Posted January 30th, 2011

With precious metals dropping seemingly every day so far this year, the question on many investors’ mind is whether gold and silver can sustain the rally they witnessed on Friday. While most market pundits believe that fear regarding the Middle East sparked precious metal buying on Friday, the reality is that both gold and silver were oversold markets, and both were fast approaching strong technical support levels.

For an indication of conviction behind Friday’s rally, we can view the volume on the silver futures contract as well as the SLV.

selling during the first four days of last week that saw silver sink to 2-month lows occurred on falling volume

The above charts show the front month silver futures contract and the SLV, along with their corresponding daily volumes. As shown by the red trend lines, the selling during the first four days of last week that saw silver sink to 2-month lows occurred on falling volume. Usually when trends are accompanied by decreasing volume, it indicates that traders’s conviction in the trend’s continuation is also falling. A reversal of the trend on strong volume can be a signal that the trend reversal will continue.

Friday’s rally saw both silver futures and the SLV trade 4% higher on large volume, signifying a possible end to the correction in the white metal. Silver futures traded ~76.4k contracts, 30% more than the 45 day moving average. The SLV traded 32.8 million shares, 21% more than the average. The significance of this increase in volume is apparent when considering that silver rallied on Wednesday, but on low volume. From the lack of participation, one could have surmised that the rally would have been short lived.

We remain bullish on silver prices in the long-term, and think that the current correction could be close to running its course. As fear in the Middle East and other concerns abroad could cause a US dollar rally, we would also like to analyze the ongoing relationship between the US dollar and precious metals.

The Dollar Index vs. Precious Metals

Much has been made of precious metals’ relationship to the US dollar. In times past, the purchase of precious metals and commodities in general was thought of as a play on a weak dollar. Since commodities are traded in the US in dollar form, a cheaper dollar makes commodities look cheaper to foreign buyers, giving them support.

However, in recent times, the dollar as it is traditionally thought of has had little correlation to precious metals prices. A chart of gold and silver vs. the Australian Dollar and US dollar index (DXY) is posted below.

The reason the dollar index has had such a enigmatic relationship with precious metals is because it is no longer an accurate measure of the US dollar’s purchasing power

The purple line shows the US dollar index, the white line shows the Australian Dollar against the US dollar, the yellow line shows gold and the light blue line shows silver.

As can be seen, the dollar index has had both a positive and negative correlation to precious metals prices over the past year. During the period between June and November 2010, there was a strong negative correlation, but during all other times (especially the past month), gold and silver have actually been positively correlated with the US dollar index.

The reason the dollar index has had such a enigmatic relationship with precious metals is because it is no longer an accurate measure of the US dollar’s purchasing power. The US dollar index is comprised 58% against the Euro, 14% against the Yen, 12% against the Pound, and the rest against the Canadian dollar, Swedish Krona, and Swiss Franc. The same problem afflicting the US, debt, is hurting these other currencies as much or even worse than the US dollar. Therefore, we could easily be (probably will be) in an environment where the “dollar” as measured by the dollar index is strengthening, but the purchasing power of the dollar is weakening.

To illustrate the weakening status of the US dollar, we included the Australian dollar on our chart. As can be seen, the Australian Dollar tracks very closely to precious metals prices. As Australia’s economy is very strong and their government’s fiscal position is even stronger, Australia’s economy is the opposite of the major currency economies, in that it is growing, not heavily indebted, and has extremely low unemployment (5% as of 12/31/10). We expect the currencies of countries such as Australia, Canada, Sweden, and Brazil that are commodity-rich to continue to outperform the US dollar.

All Major Currency Economies Suffer from the Same Problems

The data regarding the dollar index’s ambiguous relationship to precious metals confirms our belief that all major economies are suffering from the same money-printing, lack of organic growth environment that the US does. The Eurozone is heavily indebted, but suffers from slack GDP growth. The only way the Eurozone will be able to survive is through bailouts and other inflationary policies by which Euros are created out of thin air, then used to pay back debts. The UK is in a terrible position, as their GDP growth actually went negative last quarter, which will most likely prompt policy makers to turn on the printing presses and attempt to inflate their way into at least nominal GDP growth (even if this is nothing more than pure inflation). Japan is the most heavily indebted country in the world, and their government has already been vocal in their adoption of currency debasement and quantitative easing in order to support their exports.

