Precious Metals are tacking on more strength this morning after a strong showing last week.  Gold futures are now above the symbolic $1,000 per ounce level, and the December silver contract is at $16.75.  While there have been several false starts this summer where precious metals have traded higher, only to be forced back into a trading range, today’s move appears to be setting up a true (and potentially long-term) positive trend.  The following are three indications that the current move is legitimate.

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Volume – When looking at any sharp breakout in stocks, commodities, currencies or other asset class; most traders will tell you that they want to see heavy volume in order to validate the trend.  Volume which is above average usually indicates strong institutional buying (or selling in the case of falling prices), and when institutions make a move, it can take them several days or even a period of several weeks in order to build their full position.  Nimble traders can often see these volume tracks and get involved quickly in order to profit from the continual buying as a group of professional managers build positions.

Another thing that volume can tell you is that many players have been caught off guard.  In the case of precious metals, the argument against inflation has been widespread as economists believed that a weak recovery would keep loose policy from resulting in the traditional inflationary pressures.  If those opinions prove to be false, there will be many investors and traders alike, scrambling to find protection which could result in a long-term buying spree for gold and silver.

Currencies – The media has named several forces in play which are pushing gold and silver higher, but one of the most important factors is the continued weakness of the US dollar.  Take a look at the chart on the right and you will see the dollar as compared with a basket of other currencies has been trading south since the peak which coincided with the March low in equities.  The picture will look different depending on which individual currency you compare the dollar to, but the bottom line is that the dollar is quickly losing ground and becoming worth-less as we print more paper in order to meet our obligations.

Now in order for gold and silver to continue to rally, we don’t necessarily need the dollar to continue to be weak compared to other currencies.  I’m much more concerned with the actual purchasing power of the dollar when it comes to goods and services than with the comparison to other currencies.  But if we do continue to see the dollar decline on a currency basis, then gold and silver will most certainly remain an attractive hedge against the currency decline.

Stimulus – The current administration is working very hard to pull the economy out of the recession and generate new growth.  At this point, inflation would be a welcome problem as that would be considered a “growth” problem which is better than the problems of rising unemployment, destruction of wealth, and a weak and frustrated consumer population (read: electorate pool).  So the stimulus policies are actually designed to lead to inflation if necessary in order to prop up an economy and hopefully generate some new jobs.

Gold Video: Is this the move we have been waiting for?

Unfortunately, new jobs that pay dollars which have less purchasing power can be a dead end.  As the administration pumps out more currency to pay for bridges, roads, buildings, medical care and equipment, new cars, new electrical grids, and a myriad of other special projects; the excess liquidity will eventually become a problem.  Bernanke has voiced confidence that excess liquidity will be quickly sopped up, but history tells us to be skeptical of such remarks.  Loose monetary and fiscal policy will likely be another tail-wind behind rising prices for precious metals.

How to Profit From the Move

The most popular choice for investors appears to be to buy gold futures or for equity traders to pick up shares of GLD (an ETF which mimics the price of gold).  There’s nothing wrong with these two approaches, but I would suggest readers  also look at silver as a way to diversify and potentially get more bang for their buck.

Gold is the most widely accepted precious metal position, but silver actually has stronger supply / demand characteristics which could yield better investment returns.  While nearly every ounce of gold that has been mined over the last five millennia is still in existence (in the form of jewelry, packed away in vaults, as collectors items – or otherwise stored), silver is actually used in many industrial processes.  The shiny metal is used for x-rays, in making polyester, to solder electrical connectors, in high quality reflective processes, and even for medical wound dressings.  This means that silver is being used up at the same time it is seen as a storage of value.

Aggressive investors might consider buying calls on the silver ETF (SLV) and I would suggest considering the January $17 or $18 strike price which are still relatively cheap considering how close the underlying is to the strike price.  If this move is truly indicating the advent of an inflationary environment, we will likely see SLV above $20 within a couple of months and possibly even above $30 by the end of the year.  Long-term, the price of silver could increase many fold as unprecedented stimulus and irresponsible government spending leaves its inevitable mark on our economy.

FD: Author has a long position in SLV in the ZachStocks Growth Model

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