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How to Play the Sell-Off in Precious Metals


Seeing lit Molotov cocktails flying on the streets of Athens has to be a sure sign that the situation is not yet contained. At $342 billion, the size of the Greek economy is insignificant when compared to the rest of the E.U. economy that is about $15 trillion, so why the large dislocation in the euro and the resulting selling of BRIC assets, whose investment fundamentals simply do not warrant it?

Greece is not a cause of this crisis — it is simply a catalyst, the match that hit the powder keg that is the E.U. The Western world has been living beyond its means for a long time and the stress in the government bond markets in Europe is simply the market’s final realization that debt loads in the West are unsustainable. Not that they are sustainable in Japan or the U.S. either, but for the time being the crisis is centered on the old continent.

Asia Took the Bitter Medicine in 1997 — And It Worked

Investors in Asia saw the same in 1997 when the Thai baht collapsed and triggered a wave of currency devaluations and defaults — driving a good number of financial institutions out of business. Asia was overly-indebted, much in the same way Europe is today, but Asia took the bitter medicine without postponing it. Debt levels were slashed and Asian companies today offer the best fundamental secular growth investments money can buy. I believe it will pay off handsomely to use corrections generated by investor panic to build positions in Asian equities.

I don’t see any of the measures taken in Asia in 1997 taken in Europe today. Governments in Europe keep spending money they don’t have on bailout packages that won’t work. This is why U.S. government bonds are flying. I recommended that you focus largely on defensive strategies until this situation is sorted out. U.S. government bonds — represented by the iShares Barclays 20+ Year Treasury Bond Fund (NYSE: TLT) — have been on fire.

Gold bullion has taken a small hit, which is normal as there seems to be a clear unannounced intervention in the currency markets to support the euro. The ECB used to brag that the euro is a completely free-floating currency, but at this point this is simply not true. Any weakness in the SPDR Gold Shares (NYSE: GLD) driven by this coordinated monetary blitzkrieg to bring the dollar down and prop the euro should be used to buy more bullion as interventions just postpone the inevitable. The euro is going to 1 sooner or later, while gold bullion heads to $3,700.

Gold is Religion

In 2004, after a huge run in gold stocks and gold bullion, I had the great misfortune to recommend short selling some overvalued gold stocks that I thought looked vulnerable. The long-term portfolio that I was running was net long gold, so it only seemed logical to protect the gains. The trading shorts quickly made 20% or so gains, I send emails to subscribers to book them, and I received hate mail back.

“Why are you shorting gold stocks if you think gold is heading north of $3000?” was the recurring theme in most of those emails, regardless that the trades were solidly profitable and that the portfolio was still long the Midas metal. Try explaining to people sold on the idea that gold will go parabolic — and I believe it will — that trading is tactical and investing is strategic; which are not the same things.

There isn’t another sector in the stock market (maybe alternative energy, but more that later) where investors treat their stocks quite so religiously, which is why I don’t try shorting gold stocks anymore. If it makes you feel better about trading precious metals, go buy some physical bullion from KITCO and don’t sell it while you trade both sides of the market in precious metal stocks or futures. That way your conscience is clear.

Normal Correction Ongoing

I have followed the precious metals sector for a long time and I know why the stocks move the way they move. Overall, this is a bull market that will last for many years and it pays to buy the sharp corrections. But, in order to buy those corrections, one has to first sell some when the stocks are too high — it’s only prudent money management.

This is why I mentioned four silver stocks in the last issue of Asia Insider — it’s my job to follow the BRIC markets and natural resources closely. The share prices on the close of trading when the last issue went out for Silver Wheaton (NYSE: SLW), Cour D’Alene Mines (NYSE: CDE), Pan American Silver (NASDAQ: PAAS) and Silver Standard Resources (NYSE: SSRI) were $20.34, $17.10, $27.04 and $18.88, respectively.

And since then, they’ve corrected — to the tune of about 10% to 15%. As I write this, SLW is down 12.7%, CDE is down 13.7%, PAAS is down 11.0% and SSRI is down about 12.7%.

The same is going on with the hard metals. Gold bullion, which is investable via the SPDR Gold Trust (NYSE: GLD), is outperforming silver, which is investable via the iShares Silver Trust (NYSE: SLV), which in turn is outperforming both platinum and palladium, investable via the ETFS Physical Palladium Shares (NYSE: PALL) and the ETFS Physical Platinum Shares (NYSE: PPLT).

I have explained the relationship between these four precious metals, and to summarize the current action, the more industrial the precious metal, the bigger the decline.  It appears to me that the European situation escalated just in time for Chinese officials to accelerate their monetary tightening measures, which is causing a correction in the natural resource markets.

But I want to make this clear. I have seen this all before — and this too shall pass. While it is difficult to pinpoint an exact bottom, this sell-off in precious metals will look like a godsend — not a pun with “Gold is Religion” intended — a few short years from now.

So, how should you position yourself right now?

In the present environment, I think that one should have a 20% position in gold bullion, a 20% to 30% position in U.S. government bonds and the rest in BRIC equities. All four BRICs are growing rapidly and such rapid growth can only go on for so long before share prices of BRIC stocks follow.

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