Gold bugs still bullish, but with caution from this bug

Gold bugs are still bullish for all the right reasons, but I would suggest some caution illustrated in the last sentence of this otherwise bullish article:

http://www.gata.org/node/8643

But let the record show that Murphy's Lemetropolecafe does supply one (short-term) cautionary note: India has just stopped importing gold -- not an unusual response to the metal's move, but sometimes a sign that it's due for a breather.

Industrial and investment demand of precious metals tend to be inelastic. For instance, industrial buyers of silver will pay any price to keep their production lines running--even if there is a shortage. Likewise, gold consumers will step up to the gold window in a flight to safety--despite rising prices, as distrust of paper currencies grows.

Retail Indian demand tends to historically be elastic, however. Gold jewelry has been an important part of Indian culture, as they are often wedding gifts. Therefore, with high prices afoot, retail demand has decreased as households cut back on their purchases. With India traditionally the highest consumer of gold, expect reduced demand from the fast-growing country as long as gold prices remain nominally high.

However, that slack has been more than absorbed by soaring investment demand from Europeans fearful of a sinking euro. And demand from China has challenged India's lead recently, due to a rising middle class in the Middle Country.

In the overall scheme, gold and silver represent much smaller markets than other financial markets: equities, bond, real estate, and foreign currencies. A rush to gold and silver can send prices soaring.

Something strange in the precious metals pits

COMEX gold declined a small amount, but silver prices are surging today. This bifurcation is unusual, as these precious metals usually move in tandem. I've posted numerous blogs on the dual utility of silver as an investment and industrial metal--and how the price suppression by bullion banks in London and New York is exacerbating the shortage in physical inventory. Eventually, the price of the futures markets becomes disconnected from the physical markets, as industrial buyers scramble to find supply.

Unlike retail consumers who are typically price-sensitive (i.e. retail gold jewelry buyers are priced out when when prices rise), industrial buyers must find physical supply wherever they can in order to keep their production lines humming, so they will bid up prices in tight markets. For instance, a buyer of a Bill of Materials does not want to be in the critical path of the supply chain for Apple's popular IPad, because delays translate to millions in losses. There is silver content in products as diverse as electronics, solar panels, disinfectants, antibiotics, mirrors, optics, silverware--in addition to jewelry.

A run on physical silver will eventually spill over into the paper futures market where most contracts are settled via cash. However, if longs (buyers) insist on physical delivery, there would be a deeper run on silver, causing a huge short squeeze and soaring prices. Both longs and shorts scrambling to cover their shorts will intensify buying pressure. With naked shorting prevalent in precious metals futures markets, the COMEX could experience a default, where futures contracts are undeliverable. Longs expecting delivery would be defrauded.

That's why taking physical possession is so crucial in the event of a default.

Please see disclaimers in the sidebar.

Disclosure: long physical gold and silver, long mining shares.

Silver

While gold may receive most of the attention as an alternative investment, silver may offer the better value than its more infamous cousin. The gold/silver ratio is approximately 70:1 (gold is $950 and silver $14.50 currently), which makes silver historically cheap relative to gold.

Gold has maintained its monetary store of value spanning centuries, and most of its inventory above ground exists in the form of bullion, coins or jewelry. Silver on the other hand, has many industrial and scientific uses, including in electronics, batteries, solar panels, disinfectants, and antibiotics, among others. Hence, 97% of the silver that has ever been mined has been consumed, never again to be recycled. A shortage of silver appears to be more imminent than gold, as individuals recycle gold jewelry for cash.

Because silver on the COMEX exchange is a smaller market than gold (which is already much smaller than equities, bonds, and foreign currencies), it is easily manipulated. Hence, price increases in silver often lead price appreciation in gold.

Now that individual ownership of silver is encouraged to 1.2 billion Chinese, a rally in silver becomes even more probable.