Investment Contrarians

Commodity Price Cycle Bringing These Two Metals to the Forefront

By for Investment Contrarians |

Commodity Price Cycle Bringing These Two MetalsThe U.S. economy is certainly not running at 100% capacity, but one sector that is operating at levels not seen since before the financial crisis is the automotive industry. In March, automotive sales increased substantially to an annualized rate of 15.3 million vehicles per year, compared to 14.1 million vehicles this time last year. (Source: Bennett, J., “March U.S. New Car Sales Jump,” Wall Street Journal, April 2, 2013.)

American carmakers contributed with substantial increases, including General Motors Company (NYSE/GM), reporting a 6.4% year-over-year increase in March, and Ford Motor Company (NYSE/F), reporting a 5.7% year-over-year increase in March.

Two derivatives of the strong automotive sector are the precious metals platinum and palladium. Generally speaking, platinum is used more for diesel engines, while palladium is used more often in gasoline engines. The increase in gasoline engines should, on the margin, increase demand for palladium versus platinum. With European vehicle sales slow, this should reduce demand for diesel engines.

One mistake many new investors make is investing with an all-or-nothing mentality. For example, an investor might be bullish on all precious metals, irrespective of the fact that certain commodities might be better investments than others in the precious metals sector.

Recently, the Chairman and CEO of Stillwater Mining Company (NYSE/SWC), Francis McAllister, stated that he believes it is highly probable that palladium will increase in price relative to platinum. Currently, palladium trades at approximately 48% of the price of platinum, up from 30% in 2003. McAllister believes palladium will rise to 65% of the value of platinum. (Source: Hill, L., “Stillwater CEO Sees Palladium Outperforming Platinum,” Bloomberg, March 21, 2013, last accessed April 4, 2013.)

More advanced investors should incorporate some hedging strategies. In the precious metals group, having a mix of long and short positions makes strategic sense. Not all precious metals will rise at the same ratio, with platinum outperforming other precious metals at times and underperforming them at other times.

Palladium Chart

Chart courtesy of www.StockCharts.com

This is a 30-year chart of palladium in relation to platinum. Notice in late 1992, palladium started to move upward in value in relation to platinum. These precious metals then traded somewhat in tandem until 1997, when palladium started to outperform platinum.

This outperformance by palladium in relation to platinum continued until it peaked in 2001. Looking at the past decade, in 2010, palladium broke out of its downtrend against platinum, and these precious metals have traded quite tightly over the past couple of years.

Currently, palladium is at a crucial level versus platinum. If the CEO of Stillwater is correct and this ratio begins to turn in favor of palladium versus platinum, we should see this ratio accelerate. However, don’t just assume that both palladium and platinum will increase in price. Both of these precious metals could decline significantly, with palladium dropping less than platinum to have this ratio increase. This is what we call a pairs-trade. If a pair drops in price, then the profit from the position short will offset the long position.

With vehicle sales set to continue their strong pace not only in America but China as well throughout 2013, we should see demand remain quite stable. Obviously, I’m not recommending this position; rather, I am merely showing you a unique way of looking at the precious metals market.

Too many investors are solely focused on buying a holding, when in reality, precious metals are cyclical, moving up and down over time. After such a long move up for many precious metals, adding a hedge by shorting some of the precious metals and going long on others could help reduce risk for the advanced investor. Before embarking on any investment, each investor must fully understand their risk profile and conduct their due diligence.

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