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Silver Summit Report: Three Investment Approaches to the Volatile Metal

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James Turk Andrew Kaip Ian McAvity For this special report from the Cambridge House Silver Summit in Spokane, Washington, The Gold Report caught up with three silver investing experts: James Turk, chairman of GoldMoney; Andrew Kaip, vice president of Precious Metals & Mining at BMO Capital Markets; and Ian McAvity, a writer at Deliberations on World Markets. While the three didn't all agree on why silver acts the way it does, they all said that it belongs in some form in a diversified portfolio—but only for those who can handle volatility.

The Gold Report: We always hear of silver servicing two masters: one is the industrial use of silver, and the other is the physical, investing use of silver. Both of these forces are vulnerable to global turmoil manifested in the European debt crisis, slowing growth in China and a potential currency crisis in the West. What is your prognosis for silver in this environment?

James Turk: It is true that silver has two entirely different demands. One is an industrial component, much like base metals. However, like gold, it also has a monetary component. I view silver as gold's little brother. When money comes into the gold sector, it's going to have a bigger impact on silver than it does on gold because the demand for gold is inelastic, meaning that people want it regardless of the price. But the demand for silver is very sensitive to changes in price, so you get a lot of volatility in silver that you don't get in gold.

Andrew Kaip: The slowing global growth situation will probably be the main near-term driver of silver downside risk. But we like silver for the long-term perspective because we think the slowdown in the BRIC (Brazil, Russia, India and China) economies is going to be much less than what the market is currently anticipating. The market will soon become more comfortable with silver and the price will rise, bringing equities with it.

At the same time, fears about the overall economy have a positive impact on silver demand short term. As investors become more concerned about potential geopolitical or geo-financial risk, it is supportive of silver.

Big picture, investment demand and global growth could drive silver to potentially outperform gold. The current selloff is a good opportunity to take positions in quality silver names.

Ian McAvity: I think the S&P risk is sort of a deflationary risk. We have seen sharp breakdowns in the uptrends of the Brazilian real, Canadian dollar, Australian dollar, South African rand and Asian stock markets. That tells me there is a deflationary wave underway in financial assets. But, at the same time, we have the magicians of Europe trying to pull a rabbit out of a hat to salvage the euro. It's against that backdrop that I think people are going to keep coming back to the fact that gold is the only place to hide. Silver will play as the more volatile cousin of gold.

TGR: Much is made of that gold:silver ratio as one of the reasons why silver prices will increase. What's your opinion on the importance of this ratio?

JT: A few months ago, the gold:silver ratio was 31. It moved all the way up to 56. We're back down to 52 now. But in the longer term, that gold:silver ratio is going to continue to fall, meaning that silver is going to continue to outperform gold. My bottom line is that if you can handle the volatility, own some silver because silver is going to outperform gold as we go forward.

I like to use the gold:silver ratio in a couple of ways. First, it's a good indication of relative value. The current ratio of 52 shows that silver is cheap relative to gold. So, if you're going to buy precious metals and you are prepared to handle the volatility of silver, you know that you are getting a better value by buying silver today than you are buying gold, simply because of the gold:silver ratio.

I also like to use the gold:silver ratio to illustrate the major trends in the precious metals market. During precious metals bear markets, the ratio rises. For example, in 1980, the ratio was 17. In 1991, the ratio was 105 ounces (oz.) of silver to buy 1 oz. of gold. Since 1991, the ratio has been falling, and I think we can expect the ratio to continue falling for the next several years as the bull market in the precious metals continues.

AK: I'm agnostic about the gold:silver ratio. We tend to look for that ratio to be around 60:1 based on silver fundamentals in the 1990s when we were in a very different economic environment. For example, China wasn't a silver seller and we were experiencing industrial demand destruction as the photography industry wound down its use of silver. Now we are looking at growing industrial demand as China and the BRIC economies move toward industrialization with a strong middle class demanding more electronic equipment. That bodes well for silver demand long term and changes the ratio. We also like silver's new photovoltaic sector demand. This, along with increased biomedical use, is going to be a significant demand growth component long term.

IM: Last spring, silver got way ahead of itself when it made that initial run up to $50/oz. That lifted silver out of the historic range of 45:1 to 80:1 silver:gold. That ratio had dominated since 1984. We had to pull back in to digest those gains because silver was about 75% above its 200-day moving average. By contrast, gold only got about 29% above its 200-day moving average. When the gold price found some support at $1,600/oz., the silver:gold ratio came back down to about a 55:1 ratio. So it has corrected that pullback.

From here, silver is going to take the lead from gold. I think both gold and silver are still vulnerable to continuing weakness in the S&P 500. But I can start to get very excited about gold taking a run at and through the recent $1,900/oz. highs. It's on that move that I would expect to see silver come back to life.

TGR: To what extent do you think the silver ETF has changed the dynamics of the silver market?

JT: I think the silver ETF has confused the silver market. Investors have to ask themselves why they are buying silver in the first place. Are you buying it because you want exposure to the silver price? This can be done with any of the paper products—futures, ETFs, options or exotic derivatives. Or do you want silver because you want a physical metal that doesn't have counterparty risk? In this case, you want to own a tangible asset and the only way to do that is to own physical silver. I think a lot of people today really haven't asked themselves the question: Why am I buying silver in the first place?

I think the volatility in silver is going to scare some retail investors because they are just not prepared for it. They haven't done their research, and they don't understand how volatile silver can be, which is unfortunate because they shouldn't have gotten into it if they were not prepared. If you don't want volatility, then don't own silver.