Simply put, all the major currency economies have no real engines of growth but need to pay back enormous debts and so they are engaging in competitive currency debasement in order to generate artificial demand for their exports.

What Does this Mean for Precious Metals and Commodities?

If you haven’t already guessed, we believe this is extremely bullish for commodities and precious metals in particular going forward. The worldwide debt issues combined with slow GDP growth is a problem that is not going away anytime soon. Until employment, housing, and other economic growth is felt in the street, the Fed and central banks around the developed world will have a free license to print money and undertake inflationary policies. If the economy does well, inflation will come. If the economy does not do well, governments will print money to the point where it looks good on a nominal basis, and then inflation will be even more rampant when it does come.

Either way you cut it, precious metals look good for the long-term.

ALL INFORMATION INCLUDED HEREIN IS THE OPINION OF THE FIRM AND SHOULD NOT BE CONSIDERED INVESTMENT ADVICE. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Posted January 24th, 2011

For the past year, natural gas has been caught in a tight range, trading between 3.2 and 5.25. With all the talk of rising commodity prices and the upward march in energy prices, natural gas prices have not recovered at all since the depths of the financial crisis. Shown below is a 5 year chart of natural gas prices.

While natural gas peaked out just under $14, it currently stands around $4.6 and remains mired in the tight trading range of the last year. With no apparent downside or upside breakouts in the price of natural gas it can be difficult to make money trading the commodity.

At Lakshmi Capital, natural gas has been one of our primary contributors to profit in our global macroeconomic portfolio. How have we achieved this? We successfully implemented an options strategy known as a short strangle.

In a short strangle, the options trader simultaneously sells an out of the money call option and an out of the money put option. To use the current situation in natural gas as an example, a trader would simultaneously sell a March 3.95 put option for $.021 and a March 5.25 call option for $.045. As long as natural gas expires between $3.95 and $5.25 on February 23, the trader keeps the $.066 (or $660) per contract. The trade is profitable as long as natural gas is between $3.884 and $5.316 on expiration.

The advantages of the trade are multi-faceted. Since natural gas is a volatile commodity, options on it are expensive. Since the options have a high implied volatility, selling options can be a profitable strategy. The range required for profitability on this trade is wide, and at least one side of the trade must be profitable. The downside of the trade is if natural gas breaks out beyond the range of the options. Given the $4 level as a psychologically important support level for natural gas, along with the fact that we are in the midst of a frigid winter for many parts of the country, a return to $4 natural gas in the next month seems highly unlikely. On the flip side, a sustained rally above the $5 level within the next 30 days would also seem improbable. If the trade were to break to the $3.95 put strike price or the $5.25 call strike price, the trader would need to sell or purchase, respectively, a futures contract in order to hedge. Finally, the amount of margin required to implement this trade is lower than would be implementing either side independently because of the fact that one side of the trade must win.

Trading Recommendation

Utilizing a short strangle strategy can help traders take advantage of the increased volatility in markets left over from the financial crisis, and can be particularly profitable given natural gas’ range-bound trading. Our recommendation is to leg into this trade by selling calls on days when natural gas rallies hard, and selling puts on days when natural gas falls.

ALL INFORMATION INCLUDED HEREIN IS THE OPINION OF THE FIRM AND SHOULD NOT BE CONSIDERED INVESTMENT ADVICE. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Posted November 24, 2011

The silver market has been extremely volatile as of late, and today’s action has proven no different.  After peaking at 27.95 overnight, silver hovered around unchanged before dropping precipitously for no reason, ending the day down almost 2%.

The large intraday price drop is certainly cause for concern among investors, but digging into the day’s volume action may be a bit more revealing.

Both silver futures and the SLV displayed average to light volume today.  The silver futures traded ~56.4k contracts compared to an average of 58.8k contracts over the last 45 days.  The SLV traded 21.99 million shares compared to an average of 27.25 million shares.

