Mar 31 2008 10:16AM

Last week the precious metals were down-right scary. Silver fell from more than $20 to $16.80; gold fell by big numbers. And yet, a broad survey of bullion dealers reveals almost without exception they was a shortage of the physical metals, and people had to wait as much as three or four months to get delivery. It was a rare commodity dealer who had silver inventory on hand and could deliver quickly.

Theoretically, with the demands for physical silver so high and increasing, silver should have been rising, not caving in.

So what’s the mystery? Why do prices seem to be speeding in the wrong direction? Percentage-wise it’s the biggest decline in the metals since a couple of huge retreats in the bull market of the ’70s.

It all relates to the futures market. There is a big difference between speculators in the metals on the futures market ,where no actual metals change hands ,and transactions in the physical metals markets where people are buying real silver and gold. They are actually taking possession of the metals. You would think this should automatically drive up prices.

Puzzle Solved

The futures market has its own law of supply and demand. If a lot of speculators want to buy or sell contracts, prices rise or fall until the market clears. But it actually has little effect on the supply and demand of the physical metals.

The market has been “deleveragering.” Says The Wall Street Journal: “Investors with losing trades in the credit markets – mortgage bonds or collateralized debt obligations, for example – are being required by banks and brokers to set aside more cash (margin calls) to cover the money they have borrowed to make trades, a process called ‘deleveraging,’ to raise cash for investors and hedge funds. They also have sold some of their commodity winners to raise cash.”

Says one partner in an investor-advisory firm, “The unwinding of winning commodity trades has been playing out for most of this week, especially in the last half of the week. This reverse alchemy is hitting many different commodities.”

The Journal then goes on to tell us, “The Dow Jones AIG Commodity Index has fallen nearly ten percent since last Thursday, after rising 18 percent since the beginning of the year. Gold and silver suffered the most, with gold down 8.3 percent from its high of $1,003.20 per ounce on Thursday on the New York Mercantile exchange, while silver fell 8.6 percent.

“Oil is down 7.7 percent from its record of 110.33, set last week.

“Exchanges and brokerage firms across Wall Street have been raising margin requirements in response to the heightened volatility of the stock and bond markets. Futures are often purchased with borrowed money.

“When markets are calm, the exchanges and brokerage firms that regulate the amount that can be borrowed against commodity trades are generally more lax. When nerves heighten and stock prices gyrate more, they make investors set aside more cash for each dollar they invest.”

The COMEX, for example, has raised margin requirements on gold contracts and crude-oil futures big time. So when margin requirements go up, a lot of investors sell, sometimes because they have to, so the selling drives down the price. This deleveraging process has, in effect, taken a lot of the speculative fluff out of the precious metals.

The fundamentals that I’ve been writing about of gold and silver being driven by a weakening dollar and rising monetary inflation, are still functional, but they are temporarily being overwhelmed by the urgent deleveraging of futures contracts.

A lot of big investors have funded their high-stakes trades by borrowing money from their brokers. With the value of their real-estate-based bonds declining, banks have gotten more worried, requiring hedge funds to set aside more cash to weather the credit-market storm.

“This is all related to the liquidity crisis,” says the director of Commodity Research at MF Gold, Ltd in Chicago. “As assets at banks are written down, they need to shore up their portfolios by bringing in more cash from hedge funds and others trading in commodities.”

A lot of the increases in the metals over the last month and early this month came from investors piling into commodities because of the belief that oil and grain prices over the long haul will keep rising due the strong Asian demand and shrinking supply.

One broker said, “We are unwinding some of the greed in the market. We have taken these markets up, not so much on fundamentals, but now we are unwinding it without a cause.

On the other hand, some regular consumers of commodities, such as jewelry buyers, food companies and factory owners, have slowed their purchases in the belief that prices have risen too fast. Copper buyers in China, for example, have backed away from purchasing copper and are waiting for cheaper prices, while others see more rising prices ahead.”

There is a strong cyclical pullback amid a structural rally.

One economist at Goldman Sachs agrees that some investors have exited their commodity trades to raise cash for other areas.

Since the end of January, the New York Commodity Exchange has increased its margin requirements five times in platinum and palladium. The Minneapolis Grain Exchange has raised the margin on each wheat-futures contract four times this year. Last week the Kansas City of Board and Trade increased its margins on wheat futures contracts by 50 percent because of the increased market volatility.

Remember the fundamentals. When margin requirements go up, a lot of investors decide to exit the market. The subsequent selling in the futures market has driven down the prices. This market is not be really dependable on the upside until it is dominated by actual buyers of the physical metals. Right now, it’s briefly dominated by futures speculators.

Fundamentals Still Intact

The bull market in the metals has been distorted by futures buying and selling. But it will return to fundamentals, and, sooner or later, the actual buyers of the metal will be the dominant force in continuing to drive the bull market.

I’ve consistently advised you to look at declines like this as opportunities to buy more that we thought we would never see again. So my advice is still the same. Buy, buy, buy physical gold and silver. You won’t see many chances to buy it this cheaply again.

By Howard Ruff
The Ruff Times

*****

Howard J. Ruff, the legendary author and financial advisor, has re-edited and will re-issue his 1978 mega best seller, How to Prosper During the Coming Bad Years, still the biggest-selling financial book in history, with 2.6 million copies in print. He is founder and editor of The Ruff Times Financial Newsletter. This article appeared in the March 7, 2008 issue of The Ruff Times. The newsletter is much more comprehensive and deals with a broad spectrum of middle-class financial issues and includes an Investment Menu from which you can build your portfolio.

(You can learn about it here). The Ruff Times has served more than 600,000 subscribers – more than any financial-advisory newsletter in the world. His new book is now in book stores or at www.rufftimes.com.