Price Volatility of Precious Metals

Something rather strange happened to me just after publishing last week’s article. You’ll recall that that article dealt with purchasing precious metals. After the dramatic 700 point drop in the Dow, a neighbor stopped me outside my house and said: “You were sure right about the market!” Something similar happened a few years ago: the stock market dropped sharply, shortly after I had sent out an email to my circle of friends and neighbors about monetary inflation. A different neighbor at that time said the same thing: Oh, you were right about the markets!

I have the sinking feeling that my recent advice gave the impression that precious metals mitigate the risk of stock market investments. Yikes!  I’d  be happier if my neighbor had complained to me about the drop of silver prices from their high of over $20 per ounce in March to under $11.00 on September 11th of this year. A Maalox-moment if ever there was one!

The decline of silver and gold prices in the past several months illuminates some important points about the volatility risk of investing in precious metals. To begin with, let’s reiterate the risks that precious metals do mitigate: loss of principal value due to inflation, monetary collapse, and counterparty default.

Inflation

Inflation results from an increase in the “velocity” of money. That is, when the supply of money in the economy increases, spending also goes up. The increased demand then drives prices up. Money supply grows primarily through expansion of credit. For example, the housing bubble now in the process of collapsing came about because the Federal Reserve dramatically lowered interest rates in 2000 and 2001 to deal with the recession of those years. Low interest rates make credit less expensive and thereby increase the velocity of money. The dramatic rise in the price of energy and food in the past few years result from the increased money supply. (The supply-demand problem of petroleum and natural gas is a whole other problem that I shall take up at some point in the  future.)

Precious metals protect purchasing power against inflation because its price rises with everything else. Thus the rise of silver from around $5.30 per ounce in January 2000 to its highs of this past spring. Gold prices tell the same story. Holding silver and gold since the year 2000 would have compensated for the 40% drop in the value of the dollar during the same period.

Monetary Collapse

The dollars in which we transact business have no backing by precious metals or any other real commodity. Our legal tender laws force us to accept dollars as payment for business transactions. History shows that  “fiat” currencies like ours follow a particular pattern of decline in which the government overproduces money in order to cover its debts: the examples include Wemar Germany following World War I and Argentina in the late 1990s. The increased money supply causes hyperinfaltion, a situation in which the highest face-value bill has more value as toilet paper than as a medium of exchange. At that point, the populace turns to other media of exchange. Precious metals provide a reliable store of value when the currency reaches the hyperinflationary state.

Counterparty Risk


I mentioned last week that, in our fractional reserve banking system, a savings bank can lend out 90% of its deposits. By definition, a bank cannot satisfy a demand for all of its deposits at one time. It relies on most people leaving most their deposits in the bank most of the time. The borrowers to whom the bank has lent the depositors’  money indirectly owe that money to the depositors. The bank’s borrowers, not the bank itself, holds most of the despitors’ assets. If these counterparties default on their loans in great numbers, the depositors’ money disappears. When large numbers of people and businesses default on their loans, as in a severe economic downturn, depositors loose confidence in the balance sheet of the bank. In a “run on the bank” a large number of depositors demand their deposits at the same time and the bank has to close its doors. FDIC insurance protects depositors against this kind of scenario. But a massive banking meltdown could easily overwhelm and bankrupt FDIC itself.

When you physically hold precious metals, you avoid counterparty risk entirely.

So What’s The Catch?

Like any asset class, precious metals do not perform well in all economic situations, the worst situation being deflation. In the typical deflation scenario, a credit bubble reverses itself into a credit contraction. Interest rates rise and banks become reluctant to lend money even to each other. The decrease in money supply reduces the velocity of money, causing the reverse effect of inflation: the price of everything drops. The drop in the prices of stocks, energy, agricultural commodities, and precious metals in the past few weeks exemplies the kind of deflationary pressure that occurs when credit tightens. Deflation may be the only situation in which cash and short-term bonds have an advantage over other asset classes: as the price of everything drops, the relative purchasing power of cash increases. The deflationary crisis of the Great Depression presented great buying opportunities to anyone who had cash to spend: real estate, for example, could be purchased at bargain basement prices.

