Precious Metals Update

The reflation trade is a phrase used by the financial press and investment professionals to describe investment reallocation on the assumption that economic growth and inflation will rise. It is used so often that, it has become part of the vernacular. We think this is unfortunate as it connotes the idea that inflation and economic growth go hand in hand, which they do not. A derivative of this concept was popularized by a Keynesian concept called the “Philips Curve” which plots the unemployment rate on the x-axis and the inflation rate on the y-axis. The Philips Curve posits that unemployment rate goes up when the inflation rate goes down. In the final analysis, the relationships between inflation and economic growth, and inflation and the unemployment rate does not exist. All one has to do is look at the data. The highest growth rates in the US were in the 50s and 60s. During this time, we had low inflation and low unemployment. During the 70s, there was virtually not real economic growth and high inflation and high unemployment. The 80s was characterized by falling price inflation and accelerating economic activity. In the final analysis, price inflation is not a consequence of economic growth. But that does not seem to stop the meme.

After the election, financial professionals were talking about the “Reflation Trade” and the “Trump Trade” interchangeably. The idea being that more government spending on infrastructure, childcare, and lower tax rates would increase demand for labor and raw materials and increase the government’s need to borrow money. Investors fear that this will cause price inflation and interest rates to rise. What happens in the short term is anyone’s guess as we still have not seen the legislation for a roadmap of what is to come. Traditional thinking also ignores the potential productivity gains of having better roads and bridges with more capacity. The US has the most inefficient and congested airports in the world. All you have to do is travel outside the US and you will see how far behind the US is with respect to air travel. The same is true about the internet. The internets is better, cheaper and faster in Asia.

One of the areas people looked to capitalize on their expectation of inflation ahead is the precious metals markets. We are not as active in the commodity space as we are in the equity space. We only like to get involved when we think the markets are at an extreme. One of the ways we determine this by looking at the pricing and comparing it to the commitment of traders report. The following chart of gold shows the price action. The arrows show us that when the large speculators are holding extreme long position, the price is ripe for a turn. This chart shows us that gold still has some upside potential left.

The story is a bit different with silver. Speculators are holding record long positions suggesting they may be a bit too bullish. The odds have now shifted to a pullback in the price of silver before the next leg up takes hold.

The chart of platinum tells us just how hated this metal is compared to the other metals in the precious metal complex. At $988 an ounce, it trades at a discount to gold. Of the decades, platinum typically trades at a premium to gold. We discussed phenomenon this in a post we wrote on January 19, 2017. Click here to read that note.  Furthermore, speculators hold a suppressed net long position. This suggests that platinum is still the most promising precious metal for the bulls.

Palladium paints the most bearish picture of the precious metals. Speculators are holding record net long positions. This is occurring when the price action is tracing out a contracting triangle, which is an ending pattern. When complete, price of palladium will retrace the entire move. The price of palladium has the potential to fall into the $550 to $650 range.

To summarize our analysis. We think it is ok to be long gold, but we do not like silver. Silver could fall by 20% or more, or it could simply underperform gold and platinum if the precious metals complex continues to chop higher. If you own silver for long-term inflation insurance, we suggest you continue to holding it through the ups and downs. If you hold it as a trade, you might what to consider selling it here with the intention of buying it back 10 to 20% lower. If you want to take a bearish position, you might want to write a call spread on SLV, the Silver ETF. With SLV trading at $17.43, consider the following structure.

To initiate this trade, the investor will collect $69 up front per call spread. The breakeven level is $17.69, which is 1.5% above the current price. The efficient market hypothesis suggests there is a 59% chance of success on this trade. We think the probability of success is higher than that for the reasons described above. The strikes used are fairly tight, The most one can lose is $131 per call spread. This characteristic shows up in the price behavior of the company’s shares. The histogram in the chart below shows the historical distribution of share prices going back 5 years for a typical 36-day holding period. We chose to use 36-day periods in this chart, as this is the time to expiration on the call written.

Over the past 5 years, SLV has had a negative bias in its price distribution.  The histogram in the chart below shows the historical distribution of share prices going back 5 years for a typical 59-day holding period. We chose to use 59-day periods in this chart, as this is the time to expiration on the call written. Notice the historical distribution has a fat left-hand tail, as compared to a random walk. Using the historical probability distribution there is about a 65% probability of success on the trade.

As a final note, of the four metals, palladium has the greatest bearish potential. If you own it for a trade, we suggest you sell it. We are not aware of a palladium ETF that has options associated with it. As a result, we are unable to suggest an options trade and we do not recommend naked short selling for anyone but the most sophisticated and risk tolerant professional investors. As a result, we will just have to watch this one from the sidelines.

We have a bullish 19-May-2017, $17.50 / $16.00 risk reversal in our tactical idea portfolio. Given our new bearish stance on silver, close that trade out at current prices, for a nominal profit of $26 per risk reversal

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