Silver Fundamentals or Funny Mentals?
by David Morgan
October 2, 2002
financialsense.com
Football season has officially started and one word that is often uttered is fundamentals. Most people accept the idea that to exceed in a sport or academic discipline, the fundamentals must be learned, understood, and practiced. In fact not too long ago, many school districts were challenged to get back to basics with the elementary-aged children and teach the fundamentals. It seemed that new math and “self esteem” lessons were turning out too many candidates for Wall Street. True?
As important as fundamentals are to business or commodity analysis, there are those that oppose any fundamental analysis and prefer to rely totally on technical analysis. In fact one very well known commodity trader refers to any type of fundamental analysis simply as “Funny Mentals”, meaning that all any good trader needs is a firm understanding of technical analysis and that alone will provide the necessary information to trade successfully.
For the record, there is merit in technical analysis and it is used in my work. However, fundamental analysis can be very challenging, especially if the chart patterns do not support the fundamental case. This of course is one of the many problems faced by those of us that are so bullish in the silver camp.
Ted Butler did a great job in an article a few years back. He had people look at a long-term chart of silver (20 years) and then asked them to think through what the chart would represent on a supply and demand basis. Since the chart for silver had been near five dollars for a very long time, most would conclude that the commodity is in balance. In other words, enough is produced by miners at a sufficient profit to meet all demand and the market reflects that fact. The chart was simply a reflection of a market very close to perfect equilibrium.
The Longer The Base, The Bigger The Move
This is what Ted had to say about the chart pattern: One of the most bullish chart patterns for a stock or commodity is known as a basing pattern or flat base breakout. On this chart, the price movement crawls along in a straight line for months or years. It is said to be building a base. Then it breaks out to the upside. Investment lore says "the longer the base, the bigger the move." The chart for silver shows a flat base for the past twelve years with only a small interruption or two. Some of the most powerful price moves have come off a flat base. Silver has built such a base and its price can catapult upward in a price breakout at any time.
However, this is not the foundational argument of the bulls. In fact I have written several articles highlighting the basic fact that more silver has been consumed for 12 continuous years than has been produced. This is the essential principle that must be fundamentally grasped by investors. The market is not in equilibrium, primary silver miners have closed down, others have huge debt problems, and some are waiting in the wings to produce but not at today’s uneconomic prices.
In some of my early study of commodities, I found what I had thought to be a rather strong fundamental approach to trading. The basic premise was to not even begin to go long in any commodity unless the price was under the cost of production. A trader would then start to position in the given trade and scale down as the commodity dropped further. The plan was to have sufficient margin for the given trade to reach an extreme undervalued level and still have sufficient margin. The fundamental idea was simply that no commodity could stay below the cost of production forever. Although sound in principle, this method proved to wear on people’s patience. Some commodities stayed priced below the production cost far longer than one might expect.
Recently the commodity markets have shown strength. When Jim Puplava and I began to exchange ideas, one of my primary points was that a huge shift would take place from paper assets to real assets. Commodities would be the next big thing and most stock type investments would erode over time. This cycle of different asset classes is not any new idea or anything invented by me, it has been well researched by others and much has been written about this type of analysis.
What drew me to the metals was the fact that they are the only commodity class that can be stored for long periods of time without much worry. Certainly you could store wheat, corn or cotton, but there are greater risks of the commodity being ruined or in poorer condition than when received. I chuckle when the vast majority of people talk about how bulky silver is, knowing full well how much storage space would be required for just one contract of lumber, beans, or coffee. The metals offer the advantage that they can be stored for long periods of time and they are high unit value per ounce.
With this certainty of the promise in commodities in the future, I began focusing on the metals as offering several advantages to an investor with a medium to long term horizon. The next factor to examine was which of the metals were the most essential. All the metals are important, and the platinum group metals have had more and more uses discovered over the last two decades. The huge press that cold fusion received, for example, brought the word, palladium, into the average person’s vocabulary. Upon careful examination, there just is no question that silver was the most essential metal of all for a high tech world. Several articles have been written about silver’s uses. More uses have been discovered and patented for silver than for gold, copper, palladium, nickel, tin, zinc, lead, and platinum combined. The most essential metal is silver, period.
Silver Fundamentally Undervalued to Gold
What is of particular interest to investors is the simple fact of how undervalued silver really is relative to anything else. As most who have read my work know, I focus a great deal upon real money vs. fictional money. In an earlier article it was mentioned that the Federal Reserve itself has indicated that the 1913 dollar is now worth 5 cents. To get a current “dollar” back to the 1913 equivalent we would have to use twenty of them. Expressed another way, (.05 x 20 = 1.00). This gave me an idea. Let us investigate how well gold and silver have kept up. In 1913 a twenty dollar gold piece was the coin of the realm. Taking our twenty times factor we see $20 x 20 = 400, so if we trust the FED gold would be worth $400. This is approximately true because a twenty dollar gold piece is not exactly a troy ounce, however the idea is sound. But now let us have a look at silver at $1.29 per ounce (1913 official price) x 20 = $25.80. Interesting gold today is near $320 and silver is around $4.50. We can see from this example that gold would have to increase by 25% to reach this theoretical price, but silver would have to increase by 550%. Something to think about?