What this all means is that the conviction in the selloff of silver appears to be waning.  Even in the face of another big selloff in silver, with no reason in sight, silver traders did not panic and begin selling into the swoon.  Rather, it appears that most holders stood pat and did nothing.

Most traders like to see high volume behind either a downside or upside breakout in order to confirm its conviction.  Furthermore, they view decreasing volume behind a continuing trend as a sign that a reversal is imminent.  The tailing off of volume behind silver’s selloff is an interesting phenomenon that will have to be monitored.

For now, we recommend selling far out of the money put options on silver futures as a way to profit from the silver correction while still maintaining some margin of protection against a continued pullback.  The 25 puts for December futures can be sold for $2.4, meaning the trader will profit as long as silver is above $22.6 at the end of November.

We also like SLW, as it appears to have bottomed before silver.  Even with silver selling off almost 2% on the day, SLW traded up a fraction, indicating that selling pressure may have abated on the royalty trust.  As silver prices rise, SLW’s earnings will rise at an even faster pace given the fixed amount they pay for silver (roughly $4/ounce) and the variable price they collect.

ALL INFORMATION INCLUDED HEREIN IS THE OPINION OF THE FIRM AND SHOULD NOT BE CONSIDERED INVESTMENT ADVICE. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Posted January 24th, 2011

After the impressive run in precious metals last year that saw gold rise 29.6% and silver rise 83%, the question on many investors’ minds is whether there is still any run left in these commodities. Our client portfolios enjoyed a 67% return in 2010, largely due to the end of year rally in precious metals, but we also remain keen on the issue because of our continued exposure to the space.

Since the beginning of 2011, gold and silver have badly underperformed equities, which is a surprising trend given the high correlation between all 3 since August. The divergence in performance begs the question of whether investors are finally rotating assets out of precious metals (the alleged “fear trade”) and into stocks.

Why Do Gold and Silver Rally?

In our opinion, precious metals such as silver and gold do not serve as fear trades, but rather trade on forward inflation expectations. The following charts show gold and silver over the past 35 years versus the Consumer Price Index Year-over-Year % Growth (including food and energy).

Regardless of popular perceptions that people buy precious metals to protect against some type of cataclysm, it is shown clearly here that the primary catalyst in precious metals prices are inflationary expectations. From both charts, it can clearly be seen that gold and silver track very well to the CPI, with the notable exception of recent years that we will discuss later.

It can be seen that both metals peaked in 1980, at the height of inflation. The spike in inflation that peaked at the beginning of the 1980s saw the CPI Index peak at almost 15% year-on-year growth, a lofty inflation figure. This peak also marked the parabolic peak in the rally in gold and silver prices that began in 1976. For those 4 years, gold rose 508% and silver rose an incredible 775%. The rally in silver was largely caused by the Hunt Brothers manipulation of the metal, but the fact remains that both metals rallied incredibly in the face of quickening inflation. Also of note is that both metals quickly collapsed down to much lower levels as inflation waned quickly.

From an inflation fundamentals standpoint, it appears that inflation may have to top out before we see the end of the precious metals rally.

Applying this information to our present-day scenario yields a few observations. The steady ascent of both metals is not indicative of a bubble. While many consider gold and silver to be in a speculative bubble, both metals have quite a ways to go to achieve the same percentage gains witnessed 30 years ago. Also very interesting is that both metals have risen in a much more stable manner (i.e. gold at 18.3% annualized vs. 67.4% annualized) than in the late 1970s. Gold and silver would have to have a dramatic parabolic run-up, followed by an equally dramatic selloff in order to have been considered a speculative bubble, something that has not happened yet.

From an inflation fundamentals standpoint, it appears that inflation may have to top out before we see the end of the precious metals rally. Even though little actual inflation has yet to be witnessed in the CPI, precious metals have already seen a substantial rally. This is due to the expectation of a highly inflationary upcoming period.

Why Hasn’t Inflation been Reflected in CPI Growth Yet and Why Do Precious Metals Prices Already Reflect it?

