by Jason Pearce
We’ve blogged about the platinum/gold spread several times this year. The spread inverted back in January (when platinum dropped below gold) and has been there ever since, so we have been pursuing it as both a trade and investment opportunity.
In broad strokes, platinum and gold prices are highly-correlated. While gold is a precious metal and platinum functions as both an industrial metal and a precious metal, the macro trends over the last four decades show that the two markets move in lock-step. When one of these metals gets too far ahead of or behind the other, a spread trade opportunity materializes. This is what happened in 2015.
Since platinum is fifteen times more rare than gold, it normally trades at a price premium over the yellow metal. Once in a while, extreme events will cause the platinum to drop below the price of gold. These have always proven to be temporary events. When the fundamental relationship is restored, platinum reclaims its rightful place and trades at a premium to gold.
In our opinion, any instance where platinum is trading at a discount to gold should be viewed as an opportunity on the long side. To take advantage of it, spread traders would establish a long position in platinum and a short position in gold.
Now, it is important to note that this spread is not a directional bet on the metals. We are not swearing allegiance to the gold bugs camp. Rather, it is a wager on the relationship between two markets. Due to the mean-reverting nature of commodities, we believe that the odds of getting this relative value bet right are much greater than trying to nail the overall trend in precious metals. It’s just smart to play the game where the odds in your favor are the highest.
Two weeks ago, the nearest-futures platinum/gold spread closed at -$229.80 (premium gold). This set a new record low. At the same time, the nearest-futures platinum/gold ratio closed at a thirty-year low of 0.8:1. This is the second-lowest ratio in forty-five years of price history. By both measurements, the relationship between platinum and gold is extreme and has reached unsustainable levels.
In addition, the platinum/gold spread has been inverted for nine consecutive months now. This is the fourth-longest stretch of time since 1970 that platinum has remained below the gold. If the inversion lasts until Thanksgiving, it will advance in rank to the third-longest consecutive inversion.
However, be mindful of the fact that the second-longest and the longest inversions ran for fourteen months (from late June 1984 through late August 1985) and nineteen months (from mid-September 1981 through April 1983), respectively. There’s no rule that says the spread absolutely must turn right around because of the inversion. But it provides a valuable reference point to set expectations and help us calculate the odds a little bit better.
The bottom line is that, when we take into account the depth of the platinum/gold inversion (both the spread and the ratio) and the current duration of the inversion (the fourth-longest in nearly half a century of price data), the platinum/gold spread should be setup for a high-probability trade from the long side.
How’d It Get Here?
Platinum and gold have both endured bear markets over the last four years. But after posting a record low of nearly -$200/oz. (premium gold) in 2012, the platinum/gold spread staged a major rally into the middle of 2014 as it rallied $442/oz. (over $44k on a single futures spread!) off the low. While the two metals only rallied for a few months before rolling over again, the spread continued higher for nearly two years as platinum outperformed on a relative basis. That’s a great example of how you can be wrong on the overall direction of the metals and still make a profit by focusing on the spread.
Since the middle of 2014, however, the platinum/gold spread has been spiraling lower with all of the precious and industrial metals. What happened?
Fundamental factors on different continents have caused the metal meltdown. First, there’s China. They have been experiencing the slowest economic growth in decades. China accounts for nearly one-quarter of the world’s demand in platinum, so a slowing economy means less demand for raw materials like metals. Also, the Chinese stock market made a parabolic move into the first half of this year and then crashed. If nothing else, it’s a psychological hit that could dampen growth expectations.
Second, there’s South African production. This country is the world’s largest platinum supplier, accounting for nearly three-quarters of the supply. After workers spent nearly half of 2014 on strike, the issues were resolved and production came back up this year…right at the same time that global demand was slowing. That’s obviously a recipe for lower prices.
Third, the recent Volkswagen emissions scandal tarnished the platinum market. Platinum is used in auto catalysts for diesel engines. Nearly one-third of the world’s supply is used for this purpose. VW’s admission to using test-evading software on diesel cars dealt a serious blow to the diesel car market and, therefore, hammered the platinum market as well.
Finally, the monetary policy here on the home front has also been a contributing factor to lower metals. Expectations that ZIRP is coming to an end as an inevitable rate hike is coming from the Federal Reserve has beat the metals like a rented mule. Market analysts currently only seem to debate the question of “when” and not “if” that’s going to happen.
Light at the End of the Tunnel
There’s a saying on Wall Street that people are the most bearish at the bottom of the market. In regard to the platinum/gold spread, it’s hard to imagine that the news could get even worse. So is this the bottom?
Unfortunately, nobody can tell the future. What we can do, however, is study the past to determine a variety of scenarios for the future and potentially assign probabilities to their occurrence.
The first scenario is that nothing in the current bearish trajectory changes. Things would stay the same or even get worse. China continues to crumble economically, platinum production continues to increase while inventories build, and the Fed hikes interest rates for the first time since the summer of ‘06. That might keep a lid on the platinum/gold spread.
The second scenario is that something actually improves for the metals. This seems more likely since an extremely bearish environment eventually forces a fundamental change somewhere and creates the launching pad for a new bull market. For example, what if platinum miners start to slow production because of dropping profit margins? Although this does not address the demand side of the equation, slowing and/or shrinking supply can certainly be supportive for prices. Or what if the VW scandal is already factored in? This could prove to have been the catalyst for a final capitulation low in the platinum market. If the Fed raises rates 25-basis points could there be a shift in market psychology as investors realize that this is still an historic low level for interest rates? If so, it could allow precious metals to extend their recent rebound.
