April 2008


By Pratima Desai
LONDON, April 28 (Reuters) – Investment money flooding into silver has overwhelmed poor fundamentals and helped it to outperform gold, but the tide could be turning for precious metals and the probability of large losses is rising.

Silver’s price falls in percentage terms are likely to dwarf those seen in gold, which some fund managers say has stronger supply/demand fundamentals.

“History shows that when you get a substantial correction in precious metals, silver falls more than gold … It’s a more volatile market and smaller in value terms,” said Stephen Briggs, analyst at Societe Generale.

One big reason behind surging prices has been the tumbling dollar, making commodities priced in dollars cheaper for holders of other currencies. The weak dollar also prompts producers to raise prices to protect profit margins.

Last week the dollar fell to record lows against the euro, to beyond $1.60, an event which has caused many to question whether further losses can be sustained and whether it has bottomed.
“The dollar is not going to keep on depreciating forever,” Briggs said. He expects gold prices to average around $900 an ounce next year from $1,025 this year and silver to average $15.50 compared with $19.20.

Financial uncertainty, which has underpinned precious metals since last August is to some extent becoming less important to investors seeking the higher returns stocks and bonds offer.
With a weakened case for holding precious metals, prices have started to slip. Spot gold is now around $893 an ounce compared with a record high of $1,030.80 on March 17 and silver at $17 from a 27-year high of $21.24.

Goldman Sachs recently said it expects to see gold prices at $835 an ounce in 12 months and silver at around $15.50.

RECYCLING
From the end of last year to March 17, silver prices surged by more than 40 percent, while gold was up more than 20 percent. Silver’s heftier gains were built on investor flows.
Barclays iShares silver trust, the biggest silver exchange traded fund listed in the United States, now holds more than 5,770 tonnes of silver, a rise of about 10 percent since the end of last year.
Gold holdings by New York-listed StreetTracks Gold Shares, the world’s biggest gold ETF, stand at 591 tonnes, down about 5 percent since end-December.

“Silver is probably going to fall more than gold in percentage terms,” said Wolfgang Wrzesniok-Rossbach, head of sales at German metals trading group Heraeus.

“From an industrial and jewellery point of view, there has clearly been a decline in demand. There has been a lot of additional material coming to the market in the form of scrap.”

More than 20,000 tonnes of silver were produced globally last year compared with around 2,500 tonnes of gold.

The surplus in the physical silver market is expected by some analysts to rise to around 2,500 tonnes from a surplus of around 900 tonnes in 2007. The physical gold market could see a surplus this year of 600 tonnes from 500 tonnes last year.

“Fundamentals come into play when prices are coming down,” said John Reade, analyst at UBS. “Silver doesn’t have gold’s fundamentals.”

ONE SOURCE OF DEMAND
Silver is often a byproduct of other metals such as lead, zinc and copper, where miners are trying to ramp up production with some success.

That means more silver on the market and together with scrap recycling, supplies are set to jump this year, while overall demand, including that from ETFs is expected to fall.

“Silver is very dependent on one source of demand — ETFs. You can’t get excited about silver in the same way as gold. Silver doesn’t really have the same cachet,” Briggs said.

“Demand from the photographic sector has been falling fast … It’s no longer an important source of demand.” For gold, the picture is somewhat different. Mine production is expected to hold steady this year, but analysts expect output in South Africa, a major producer, to fall over coming years because the ore that remains is deep and expensive to access.

Fabrication demand — jewellery and coins — is expected to continue unabated as rising incomes in emerging market countries such as China and India allow people to choose gold over silver.

The supply and demand curves for silver as a commodity have had over the last fifteen years extended periods of deficits. This is partly due to the fact that silver supply is in large part a by-product of other metal production, or from scrap.

Silver Supply;
Silver is mined world wide, much as previously noted from polymettalic mines.
Approximately 530 million oz mined each year
Approximately 230 million oz year from scrap [mostly jewelry]

Total production:
Estimated mine production…………………….62 billion oz
Bars & Coins……………………………………..21 billion
Jewelry…………………………………………..20 billion
Fabricated products……………………………21 billion

Silver Demand;
On the demand side, the price for silver is economically insensitive. This is due to the following characteristics of silver;

*price increases in silver can be generally passed onto the consumer
*price increases in silver do not impact profit margins
*world has large inventories of silver [5000 yrs+]

The interesting story with silver, is in the same way as gold, silver is traded as a financial asset. Silver, like gold has during periods of history acted as money or a currency of trade.