While the money supply of the US has grown exponentially since the financial crisis, CPI growth has remained muted due to the low velocity of money. Simply put, the velocity of money is a measure of how fast money changes hands in an economy. If the money supply is high, but the velocity of money stays low, inflation will not happen. To make this theoretical argument more concrete, consider that most of the money the Fed “created” since the financial crisis has gone to banks balance sheets. The banks have not turned around and lent that money, because their lending standards and underwriting process are still extremely strict due to wound-licking left over from the credit crunch. Once the banks start lending money more freely, the effect of the hugely larger money supply will start to be felt in CPI growth. This coming CPI growth phenomenon is the event that precious metals are pricing in. There is no question as to if the velocity of money will increase, only when.

Global Rate Increases and Trichet’s Aversion Towards Inflation

While banks around the world from China to Australia to Brazil are raising interest rates to tame inflation, the major currency economies (US, UK, Euro, Japan) have no ability to do so and will not in the near future. The countries that have raised interest rates are the ones experiencing massive organic growth, huge capital inflows, and food price inflation problems. However, the major curerncy countries have no engines of growth, are experiencing capital outflows, and have no shot at anything but paltry GDP growth for the foreseeable future. In order to ensure their economies do not fall back into recession, these countries have engaged in competitive currency debasement (i.e. seeing who can print money the fastest) in order to make their exports look more attractive to emerging economies as well as each other. Printing money and creating excess liquidity also has the added bonus of inflating risk asset prices and making things look generally rosier through the glasses of inflation. As long as this situation persists, precious metals will continue to be an extremely worthwhile asset to own.

Portugal has the same level of debt as Australia, yet 25% of the GDP

Even though ECB President Jean-Claude Trichet spoke recently about his vigilance in raising interest rates in the Eurozone soon, this is nothing more than lip service. Both Greece and Ireland have already slipped back into negative year on year GDP growth, and many more countries risk following suit. How exactly can Trichet raise rates in a time when his economy is at risk of falling into an all out depression? The simple answer is he can’t, but not only can he not raise interest rates, he is going to have to undertake even more inflationary policies than he has already just to ensure the continuity of the Eurozone. It remains to be seen exactly which policies the ECB will undertake, but rest assured that no rate rises are coming out of Europe any time soon, and the Eurozone debt crisis is far from over. After all, Portugal has the same level of debt as Australia, yet 25% of the GDP.

This Week’s CFTC Commitment of Traders Report

This week’s COT report indicates that Managed Money net long positions fell yet again to their lowest level since November.

The gray line shows the price of silver and the green line shows Managed Money net long positions. As can be seen from the chart, silver has rallied each of the times the Managed Money longs has hit this level over the past 6 months.

The above chart shows the same data over the last 3 years. As can be seen, the Managed Money net long position has been volatile, but continues to make higher lows since the secular bull market in silver began in late 2008. It is our view that the Managed Money net long position will continue to rise over time, fueling a renewed rally in silver prices as fundamentals and price movement become more bullish.

Doug Kass Gold Price Prediction for 2011

It is our view that the Managed Money net long position will continue to rise over time, fueling a renewed rally in silver prices as fundamentals and price movement become more bullish.

Doug Kass of Seabreeze Partners recently predicted that gold prices would fall to $1050 in 2011. Doug Kass calling for a huge drop in gold prices is nothing new, as he called for silver prices to fall to $900 in 2010. Obviously, he was wrong then, and he will be proven wrong now. In fact, of his top 20 predictions for 2010, not a single one came true.

The fact that there are so many doubters out there like Doug Kass is highly bullish for precious metal prices, as it indicates there is still a large amount of skepticism left towards the metal, and plenty of new buyers on the sidelines. Once we see precious metals detractors like Mr. Kass become bullish on the metals, that may signal an exit point.

Trade Recommendation

We remain long silver and gold futures contracts, as well as miners through GDX and GDXJ. Additionally, we like SLW, as it provides excellent leverage to silver prices without execution risk, as it is a royalty trust. We recommend building a position in all of these securities and adding on pullbacks.

