Today's Market WrapUp 03.04.2003 Mon Tue Wed Thu Fri Puplava Archive
SPECIAL EDITION
Five
Smooth Stones: How to Fight the Gold Goliaths and Win
BY
JAMES J. PUPLAVA, CFP
One of my favorite stories as a young boy in parochial school was the
story about David and Goliath. A young shepherd boy taking on a great
warrior and slaying the giant has been read and told throughout the
centuries. There are several aspects to this story that seem to
resonate in today’s investment markets. If we look at the story of
David and Goliath, the odds were against David. He was a boy; Goliath
was a giant warrior. In battle the odds favored Goliath. He had
height, strength, experience and heavy armor. David had speed and
cunning. When the Israelite King Saul heard David had volunteered
to fight the Philistine giant, he was told he didn’t stand a chance.
David responded that as a shepherd he had killed a lion and bear to protect his flock of sheep. The Philistine
giant would be no problem.
In making preparations for battle, the king dressed David in his battle armor. The armor was so heavy that he had difficulty walking. David was smart enough to know that he couldn’t fight Goliath on his own terms. The heavy armor wouldn’t protect him since it weighed him down and he needed to keep his distance to stay out of the range of Goliath’s spear. David needed speed and distance. Instead of fighting the giant on his own turf, David relied on what he had used to kill a lion and bear: a simple slingshot. As he prepared to meet Goliath, he reached down and picked up five smooth stones. He put the stones in his shepherd’s bag and went out to challenge the giant. As the Philistine moved in for the kill, David reached into his bag, picked a stone and struck the giant on the forehead. David then took the giant’s own sword and beheaded him. David triumphed over the Philistine by adopting different tactics than those who went before him. He was smart enough to know that fighting the giant in hand to hand combat would only end in his own death. The giant was stronger and more experienced. David instead relied on his own faith and his own tactics to overcome the giant. David triumphed over the Philistine without sword or armor, but with a sling and a stone.
There is an important lesson here to be learned by the gold community. For the last three years, I have observed the futures markets and precious metals equities markets. The goliaths of the investment markets dominate this market. Large commercial hedgers, Wall Street firms and bullion banks control this market. Time and time again I see the commercial hedger go short silver and gold; while small traders and technical trading firms go long. In the end, the commercials end up driving the price down with their large short positions and the small traders and technical trading firms end up withdrawing from battle after heavy losses. The larger commercial hedgers then come back in and cover their short positions at lower prices. It is a game that I’ve seen played over an over again.
Slaying The Philistine
As I began to understand more about silver and gold’s fundamental position, it struck me why the small trader lost each battle. The small trader was taking on Goliath and fighting him at his own game. I also realized that the way Goliath fought made him vulnerable to the stones of a small shepherd boy. Gold Goliaths have heavy armor. In this case, that means access to capital at favorable rates. The Gold Goliaths also have strength, which comes from the leverage of their capital. This capital is leveraged through derivatives. Derivatives in this case act as a force multiplier. Gold Goliaths also have experience. Their technical expertise in trading, as well as access to information and capital, gives them a great advantage on the investment battlefield. Playing the futures game or the equities markets on the giants’ terms will only end up in defeat for the small investor. The giant is vulnerable and the giant knows it. He can only win if the small investor plays by the terms and rules of the giant. If David would have put on heavy armor and fought Goliath in hand to hand combat, it would have been David’s head that would have been displayed on a pole on the battlefield that day. Instead, David worked with what he knew and understood.
When it came time for battle, he would rely on his own faith to bolster and give him confidence. He chose to fight the giant on his own terms. David also saw one of Goliath’s main weaknesses: the giant’s own hubris and conceit. He looked in disdain at the small, unarmed shepherd boy. He was confident he would overcome David as he had done to many others in the same way by using his strength and armor to assail his opponents. He never saw the stone coming until it was too late. The small, smooth stone slung by a small shepherd boy had slain the giant Philistine. The lesson learned here is never confront a superior force directly and never fight a battle on the enemy’s terms or from a position of weakness. In this gold war, investors have been fighting and losing this battle in the futures pit and in the stock market. They have been fighting on terms and rules set forth by Goliath. This strategy is bound to end in defeat. It is time to turn the tables.