Other factors affect the price of precious metals. Many hedge funds hold precious metals in the form of paper-based obligations. That is, they do not hold physical precious metals, but hold various kinds of financial instruments that represent precious metals. As shareholders in these funds demand redemption of their shares, the hedge funds dump their precious metal holdings (along with other commodities) to raise cash.

Intervention in the markets by central banks to undermine gold as the primary competitor to fiat currency also plays a role. The Gold Anti-Trust Action Committee has for years chronicled interventions of this sort.

If any of this seems counter-intuitive, take note of the the fact that precious metals dealers today have difficulty fulfilling orders — gold and silver bullion are flying off the shelves faster than the refineries can produce it, and it can take several months for the backorders to be filled. Based on physical demand the price of precious metals should be much higher right now. The disparity between the market price and physical demand suggests either deliberate market manipulation or the short-term effect of hedge funds dumping their paper proxy holdings of precious metals.

My belief in the long-term outlook for inflation remains firm. The recent spate of bailouts have increased the Federal Reserve’s balance sheet dramatically. And as the default credit swap crisis enlarges the circle of credit problems from the mortgage sector to the economy as a whole, more bailouts will come.

But that’s not all. In the next few years, the retirement of the baby-boomer generation will put tremendous pressure on government entitlement programs such as medicare and social security. The government will have no way to meet these obligations other than borrowing more money. Through the machinations of the Treasury department and the Federal Reserve, the government debt will further increase the money supply and inflation will run rampant.

Precious metals will do well in the long term as our monetary system unravels. But, as we see today, the volatility of precious metal prices make them a poor choice for money that you need to access in the short-term.  Holdings for more immediate use are better held in the short-term bonds of foreign countries that follow more conservative monetary policies. One mutal fund to consider, the Prudent Bear Global Income Fund (ticker symbol PSAFX), holds a diversified portfolio of short-term bonds in a number of such countries. You will need to figure out the right mix of physically held precious metals and something like PSAFX for your own personal asset protection plan.

A Slightly More Useful Disclaimer

This is the point in my post where I have been saying “I am not a professional financial planner and have no credentials in this area. You should always review your long-term financial plan with a qualified financial planner.” That of course is true. But this time I would like to offer you the view of Chris Ciovacco, who is a professional financial planner and does have excellent credentials in this area. In his recent article Investing Now: The Big Picture, Chris observes:

While there is no question gold still has very positive long-term prospects for a variety of reasons, risks remain in an environment where there is open trader talk of possible U.S. dollar intervention by global central bankers. . . . Gold’s lower lows and failure to make a new high during a very serious financial crisis, tells me the following:

  • For the moment, the markets are more concerned about economic weakness rather than inflation (the focus will change in the months and years ahead).
  • Dollar strength is curbing the demand for all commodities, including gold.
  • Central bankers and policy makers do not want to see high gold prices. High gold prices put a spotlight on excessive money creation and government intervention into the free markets (all related to debt and currency debasement). Central bankers and policy makers still carry a heavy hand in the financial markets. They can crush the little guy in the short run. They can alter markets in the short-run. Gold’s 28% drop between July 15, 2008 and September 11, 2008 is a painful illustration of this concern.

In the interest of brevity I have left out the parts of this section of the article in which Chris advocates for reducing one’s exposure to gold (and by extension we would say silver as well) during this period of uncertainty in asset values. That would not be my personal approach because I have more of a buy-and-hold orientation. But please take a look at his article for further and more technically detailed insight into another view of how one might proceed in this market environment.

© 2008 Philip Glaser

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3 Responses to “Price Volatility of Precious Metals”

  1. Physical Versus “Paper” Silver And Gold « From The Tower Says:

    […] have already discussed the price volatility of precious metals. Let me reiterate: I do not advocate that you put all of your savings into […]

  2. Michael P. Yates Says:

    I’m a friend of Leah’s. She sent me links to your blog. Well written and informative. Very timely.

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