Currently silver trades in financial asset forms;
*Physical
*Futures
*Options
*ETF’s
*Common shares of production companies

Volume of trades;
Circa 50 million oz/150 million oz per day
Circa 30 billion oz/year

During the 1990’s this was substantially higher.

The Gold/Silver ratio [basis of trades]
This ratio has through traders lore been mooted to exist and be a profitable way to trade the two separate commodities.

The ratio has varied through history from a low of 14/1 to a high of 100/1
The fluctuations are quite high. Silver has had historically a more volatile price.

Historic Ratio’s:

Year…………………………..Ratio
1687-1777…………………14.5/15.5
1800-1900…………………15.0/17.00

1925……………………….29.7
1926……………………….33.1
1927……………………….36.5
1928……………………….35.3
1929……………………….38.8

1970……………………….20.5
1971……………………….26.6
1972……………………….34.7
1973……………………….38.2
1974………………………33.9
1975………………………36.5

1979………………………27.6
1980………………………29.6
1981………………………43.6
1982………………………47.2

1994………………………72.9
1995………………………74.8
1996………………………74.8
1997………………………67.9
1998………………………53.2
1999………………………55.9

2000……………………..55.9
2001……………………..61.9
2002…………………….67.3
2003…………………….74.2
2004…………………….61.3
2005…………………….61.5

% Changes in price [random years]
2003………………………Gold +12.5%………….Silver +35.9%
2004………………………Gold +7.0%…………..Silver +6.8%

Just as a point of interest, “The Wizard of Oz” was an allegorical tale depicting the political struggle between William J Bryan Vs W. McKinley in the US Presidential race and the issues surrounding the Silver Purchase Act 1890

At about this time there was available an arbitrage available between a Gold dollar, and a Silver dollar that could be bought for $0.60 [risk free profit of $0.40]

Valuation;
There are three equally valid methods of valuing silver. The first is on a commodity basis, the second on a financial asset basis and the third on an aggregate ratio basis.

Commodity basis……………………………Value = cost of production
Financial basis………………………………Value = inflation hedge
Ratio basis ………………………………….Value = aggregate ratio over 5 yrs

Ratio value =……………………………….65.0
[$662.0 * 65 = $10.18] thus @ $16.0 overvalued
Inflation value =……………………………$5.38
Commodity value…………………………..[no value calculated yet]

With Silver closing at $13.003/troy oz I would say that silver is currently very overvalued on a fundamental basis [financial] and is in speculative territory.

After I have calculated the *production value* a slightly clearer picture might present itself.

The production value of one of the higher efficiency miners and an aggregate cost basis of some randomly picked silver miners gave a production value of;

Production value = $3.90
Investment value = $5.38
Ratio value = $10.18
Spot price = $16+

Some rather large differences in the prices

The supply of silver from above-ground stocks on a net basis dropped by 4 percent in 2006 to 194.4 Moz. The decline was the result of a shift of net producer hedging to the demand side. Total scrap supply provided the market with 188.0 Moz of silver in 2006, virtually unchanged from 2005.

Supply from Above-Ground Stocks
(Million ounces)………………………………….. 2005………………………… 2006
Bullion
Implied Net Disinvestment…………………… -77.2……………………….. -64.5
Producer Hedging……………………………… 27.6 ………………………….-6.8
Net Government Sales……………………….. 65.9…………………………. 77.7
Sub-total Bullion ………………………………..16.3…………………………… 6.4
Old Silver Scrap………………………………. 186.4………………………… 188.0
Total…………………………………………… 202.7………………………… 194.4

From the demand graph, it is quite easy to visualize the gap that exists between industrial demand/pricing/supply and where the current price is. This would suggest a speculative component within the pricing currently, based in no small measure on US$ weakness.

From “Kat” an interesting history of the ratio of prices twixt Gold/Silver;

The banking crisis, as noted several weeks ago, pretty much resolved with Bernankes intervention and rather innovative solutions to the banks dilemmas. Whether they were all legal, is immaterial, they cauterised the hemmorage.

Not so easy a problem to solve will be the increasing momentum within unemployment. Employment is known as one of the sticky economic metrics, and for good reason.

The crisis will simply morph from the financial sector [in stock market terms] into any and all sectors where employment impacts the financial condition of the statements.

Economic data in the US have taken a notable turn for the worse. Most im­portantly, the already weakening employment outlook is being further undermined by a widely diffused build-up in inventory and falling profitability. History suggests that the latter two factors lead to significant employment losses.