Your Five Smooth Stones
The
story of David and Goliath demonstrates the futility of fighting
directly and in a way that favors the giant, so a different tactic is
necessary. It is time to adopt the strategy of David and choose five
smooth stones for your sling. These five smooth stones are as follows:
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Fundamental knowledge of the precious metals markets.
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Technical knowledge of the primary trends of the markets.
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Understand short selling and how this is the giant’s Achilles heel. Learn to buy and turn this to your advantage.
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Learn to master and control your own emotions.
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Buy and take delivery of your bullion positions and hold your ground in precious metal equities.
Now let’s discuss how these five stones give you the ammunition to slay the giant and turn a losing battle into victory. All stones work together and become your arsenal.
Stone Number 1: Fundamental Knowledge
Understanding the fundamentals of the gold and silver market is akin to the battleground. Every great general surveys the battlefield before the battle is fought. Unless you understand the fundamentals behind the silver and gold markets, you will not have a firm understanding of the battlefield. You will operate blindly without confidence and be played like a fiddle by the Gold Goliaths. The first task is to understand the supply/demand position of silver and gold. In simple terms, the demand for silver and gold has been growing each year. Demand increases; while supply is starting to decline. Silver has been running a supply deficit for 13 years with gold not far behind. There are 2,500 tonnes of gold mined each year; while demand is running at close to 4,000 tonnes. Selling aboveground stockpiles, scrap metals and melting old coins has made up the deficits. The biggest supplier of meeting those deficits has come through central bank sales and gold leasing by bullion banks. These four charts supplied by Sharefin show the continuous deficits of gold and silver over the years. The bottom two charts show the cumulative deficits or the draw-downs of aboveground stockpiles of gold and silver.
Courtesy of Sharefin
The Gold Goliaths would have you believe that it is natural for gold and silver to run supply deficits and see the price of both metals decline. Can you think of any other commodity whether it is oil, natural gas, wheat, corn or orange juice where that is indeed the case? The price of gold and silver have been kept suppressed through the sale of aboveground stockpiles by central banks, by borrowed gold sold by bullion banks and by the dangerous use of derivatives. In the words of Warren Buffett, these derivatives are ticking time bombs that are ready to set off a nuclear explosion in the financial markets. There are numerous stories and fundamental information on the gold and silver supply deficits that can be found on our gold site and those of others that will give you a better understanding of this condition. There are numerous books on gold and silver fundamentals that follow this essay. I encourage you to read them.
The more you know and understand about gold and silver fundamentals, the greater your understanding will be. I also would say the stronger your faith will become. It was David’s faith that gave him the courage to take on Goliath. Unless you are willing to invest the time and do the reading and research to understand gold and silver fundamentals, you will be at the mercy of the Gold Goliaths. You will end up running instead of using your sling. This point is critical to winning the investment battle. Unless you understand the investment you are making, you don’t belong in this market, especially in gold where there is so much misinformation.
Stone Number 2: Technical Knowledge of Primary Trends
The second stone is a basic understanding of technical trends in the financial markets. You don’t have to be a technician to understand graphs and use this stone or tool. What you do need to know is how to read a chart and know what that chart is telling you. There are three trends in any market. The first is the primary or main trend of the market. This is the direction in which the wind is blowing. Primary trends can last a long time, go on for years, and even decades. The second trend in the market is the intermediary trend, which is counter-cyclical to the primary trend. This trend is shorter-term and can last as short as six weeks or six months. This trend is in the opposite direction of the primary trend. For example in a primary bull market (primary trend), an intermediate trend will take the form of a correction. In a bear market, the same holds true, but this time the intermediate trend may be a temporary rally. In a bull market, temporary corrections from the primary trend are usually good entry points for taking a position. Lastly, there are the short-term trends, which may run as short as six days to six weeks. Unless you are a fully competent and experienced trader, I would avoid these short-term trends. This is best left to experts.
What you need to grasp here is a basic knowledge of charts. It is similar to looking at a map of the battlefield. You need to have a full understanding of the battlefield and the terrain. The accompanying notes list a number of books to help you.
