COMMODITY FUTURES FORECAST WEEKLY REPORT
Gold And Silver: Economic Linkage?
Philip Gotthelf
In last week's review of 2005 economic trends, I concluded with the teaser that this week would examine the economic linkage to gold and silver as well as the potential for U.S. equity markets moving forward. I called attention to the great deal of skepticism remaining as our equity markets have failed to rally above long-term resistance. Indeed, yesterday's action confirms my overall assessment looking backward, however, it was a forward prediction as of last Thursday.
I posed the question, "Will a rising dollar and higher interest rates hurt stocks?" As mentioned, the answer is complex because it involves multiple predictions that may not necessarily dovetail into a perfect picture moving forward. Consider that our short stance in T-notes has yielded a nice gain and our timing could not have been seasonally better. We were short the Calls and Puts for more than a full point and, bingo!...the puts expired worthless. Yet, we held our short position beyond option expiration to enjoy a continuing downside.
With interest rates rising and unresponsive U.S. Dollar, analysts are looking toward gold and even silver for clues about the eventual direction of everything from stocks to interest rates and the dollar. Hence, these venerable metals have begun re-linking as monetary symbols. This process comes at a very unusual time because gold has been out of favor for so long and remains well below any inflation-adjusted price level when compared with the average price during the 1980's. After more than three solid decades of inflation, gold owners are worse off than they would have been were they to have invested in bonds or stocks...even with the crash following March of 2000.
The linkage phenomenon is not direct, but it is materializing, nonetheless. Even the emergence of Exchange Traded Funds (ETF's) that represent physical gold suggests investors are interested in probing this area for security and as a hedge against further paper asset volatility. The question is whether gold will provide the protection sought through physical ownership and the new ETF's. Based upon the current advertising, hucksters are already calling for gold to reach "$1,000 per ounce" as crude oil rockets toward $100 and basic raw materials soar to all-time records.
Undoubtedly, the Commodity Research Bureau Index (CRB) has sparked concern that inflation has returned with a vengeance. The Department of Labor is no longer looked upon as a reliable inflation prognosticator when the claim of low inflation persists in the face of all-time record energy prices and near record copper, iron, aluminum, zinc, and other base metals. Can gold and silver be far behind?
Whether gold appreciates in tandem with other commodities or rises as a function of inflation remains a central issue in the overall evaluation. Gold demand is primarily driven by investor interest. In this respect, gold remains unique because the other precious metals rely upon industrial demand more than speculative accumulation. Thus, if gold resumes a monetary posture, it will be a major revision back to traditional "values" at a time when most investors do not even have firsthand familiarity with gold.
The last generation to embrace gold was the "Great Generation" that parented the Baby Boomers. Baby Boomers who were born between 1945 and 1955 were, at best 30 years old when gold was legalized in the U.S. in 1975, and at worst, about 20. The love affair lasted for less than a full decade...From the time gold was introduced to its 1980 peak was only five years.
Yes, those who were young adults during the 1920's up through 1933 had the privilege of carrying gold coins and convertible gold certificates. But, that generation is rapidly diminishing. Therefore, any flight back to gold will actually be a first-time experience for investors.
There are those who believe that this first time experience lacks perspective and depth. The transition from gold in 1933 involved a move away from gold as currency whereas the present interest is as an investment "store of value." The distinction is far from subtle because gold's price was previously fixed by the government while today's price is determined by market forces.
The interesting adjunct to gold's present function is the fact that even interest rates and currencies float as quasi commodities. All are traded as futures and options. Therefore, the entire financial environment is substantially different now then it was then. This suggests that the security of all markets depends upon the demand for underlying instruments. The gold link derives its validity from a potential deterioration in confidence related to paper assets and their derivatives.
Notice the current April gold chart. After a long and steady trek higher from last September's breakout, we saw an abrupt reversal followed by an upward channel that was violated to the downside at the close of 2004. This became a reversal formation that took prices to a new, albeit temporary consolidation range between 42250 and 43000.
My interpretation of the December rally led me to believe that between December and April, gold would trade around 45000. Thus, I recommended selling April gold 450 calls and puts for the short straddle. Just in case, I placed protective wings at 475 and 425 buy buying the respective call and put. When prices collapsed below 42500, my defensive strategy was to sell the 425 Put in favor of a cheaper 410.
