From the May 01, 2008 issue of Futures Magazine • Subscribe!

Silver shining brightly

Without a doubt, most investors, if they could, would only employ investment strategies that maximize their profit opportunities, minimize their risk and take little time or effort. Call it human nature. Call it wishful thinking. Call it pure fantasy. We’ve all at least hoped for such a dream investment.

The truth of the matter, however, is that such dream investments do exist — with hindsight. If you had, for example, bought into the Japanese markets in the early 1980s, rode through the ups and downs and cashed out in 1990, you could have retired on the spot. The same goes for the U.S. tech boom during the 1990s. The gains in that decade could have been truly spectacular.

Alas, we can’t trade on hindsight, but we can learn from it. Perhaps lessons learned during these two recent massive bull markets can guide us as we assess a current bull move, the one occurring in the metals markets. We will apply some of that perspective to the silver market, discuss some of the major fundamentals that drive silver, and examine some techniques for guiding your entries into the market.

MONEY METALS

Gold and silver have been recognized as stores of value for thousands of years. Gold has certainly done its job, preserving wealth for those who have invested in the yellow metal. But despite its exceptional performance of late, gold hasn’t always offered the best returns. In 2004, silver outperformed gold. While the price of gold increased approximately 6% from the last day of 2003 until the last day of 2004, the price of silver increased more than 15% during the same period. Silver also outperformed gold in 2005 and 2006; however, gold returned to the lead in 2007.

Going forward, there are several reasons silver likely will continue its position of strength. One of the most bullish factors is simply that demand outstripped supply for 16 straight years. That means that from 1990 through 2005, the world used more silver each year than what mines took out of the ground. Because of that, the above-ground stockpile of roughly two billion ounces of fine silver has fallen to around 500 million ounces or less. While we’ve returned to a net gain in silver production in the last few years, silver investors also have flipped from net sellers to net buyers, easily taking the excess production back out of the market.

Silver also has a considerable industrial use. Indeed, few realize that there actually is less silver bullion available for investment than gold, which continues to move higher despite not experiencing the same demand/supply imbalance that persisted in silver (see “Which is more precious?”). For both silver and gold, we are not talking about jewelry or art forms of the metals. However, if silver coinage were added to the silver bullion, the total would still be approximately one billion ounces, which is less than one-third of the gold supply, if gold coins are added to the mix as well.

The silver market is not only much smaller than the gold market physically, but it is also smaller monetarily. The total amount of silver, in price terms, might equal $18 billion (factoring in bullion and coins), whereas gold bullion and coins would be worth well over $1 trillion. This fact plays out in the price action of the two metals, making silver far more volatile than gold. However, as the precious metals markets continue to gather strength throughout this decade, just a small increase in new silver purchases could have a far greater impact on silver prices than the same amount of money invested in gold.

Although no one can predict when it will happen, the infrastructure of the silver market itself suggests that once the physical supply is so small that commercial users sense a coming shortage, silver will show price strength that few believe possible today. At that point, silver users in the defense, medical, automobile and electronics industries will all compete for limited stocks, while investors and traders are chasing the profit potential.

PRICE-INELASTIC

The largest use of silver comes from industrial demand, jewelry/silverware and photography, in that order (see “Uses for silver,” below). Industrial demand for silver makes up 51% of total demand, and this area is also the fastest growing area of silver demand. The industrial portion of the market is growing at about 2% per year. It is important to understand that in almost all instances, the amount of silver used in a cell phone, laptop computer or microwave oven is so small that it cannot be recovered. For all practical purposes, the silver used in these applications is lost and unrecoverable.

Economists describe the industrial demand for silver as price-inelastic. Price inelasticity means that demand for the product does not move much relative to changes in price. One reason might be that because a small amount of silver is used in each application it’s an insignificant factor in the price of the product.

The amount of silver used in the manufacture of a battery, an automobile, a computer or cell phone is insignificant when compared to the price of labor and other materials. A doubling in the price of silver would not affect, for example, Honda’s cost in making an automobile. Because the price of silver has such a small relationship to the cost of the finished product, companies have had little incentive to seek out a reliable substitute.

