. Meanwhile, someone who bought Gold in 1960s at $37 per ounce managed to return over 20 times by January 1980 as Gold touched the nominal value of Dow Jones.

If we overlap the last secular equity bear market with the current one, which started in 2000, we can see a lot of similarities. What seems to be happening is a sideways pattern in stocks, as valuations reached extreme levels during the late 1990s tech bubble. At the same time, on a relative basis precious metals are once again in a secular bull market. This is commonly known as the relativity between the Paper Asset Trade vs Hard Asset Trade. This type of a phenomena occurred during the 1930s depression, during the 1970s stagflation and once again during the 2000s as the economy swung between a depressive state (deflation with everything falling) and stagflation (inflation with weak growth and rising commodities).

A lot of investors seem to think that Gold is overvalued and the 13 year sideways action in stocks has brought them to levels which one would call "cheap". I tend to disagree as I believe the trend in the ratio between the Paper Asset Trade vs Hard Asset Trade has not yet run its course. Furthermore, I also believe that the last part of the trade should have some powerful movements in both asset classes.

Chart 2: Conservatively, Dow could be valued at 3 ounces of Gold or even less

Source: Macrotrends

As the economic troubles and high debt levels continue to push the global economy towards slow growth and de-leveraging, one theme remains constant: central bank currency devaluation. As we move into 2013 and 2014, I believe that economic activity will only get worse. Naturally, we should expect more money printing as presses keep running, I believe precious metals will benefit. After all, almost all great bull markets eventually end up in a gigantic bubble that reaches total frenzy and euphoria. Last time we saw something similar was in the late 1990s, as the Nasdaq Composite kept rising higher and higher... and even higher. By 1998, when the majority of us thought it was all over, Nasdaq went to double yet again from already incredibly overvalued levels.

Let us assume we run with that conservative ratio where the Dow Jones Industrial is at 13,400 and Gold is at 1,675 today. One could come up with a variety of figures that link prices to the 3:1 ratio, including stocks doubling from here while Gold touching the moon (and the sun); or stocks halving from here and Gold tripling from the current levels and so on. During the 1970s, the average price of the Dow Jones was about 850 points as Gold managed to almost reach that point. During the 2000s, the average price of Dow Jones is about 10,000 so could Gold once again touch that level?

Chart 3: Last stage of the secular bull tends to accelerate into a bubble

Source: Erste Group

I am not sure how far precious metals will run, but we are definitely in the long term uptrend. It all really depends on the action of central banks and governments, which will influence the behaviour of investors and more importantly the public. Since precious metals market is relatively small, even a slight shift by pension funds into this asset class could create huge price movements. One thing I do know is that the best is yet to come from Gold and especially Silver. 

I perfectly understand that if one does not believe precious metals are in a secular bull market, one also does not believe in the fundamental backdrop. Therefore, it is going to be very difficult to convince one to purchase Gold... let alone a more volatile asset like Silver. Those who are not bullish are probably reading this article and thinking... "what a load of s%#t". To be quite honest, that is only normal. Disagreement is very common in markets (and should be always welcomed ). On the other hand, if I am right about the precious metals secular bull continuing, those invested could be handsomely rewarded in the long run and the best way to play the final phase is through Silver.

Chart 4: Historical valuation shows Silver to be cheaper than Gold

Source: Macrotrends

Looking at the chart above, we can see that in 1980, Gold and Silver went parabolic as the secular bull market came to a close and I believe a similar event is coming yet again. In nominal price, Gold touched $800 while Silver touched $50. When adjusted for inflation, Gold managed to reach well over $2000 in todays dollar value, while Silver went well above $100. As we study the chart, we should notice that on a relative basis Silver is much cheaper than Gold today. The yellow metal trades in mid-1600s, as it has managed to double from its nominal high of $800 in January of 1980.

The same cannot be said about Silver. If you hold a view that almost all assets make a new all time high during a secular bull market, as I do, than you probably also find it interesting that Silver remains very attractive. Today, Silver trades at $30 which is 40% lower than the last record at $50 from 1980. Furthermore, adjusted for inflation, Silver's January 1980 peak of $50 in today's money value is well above $100. So one could make an argument that Silver is actually more than 70% below its all time high and has a chance in getting to a triple digit territory before the secular bull market ends.