Stone Number 3: Understanding Short Selling
Short selling is selling something you don’t own at today’s price in the hopes of buying it back later at a much lower price. When you buy a gold stock or buy gold or silver bullion you are considered long the position. You actually have bought and taken an investment position.
A short seller on the other hand does just the opposite. He tries to profit on the price of an investment declining. So if you expect the price of IBM stock to go down, or the S&P 500 to go down, you sell at today’s price. You don’t own the stock, so you have to borrow it from your broker. You must post margin (currently 50%) of the proceeds of the sale. Since you don’t own the stock, you owe your broker interest on the shares you have borrowed. In effect you have sold something you don’t own and which you are going to have to buy in the future to cover your short position, or in this case pay back your broker who loaned you the shares in the first place.
Short sellers hope to profit from falling prices just as long investors hope to profit from rising prices. In going short, you need to understand not only the fundamentals, but also the primary position of the markets. If you are in a bull market you go long and in a bear market you go short. As shown in the graphs of the S&P 500 and the gold market, it is obvious from viewing these two graphs which market is in a primary bull market and which one is in a primary bear market. The counter trends or intermediate trends are good times to add to positions in a bull market and add short positions in a bear market. An experienced trader can play the short-term trends, but it is inadvisable for inexperienced investors to try and do this. As I wrote in “The Next Big Thing,” you only have to make a few key investment decisions in your lifetime. If you can get in at the beginning of a new bull market, ride that market until the primary trend changes.
Three-Year Primary Trend Charts for S&P 500 and Gold
The Futures Market
This is where the short positions come into play. Think of making an investment decision in the same way that you would a major consumer purchase for a car, TV set or furniture for your home. You would want to shop around for a sale and buy that item at its lowest price. The old adage "Buy low and sell high" comes into play. In a bull market, your greatest chance of buying is when prices pull back in an intermediary correction. This happens more frequently in the commodity markets because so much of commodity investing is short-term oriented. This is a field dominated by the Goliaths. When you buy a futures contract, you must post margin or collateral to cover your purchase. Today that is around 15% of the total contract value. The problem arises is if the price goes against you. If this happens, you must post additional margin or collateral to back your purchase. Most futures contracts are settled in cash or paper. Most investors or speculators don’t take actually delivery of their future contracts unless they are in the business. For example a dentist may hedge the cost of gold used for fillings by locking in a price in the futures market today for a delivery to be made in the future, hence the name "futures market."
The futures market has been used as a means of hedging and locking in prices to guarantee costs. This market has been used by farmers for centuries to hedge their crops and make their harvest results predictable. It is hard at the time crops are planted to know what the price will be at the time those crops are harvested. So farmers buy futures contracts today to guarantee a price in the future when those crops are harvested and brought to market. In any market there are those who believe prices are headed down and those who believe prices are headed up. The price in the futures pit is determined by this battle between supply and demand forces that determine prices. If you think prices are going up, you would go long a contract. If you thought the opposite, you would go short.
There are times when professionals can alter the outcome or price of a commodity by taking large positions on either the short or the long side of the market. These positions can get to be so large because of the amount of leverage involved, that prices can be influenced by the size of the position. This is indeed the case we find today in the metals markets in both gold and silver. It is also a position found many times in other commodity markets. In one sense you can say that the gold and silver commodity markets now function like our fractional reserve banking system, since there is only a small amount of silver and gold in the commodity warehouses as collateral to back up all of the long or short positions taken in the market. This is because most futures contracts are settled in cash or paper. Very few investors actually take delivery of the commodity. Unless you are a business that needs or consumes the commodity, you have no need to take delivery. Investors or speculators own many of today’s commodity contracts. This is a market dominated by the Goliaths or The Big Boys. Very few investors actually make money this market over the long run. The Goliaths that have large amounts and access to large credit lines and the ability to leverage their positions have superior staying power and end up dominating this market. If you are a small investor, the odds are against you. Unless you have a large amount of capital, access to large lines of credit at low costs, and have technical and fundamental trading skills, you will find yourself outmatched.