THE DIGITAL EFFECT

A lot of analysts like to point to the photography industry as a major driver of silver prices, but the color photography market uses no silver, because all silver on the film is brought back out into solution when the color print is made, allowing it to be recycled.

The industry jargon for the silver from photo recycling is, as you might imagine, “scrap.” Certainly, there is little in the way of people sending in their used silver items to be smelted down. (Yes, some of this does take place, but it is insignificant.) Almost the entire scrap silver market comes from film recycling.

So, does digital photography, which eliminates the need for film processing, impact the silver market? Yes, in the areas of graphic arts and radiography, it does impact the market slightly. However, although some can’t seem to accept it, photography always has been such a small factor that there really is no noticeable impact.

In terms of future growth, there are more patents issued for silver on an annual basis than for all other metals combined. Reasons are numerous. Silver reflects light better than any other element. It also is an excellent conductor of electricity. In fact, it’s the only element for which this attribute doesn’t change with oxidation. Plasma screen TVs use silver. All of these attributes add up to make silver one of the best non-stock “technology stocks” you can buy.

TRADING TECHNIQUES

It is best to develop a strategy based on our overriding assumption that silver is in the midst of a long-term bull market. Our goal here is to capture intermediate-term pullbacks in this extended up move in the context of the current silver fundamentals.

A solid base is to study the Commitments of Traders Reports (COT), looking specifically for spike high and lows. The COT reports are issued by the Commodity Futures Trading Commission (CFTC) and tell us the positions of commercial entities and extremely large traders. You can find them on the CFTC Web site at www.cftc.gov. Silver, more than most commodities, exhibits a behavior of going parabolic for approximately three trading days before the intermediate top is reached. If the parabolic move coincides with a COT report that shows large short open interest for commercials, a favorable entry point may follow (see “Spiked!”).

There are two significant drawbacks to this method. First, the number of trades per year is few, so extreme patience is required. Second, after you’ve spotted the downturn, you now need more patience to wait for the bottom to completely form. Often, but not always, a spike bottom is a good indication that the market is safe to be re-entered on the long side.

DOLLAR’S ROLE

Investors are concerned with profits, but also security. This often extends to preparing yourself for retirement, but there’s something even more basic than investing for the future. There’s the core issue of money itself. Consider this statement by Robert H. Hemphill, credit manager of the Federal Reserve Bank, Atlanta, Ga.:

“We are completely dependent on the commercial banks. Someone has to borrow every dollar we have in circulation, cash or credit. If the banks create ample synthetic money, we are prosperous; if not, we starve. We are absolutely without a permanent money system. When one gets a complete grasp of the picture, the tragic absurdity of our hopeless position is almost incredible, but there it is. It is the most important subject intelligent persons can investigate and reflect upon. It is so important that our present civilization may collapse unless it becomes widely understood and the defects remedied soon.”

Although this statement seems harsh, it is accurate. The main problem with modern money is that it does not constitute a store of value. Since the founding of the Federal Reserve System, today’s dollar is equal to less than four cents were worth back then. The only two assets that are fundamentally money, and do not rely on credit, are silver and gold.

Many financial authors explain that silver is simply a commodity and, as such, lacks monetary or investment demand. This belies that the word for “silver” and the word for “money” are identical in languages used in 51 countries. Just because Americans or Canadians do not think silver is money does not mean the rest of the world thinks the same way.

Time has shown that, eventually, all fiat currencies eventually reach the dustbin. Throughout monetary history, people have sought alternatives to currencies to protect their savings. This action takes place as increasingly more people wake up to the reality of a credit-based monetary system. When enough people wake up, silver will no longer be a sleeping opportunity, but one of the brightest and smartest investments one can own.

David Morgan is a silver trader and analyst. His books include: “Get the Skinny on Silver Investing” and “Ten Rules of Silver Investing.” He also publishes “The Morgan Report” newsletter. You can reach him via his Web site at www.silver-investor.com.

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