Silver Fundamental to War
One item of paramount importance to nearly everyone is war. According to data in the early 1980’s, the U.S. military used more than 5,000 items containing silver, ranging from a naval torpedo using 4,161 ounces of silver to the smallest relays using less than 23 grams. The Defense Department has acknowledged that there are over 150 different kinds of bearings containing silver. The Defense Department also states that over 100 different kinds of batteries containing anywhere from a few grams to over 1000 ounces of silver are used in military applications.
A good amount of silver is used in jets, ships, submarines, and rockets. Silver is used to provide bonding of titanium and stainless steel. In most military applications it is necessary that all equipment work accurately and reliably. Only silver enables this military hardware to meet these requirements.
At one time an official government report stated:
“The increase in the use of precious metals in both military and civilian commodities has been phenomenal. Indications are that this use will continue or increase in the coming years.” At the time, President Regan had pledged to build the MX missile, which would have required massive amounts of silver for backup battery systems.
According to “Silver Profits in the Eighties” by Jerome Smith, a very interesting condition was mentioned. “In the event of a major war, no matter how much per ounce it would be willing to pay, there is no way that the U.S. military could purchase the silver it would require for such a conflict. Using the estimated silver usage during WWII, all the available silver bullion in all commodities exchanges and in private stockpiles worldwide would only satisfy the national need for two years. After that ….?” 1
Silver Fundamental to Peace
In the rapidly expanding technology-based world we currently live in, three facts about silver make it imperative to technology and in particular the electronics industry. Silver conducts electricity more efficiently than any other metal. Silver conducts heat more efficiently than any other metal. When it oxidizes in air, it does not form an insulating coating like most other metals.
Most electronic applications use only a small amount of silver. For example solar cells are crisscrossed by silver wire. The cost of silver for plating switch contacts is less than perhaps 5% of the total cost.
In medical and dental applications the cost of silver in relationship to the professional service is trivial. A silver dime would provide enough for four average size fillings for example.
The sterling silverware industry does require a great amount of silver relative to the end product. In this industry, the cost of silver does represent perhaps 20% of the final cost. The jewelry industry also needs a high percentage of silver to the end product. Unfortunately, the true quality of silver jewelry has come into question recently. [See Silver Swindle!]
Silver Fundamental to Industry
Industries that use silver do so because they have to. In almost every case, silver has characteristics that are vital to the product. In most situations, the usage is tiny relative to the finished product. The cost of the metal is insignificant in relationship to the importance of the final product. Modern industry cannot sustain itself without silver.
Many new uses have been reported in medicine, power generation, environmental cleanup, and a host of others.
Silver Fundamentally Price Inelastic
Silver is what economists call price inelastic. With most products, if the price increases, the production will increase. Conversely, if the price goes down, production will decrease. Since silver is largely a byproduct of the production of other metals, it does not respond to the market price in this normal way.
For example: A lead/zinc mine might receive 80% of its revenues from lead and zinc and only 20% from silver. Now assume the price of zinc and lead both double. This would be incentive to increase mine production. However, assume that the price of lead/zinc fall substantially and the price of silver doubles. To increase the production of silver, you would also be increasing the production of lead and zinc. This oversupply should cause prices to decrease. In other words, do you speed up production to respond to the higher silver price? Only if you can absorb the increased production of lead and zinc at a profitable price.
So the production level of silver depends not so much on its price, but on the market price of the associated base metals. The production and consumption of base metals, which are primarily demanded in the automotive and electrical industries, are very dependent to business conditions. Demand for lead, zinc, and copper and their rate of production drops more sharply than silver consumption in a recession or depression.
Silver Opportunities are Rare and Ignored
Truly great profit opportunities are exceptional. Most people never see them or take advantage of them. The secret to capitalizing on these "once in a lifetime opportunities," is to buy at a relatively low price and ahead of the crowd. While most investors state that this is a primary rule of investment success, few actually practice it. As more and more people become aware of an opportunity, the price appreciates and the potential for a big percentage gain lessens. This type of action takes courage. Most people are followers, not leaders, although they like to think otherwise. Looking over a recent issue of Forbes Magazine featuring the richest 400 people, number one Bill Gates and number two Warren Buffett are both silver investors. These two gentlemen, and obvious leaders, have the courage to buy without concern of what is currently “investment fashion.” Gates’ worth is estimated at $43 Billion. A mere 1% of Gates’ wealth, devoted to silver, would buy up nearly all that is currently on the COMEX.
Fundamentals Prevail
Most Austrian economists agree any kind of intervention in a free market will eventually boomerang. Sooner or later the Free Market price will assert itself. One of the first books written about silver’s investment opportunity was authored by Jerome Smith. The book was titled "Silver Profits in the Seventies.” It was a powerful and accurate analysis of silver that was said to have heavily influenced the Hunt Brothers. At the time of publication, Smith made an important point; silver and gold were coming off a period of government price controls. This had artificially depressed the price. According to Smith, a powerful upward surge was inevitable after this price suppression ended. He claimed that the price of silver would explode upwards after the controls were lifted. It did.
A similar situation exists today with silver short sales that artificially suppress the price.
Simply stated, a tremendous amount of silver has been borrowed and then sold. The entities that loaned the silver expect to be repaid and most would not have sold it at $5.00 an ounce. The market will have the final word. Then the price of silver will have to reflect true supply and demand factors.
© 2002 David Morgan
October 2, 2002
1 Smith, Jerome, Silver Profits in The Eighties, ERC Publishing, New York, NY, 1982 |