While the financial system, within the major money centre banks and broker/dealers, have taken steps to enhance balance sheets, they speak essentially to addressing the consequences of excessive leveraging and imprudent financial alchemy. As such, the nasty turn in the real economy may fuel another wave of disruptions that, this time around, would also have an impact on mid-size and smaller banks

The focus will also be on the reaction of policymakers. Here the outlook is mixed. The good news is that the crisis is now moving to an area where traditional policy tools are more effective. This is in sharp contrast to the situation of the past few months, where central banks were forced to use instruments that were too blunt for the purpose at hand.

But there is also bad news. The sharp slowdown in the US real economy will occur in the context of continued global inflationary pressures. As such, the Federal Reserve’s dual objectives – maintaining price stability and solid economic growth – will become increasingly inconsistent and difficult to reconcile. Indeed, if the Fed is again forced to carry the bulk of the burden of the US policy response, it will find itself in the unpleasant and undesirable situation of potentially undermining its inflation-fighting credibility in order to prevent an already bad situation from becoming even worse

Hours worked, is the sharp end of the stick with regards to employment. Employment is sticky, thus, overtime hours are always reduced prior to any permanent reductions in the workforce.

We have seen over the past few months increasingly poor employment stats, sugar coated via the birth/death black box model

Let’s look at different sectors;

Financial sector

Construction;

Retail;

Mining;

Transport & Utilities;
Note here, the interesting divergence twixt the real economy, and stockmarket.
More on this at a later date.

Education & Health

But you get the general idea. The market has been through all of this previously, historically speaking, thus, it is unlikely that there will be a new bull market, based on the facts that too many sectors are going to be problem areas.

Obviously, further analysis into business cycles, sector rotation, and asset classes would potentially improve returns down the short-term, intermediate term road.

I have been a naysayer in the past on this Australian biotech, however, they seem to have turned the corner from speculative start-up to investment grade [not there yet]

There is potential also that they may be subject in the future to an acquisition, as many of the huge behemoth US drug companies are running pretty lean on pipeline.

I like trading high priced stocks. Has anyone traded this stock before, or even better trading it currently? Check it out.

There seems to be an enduring misconception that the Treasury is printing currency, and that this excess currency is driving inflation.

This simply is not the case.

This is a chart of M1 money, or currency. It clearly shows that far from expanding, M1 is actually contracting.

Inflation, defined as; a reduction in purchasing power, is being driven by a depreciating US$, which is exacerbated by real interest rates that are negative. The real rate is negative, as the Fed was forced to bail out the US Financial system. One major problem that necessitated this course of action was the inversion of the Yield curve, and the perculiarities of convex duration on MBS. [see http://leduc916.wordpress.com/2008/02/28/bondjames-bond/#comments%5D

I have been waiting on this development for a while, via my FXY position [see portfolio] This increase in interest rates, should it eventuate, is long overdue…however, we shall see.

From Financial Times;

Amazing action in the normally sedate Japanese government bond market actually forced the Tokyo Stock Exchange on Friday to order an unprecedented 15-minute halt in trading of JGB 10-year bond futures. The Exchange made the move in an effort to calm hectic dealing in what Reuters described as “one of the worst sell-offs in the past decade”.

JGB bond futures ended down 1.40 per cent after plunging as much as 1.8 per cent – causing the biggest jump in five-year yields in nine years after inflation accelerated, global stocks climbed and the dollar rallied against the yen.

Behind the extraordinary rout was new speculation that the Bank of Japan would increase its target interest rate this year. Yields on five-year notes have risen half a percentage point since reaching a 2.5-year low on March 17 as the dollar rebounded, commodity prices jumped and traders bet new central bank governor, Masaaki Shirakawa, will focus on curbing inflation.

Driving the concerns, the Japanese statistics bureau said consumer prices climbed 1.2 per cent from a year earlier in March.

JGBs had rallied since June last year as some of the biggest global funds, including Pimco, bought the world’s lowest-yielding debt on expectations the yen would gain and the US and Japanese economies would enter recession, noted Reuters. But so far this month, they have handed local investors a loss of about 1.2 per cent, according to a Merrill Lynch index, while the Nikkei 225 Stock Average has climbed 11 per cent, according to Bloomberg.

According to one man who knows more about JGBs than most – Tohru Sasaki, forex strategist at JPMorgan Chase in Tokyo – Friday’s drastic movement in Japanese yields should be regarded as driven by technical, rather than fundamental, factors.

A Lex note (coming later) will note that what could have been an orderly unwinding “turned into a rout on the back of technical issues”.

“Golden Week”, a string of national holidays kicking off on Tuesday, means trading volumes will be feeble over the next fortnight. That period coincides with a couple of big events: the Fed meeting and the BoJ’s release of its quarterly economic outlook, which is widely expected to prune growth expectations. It would “take a brave bond holder to take a contrarian stance ahead of a week like that”.