ALL INFORMATION INCLUDED HEREIN IS THE OPINION OF THE FIRM AND SHOULD NOT BE CONSIDERED INVESTMENT ADVICE. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Posted January 17, 2011

Falling outside our standard Global Macro and Income Portfolios, we have been intrigued by the growth of Neutral Tandem since their IPO in 2007, and more recently given the substantial retreat in their share price since summer 2009 and the acquisition of Tinet this past October.

Consider an AT&T phone customer who calls a Verizon customer. For the call to reach its destination, more than one network of a Competitive Local Exchange Carrier (CLEC) must be used. Any company other than AT&T whose network is used to connect the call should benefit from the usage.

This has led to the development of the wholesale business for CLECs. They have built tandem switches which allow for transferring calls from other networks to theirs. CLECs charge for access to their networks and for using the tandems. The problem with this model is that a company may not be interested in providing access to its network to major competitors. Neutral Tandem (TNDM) managed to find a solution. It started building tandem switches and charging for interconnection services, while not caring about competition over customer base. The company was experiencing amazing growth since going public in 2007 until mid-2009. Since then, growth pretty much stopped, and in a year the stock went from over $30 to $10.

Last October TNDM acquired Tinet, a global IP Transit and Ethernet services provider. We believe this acquisition will result in continuing rapid growth and expansion in the global market for TNDM.

Business Model – Exceptional Value Creation

Let us first review the incredible value creation in the tandem switching business, not yet taking into account the Tinet acquisition. Neutral Tandem’s original model provides two outright advantages over CLECs. First, TNDM can build a better tandem network. According to the company website, its network is more efficient than that of CLECs and is able to reach 518 million terminating customers in US. Furthermore, the tandem switches can connect any two networks, as long as their respective owners agree to the connection. For CLEC tandem switches, one of the networks connected to the switch must be that of the parent company, resulting in a much smaller interconnection market.

Secondly, this business model is more cost-effective. TNDM only needs to maintain and build its tandem network, which costs much less than laying thousands of miles of cable, which is what is being done by CLECs. In fact, Neutral Tandem benefits from the expansion of exchange carrier networks, while incurring only the costs of building extra tandem switches. As a result, the company does not need much fixed assets to generate revenue. The company’s depreciation expense has been around 9% of revenues for the past 5 quarters, much lower than 15% or more for its major competitors – AT&T, Verizon, Qwest, and Level 3 Communications.

This cost efficiency has resulted in extremely high operating margins in comparison to competition:

Because TNDM does not need to heavily invest in fixed assets, it does not have to take up significant long-term liabilities. The company had no long-term debt at the end of Q3 2010.

Because TNDM does not need to heavily invest in fixed assets, it does not have to take up significant long-term liabilities. The company had no long-term debt at the end of Q3 2010. In comparison, Qwest and Level 3 have serious issues with debt. Qwest’s interest expense for the last 5 quarters has been 9% of revenue, in comparison to under 3% for AT&T and Verizon. The company has been significantly cutting debt in the last 12 months, and its rating was upgraded by Moody’s to Ba1 from Ba2 last August. Qwest’s outlook is good (considering also the CenturyLink merger), so it should be able to effectively handle its debt in the near future. Level 3, on the other hand, is on the verge of bankruptcy. The company’s interest expense for the last 5 quarters has been 16% of revenue. Level 3 has $1.3B in bonds with 9.24% YTM maturing in 2014, while current assets were only $940MM at the end of Q3 2010.

Meltdown in 2010 – Stagnant Growth and Increased Competition

Since its IPO in November 2007 and until the end of July 2009, TNDM rose more than 50%. Much of this increase can be attributed to explosive growth of the company. Net Income increased 10% or more quarter-over-quarter from $1.8MM in Q4 2007 to $9.0MM in Q1 2009. The company was taking full advantage of its position in the niche market, and there did not seem to be anything slowing it down. At that point Tandem was viewed as a growth stock. Despite reporting a great Q2 2009 on August 6, 2009, the stock dropped 11% that day. One explanation for this is that revenue growth compared to the previous quarter was 7.8%, compared to a 9% or higher quarterly growth for the previous four quarters.

