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Fundamentals still apply: lessons from the precious metals markets.

The prices of gold, silver, platinum, palladium, and other commodities are determined, both in the intermediate term and in the long term, by fundamentals of supply, demand, and inventories. Short-term price trends are influenced by other factors as well as these fundamentals. These short-term factors, which include exogenous trends and speculative forces, actually can be defined as fundamentals if one understands the dynamics of these markets.

The problem is not that fundamentals do not apply and do not affect prices. The problems are in the definition and measurement of these fundamentals. These are the facts:

* Many analysts do not understand what the fundamentals are in each of these markets, and there is a great deal of misdefinition.

* The measurement of these fundamentals is much poorer than most analysts and observers realize.

* The relationships of various fundamentals, exogenous variables, and price movements themselves are complex and do not lend themselves to simple, univariate explanations and analyses.

None of this information is new, nor is it limited to precious metals market analysis or even to commodities. These are universal problems in the realm of market analyses.

Given this, there are two issues worth discussing contained within the question: "Do fundamentals still apply?"

* What are the definitions of fundamentals?

* Why would people consider it legitimate to ask whether the fundamentals still affect precious metals and other commodity price trends?

Supply and demand define fundamentals. One must add in investment demand, especially for physical commodities, although one can also argue that paper transactions are in many ways fundamentals of these markets.

The flow of gold into and out of the market - the current account of new supply and demand - was around 100M oz last year. The turnover in the London interbank market was more than four times as large. That represents not only spot purchases and sales, but also forwards, swaps, leases, options, and other transactions. These are the fundamentals of this market. To argue that these trading patterns are not a fundamental part of the market is absurd. But to concentrate on only new supply and demand, to expect to be able to explain price movements only based on new supply and demand, is equally ludicrous. That said, most commodity analysts concentrate only on new supply and demand and ignore the larger spectrum of market transactions.

Now add this to the amount of training in the paper markets, futures, and options: One can see that turnover in the world's futures and options market last year totaled 1.4B oz, more than 12 times larger than the physical flow. To define the fundamentals of gold or any market as the flow of new supply and demand for this physical metal is to exclude 95% of market transactions from one's analysis.

One must also add in inventories and changes in inventory levels. CPM Group has conducted research that shows the importance of inventory levels not only in silver but also in copper and used the findings of these studies to improve our overall silver and copper price models. Fundamentals often are defined too narrowly, excluding important fundamentals. For example, many metals analysts still exclude secondary supply and investment demand as fundamentals. CPM Group segregates investment demand from fabrication demand, since the factors that drive each of these market segments are so different, and the effects of each of these market segments on prices are so different. But CPM Group includes investment demand as a fundamental factor.

Another recent problem has been the mislabeling of some paper transaction and the use of unrepresentataive data streams as statistics of supply and demand. Using these bad statistics as estimates of supply and demand leads to the cursory conclusion that there is no relationship discernible between the fundamentals and price developments. It is not that the fundamentals are not reflecting in prices, but rather that the data do not represent the fundamentals.

There is a sparse amount of "real" data and research available on the precious metals markets. In gold, there is one other group besides CPM Group that undertakes field research programs, collecting statistics and developing data series on supply and demand. The same is true on silver and platinum group metals.

There also is a problem with "made up" data series. Many people simply make up statistics to support their preconceived conclusions or rely on truly twisted forms of logic to bend and contort the available data to meet their needs. Others rely on trade data showing imports and exports and often wind up double- or triple-counting metal because of the numerous transactions in which a single ounce of metal is employed.

If faced with a situation in which the data suggest one market outcome but the market behaves differently, one should assume that the data is wrong rather than assume that the market, the price, is wrong. When the markets do not live up to their preconceived or ill-conceived notions of what prices "ought" to be, they resort to complaints that the data are wrong or that there is a conspiracy to distort the markets.

There has been a spate of assertions in the precious metals and copper markets lately. More often than not, there is no conspiracy, and it is simply a matter of someone not having the gumption to admit to the errors of his or her analysis.

This leads to a corollary: If one's analysis based largely on fundamentals and macroeconomic variables consistently projects long-term price trends with a reasonable degree of accuracy, it just may be that the analysis and the underlying statistics are correct. If that is the case. one need not resort to conspiracy theories to explain market behavior.

What was it that caused gold to lose a quarter of its value recently, to fall from around $400/oz to around $300? It was fundamentals. On the surface, narrowly defined fundamentals do not seem to support this conclusion. Broader fundamentals do. Fabrication demand has been rising sharply, in which supply, as traditionally defined, seemed relatively stable. This does not point to declining prices. Prices have a greater influence on fabrication demand than fabrication demand has on prices: The decline in prices contributed to the rise in fabrication demand, since fabrication demand is negatively correlated to prices.

The two fundamentals that exert the strongest influences on prices of gold were changing dramatically in a negative way for gold prices, however. Investment demand was falling since there were no good reasons for investors to abandon stocks for gold, at least until the middle of last year. And central bank sales were high and rising. Investment demand has a greater price-setting role than do central bank sales, and it is CPM Group's view that this decline in demand from this segment of the market was behind the drop in gold prices.

Why would anyone think it was worth asking whether fundamentals still apply? One reason is that many analysts have been dead wrong. Another is that the markets have changed. One of those changes has been the prominent role of varieties of institutional investors and proprietary traders. A third reason has been the diminution of fundamentally based research groups in the financial community at mining companies. A final reason has been the increased reliance on technical, chart-based, and computer-based price patterns and momentum indicators as the bases for the increased volume of short-term trades occurring in the interbank and paper markets.
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Publication:E&MJ - Engineering & Mining Journal
Date:Aug 1, 1998
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