The market is now pricing in more than 100 per cent probability of a Japanese interest rate hike by next February – it was only 50 per cent on Thursday, he says. Bloomberg adds that the odds the central bank will raise rates this year climbed to 83 per cent from 39 per cent on Thursday, according to calculations by JPMorgan using interest-rate swaps. This is compared to last month, when the market was betting that the chances of a rate cut were more than 70 per cent, according to JP Morgan.

“It’s hard to think the Bank of Japan’s stance on monetary policy will change just because of a rise in cost-push inflation,” Mamoru Yamazaki, chief economist at RBS Securities, told Reuters.

“But it may stir talk among market players that it may become more difficult for the BOJ to lower interest rates … so I think it is negative for Japanese government bonds.”

It’s seldom said, concludes Lex, “but the JGB market will be no place for the faint-hearted in coming weeks”.

There was I believe an Oil ETF [inverse] or somesuch that totally imploded recently. In that vein, here is an article from Index Universe on commodity ETF’s

From Index Universe;

Bigger is not necessarily better. Oh, sure; you’ll always want bigger returns, but what about downside variance or bid/ask spreads? Those you’d want to be as small as possible, wouldn’t you?

Investors considering a portfolio allocation to commodities for the first time are being tempted by an ever-widening assortment of competing products. Just this month, for example, a flotilla of Bloomberg/CMCI exchange-traded notes was launched. Just how do you select the right exchange-traded fund or note to place in your portfolio?

First things first. Let’s look at the choices you now have to gain broad-based commodity exposure:

Dow Jones-AIG Commodity Index: This index can be accessed through a Barclays Bank-issued iPath note (NYSE Arca: DJP). Made up of 19 futures weighted primarily for trading volume and secondarily based on global production, energy carries the topmost weight, followed by metals, agriculturals, soft commodities and livestock.

The S&P GSCI is a production-weighted benchmark of two dozen commodities adjusted for liquidity and investability. Currently, the S&P GSCI is most heavily weighted in energy products. Investment in the index can be proxied through a Barclays Global Investors-managed iShares fund (NYSE Arca: GSG), an iPath note (NYSE Arca: GSP), or, in modified form, through an ETN issued by Goldman Sachs (NYSE Arca: GSC).

The Deutsche Bank Liquid Commodity Index: Comprised of only of six commodities, all purported to be the most liquid in their respective sectors, DBLCI is most heavily weighted in energy, then agriculturals and metals. There is no exposure to livestock or softs within DBLCI. A dual rebalancing policy is designed to maximize the return, or minimize the costs, of rolling futures forward. DBLCI underlies the PowerShares DB Commodity Index Tracking ETF (AMEX: DBC).

The Rogers International Commodity Index, the broadest and most international of the benchmarks, consists of 35 commodities. Weights are determined by a commodity’s importance in international trade, with energy weighted most heavily, followed by agriculturals, softs, metals and livestock. An ETN tracking RICI (AMEX: RJI) is offered under the ELEMENTS brand.

The Continuous Commodity Index is, in fact, the original Commodity Research Bureau Index. The index is made up of 17 equal-weighted futures contracts. Sectorwise, agriculturals and softs are the heftiest, comprising nearly half the benchmark’s weight. Metals make up about a quarter, with energy and livestock splitting the balance. The GreenHaven Continuous Commodity Index ETF (AMEX: GCC) provides access to the benchmark.

The Lehman Brothers Commodity Index Pure Beta Total Return Index, the basis for an ETN bearing the Opta marque (AMEX: RAW), is comprised of 20 futures contracts weighted most heavily to the energy sector, followed by smaller exposures to metals, agriculturals and livestock. The index dynamically underweights and overweights sector allocations to maximize roll yields.

The UBS Bloomberg Constant Maturity Commodity Index can be accessed through an ETN issued by UBS (NYSE Arca: UCI). The index tracks the returns from a basket of 28 commodity futures covering the energy, metals, agricultural and livestock sectors. Component futures are diversified across five constant maturities ranging from three months up to three years.

Now for the fun part.

Product selection starts by identifying those features most important to you. If you think seasoning, cost, liquidity, return and volatility are critical, construct a grid showing the appropriate raw data:

Each metric, i.e., bid/ask spread size, return, etc., should then be weighted for its relative importance. If current returns are most important, you might, for example, assign a weight of “10” to the category. Equal importance given to average daily volume would be signified with the award of a “10” to that category, while the assignment of an “8” to the downside variance metric denotes a characteristic of lesser importance. The weighting scheme is entirely personal. There’s no “right” or “wrong” system.

