Silver Bubble or Ground Floor? (Part III) - Mandatory Mass Hysteria

My conclusion

I do not believe silver to be in a bubble today.  It has had a good performance over the past 10 years, moving upwards by a factor of 8x, but this is not enough to judge whether or not silver is in bubble territory.

I want to share with you some of my rationale.

Consideration #1:  Bubble prices cannot form if fake supply is used to distort classical supply and demand pricing mechanisms for what is supposed to be a physical asset (e.g. silver).

In the silver market the price setting mechanism is the clearinghouse of the electronic futures markets, which as discussed is dominated by a few market speculators who are in a zero-sum game making bets with each other that have short-term expiration dates.  This is different from the stock market.  While it is called the ‘futures’ market it is in many respects one of the most short-sighted markets out there.  

Further the futures market is using Monopoly Money to set the price of real silver.  This is called paper silver (or as I call it, "digital silver").  As of March 2010, 100 ounces of digital silver trade for every ounce of physical available for delivery.  I suspect that ratio has grown by at least 2-3x since then, given the rapid draw-down in COMEX bullion coupled with increased volume.   

100 or more digital ounces for every physical ounce.  With no changes to the present price-setting mechanisms, does this mean one could acquire every physical ounce available for delivery and only influence 1% of the futures price?

This is irrational from a classic supply and demand perspective.  This kind of distortion is certainly not taught in econ 101 nor are these types of mechanisms clearly mapped out for investors by the financial media.  In fact when it comes to most investing stories, especially commodities, the media generally gets away with reporting daily quotations, and if you are lucky tosses out a few chummy soundbites on why something did this or that.  What a bone. 

No, in order to have a bubble we have to have a clear mechanism by which extremely high prices can be obtained, sustained, and launched into the stratosphere.

If digital silver significantly outweighs physical silver for setting price, then the means for a bubble in price takes one of two forms:

1. The exchange and regulators lose control of digital silver, reversing their present course of actions which involve raising margins for speculation, or
2. When existing physical supply is no longer able to meet demand for physical by industry +  investors, breaking the market-setting mechanism of digital silver.  In this scenario a secondary market for physical acquisition is created and the bullion trades at much higher prices to the digital, which either must adjust upwards or decline into irrelevance.  (picture, the official grocery stores in Soviet Russia that boasted low prices but had empty shelves because the black market  was the only place with the physical groceries).

Consideration #2:  Meaningful real accumulation of the asset is not possible

Nobody knows the percentage of households that own physical bullion.  I would suspect less than 10% have any silver whatsoever, and that in total maybe 1-5% hold more than 50 ounces of silver troy oz in any form. 

I come to this estimate in a reasoned but  circumspect manner.  I see many online reports that estimate only 1 billion oz of physical silver exist above ground in investable form.  If this is true and American households owned the entire world supply, an impossible scenario, then the maximum silver allocation on an equal basis would only be 10 troy oz per household (1 billion ounces / 100 million households = 10 troy oz / HH).... I'm rounding down on HH from 114 to 100 million for simplicity. 

Ten ounces is good but far from a meaningful amount. 

In capitalist systems wealth concentrates.  If just 1% of households owned the entire supply then this would average 1000 oz per household (1 billion / 1 million households = 1000 troy oz / HH).  This seems high but is just an estimated boundary.  If the hypothetical billion ounces is spread over 5 million households then the average would be 200 troy oz (1 billion / 5 million households = 200 troy oz / HH).  

200 oz is a more meaningful amount of silver for a household, but it would vaporize the above ground supply and leave none for the other 95%.  

There is very little physical out there for acquisition.  

If 10% of households acquired 50 ounces each that would consume half the above-ground supply.  If just one of their neighbors wanted to acquire their own 50 ounces they would consume the rest, leaving the other 80% high and dry.  

And all this assumes the price of silver continues to be attainable on a per oz basis, that early buyers stop when their ‘fair’ share has been acquired (i.e. no hoarding by those with more money to spend), that no one else in the world wants silver bullion except Americans, that industry declines to build stockpiles for manufacturing, and that this 1 billion oz above-ground supply, does in fact exist and is not appropriated by governments as supply vanishes.  

Consideration #3:  Silver is more rare than gold on an above-ground basis.

Almost all gold mined in human history has been recycled and retained, about 5 billion troy ounces.  Much of this sits in central bank vaults under careful lock and key, and will never circulate among regular people.  

In comparison, almost all the historic silver that has been mined has already been used up by industrial processes.  Given the lifespan of electronics and related consumables, a fair amount of mined silver now lay scattered in microscopic quantities throughout American landfills, in millions of discarded electronic devices.  

With 5x more above-ground gold than above-ground silver, one would expect the natural price of silver to be at least par with gold in a normal supply and demand scenario, instead of 1/43^rd its price,  Just a few years ago it was 1/75^th the price, so perhaps that correction is underway   

We shall see.

Consideration #4:  Bullion is mined from the earth.  Stocks and money can be printed at-will.

We keep forgetting that bullion is the end-product of an industrial process.  It is the result of lots of money and time invested by miners to figure out where it is concentrated in the earth, who then must get tons of rock lifted out of the ground for crushing and refining into bullion, often in remote parts of the world where basic infrastructure does not exist.  

Stocks can be diluted with a simple vote by the Board of Directors to issue more shares.  Money can be created out of thin air by the Federal Reserve.  They don’t even bother to print physical certificates or paper money anymore... that would be too expensive and slow it all down.   

• For the astute investor, when given the choice between two assets, choosing the one that is less able to be diluted has better odds of concentrating value than an asset that can be multiplied at will.