The Strategy: Use Cash, Take Delivery & Hold
There is a way however to use the giant's leverage and turn it to your advantage. You want to keep you distance from the Goliaths and not take him on at his own game. Instead when you find him heavily burdened by his heavy armor, in this case heavily leveraged by being short, you simply take advantage of his weakness. Those large short positions in silver and gold have suppressed the price of the metal. Rather then leverage your position and play the giant's game, you need a different strategy. Instead of leverage, use cash and then take delivery. This removes supply from the warehouse and weakens the giant’s position. The giant is able to leverage his position through derivatives. His position is in paper not physical. As long as delivery is not demanded, the giant can use his superior strength in paper to outwit and outmaneuver you.
Bullion
Instead of playing the giant's game, you pay cash and take delivery.
When you do this, the gold or silver is in your possession. It can’t
be sold out from underneath you by a margin or collateral call if the
price moves temporally against you. It is yours. You own it and the
exchange or the giants can’t take it away from you. In essence, you
remove the small physical base that supports the giant's large and
heavy armor. By reducing supply on which paper positions can be
pyramided against you, you are taking control of the battlefield and
fighting on your own terms. Once you have bought, paid for and taken
delivery, the silver and gold is yours and they can’t take that away
from you. Now you are using the giant’s leverage that has suppressed
the price to fortify your own position. This is the biggest kept
secret in the bullion business. Supply is being drawn down as demand
increases. That is why there is so much disinformation. This fact
makes the gold and silver Goliaths vulnerable. That is why you need to
understand silver and gold’s fundamental and technical trends. It is
also important to become knowledgeable when the giant has the most
exposure. In this case, when he has gone short so you can have the
giant subsidize your purchases.
Equities
The same strategy holds true for shares in silver and gold equities.
When the Goliaths increase their short position, the price of the
shares fall or weaken. The price goes down and you are afforded
another opportunity to buy at attractive prices. In the case of
precious metals equities, I don’t believe you need to take delivery.
All that is necessary is for you to make your purchases at lower
prices and then hold your ground. Remember, if you don’t sell, the
short-seller will eventually have to cover his short position. If you
don’t sell, then the short-seller has less available shares to buy
in order to cover his position. Holding your ground is to fight from a
position of strength. Selling your shares is playing the giant's game
and operating from a position of weakness. All of this assumes that
you have done your homework and understand the fundamentals and
primary trends of this new market. If you don’t do your homework and
understand silver and gold fundamentals, you are operating from a
position of weakness and playing by the giant’s rules. Under these
circumstances, you will inevitably lose.
Stone Number 4: Learn to Control Your Emotions
If you have done your homework and have a full understanding of silver and gold’s fundamentals and the technical position and primary trend of this new bull market in metals, then you need to operate from a position of strength and faith. You don’t cave in and run when the battle starts or when faced with a cavalry charge. You need to learn to control your emotions. It is your knowledge of fundamentals and technical positions of the market that should give you the courage to stand up against the forces rallied against you. I say "WAR!" because that is what it is. A war is being waged against honest weights and measures represented by gold and the freedom and protection it gives the ordinary investor. I would suggest reading Gold Wars by Ferdinand Lips this week’s guest on Financial Sense Newshour. It will give you a better understanding of the battlefield terrain and the war waged against gold.
The reason for understanding all of these things is so you don’t panic and that you begin to use the markets to your advantage. In the words of Warren Buffett, "You become fearful when others are greedy and greedy when others are fearful.” You use a valuable aspect of the markets that Warren Buffett learned from his mentor, Benjamin Graham. Mr. Graham’s analogy of Mr. Market can be read in his book The Intelligent Investor which I suggest you buy and read over and over again. Reading The Intelligent Investor will give you a better understanding on how to use the vagaries and moods of the market to your advantage. You will also learn valuable lessons about investing and managing your money. In Warren Buffett’s words “I read the first edition of this book early in 1950 when I was nineteen. I thought then that it was by far the best book about investing ever written. I still think it is.” Graham’s concepts of “Margin of Safety” and "Mr. Market” will prove to be invaluable in your success as an investor.
Stone Number 5: Take Delivery and Hold Your Position.