A third scenario is that a black swan event occurs and causes a major disruption in platinum, gold, or both. Maybe another big mine worker strike in South Africa? How about a military strike that causes gold to surge on safe-haven buying? Or a central bank making a drastic change in the size of their gold reserves? Could we see yet another scandal in the automotive industry? It’s actually impossible to say what the black swan catalyst would be. By definition, a black swan event is one that was not anticipated. The point is that anything could happen (bullish or bearish), so traders and investors better have a plan in place to know how to deal with the market’s reaction when the you-know-what hits the fan.
For spread traders, we still advocate taking a long position once the platinum/gold spread makes a two-day close above the declining 75-day Moving Average. This hasn’t happened since the first week of August 2014. Prior bounces this year petered out near the 75-day MA, so a sustained close above it could indicate that the trend has finally turned bullish. This is a classic trend following trade.
For investors, the IMC blog initiated a long position when the platinum/gold spread dropped to -$200.00 (premium gold). The investment is backed with $113k, which was approximately the value of the gold in the spread. This provides any cushion that could possibly be needed to ride out any drawdowns and avoid getting on margin call. We mined several decades of price statistics on this spread, bought near record lows at historically unsustainable levels, and established a long-term position (initially unleveraged) without stops. This is a classic value investment using futures contracts as the instrument of choice.
Stock and ETF Traders
Although the blog focuses on the futures markets, traders and investors can utilize the ETF markets to do the platinum/gold spread as well. Using the gold ETF (GLD) and the platinum ETF (PPLT), a spread position can be created by shorting GLD and purchasing an equal amount of shares of PPLT. Another option is to short GLD and purchase an equal value of PPLT. This would give you more shares of PPLT (since its cheaper than GLD) and weight your position in favor of the platinum side of the spread.
As you can see, the PPLT/GLD spread clipped just below the 2012 prior record low a couple of weeks ago and quickly turned around. This Wash & Rinse signal (a failed bearish breakout) on the weekly chart is indicative of a trend change.
It is also very important to note that the charts of the platinum/gold spread in the futures market and the PPLT/GLD spread are identical. Some commodity ETFs have failed at being an accurate proxy for the underlying commodities for various reasons, so it is imperative that you know it before trying to replicate a futures market spread with ETFs. The gold and platinum ETFs pass this test with flying colors.
Using the Spread for Building Bullion Reserves
Another way that knowledge of the platinum/gold spread can be of great value is by using it as timing tool for physical bullion holdings. It can alert investors to times when they should trade their gold in for platinum. Done correctly, this bullion switching can allow an investor to increase their physical holdings for ‘free’ by swapping what is dear for what is cheap. It requires patience, but it is well worth it.
To show how this quantity play works, first recall that the nearest-futures platinum/gold ratio recently plunged to 0.8:1. Stated another way, gold hit a 25% premium over platinum. As the long-term price history shows, platinum normally has the premium over gold. Therefore, we know that gold is currently dear and platinum is cheap. At this level an investor could trade 100 ounces of his gold bullion for 125 ounces of platinum. This will immediately increase the amount of physical bullion he owns by 25%.
The Switch Back
Once the platinum/gold spread goes back to normal and platinum is trading at the premium, the platinum bullion can be traded back in for gold. Because of the premium on platinum, the 125 ounces of platinum will now fetch more than 125 ounces of gold. Just how much more is dependent on where the platinum/gold ratio is at.
A minimum expectation based on history is for platinum to have at least a 15% premium over gold. At that level, the 125 ounces of platinum could purchase nearly 144 ounces of gold. If so, the original size of gold holdings will have increased nearly 44% by simply swapping out at the right times.
Now every few years, the platinum premium balloons to 40% or more. Can you imagine switching your 125 ounces of platinum in for gold with a 40% premium on platinum? This would buy you 175 ounces of gold. If so, the original size of gold holdings will have increased 75% by simply swapping out at the right times. Platinum has not had a 40% premium over gold since the spring of 2010, so it’s probably due within the next couple of years. When you own physical bullion instead of futures contracts that have to be rolled, it’s easier to wait patiently for it to happen.
A bullion investor can also consider scaling out on the way up. For instance, a portion of the platinum can be traded for gold when the premium hits 15%, another portion can be traded in when the premium hits 20%, etc. That way, you are not concerned with trying to nail the very top.
Furthermore, if the investor is on some sort of time schedule that calls for buying more gold bullion periodically, he could have a standing rule to buy platinum in lieu of gold as long as platinum is trading at a discount. This buys more ounces of platinum than gold for the same amount of money. Once again, the platinum would then be swapped out for gold once the inversion is eliminated.
This bullion swapping idea is a bit simplified. It does not include transaction fees, taking a hit on the bid/offer (some dealers mark prices up 20% or more!), etc. However, the theory behind it is that knowledge of the historical boundaries of the platinum/gold ratio can provide investors with high-probability levels to watch for. If it’s timed right, swapping back and forth from platinum to gold can allow an investor to increase their physical bullion inventories without laying out more cash. Now, who doesn’t want free gold?!
Whether you are a trader or an investor, a leveraged gunslinger or a conservative capital allocator, whether you trade futures and ETFs or buy the physical bullion, one thing is clear: the platinum/gold spread is inverted and is currently priced at historic levels. This presents us with a rare opportunity.
You should be monitoring the situation closely. Time this right and the profit potential is both significant and highly probable. Start working on your plan (entry signals, exit signals, position size, algorithm for adding/decreasing the position, etc.) now so that you can take full advantage of it. Best of luck!