Consideration #5:  Mandatory mass hysteria...  in a bubble the prices have no rational connection to the supply of the given asset, which can take on unbacked synthetic forms, and credit mechanisms break down.

A bubble means price appreciation has become a self-sustaining cycle, a Ponzi Party of greed, fear and frenzy where the act of buying itself begets more buying.  The fans scream and pass out when the boyband-of-the-day just walks on the stage and says 'hello'.  The fundamentals of the underlying asset ... often plentiful in supply... fades into the background as greed takes center stage.  The Herd is mystified by each leap forward and rushes to acquire diminishing amounts before the next round of bids takes it higher still.  Breaks in price appreciation are few, if non-existent during full-blown mania phase.  Naysayers warning of a bubble are disregarded and ridiculed by the financial media, the thundering masses and the self-interested promoters in-kind.  Politicians may even get into the act, praising the newfound 'prosperity' and searching for ways to connect this democratization of wealth with whatever it was they did in office, no matter how flimsy. 

A bubble means everyone is scrapping in the streets to acquire the last bits of the asset.  A scrum.  A mad scramble.  A mania.  

We have nothing like this today.  In fact we have the opposite, where people are throwing away their bullion for a few paper Franklins.  

Without extreme demand by the masses, the markets will not invent absurd credit instruments for people to engage in leveraged buying to amplify their returns.  As that demand ramps up these credit instruments are invented, rationalized, and disbursed throughout the system, setting the stage for catastrophic knock-ons during the contractionary deflationary period.

When you see ads for "BUY SILVER ON CREDIT AT 0%" instead of "WE PAY CASH FOR SILVER".. then ... perhaps its time to start trading silver for something else. 

Acquiring Physical Silver establishes a foothold in traditional, long-term monetary solvency for you and your family.

We manage risk in all kinds of ways in our everyday lives.  None of us wants to be involved in a costly car accident, but if we are, we want to be insured.  We buy life insurance for much the same reason, to provide for loved ones in case of an untimely passing.  We stock up on food essentials when we can in case of a sudden storm that might prevent us from getting resupplied in a timely manner.

We make these kinds of choices not because we want them to occur, but we want to be prepared if they should happen.

I do not believe our elected leadership in Washington has either the capability or the interest in bringing together Americans, and explaining to them what shared sacrifice really means.  I do not believe they are capable of communicating that American Patriotism that built our country was not the result of a free lunch, it was full of sacrifice, shared purpose, and lots of backlash against progress that had to be fought for and overcome.  Politicians today pander to us and tell us we can have the good life without paying for it, can engage in military adventurism without shared sacrifice of taxation or military service.  Those that tell the truth are defunded in their campaigns and subsequently voted out of office.  We don't want to hear the bad news.  Fuck yeah we're America!  We're number one!

The world is coming to see Americans as obstinate, corrupt, incapable of change, and who insist upon living beyond their means.  Our leaders choose to exacerbate these tensions in a zero-sum game of their own.  The Tea Party Movement represents the latest incarnation of this stubbornness and their intransigence over the debt ceiling these past few weeks has caused damage to our international standing.  And they didn’t even gain politically for all their effort, polls show them having lost credibility for their bully tactics.  

Changes to our way of life are coming.  I believe it is more likely these changes will now be imposed upon us in a much more severe way, from market forces that destroy the purchasing power of the US Dollar.  These changes may be sudden and sharp, or continue along a more subtle route, but changes will occur and it will be more difficult.  These changes will not be easily countered or mitigated by our politicians, and part of our sovereignty will disappear when this occurs.  

I am by no means the most experienced traveler but I have seen enough countries, first through third world, US locations rich to poor, so appreciate what happens when people lose control of their economic fate and become stuck.  It is not pleasant:

Transportation becomes a luxury commodity, not an everyday convenience.  People become much more reliant upon local production without systems to move surplus from one place to scarcity elsewhere.  Corruption rises.  Job creation all but disappears and informal barter systems arise.  Depreciating currency is not wisely held for opportunistic investment;  instead it is traded as quickly as possible for tangible items before it falls in value more.  This leads to misallocation of capital and of course lending stops as banks refuse to accept the depreciation risk on their balance sheets.  Credit becomes scarce, and is shunned as a primary means for building commercial enterprise. 

I am not suggesting this is a pre-destined future for the United States.  But we are behaving as if the odds of this occurring are 0%.  

Reliance upon a depreciating fiat currency as the sole means for ones long-term welfare is a bit like buying a stock in a company that insists on selling new shares every quarter, diluting your stake and requiring you to buy more just to stay even.  Companies that do this don't last very long.

I hope silver never goes into bubble territory.  This is because it would probably be commensurate with full-blown monetary chaos as people flee the dollar.  The subsequent social disruption would be far more hassle than any benefits of treading water and your retained 'purchasing power'.   It would be like being glad you had the foresight to buy a sturdy boat... but without considering that you still have to weather the storm tossing you about.   

But investing, like life, is about preparing for as many circumstances as possible.  No one is immune from all setbacks all the time.  That is why we should diversify across as many uncorrelated asset classes as possible.  Don't look to the financial media as your only source of information for diversification, at least not any more than you would ask someone like Jim Cramer for advice on fixing a leaky roof.  Get the roofing guy to do that.

And if silver never goes into bubble territory, odds are strong it will continue to experience apparent price appreciation, if for nothing else because fiat is expanding at a much higher rate than bullion production.  

Learn as you go, no one's perfect.  Salt your portfolio with physical (not digital) metal.

Acquisition of bullion has been going on for thousands of years, well before stock markets and corporations themselves were invented.  As far as asset classes are concerned, I'd say the odds are pretty good bullion is a going to hang around for awhile.

Peace out.