Once you understand the fundamentals and have a clear understanding of the primary position of the markets, you wait for opportunities to present you with your buying opportunity. Understanding primary trends and short positions will provide you with the best buying opportunities. You will be able to leverage your position at the expense of the giants. In effect you are going to learn to use their short position in driving down prices to subsidize your purchases. If you are buying physical, this means taking delivery which moves the supply off the market. If you don’t take delivery in the futures market, you are playing the giant’s game and will probably lose longer-term. I have met very few wealthy commodity investors. I have known and have come to know many wealthy investors--all of whom made their money by taking positions and holding them longer-term in a primary trending market.
Think back to the last bull market in technology. Most of the money was made in the early years--in the 90’s when techs were cheap. Those who bought Dell, Microsoft, Cisco, and Intel made the majority of their money by buying early when they were cheap and then having the good sense to hold on for the ride of their lifetime. If they had traded out of their positions at the top of each rally and then tried to buy back in, they would have been worse off due to taxes. It is doubtful if they would have ever have bought consistently at the bottom and sold at each new top. In fact, technically speaking, many of these stocks remained in oversold conditions throughout tech bull market.
Profit
From The Paper Chase With a Gold or Silver Paperweight
So if you believe in gold and silver fundamentals and want to invest
in physical, pay cash and take delivery. This means if you're buying
in the futures market that you pay cash and take delivery. This takes
supply off the market and makes it harder for the Goliaths to leverage
their paper positions when delivery is demanded. Their enormous short
positions are predicated on the fact that buyers settle in paper or
don’t demand delivery. Like fractional reserve banking, their
strategy falls apart when there is a run on the banks. The only way
the derivative pyramid can work is if you play their paper game. It
doesn’t work when contracts are settled by physical delivery. So if
you are buying physical, take possession.
You don't have to be a major player to buy gold and silver bullion. You can start out small at your local coin shop. You can buy gold coins, junk bags of silver, silver rounds or ten ounce bars of silver. It is probably easier to buy gold coins because of the current cost of gold. You can do so monthly and average your cost or quarterly whenever funds are available. The important point is even small stones will work to slay the giant. Besides, owning gold and silver coins or bars give you the added pleasure of admiring their beauty.
Profit
From Short Subsidies
In the precious metals equities market, it isn’t necessary in my
opinion to take delivery of shares. You simply buy and hold them. If
shares are sold short, as they are today, the short seller eventually
has to return to the market and buy them back. What you don’t want
to do is panic when short selling piles up and drives down prices. How
do you think the short seller is going to cover his short position? He
will cover when the price drops and that is when you panic and sell
your shares. When you buy, plan on holding your position. By denying
the short seller available supply to cover his short position, you
reduce supply. This means when he moves to cover his position, he will
create additional demand and drive up prices. The short seller is
counting on you to panic and sell. Instead of panic, learn to profit
by his short subsidies.
Unless you fully understand the previous four stones and how to use them, you aren’t standing on firm ground. Your position is one of weakness instead of one of strength. You don’t want to take the Goliaths of the gold market head on. You would be playing their game and you will end up losing. Imagine if David would have put on Saul’s heavy armor and faced Goliath directly. I would venture to say we wouldn't have been reading about him in the Bible. It would have been David’s head instead of Goliath’s that would have been on the top of that pole.
Pick up your sling and find your five smooth stones. Goliath stands proudly and arrogantly on the battlefield. If history teaches us anything, it is that the strong and mighty can be humbled. This includes giants.
Copyright
© 2003 Jim Puplava
March Forth
Charts courtesy of www.sharelynx.net and www.stockcharts.com
Recommended Reading
The
Intelligent Investor by Benjamin Graham
Gold
Wars by Ferdinand Lips
(on FSO)
Tomorrow's
Gold by Marc Faber
(on FSO)
The
Power of Gold by Peter L. Bernstein, John Wiley & Sons, 2001
Gold
and Economic Freedom by Alan Greenspan, The Objectivist, 1966
Silver Bonanza by James U. Blanchard III and Franklin Sanders,
Jefferson Financial, 1993.
Money: Ye Shall Have Honest Weights and Measures by
James E. Ewart (on FSO)
Introduction
To Technical Analysis by Martin Pring
How
Technical Analysis Works by Bruce M. Kamich
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