Here’s the Long-Term Case for Precious Metals

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The year 2013 brought us one of the best bull market in equities since the mid 90′s. At the same time, to fund equity purchases and flee ‘safe assets,’ we saw a historic sell-off in silver (NYSEARCA:SLV) as well as gold (NYSEARCA:GLD). This selloff has given investors an excellent chance to accumulate a long-term position in physical holdings and silver companies.

Gold and Silver seem to have found a floor around $117 and $18.50 only trading below these levels briefly. As the price of both have come down I have been recommending long-term investors, not “traders,” to dollar cost average and/or pyramid down into silver and silver equities. For 2014-2015, I am recommending silver, platinum, gold and palladium in that order and I think while prices are depressed it is a good time to buy for the long-term investor.

In fact, technicians are seeing bottoming action in the metals. We have an attractive price at which to come in long-term, but also have a ton of fundamentals on our side. One of my primary hypotheses is that the endless easy money policies from central banks around the globe have created a long-term tailwind for the various precious metals. Many on the other side of this trade disagree with this assessment, and some question it historically. Only time will tell which of us is right. What we do know is there is short-term pressure on the metals despite long-term fundamentals.

Short-term pressure but solid long-term case

There is no question that the short-term pressure on precious metals has crushed those holding silver and gold. That said, the Federal Reserve’s continued accommodative and dovish policies should create a weaker dollar in the long run, lead to eventual inflation and in turn, bolster the prices of gold and silver. It has yet to happen as the Fed and government indicators continue to indicate that inflation is not an issue (but have you been to the grocery store lately?) I’m not advocating that you trade all of your cash in for metals. I’m not arguing that you should sell all of your equities and go “all-in” on silver and gold.

However, the reality is that precious metals hold value and increase their buying power when inflation ticks up. While this has yet to occur in the U.S., it will be a likely result of a diluted money supply. Further, the level of bearishness on the metals is at historic highs. Former Blackrock chief strategist Bob Doll (now of Nuveen) sees a major stock market correction AND the precious metals continuing to fall. Generally, the metals rise as equities fall, and vice-versa.

The long standing belief is that gold is the ultimate hedge against inflation. But we are entering a new age and with it we must recognize that other precious metals, such as silver, platinum (NYSE:PPLT) and palladium (NYSE:PALL) all tend to move higher when inflation creeps up. Gold has long been considered the best of the precious metals. In more recent times gold investors have turned to platinum as well. With GLD and PPLT prices having been driven way up, retail investors have turned to SLV and PALL as an alternative precious metal investment. Unlike gold, the great thing about silver, palladium and platinum is that there is huge industrial demand as well (gold does have some industrial use, but silver and palladium use far outweigh it).

The second key driver that I believe could cause a surge in all the metals off the recent lows in the next few years is the multiple sources of growing demand for the metals, in particular the technology, industrial and medical sectors. However, there is also incredible demand for not just gold, but also silver, platinum and palladium in precious metal form as well. This makes the later metals winners in both economic booms (industrial demand) and busts (precious metal demand)

Gold

Just as the sun never set on the old British Empire, Gold demand never really diminishes. There are always buyers in Asia, India, Europe and the Americas. Demand fluctuates here and there, but demand for investment gold is universally very strong, particularly among physical investors. Earlier this year, the U.S. Mint ceased production of the 1/10th oz American Gold Eagle due to record demand.

This was a sign of record buying, but what is more interesting was the recent World Gold Council Report, which highlights the demand worldwide. Highlights from the report include continued strong demand in jewelry, particularly in India. The report also suggests increased demand for investment gold. The jewelry sector delivered another quarter of solid year-on-year growth as consumers across the globe, encouraged by lower average prices, showed an increasing demand for larger amounts of gold. Demand for bars and coins grew 6 percent to 304.2 tons, with growth mainly coming from Asia and the Middle East, including Turkey.

Outflows from ETFs actually slowed to 119 tons. In technology Q3 2013 was another period of robust demand for gold in the tech sector. Demand related to the use of gold in electronics has shown the most resilience, aided by demand for tablets and smart phones. The Central Banks banks continued to accumulate gold, but at slower rate than the elevated levels seen in 2012. Year-to-date, global central bank gold reserves have increased by almost 300 tons!

And what about global supply? For the first quarter of 2013, there was supply of 1,050 tons. This was little changed from first quarter of 2012 but also means central banks purchased 10 percent of the world’s gold supply during the quarter. Well they certainly got a bargain as prices dropped dramatically in the first quarter. The supply of gold in the third quarter fell by 3 percent from the same period in 2012.

