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Gold & Silver...A good Read...

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    A good read for all the gold bugs out there for which I'm one.

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    When the going gets tough for investors, tough investors go shopping for gold and silver. Thanks to fears of nuclear war, terrorist strikes, inflation and more damage to stocks, investors have rediscovered their love of precious metals and the security they think they find in them.Car? Home? Home equity?
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    By early June, mining stocks -- as measured by the Philadelphia Gold Silver Index ($XAU.X) -- had gained 60% from the start of the year. The metals themselves had advanced about 20% above last year’s average prices, to $330 an ounce for gold, $5.12 per ounce for silver.

    In the past week, however, they’ve all beaten a fast retreat. Is this the end of the road for these precious metals? Or is it the proverbial pause that refreshes ahead of more advances?

    The answer has little to do with the actual demand for gold and silver by companies that use them to make things such as jewelry and the film for your camera. Instead, gold and silver prices are tangled up in a complex web of investor hopes and fears about the outlook for inflation, for competing investments like stocks and for geopolitical harmony.

    Fundamental beliefs
    If you are thinking of buying gold and silver in this pullback, here’s what you have to believe:

    The Federal Reserve Board is not raising interest rates soon. For all you’ve heard about people buying gold and silver because of worries about nuclear Armageddon, there’s a more mundane reason investors have been flocking to these precious metals. It’s a way to make money from inflation. Right now, borrowing costs are much lower than expected inflation. So you should be able to profit by borrowing money now, parking it in gold, and paying it back later in cheaper currency that was devalued by inflation. In theory, your interest costs will be lower than what you should make by paying your lender off in cheaper dollars.

    "Because gold and silver are non-producing assets, the only time they should move up is when the holding cost, or the cost of capital, goes below expected rate of inflation," says Howard Simons, a professor of finance at the Illinois Institute of Technology. Right now, borrowing costs are about 1.9% per year, while expected inflation next year is 4%, judging by the difference in interest paid on long-term debt vs. short-term debt, says Simons.

    The main thing that might reduce those inflation expectations -- and cut back on the demand for gold and silver as an inflation hedge -- is a Fed rate-increase campaign. But it’s not likely soon, given the weakness of the recovery. “If the Fed doesn’t appear anywhere on the horizon, I’d say we are in a bull market for gold well through 2003,” says Simons.

    For what it’s worth, history suggests gold and silver could weaken during second half of this year. RBC Capital Markets analyst Stephen Walker examined the relationship between gold and Fed interest rate cycles, since gold was unlinked from the dollar in 1971. He found that gold stocks typically did the best five quarters after the first Fed cut, which would be last quarter. On average, gold stocks underperformed 18 months into a Fed cutting campaign -- or the second half of this year. But if the economy recovers at a slow pace, that would delay the next rate-increase campaign, and reduce the significance of those historic averages.

    The stock market weakness and scandals will continue. Many analysts believe investors have moved back into gold and silver because they don’t trust the stock market. They blame questions about the strength of the economic recovery, as well as fears of more accounting scandals, and a sense of betrayal after big losses sustained in the tech bubble.

    “It took 20 years to get to an incredibly overvalued stock market in which investors made all kinds of stupid mistakes,” says John Hathaway, manager of the Tocqueville Gold (TGLDX). “Why should we be off the hook after only two years? We could be. But usually when bubbles break, you don’t tidy it up that quickly.”

    In other words, investors who expect more problems for stocks should be bullish on gold and silver because those problems will continue to drive investors to the precious metals.

    World conflict will worsen and the dollar will continue to weaken. “The world has changed since Sept. 11, and in times like these investors have sought safety,” says Leonard Kaplan, president of Prospector Asset Management, a commodity and futures brokerage firm based in Evanston, Ill. “And precious metals are the traditional venue.” Investors are also seeking safety from a falling dollar. “When you have strong currency of choice among investors, they tend towards that currency,” notes Jeffrey Christian of CPM Group, a New York research firm. “When there is no flavor of the month in the currency market, investors park assets in gold and silver.”

    Christian, who advises professional investors on the outlook for prices of gold and silver, believes both are in a sustained uptrend. “We think that gold and silver have made major bottoms over the past few years and are likely to rise. For the first time in a while, we are able to say gold will be higher two years out and silver will be a lot higher.”

    Investing in gold and silver
    When buying mining stocks, it makes sense to avoid companies that have hedged against gold and silver declining in value. This means they’ve already locked in the future price they’ll get. So as prices rise, they lose relative to their competitors. Gold mining companies with little hedging of this sort include Harmony Gold (HGMCY, news, msgs) and Gold Fields (GFI, news, msgs). Since silver is often the byproduct of mining and producing other metals, there are fewer pure plays on silver mining. One company that offers good exposure is Apex Silver Mines (SIL, news, msgs).

    Another option is to buy the metals themselves. Investors used to $10 stock commissions will find the fees a little rich, but owning the metals might make sense for a couple of reasons. First, it’s a cleaner play on price moves of gold and silver. You aren’t betting on management, or its ability to control costs and avoid problems such as mine floods or environmental hassles. “Too many things can happen to a stock that can’t happen to silver,” says Kaplan. Besides, mining stocks tend to move up ahead of any price gains for the metals. So a lot of the gains in these stocks may already be history, relative to what may lie ahead for the prices of the metals.

    If you decide to buy the metals outright, it may be better to go with silver rather than gold. Fundamental supply and demand do matter -- as well as the factors outlined above -- and the outlook for silver on this front is better. Silver is used for a lot more than just jewelry, unlike gold. So demand should increase as the economy comes back. Next, since there are fewer pure plays in silver mining, big institutional investors who want exposure have to buy the metal. But the market for silver isn’t as big and liquid as the market for gold. So its price is typically more volatile. This suggests more potential upside for silver than gold in a bull market for precious metals. “We expect silver prices to rise more sharply in percentage terms than gold prices,” says Christian.

    Heavy commissions
    How do you actually buy silver and what are the costs? Specialized brokerages such as Goldline International, in Santa Monica, Calif., or Kaplan’s Prospector Metals in Illinois offer retail investors bars of 1,000 ounces, as well as other sizes. You’ll pay anywhere from 2.5% to 6% in round-trip commissions, depending on how much you are buying. Unless you have the stuff delivered to your door, which is cumbersome and costly, tack on another .75% to 1% of the value per year for storage. If you store the bars with someone else, be sure to put ownership in your own name, which protects you from losses if your broker goes out of business. Make sure the bars are kept depository-certified by the New York Mercantile Exchange, like Delaware Depository or HSBC.

    You can bring down commissions, notes Kaplan, by purchasing silver through a futures contract, which costs about $100 round trip. Futures contracts are financial instruments that allow you to lock in a price right now on delivery of something at some point in the future. The bad news is the minimum futures contract is for 5,000 ounces, or around $25,000 at current prices. That may be more than you want to put into silver. Investment advisers suggest it’s best to limit the amount of precious metals in your portfolio to 5%-10% -- even if you think you’ve found a silver lining in all the world’s problems.

    At the time of publication, Michael Brush did not own or control shares in any of the companies listed in this column
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