The logic was partly fundamental as crude oil continued to push higher and the dollar was unable to break out of the continuing doldrums. With an admitted sigh of relief, gold began to rally from a 41200 low to bring hope of a recovery. With 2380 points collected in net premium, we were safe all the way down to 42620 and April had recovered to 42760. The question was whether gold could pop back to 45000 before the April expiration in about 18 more days.
The bullish consensus suggests gold can make it back to 45000 and, perhaps higher. However, I do not expect to see a $30 rally between now and option expiration which would cause our calls to appreciate above the value of our premium. We would have a small offset from our long 475 calls that were placed as protection, but time on those has essentially run out.
Gold In 2005
Can gold resume its former investment luster? There are two developments that could allow gold to achieve the elusive $500 mark and higher. The first would be a continuing appreciation in crude oil. This is gold's focal commodity as seen by the chart comparison.
The correlation appears remarkable and supports the theory that both gold and oil's appreciation is highly dollar related. Indeed, the dollar is the global pricing medium for both and, hence, the relationship is somewhat automatic.
However, oil can and does move independently. For the moment, media is fixated upon a bullish scenario with China and India acting as catalysts for a huge upward thrust above $60 and even $70 per barrel before June...the "driving season." Senator Chuck Schumer (D. New York) has cried for the release of the Strategic Oil Reserve as he squeals about gasoline prices hitting as high as $3 per gallon for regular over the peak summer months.
Looking at the inventories, there is no fundamental basis for a $3 gasoline price. There may be a temporary squeeze on gasoline as refineries make the transition to smog-reducing summer formulations, but that is an annual event. Further, inventories are actually higher now than they were this time last year. If anything, we could see a 20 cents to 30 cents decline in wholesale unleaded regular and crude is more likely to stall below 5500 than rise above 6000.
What is the implication for gold? My feeling is that gold wants to seek equilibrium around 45000. I cannot see a pop to $500 if oil fails to reach $60/bbl. On the other hand, gold already tested near $410/oz. and managed to come back to my anticipated midpoint. I can see gold reaching as high as 48000 before encountering resistance or dropping as low as $405/oz. should oil collapse or the dollar gain upward momentum.
This brings me to a trading range strategy just like the one in place right now. I may opt for something more modest than a straddle since many subscribers became uncomfortable as gold plunged below 42500 while we held a short 450 put! Okay, I'll use a strangle rather than a straddle to add a comfort zone.
Along similar lines, March silver has broken out above 75000 to encourage silver lovers that the metal can achieve $8, $9, and even $10 "before too long." I view silver as presenting the same opportunities for selling premium. We were lucky enough to collect 14 cents for the 900 silver calls and another 14 cents for the 925 calls when silver had its last rally. Now, silver is wooing speculators to 800 May Calls that are selling for about 15 cents. The 700 May Puts are offered at about 10 cents to give approximately 25 cents.
This is the approach I would use in anticipation of an expiration between 82500 and 67500 within the next 47 days.
May silver shows 70000 support and is forming an upward channel that is similar to the formation seen in December. Unless there is a breakout above 86000, silver will remain in a wide trading range.
Why would silver move to $9? The only force that could bring silver that high is speculation. Industrial demand is down and secondary production is up. Exceptional copper prices have coaxed copper producers to increase operations and silver is becoming a sacrificial lamb. However, with prices above $7, silver is not such a sacrifice. A look at the various copper mines that produce secondary silver shows extremely low production costs for copper because silver revenues are used to reduce costs on the books rather than as an independent profit center. Thus, we really do not know what silver costs to produce or what it actually contributes to the net bottom line.
The Silver Manipulation
A great deal of buzz on the Internet deals with a pending silver manipulation. Silver advocates insist that we are experiencing a huge deficit of consumption over production. Despite the rapid substitution of digital imaging for silver halide film, proponents of the white metal insist that demand is up and supply is down.
I do not see the supply/demand equation as bullish, but there is a possibility that speculation can drive silver to new interim highs above $9. The problem with such an accumulation effort is that it tempts producers to sell inventory forward and expand output. This is more the case with copper over $1.25/lb. Simply put, the prices are too good to pass.
I do not like to see traders get caught in temporary price spikes that result from intentional manipulations. Although we may believe manipulations are illegal, the truth is that they take place all the time. Just look at palladium's price after Russia suspended exports. Do you think that was not a manipulation?
In silver's case, any squeeze is not likely to endure more than a quarter...three months. So we can sell the options!
March 11, 2005
Philip Gotthelf
Commodity Futures Forecast
P.O. Box 566, Closter, New Jersey
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