A sharp contraction in the supply of gold from recycling accounted for the decline as mine production increased by 4 percent. The US Geological Survey reveals that gold mine supply had dropped nearly every month in 2013. Thus, less gold is coming to market. With less gold coming to market, obviously supply is decreasing in the face of steady and/or increasing demand. Eventually, the laws of economics will catch up.

It is painful to be a holder of gold, particularly if you have purchased in the last year or so, to watch the value decrease while demand is so high and supply is diminishing. However, for the long-term, it is worth holding onto your metals, or buying at these levels, despite the fear that is prevalent in the market. If central banks are huge buyers at these prices, it would not be illogical to purchase some as well.

Silver

In 2013 there was a significant shortage of both American Silver Eagles from the U.S. Mint as well as junk silver available (that is, pre-1965 U.S. dimes, quarters and half dollars) as a direct result of record high demand. Further, silver ETFs have continued buying silver bullion at a record pace. Thus, demand for the metal as a precious holding is there from physical investors, and has helped get silver hold the $19.00 mark per ounce. Aside from silver being a precious metal, it also has many industrial and technological applications. Therefore, there will always be some level of demand, but such demand should pick up significantly when the global economy comes fully out of recession.

Industrial Demand

When the economy rebounds, there will be a spike in demand in many areas. The demand will not be just in coin and bullion form, but also in jewelry, silverware and dentistry. On the technology front, silver is one of the most conductive metals out there, and thus is utilized in photography, electronic devices, optics, medical devices/tools and most recently, in nanotechnology. One of the factors driving the forecast improvements is demand for ethylene oxide, an intermediate chemical in industrial processes that requires silver. The production of that and other intermediaries will help the U.S. run counter trend to other industrialized nations, which according to Thomson Reuter GFMS predicts will see slow growth. In absolute terms, the GFMS expects China to achieve successive record highs in terms of its industrial use of silver over the forecast period, along with the U.S.

Industrial growth in demand from the auto sector is also expected, and will help further underpin the performance of the electrical and electronics segment. Auto production is expected to rise, boosting silver usage due to the growing number of units. However, auto-related silver demand has already outpaced production because of the growing number of electronic accessories in each unit. GFMS expects this trend to continue as features once reserved for luxury vehicles become more standardized. Improvements in the economic backdrop are also expected to boost silver demand from the housing and construction industries.

Silver Supply Eventually Won’t Meet Demand

Industrial processes have been intentionally designed not to consume gold (and silver is a better conductor), and at the high prices gold has commanded for decades, it is nearly all recycled. It is said that 99 percent of all gold ever mined is still in existence above ground. For these reasons, silver stockpiles as a percentage of all silver ever mined is so much smaller than gold stockpiles as a percentage of all gold ever mined. My favorite way to think about silver demand is by quoting Ted Butler who said this 15 years ago and I have paraphrased many times before:

at the end of World War II, total known stocks of silver amounted to ten billion ounces (with the US government holding 4 billion ounces of that total amount). At that time, we were just entering an era of unprecedented global economic expansion that has lasted to the present. In this era, silver was consumed in a variety of vital modern applications at a phenomenal rate. Today, known stocks of silver have shrunk over 95 percent, to maybe a half a billion ounces. The nine and a half billion ounce draw down in total silver inventory, was the result of the persistent shortfall between supply and demand, which continues to this day. Not coincidentally, the current 200 million-ounce annual deficit in silver mirrors the long-term trend line average. This continuing deficit is remarkable in that there has been decent growth in world production of silver over the past 50 years, but obviously not enough to satisfy the surge in industrial demand.

Demand for silver is really near all-time highs, not just for precious metal investment, but in industry, particularly in technology. It’s not some manipulated statistic. The plain fact is, the laws of supply and demand will eventually catch up to silver prices. It bears repeating, in smart phones alone, over $1 billion worth of silver is utilized annually. Add a few another billion dollars for all of the computers, tablets and televisions sold each year. Now think about all of the other industries using silver (jewelry, dentistry, nanotechnology, etc). It is in finite supply with ever increasing demand. Eventually, this needs to normalize, and when it does, silver prices stand to benefit, and I believe that tremendously.

Gold-to-Silver Price Ratio

The fundamentals are pretty clear but it’s good to have the technical on my side, too. At the time of this writing, silver is priced around $19.70 an ounce, approximately 60 percent off its recent highs set in April of 2011. Gold is currently priced at about $1,225 an ounce. That represents a 62.5 to 1 gold-to-silver price ratio, whereas the historical ratio is 16 to 1. Now granted it has not seen that ratio in many years. The respective prices of gold and silver have not approached this historical ratio since silver was widely used in common currencies.