Since then, growth slowed down significantly, and TNDM went from an all-time high of $33.24 in the beginning of August 2009 to just under $15.5 at the end of January 2010. Around February 2010 many articles (including three at Seeking Alpha: here, here and here) were recommending to buy the stock, citing great value, excellent cash position, and no long-term liabilities. We agree that the value for the stock was (and is) great, however it is not as good as it sounds considering that the company was not paying dividends or growing. In its annual report for 2009, the company stated that they did not “anticipate paying any dividends on [their] common stock in the foreseeable future”.

We think that this strategy for Neutral Tandem was not effective, considering that its major public competitors AT&T, Verizon, and Qwest were paying large dividends with annual yields of over 5.5%. Having lots of cash is great, as long as it is used to expand or to provide shareholder value.

We think that this strategy for Neutral Tandem was not effective, considering that its major public competitors AT&T, Verizon, and Qwest were paying large dividends with annual yields of over 5.5%.

Furthermore, TNDM was facing increasing competition, in particular from Level 3, HyperCube, and PeerLess Network. PeerLess managed to win a big lawsuit against Tandem last September, which allowed them to more effectively compete in the tandem switching market. We believe that despite increasing competition, TNDM’s well-established position and experience, as well as the recent acquisition of Tinet, will lead to a return to growth, as we will discuss below.

Tinet Acquisition – Strong Growth From New Markets Ahead

In their 2009 annual report, TNDM mentioned that it was facing “indirect competition from carriers that directly connect their switches… The risk of direct connections will increase as more carriers move to an IP-based interface, because direct connecting between two IP-based carriers is less complex.” The shift towards IP interfaces and data transmission in US is apparent, as mobile data traffic surpassed voice traffic worldwide for the first time in December 2009 according to Ericsson. Furthermore, data traffic in US doubled in the first six months according to Chetan Sharma Consulting.

Neutral Tandem was originally a voice interconnection company, and despite their impressive growth in minutes, the average fee per billed minute is decreasing – down 15% in the latest quarter compared to the 2008 levels. The Tinet acquisition has established TNDM as an IP-network services company, focused on delivering connectivity not only for voice, but also for data and video. Furthermore, TNDM has now established itself as the largest Ethernet Exchange company in the world, operating in US, Europe, and Hong Kong.

Because of the expansion into new markets and cost-effective business model, we expect TNDM to again start experiencing rapid profit growth

Because of the expansion into new markets and cost-effective business model, we expect TNDM to again start experiencing rapid profit growth. The connectivity services provided by Tinet should also contribute to higher profits, considering the rapid growth of Ethernet services worldwide. Tinet is offering Ethernet connectivity at 10 gigabit per second, with its Ethernet Points of Presence having 40 gbps capcity. The 10 gbps market is expected to experience 42 percent compound annual growth through 2014, according to the Linley Group. We expect to see a trend in revenue growth provided by Tinet’s connectivity services similar to that of AboveNet, which also provides high speed bandwith solutions:

We believe that TNDM will be able to maintain its high operating margins, although they may slightly decrease since Ethernet services is a more capital-intensive business than tandem switching. Right after Tinet’s acquisition, Neutral Tandem paid off all $24.4 MM of their long-term debt, thus eliminating potential interest expenses. We do expect higher depreciation expenses because of the Ethernet network assets, however this should not be a problem considering the profitability of Ethernet services (AboveNet has posted operating margins of over 25% since 2009).

Trade Recommendation

The recent acquisition of Tinet has positioned Neutral Tandem for rapid growth in the near future. The company’s P/E is under 15, and forward P/E is 13, making it a relatively cheap buy. We recommend to buy the stock not just because it is undervalued, but because of its excellent growth potential. Due to its high-margin business model, we expect TNDM to keep generating great cash flows, allowing for further expansion in new markets.

Analysis contributed by Lakshmi Capital Analyst Alexander Remorov

ALL INFORMATION INCLUDED HEREIN IS THE OPINION OF THE FIRM AND SHOULD NOT BE CONSIDERED INVESTMENT ADVICE. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.