Next, assign a ranking order, 1 through 9, to each of the nine products in each category according to its attractiveness. The product with the tightest spread, for example, would earn a “9” for being most attractive while the fund with the highest fees would warrant a “1” as the least attractive choice. When a category has products with identical characteristics, assign a priority to those products consistent with your overall investment preferences. For example, if you prefer seasoned over untested products, ties would be broken in favor of the investment with the earlier inception date.

Complete the matrix by multiplying each ranking order by the category weight. For example, a “9” in the expense/fee category, which is weighted as “6,” earns the product a “54.”

Then, simply tally the results across each product’s row to arrive at a total. The highest score denotes the most attractive product.

With these parameters in mind, the Powershares DBC ETF, with a score of 336, fits your investment demeanor best.

France Telecom SA offers its individual customers, businesses and other telecommunications operators a line of services covering fixed and mobile communications, data transmission, the Internet and multimedia, and other added-value services. As of December 31, 2007, the Company provided services to 170.1 million customers. The Company operates three business segments: the Personal Communication Services (PCS) segment, the Home Communication Services (HCS) segment and the Business Communication Services (BCS) segment. The PCS segment consists of the mobile telecommunications services in France, the United Kingdom, Spain, Poland and Rest of the world. The HCS segment includes the telecommunication fixed-line services in France, Poland and the Rest of the world, as well as the distribution operations and support functions provided to the France Telecom’s other business segments. The BCS segment holds the communication solutions and services dedicated to businesses in France and worldwide.

With the huge rally in the market today within the financial stocks, in response, in part, I’m sure to the Fed Auction, we again have history repeating itself.

Bank capital is in part a function of the number of common shares, multiplied by the share price, which then accounts for equity capital.

When common stock prices fall, equity capital falls, thus increasing the leverage ratio of the asset side of the Balance Sheet. Exactly the opposite occurs within a rising common stock price. With the sale of additional Preferred Stock, most of it convertible, we have an interesting condition. What was dilutive, and a negative, has now become an asset as far as regulatory capital goes…a rising common stock price, raises the price in convertible Preferred shares, thus equity capital.

This is a very similar condition to 1982, when the Banks were embroiled in defaulting loans to Mexico, Argentina, Brazil, and again their Balance Sheets and equity capital were under strain. The bull market, in addition to various bailouts, saved the Banks.

Plus ça change, plus c’est la même chose

The Federal Reserve announced Wednesday it will auction an additional $75 billion in super-safe Treasury securities to big investment firms, part of an ongoing effort to help strained credit markets. The auction — the fifth of its kind — will be held Thursday.

In exchange for the 28-day loan of Treasury securities, bidding firms can put up more risky investments, including certain shunned mortgage-backed securities, as collateral. In the four auctions held so far, the Fed has provided close to $158.95 billion worth of the Treasury securities to investment firms.

The goal is to make investment houses more inclined to lend to each other. It also is aimed at providing relief to the distressed market for mortgage-linked securities. Questions about their value and dumping of these securities had driven up mortgage rates, aggravating the housing slump.

There has been analysis to the fact that the Fed is exchanging Junk, for Treasury paper, which is true, but that this will impact the Fed in the same way that it impacts the Banks/Brokers.

This I believe is faulty analysis for the following reasons;
*Fed does not mark-to-market
*Assets [Junk paper] will not not ultimately be worthless

The Banks that carry these assets, have to mark-to-market, thus, every earnings reporting season they are required to take writedowns, if the assets are showing deterioration. This seriously impacts their regulatory capital, and has made inter-bank lending virtually non-existent.

The Fed simply does not have the same problem. They do not, and are not required to, and will not mark-to market, thus, the Fed can be classified as “strong hands”

Of course this leads into the second part of the argument, which is, that’s all well and good, but the Fed is being landed with worthless junk. In the short-term, there will be losses, and quite possibly long term losses. However, the losses will not aggregate at 100%

The paper has collateral behind it. The problem is twofold;
*Collateral was overvalued
*Collateral was [is] illiquid

Due to the overvaluations, there will be [probably] real losses, but, they will not worthless. See *Resolution* post for details.

The liquidity issue, is a non-issue, as long as you can hold until sales are effected. Thus, the Fed, I believe is correct in bailing out the Banks/Brokers/Fools, as had they not, the financial system itself was at risk.

Of course, new regulation [after the horse bolted] will be reinstigated, as the Bank/Brokers/Fools have demonstrated that they simply are not responsible enough to cross the road without mummy holding their hand.

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