However, I believe a reversion is long overdue toward, at a minimum, the more modern ratio of 50 to 1. To achieve this reversion, gold would have to fall under $1000 an ounce while silver remained stagnant, or silver will have to rise at a greater rate than gold in value in the coming years. I believe the latter is far more likely than the former, especially in a climate of endless monetary easing as well as unprecedented demand in the technology sector. Combine this with the fact that industrial demand will return in full force once we have moved completely out of the recession and we have a strong case for an investment in silver. The ratio has generally been in the 45-55 range for some time.

Platinum and Palladium

While gold and silver are the most popular precious metals, one of the world’s top precious metals is often ignored. Platinum, which is rarer than gold and silver and also has many applications beyond being a precious metal as it is used in the industrial sectors was in a deficit last year due to South African mining strikes. Platinum production in South Africa was diminished by about 350,000 to 400,000 ounces for 2012 and by another few hundred thousand in 2013. Platinum is a high-demand metal, and thus a deficit should be a tailwind for the price as supply will be limited to meet a higher demand. Palladium is often mined and found with platinum. Together the two are known as platinum group metals (along with others).

Like silver, platinum, palladium and platinum group metals are utilized in many everyday items such as:

  1. Automobiles and machinery; used in catalytic converters, spark plugs and sensors
  2. Chemical processing; can serve as a general catalyst to speed reactions
  3. Electrical/electronics; found in high-temperature and non-corrosive wires and contacts
  4. Petroleum/oil refining; serves as a catalyst for crude oil cracking
  5. Jewelry; often used as a substitute for gold
  6. Dental/Medical equipment
  7. Investment form; bullion and coins
  8. Glasswork

Platinum To Gold Ratio

Further, gold had been trading at a higher price than platinum in the last decade. This is however historically rare and could mean platinum is due for a rebound above gold prices. Right now that is starting to happen. Since the mid-1990s platinum has often cost 1.5 to 2 times as much as gold. Platinum currently trades at $1407 an ounce, whereas gold is now trading at $1225 an ounce, for a ratio of 1.14. Still room to move historically.

Palladium trades at $739 an ounce. Its price action has oscillated over the last year, but is near where it traded one year ago. Its been a winner versus the other metals, by way of comparison. Given the race to debase currencies by central banks around the world, I think precious metals such as gold, silver and platinum stand to gain significantly. With supply predicted to not reach demand in 2014, platinum and palladium could be real winners. The deficit in is expected to reach nearly 700,000 ounces! But where will the demand rest in 2014?

Platinum Demand

Demand in autos for platinum and platinum group metals will fall by about 2 percent to 3.13 million ounces, reflecting weakness in the world’s two largest markets for diesel cars, Europe and India. There will also be some additional recycling by those auto makers still using platinum in gasoline catalysts. However, the use of platinum in heavy-duty applications will rise, with a greater number of diesel trucks meeting strict Eurozone limits. Gross demand for platinum in jewelry will slip by about 1.4 percent to 2.74 million ounces. Unprecedented demand by ETF investors in the new Absa fund in South Africa is expected to lift investment demand by 68 percent to a record 765,000 ounces

What about supply? With Industrial demand projected to rise by 11.5 percent to 1.79 million ounces the pressure is on. The construction of new production facilities in Asia and the Middle East is expected to boost purchases of platinum catalysts by the chemical sector. A recovery of demand for platinum in the manufacture of glass and computer hard disks will be partly offset by lower purchases by the petroleum industry. Primary platinum supplies are unlikely to grow significantly in 2014, and thus a continued deficit is projected. With the demand for precious metals supporting prices and industrial demand rising, platinum and platinum group metals prices should rise into 2014 and 2015.

How To Get Precious Metal Exposure

Generally speaking, there are three ways investors can get exposure to precious metals. My top approach for exposure to these metals is purchasing physical bullion and coins, followed by purchasing shares of ETFs that track the metal prices, and finally through the stock of the individual companies/miners of the metals.

Conclusion

Long-term precious metals stand to gain significantly from balance sheet expansion at central banks and currency debasement despite criticisms that this will not happen. While gold is an excellent play off of the stimulus coming from governments worldwide, I believe silver, platinum and palladium as well as ETFs that rack these metals along with individual companies in the sector could outperform gold in the next few years.

Regardless of the precious side of the metals, which have seen demand, these metals all have (with the exception of gold) massive industrial demand, particularly in the technology sector. Smart phones alone generate billions of dollars in silver demand. The auto industry consumes much platinum and palladium. Jewelry is huge as well. I see the bottom as forming, with unprecedented demand, the time to buy for the long-term is now. Physical holdings are my preferred way to go, ETFs can be very profitable. I believe at current levels, the precious metals and the individual companies that are involved with them are significant opportunity buys, especially for the long-term investor.

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