Chart 5: Historical ratio of Gold and Silver is narrowing

 Source: Erste Group

And with such inexpensive prices on a relative basis, this is where the opportunity lays ahead. During the 1980 peak in precious metals, Silver managed to reach a ratio of 16 ounces per 1 Gold ounce, as it outperformed Gold in the final panic spike. If I am correct in predicting a precious metals frenzy in the coming quarters and years ahead, Silver could become incredibly overpriced. Today, the ratio stands at 54 Silver ounces per 1 Gold ounce, which tends to be a historical average. Even though I am not sure if we will once again see 16 to 1, like we did in 1980, it is very possible that Silver could reach much lower ratio than where it trades today.

Chart 6: In the near term, precious metals are still correcting

 Source: FinViz / Short Side Of Long

Now that we have established the long term perspective, let us look at the closer term perspective. Precious metals as an asset class has been in a correction for over a year now. Gold peaked out in late August and early September just above $1900 per ounce and has moved sideways for over 1 year and 4 months now. Interestingly, at no point did Gold officially enter a bear market phase (decline of 20% or more), so there is still a possibility of lower prices ahead, before we bottom out. I want to make it clear that I am not predicting that, just stating that it would be perfectly normal for Gold to have a bear market correction before an uptrend resumes. Simply, that is how markets work and have always worked throughout history. On the other hand, Silver investors have suffered over the last several quarters. The correction still seems to be in progress (currently over 1 year and 8 months) with a decline as bad as 48% from the peak in early May 2011 towards the trough in June 2012. So are we near the end of a correction?

Chart 7: Silver's sentiment is once again at pessimistic levels

 Source: SentimenTrader

Source: SentimenTrader

While I am not 100% sure when the markets will bottom, sentiment itself is once again starting to turn pessimistic. The recent Daily Sentiment Index readings on Gold and Silver reached single digits. Last Friday, we witnessed only 6% bulls, which is one of the lowest readings since May 2012, when Gold bottomed at $1530. Furthermore, as we can see in the charts above, Silver's public opinion is entering levels usually associated with extreme pessimism while the Hulbert newsletter advisors are recommending one of the highest short exposures to Gold in years. While all of this does not have to indicate higher prices automatically, it tells us that we are much closer to the intermediate bottom.

Chart 8: Gold Miners are the only oversold US equity sector

   Source: SentimenTrader

As already explained above, I definitely do not favour equities, as the majority of the sectors are now extremely overbought, while sentiment is at levels usually associated with intermediate or larger degree peaks. On the other hand, the only sector within the US equity space that presents opportunity seems to be the very oversold Gold Bugs index.

If we were to look at the long term picture via a detailed breadth chart, assumption could be made that the extreme selling we saw in May 2011, could mark a major low for this sector. We witnessed all of the right ingredients when it comes to a selling climax or the so called "end of a bear market" including:

Chart 9: Gold Miners bear market of 2012 could be behind us

  Source: SentimenTrader

• Extremely oversold nominal Summation Index level
• Prolonged 0% reading in Miners Stocks Above 200 MA
• Spike in 52 Week Lows signalling a selling climax
• Breakout in the price, AD line and Summation Index
• Improvement in other breadth readings and indicators

It is very possible that the current sell off in Gold Miners is a retest of the previous bear market downtrend line, similar to what we saw in early 2009. If this is true, and bottoming process is in progress, substantial price appreciation could be ahead of us. Furthermore, it has come to my attention that many Gold bugs, precious metals bloggers and newsletter writers have now been shaken out of their speculative and leveraged positions in this sector. Some have blamed the recent price drop on "manipulation" while others are now starting to predict the possibility of a "bear market". As prices have declined and the mood has turned sour, many have been forced to liquidate their positions. As a long term investor, this is music to my ears.

In summary, while I do not see equities as an attractive long term investment, I definitely think precious metals will have a strong run in the quarters and years ahead. Within the sector, I prefer to own Silver, which is historically much cheaper than Gold and in my opinion presents a magnificent opportunity for those that have patience in the long run. If you have been following the blog for awhile, you should also know that I have purchased Silver on multiple occasions between late December 2011 and early July 2012, with a view of higher prices in the years ahead. While the majority of these positions have not performed at present, I hold a very high conviction that in due time the precious metals sector is headed for a euphoric run up with a lot of similarities to the late 1970s.

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