In last week's update we made the case it was not too late to buy into the precious metals rally, and revised our standing forecast to reflect the fact that gold and silver had overtaken their September highs and are now in a position to challenge the highs for the year based on interest rates and economic outlook. The article anticipated much of this week's chatter as the bond market moved to price in greater odds of a rate cut in the first quarter of next year. In fact, we specifically examined gold's response to changes in the Fed funds rate in recent history and looked ahead to a possible "sell the news" reaction if the Fed actually realizes the current rate-cutting expectations.
For weeks, we've been outlining how the Fed's steadily hawkish comments had put it in a position to suddenly cut interest rates if economic data deteriorates. Where we were wrong last week, or at best even, was in our anticipation that the Fed would continue to be accurate in its forecast of the economy's future. Of course, the Fed had been looking for a moderately expanding economy and, as we now know, manufacturing data on Thursday and Friday pointed to both a slower economy and higher inflation, precisely the bugaboos of which Bernanke warned in his speech on Tuesday.
Fortunately, our error was too much caution and, as the economic outlook began to sour, the dollar steepened its decline, sending metals higher. Bernanke's speech reaffirmed our bullish interpretation that the Fed will not view modestly higher commodity prices as inflationary and actually sees increased mining activity as sign of a strong global economy. He also described the cost of capital as "low", confirming our view that current interest rates are modestly accommodative and bullish for metals, particularly in an environment of rising interest rates in Britain and, potentially, Japan. To last week's assessment should be added the note that current high levels of liquidity decrease the odds that a lower Fed funds rates would spark gold and silver selling as it did in the early 90's, when rate cuts were an admission of an obvious overly restrictive monetary policy.
Last week we said:
"The Fed is now on the side of precious metals, or, at least, they're no longer in the way. The Fed simply could not rest with gold and silver shooting to the moon, but they now appear content with allowing modest, gradual gains. If anything, higher commodity prices reinforce their view that the economy will continue to expand at lower levels of non-inflationary growth if energy prices remain low.
Why buy now? To the extent that this picture remains intact, we would expect to close in on $700 gold and $15 silver in gradual steps, but expect profit-taking to bring any rapid increases back in line with a more modest uptrend."
And buyers were rewarded this week with a 1% gain in gold and 4% for silver. While the economy currently appears to have cooled somewhat below the comfortable Goldilocks level, the bullish picture we've been tracking has only gotten hotter. We continue to caution that to avoid overstepping the Fed's tolerance for higher prices, precious metals, at least gold, should avoid making huge, headline-grabbing gains. While up 12% since the October FOMC statement we heralded as a screaming "buy", gold has in fact moved in a discrete, orderly fashion. Silver, on the other hand, probably due to its superior fundamentals and 'stealth' status, is beginning to look parabolic on the weekly chart. We never expected the triangle most people were seeing to actually hold, and silver has broken out to near our two possible targets. If we are correct, silver will find resistance between the 14.11-14.16 area. But, as the white metal is not generally used to gauge inflation, and can therefore be tolerated to run higher, it might, in favorable market conditions, break through this range and make a slightly new high for the year above $15 before some temporary consolidation back into this area.
Looking to the week ahead, it's obvious that if the economy stays on ice and the Fed cuts rates sooner than expected, aggressive precious metals traders will want to be "all in" as gold and silver rally to take out the year's highs and, if China makes good on its threat to diversify out of dollar reserves, maybe even challenge all time highs in 2007. But, it's important to keep in mind that it's still unclear to what extent old benchmarks in the ISM still prognosticate the health of the current non-manufacturing based economy. Some of the economic data that set off the recent selling in equities could be revised upward, but even so, with the Fed's focus squarely on jobs, as described by Chairman Bernanke on Tuesday, next week's data could very likely outweigh this week's news whether good or ill. Furthermore, the current action in stocks, bonds and commodities is exacerbated by aspirational terrorist threats to online banking and ATM systems, factors that decrease investor rationality and emphasize technical rather than fundamental analysis. To the extent that the perennial terrorist threats fail to materialize during this holiday season, and economic data comes to reflect moderate expansion instead of recession, cooler heads and optimistic outlooks, not necessarily inducing rate cuts, could still prevail and this would put serious brakes on the recent gains in precious metals.
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Featured Mining Stock
Silver Dragon Resources (SDRG)
SDRG is the creation of private equity manager Marc Hazout, who, in March 2005, changed the name of his American Entertainment & Animation Corporation to reflect the company's new direction and focus. At the time, he said, "China is currently the 4th largest silver producer in the world and appears to host significant silver reserves. In order to fuel their own internal demand, China needs Western expertise and funding to fully develop their vast resource base. By combining the growth of China with the potential for rising silver prices, our objective is to create value for shareholders by building a portfolio of high quality silver assets." Since then, Hazout has assembled a team of experienced mining industry executives, including Donald Robinson from Eastmain Resources and Bill Reed from Hecla Mining, to supervise the purchase of property rights in China and Mexico.
The 30-day chart above reveals the recent history of Silver Dragon, which, on November 21, announced the pouring of the first silver bars at the Erbaohuo mine in Northern China. The company acquired 60% of the production company for $450,000 and 4 million shares of stock. Silver Dragon's lack of significant mining equipment and technical resources means it must contract with outside engineers to construct facilities for future production on the property.
Probably the greatest asset to Silver Dragon, besides its mineral rights, is the mining experience represented in its board of directors. Their collective connections in the mining industry have allowed the company to move quickly and successfully in its acquisition of commercially viable silver properties. Unfortunately, the financial expertise of its CEO has created drama and resulted in a reported $492,043 loss on marketable securities in the three month period ending September 30, which partially includes aggregate losses of $384,698.31 in purchases and sales of Qualcom stock ordered by Marc Hazout between May and November this year through a trust arrangement with Travellers International, Inc., a company of which he is sole director and shareholder. Silver Dragon has announced it will hire a CFO to prevent such further speculation with company funds and is investigating whether there were violations of applicable SEC regulations. Damage to the company appears minimal and contained, more of a black eye than anything else.
Potential fraud notwithstanding, the financial outlook of Silver Dragon is now brighter than ever... if the spot price of silver continues to increase year-over-year. The company's aggressive anti-hedging policy actually has it hoarding its current production, yes, like a dragon, to be sold at a future date at, hopefully, higher prices - an arrangement that is essentially a hedge in the opposite direction. If indeed silver appreciates in value, this will prove a brilliant approach to creating shareholder value. In the meantime, the company will have to raise additional financing to develop its Mexican properties.
As evidenced by it's share price and the fact that it trades on the over the counter bulletin boards, Silver Dragon represents a far greater risk to investment than larger, more established mining companies. It's management has chosen an extremely risky approach to create a stockpile of silver for future sale. Of course, with this higher risk also comes the potential for higher returns, and shares are currently trading 30% higher than their initial listing price in May of this year and 215% above the close on Aug 1. Barring any unforeseen calamities or executive shenanigans, SDRG should continue to trade in the short term as, in effect, a call option on silver. With a new drill test due soon at Erbaohuo, if financing can be raised on acceptable terms, new production and sales could continue to add additional premium over gains in the metal.