Apr 25, 2009

Silver Lining: Why silver will explode and how best to play it

First of All, Why Silver? Those who aren't gold/silver/oil bugs like myself may find this helpful. Along with gold, silver is also a worldwide currency, though not officially recognized by the government. I think gold has made a rally for the wrong reasons thus far, though I expect this to change in the coming months. People have been fleeing to gold as a safe haven investment rather than the fundamental reason that will drive it to, in my opinion 3k+ USD  over the coming years. It will be driven to these heights (however ridiculous it sounds today, trading around 880). Gold and Silver are and have been a store of value for over 5000 years, which will not change in our lifetimes.  Safe haven buying for gold has created a great opportunity in silver, which historically (35 years, post bretton woods when gold was fixed to the dollar)  has been 55:1. It is currently trading substancially above this ratio (70:1- 72:1) over the past few weeks. Ok, this is of minimial importance but worth mentioning nonetheless. 

 The two faces of silver:(Monetary Value) In the case of hyperinflation, (Zimbabwe, 20th century latin american hyperinflations, 1921 germany, Post revolutionary france, etc), are great examples illustrating gold and silver are real currencies. In those cases silver is much more practical to purchase basic consumer goods to survive i.e bread, water, etc. In other words a silver coin is a more practical medium of exchange as opposed to half grams or less of gold in these situations. It is therefore thought of inflationary hedge in high inflationary environments as well(the late 70's and early 80's). This reasononing has been commonly discussed on these blogs, but the other side of the coin is what influences me the most. 

Investment demand for gold has been quite high for some time now, but the industiral use (jewelry, etc) has fallen off the cliff. Though mining production has only slightly recovered from the decade long decline of the net surplus of gold throughout the world, scrap gold has hit a record high. At first glance the previous sentenes may seem like i'm a but bearish on gold at the moment. But it is the exact opposite, I'm very bullish on gold, but prefer silver at the moment. Yes the industrial demand demand for silver has slowed significantly becuase of the worldwide slowdown(which I think will come to an end over the next two or three quarters: ex- U.S and Britain). Thus the supply of silver has significantly declined as it usually mined as a bi-product of base metals. The supply of gold has not declined nearly to the degree of silver as the investment demand more than negated the industrial. China, Brazil, Russia, India and all the emerging countries, will have a high demand for silver for industrial purposes while the inflationary countries U.S, Britain and parts of europe will flee to it for a store of value / protection against the destructive properties inflation has one peoples wealth. In Short, The industrial demand, Investment demand coupled with the fact the supply of silver has been declining and continues to do so up to this day. These dynamics are the perfect storm for an unprecedented silver bull market in the near future. I believe the Supply-demand disconnect with cause the G:S ration to drop below the historical average for at least a few months.  

Strategies: * This is not a reccomendation: It is my opinion concerning the best strategies to institute given the fact you know all the risks involved. 

1) My personal favorite are silver future contracts for obvious reason. I believe the downside is very small while the upside is a risk/reward is the best in the commoditty market (Oil being the one possible exception). It is always prudent to use future optoins to hedge the downside risk and a possibility of a margin call. My future portfolio has a full position on at the current time, with 75% being hedged. Should it drop below 12, I plan to add mini futures incrementally. This is my reccomendation for those who want to be involved in futures yet feel the risk is to high. For silver a mini future is 1/5 of a whole future, more specifically it controls 1k oz as opposed to 5k oz. The downside risk is substancially lower as you would lose 1,000 for every point below your purchase price at expiration. A quick example would be if you bought a dec mini silver contract at $13.20, then supposing at expiration it drops to 11.20 (which I think is highly unlikely), a 2000 loss would be incurred. To be conservative you could purchase a mini silver dec 2010 for 13.75 - 14, giving you a larger margin of safety. Again, this is my own opinion and there is the potential to incur substancial losses.

 2) I believe investing in silver producing or silver royalty equities as having the best risk/reward for investors who don't care to be involved with the futures market, and the second best who do. My only two holdings, i believe are the only silver equities worth owning. Silver Wheaton is the top equity holding in my portfolio. For more information on this Gem which i frist bought at 3.27/share in nov, and continue to buy as good-news after good news keeps coming out of this company. TMFsinchiruna has a great article about this as well. A more up-to-date, news wise can be found here. I will try to add my valuation model in excel but it is well worth a look. 

3) Physical Silver- It is always good to own physical metals as a diversified investment portfolio should. They are rather easy to obstain a few % above spot at bulliondirect.com and Goldeneaglecoins.com. The former is has the best prices for most coins and bullion, while the latter is a very good site for such things as morgan silver dollars, as well as proofs and uncirculated coins. It also has a vast array of common(semi-rare) to very rare gold and silver coins. Rare coins have the advantage of going up a multiple(the degree depends on the multiple given) of the physical metal itself. I think it is also wise to invest a small amount in semi-rare coins. I saw first hand the multiples applied as gold and silver hit their high in 08.

 4) TMFsinchiruna also mentions what i think is the only precious metals etfs worth buying CEF. It is worth reading and a full audit is done on their holdings as opposed to GLD which who is audited (but a real audit however). The same goes for slv, therefore i think that is the worst way to invest in them. 

5) finally i fund some equity purchases by selling at the money put options (jan 2011), which negates the inherent volatility, as i believe PM prices will be substancially higher when the time comes. You can also buy them back whenver these metals rise in the meantime (many times at 10% of what your wrote the contract for).

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