Rise of the Silver Surfer

I have a new sector, a new weapon in my arsenal, an area of the market that I’ve ignored for over 10 years due to the lack of quality pure-plays. I’ve been trading and investing in various gold ideas forever, but a lot has changed with the white metal, and now I’m happy to report that Daddy’s become a Silver Surfer.

Before I continue, I want to remind my readers that I don’t make trading recommendations, market calls or give any investment advice whatsoever on this site…I get paid to do that in the real world, not for free on the internet.  There is no simple, one-size-fits-all advice that makes sense for everyone who reads my stuff. So don’t trade based on anything I say on this site.

OK, that’s out of the way, now let’s talk about the silver sector, and why I think it’s an interesting idea to at least be familiar with.

It’s been said that Ben Bernanke and the Federal Reserve will stop printing dollars when they run out of trees. We still have deflation in autos and homes, but that’s because the Chinese don’t want our split-level ranch’s or Pontiac Sunfires. What they do want is the material to run their economic go-faster machine, and with the trashing of our dollar, hard asset prices have been headed higher this Spring.

As these factors coalesce, the classic inflation hedge that gold offers will be heavily in demand. Everyone knows that gold should work under an inflationary scenario as people switch out of dollars that are losing their purchasing power, but how many people are aware that silver has the potential to move even more than gold percentage-wise, and at a faster rate?

Silver is a precious metal just like gold, and has been used as a form of currency going back to the ancient Sumerians.  In addition to it’s use as a store of wealth or as jewelry, silver has something going for it that gold doesn’t…it has real applications in both industrial and technological products and processes.

Silver was always involved in traditional photography, but it’s also an important component in many newer, eco-friendly technologies.  Photovoltaic solar cells as well as hybrid and electric car batteries are two examples of this.  Silver is so important and irreplaceable to the manufacture of these items, it has recently picked up the nickname “the green metal“.

Let’s talk valuation.  An ounce of gold had historically traded at a ratio of around 15 to 1 versus an ounce of silver for many decades.  This was not a man-made ratio; there is, in fact, roughly 15 times the amount of silver as there is gold in the earth’s crust, so this ratio was more of a geological truism.  Gresham’s Law, however, brought this ratio into focus; Named for a Tudor-era English financier, the law held that as either gold or silver got ahead of itself in price, you could just buy the other one as a form of arbitrage, so this 15 to 1 thing was fairly solid.  That all changed between the 1960’s and 1980, a period of time during which silver was largely de-monetized.

The yellow metal is trading at around $950 an ounce as of this post and silver’s at slightly above $14.  The gap right now between gold and silver shouldn’t be anywhere close to that historical 15 to 1 spread, but should it really be at 70 to 1?  The smart money may be looking for a reversion to the mean with the gap this wide.  There could be a ton of ground for silver to cover while narrowing that gap, and that brings me to the exciting part…The Slingshot Effect!

At current gold prices on the spot market of around $950 an ounce, a more traditional ratio of 50 to 1 would look more like $20 plus for an ounce of silver, a gain of 40% in the commodity itself.  Now, picture the price of gold finally cracking above the $1000/ oz mark that it’s been flirting with for a year…and staying up there!  The torrent of buying that could come in would probably be ferocious enough to wrench the price of silver higher at a much faster rate than gold, as silver is a much smaller market.

It’s been posited that the silver market is so tight and unaccustomed to speculators (compared to the gold market), that if someone calls for physical delivery of the metal (which a contract enables them to do) the entire mechanism could break down, triggering an explosion in prices due to the physical scarcity.

Picture the stored potential energy of one end of a rubber band being held back (representing silver prices) as the other end of the rubber band is being pulled forward (gold prices).  The further you stretch the “gold” end of that rubber band, the more the potential snap you’re going to get when you finally release the silver end.  That’s what we could be looking at with a 70 to 1 gold to silver ratio and a tight market with few ways to get exposure.  That’s the Slingshot Effect.

Gold is within spitting distance of it’s 2008 peak price as well as it’s all-time high price.  Silver, on the other hand, has been cut in half from it’s 2008 high.  As far as the all-time high for silver?  We’re talking $50 back in 1980, not adjusted for inflation.

I alluded to the fact that silver is a smaller market than gold and that there aren’t many ways to play it.  There are a few, however, but I’m going to speak very generally here so that my words are not construed as an endorsement of any of these vehicles.

You’ve got 4 decent-sized publicly-traded silver miners of varying degrees of corporate quality.  Coeur D’Alene Mines (CDE) is an Idaho-based concern with a $1 stock price and plenty of debt…I’m not even looking at it.  There is also Pan American Silver (PAAS) and  Silver Standard Resources (SSRI) and these appear to be better-run companies.  The fourth is the one I’ve done the most work on, it’s called Silver Wheaton (SLW) and it has a very interesting business model…it’s a miner without a mine!

70% of all the silver that is produced in this world comes out of a mine as a byproduct of gold or copper mining.  The largest mining operations in the world, Goldcorp (GG) for example, end up with a large supply of silver while mining for other metals and they don’t necessarily want to deal with selling it.  Instead, they contract with Silver Wheaton Corp, to take it off their hands at a predetermined price.  SLW’s all-in cost across their portfolio to buy the silver from these miners is said to be between $3 and $6 per ounce, so whatever they can sell it for above that price on the spot market is theoretically a profit (they do not hedge).

They don’t have cap-ex or physical mines, no labor disputes, geopolitical issues or technical problems…again, they are the miner that doesn’t have the hassle of owning a mine, pretty cool.

Jim Simons of the $30 billion hedge fund Renaissance Technologies has bought almost 4 million shares of SLW as of his latest filing.  Another large buyer of the company’s stock is Canadian fund manager and commodities expert Sprott Asset Management, they’ve recently made SLW shares their largest holding.  The market cap is about $2.5 billion, making it the largest of the pure-play silver miners.

The point of investing in metals miners is to get a leveraged play on the commodity itself, but many market participants these days have more of an interest in owning the commodity itself.  There are two different ETFs that are silver only, but discussing them here (or even mentioning their names) would trigger a tornado of disclosures and disclaimers that I don’t feel like dealing with.  You know how to find them if you want to.

To sum up my new-found interest in the silver story, I believe that the longer we keep nominal interest rates at zero, the higher potential there is for inflation.  I also do not believe that Bernanke will have the independence or the guts to begin raising rates when it’s time to (at least not quickly enough).  The unemployment rate will make it politically unpleasant to do so, and Bernanke’s no Paul Volcker.

If our dollar is going to be a global rag doll, the demand for precious metals should balloon, and I think silver has more room than gold for appreciation if I’m right.  I also like the metal’s involvement with electric car batteries and solar cell technology.  The price is pretty inelastic for what silver does in these things as it cannot be substituted with anything else.

If you are interested in the ideas I’ve discussed in this piece, I urge you to do your own homework.  There is still a lot that I wish to learn about this metal and the way it trades, so if I missed any important points, please feel free to give me a shout.

Full Disclosure: I currently manage both client and personal accounts that are invested in or trading securities related to both gold and silver.  My commentary here should not be considered as research, nor should it be viewed as an invitation to buy or sell any securities.  I have enough to worry about, so please don’t make any investments based on anything you read on any blog, especially this one.  See my Terms & Conditions page for a full disclaimer.