AK: The ETFs have had a similar effect on silver as they did on the gold market. The silver ETF provides investors an easy way to play the movement in the metal. That detracts to a certain degree from the equity. What is not being factored into the market is that those equities that show very good growth on a production level and on a reserve level, over the long term, provide investors more leverage to the underlying metal. Numerous examples over the past several years show where the equities have substantially outperformed the metal. Those are the kinds of quality investments that investors want to position themselves in.

IM: The ETFs really provided competition for the miner shares and, I think, will continue to do so for some time to come. They have taken a tremendous amount of capital flow away from the shares of the underlying miners. They have certainly made gold and silver price tracking much more readily accessible to the average investor. They have also contributed to a rise in the price of the metals, but the mining companies haven't really shown very great skill at increasing their margins. Rising oil prices, depleting reserves and diluted shareholder value from the resulting takeover premiums have hurt major gold mining shareholders. Silver has suffered a bit less, but they haven't really expanded either.

Paying dividends would be one way to compete. I think that there is going to be increasing pressure to start distributing the wealth out to shareholders. In an era of zero interest rates where Fed chief Ben Bernanke is talking free money for the next few years, someone who will pay the investor cash dividends while they wait for the longer-term growth to materialize, I think, will begin to command increasing premium valuation. Companies claim that paying dividends subjects the capital to double taxation, which is a valid argument. And then they turn around and argue that they are funding internal growth and developing internal rates of return. If they are legitimately expanding production—adding in new projects and building future production sources—there is a valid case for it. But the share prices don't seem to reflect that growth. For the most part, in the past couple of years, the larger producers' shares have not really done much better than the metal price and in many cases have done worse than the metal price.

TGR: To what extent can or are silver prices manipulated?

JT: I believe that governments have been trying to cap the price of gold for a long time now. They allow the price of gold to rise just a little bit every year. In fact, through this decade the price of gold has risen about 17%–18% per annum on average. You can't cap the price of gold without also capping the price of silver. As a consequence, I think silver is also a part of this overall effort to keep the monetary metals from rising in price. They are the canary in the coal mine. When the price of gold or the price of silver rises, people understand that there are problems with the national currency and that, consequently, central banks aren't doing their jobs properly by preserving purchasing power of money. When we touched $50/oz. earlier this year, that was a clear sign that the attempts to keep the lid on the silver price have been falling apart.

There is another big difference between gold and silver. Gold is already in the second stage of its bull market. Every bull market has three stages. Stage one is apathy and neglect. Stage two is when you start seeing price appreciation. That is the longest stage, when more people become involved by purchasing the metal. The third stage is the speculative blowoff. Silver is still in stage one of its bull market even though gold is in stage two. Silver won't get into stage two with a lot more people coming into the market until it goes over $50/oz., which was the high in January 1980, the record all-time high price in silver. Inflation adjusted, that would be almost $500/oz. today. That really illustrates the debasement of the U.S. dollar over the past three decades.

IM: I have heard the manipulation argument going back 30-odd years. There is no question that from time to time, sloppy buying and selling can be done. Some of the computer algorithm trading can play with the market as well. But I have a hard time buying the notion of price levels being aggressively manipulated. These markets are extremely broad and liquid and you never really know who all of the players are.

TGR: How important is China's entry into the silver buying market?

JT: The fact that China is now a net importer in silver is of huge importance. For decades, it has been a net exporter. But inflationary pressures are causing people in China to take steps to protect their purchasing power. China has a history of being very silver oriented. Consequently, you are seeing a rush into silver. That will have a huge impact on the price of silver in the months and years ahead.

IM: China has been the biggest importer of virtually the entire metals complex. There is no question, China is accumulating very large quantities of paper currency, and it is very aggressively trying to convert that paper into tangible items. One of the tangible items would be to diversify it into metal, both from a monetary preservation point of view but also in the context of building future inventory. I am pretty sure that it is significantly importing silver, copper and many of the other metals as well.

It's not just China, either. A total of 15 non-G7 countries collectively have about $6.8 trillion of foreign reserves—the bulk in dollars or euros. I don't doubt that all of them are watching what the West is doing, shuffling debt around and trying to figure out how to convert that paper into something tangible that will preserve purchasing power as debt degrades the value of paper money.

TGR: What advice would you give to investors on how they should view silver as part of their portfolio or financial plan?

JT: Well, silver is like gold. Precious metals are not investments; they are money. They are a place where you put your liquidity after you have sold an investment and are waiting to make another investment or purchase a consumer good. So you have to compare gold and silver to other forms of money. And you have to ask yourself: Would you rather own gold and silver now, or would you rather own a U.S. dollar or some other currency? Given the fact that we are in a zero interest rate environment with rising inflationary pressures and central banks are taking actions that debase the purchasing power of all national currencies, I don't see any reason to own a national currency. I can, however, make the case that you really should be owning gold and silver as a way of preserving your wealth and protecting your purchasing power.

IM: Silver, along with gold, has a very definite portfolio role. Each investor has to determine how much volatility he or she can tolerate. Silver will almost always tend to be more volatile than gold. Maybe I'm old-fashioned because my primary backdrop would be in gold, but because I like the relative volatility of silver and I'm prepared for the risk, I have no problem going as much as 50/50 between gold and silver. Within the gold component, I am happy going with predominantly bullion, but include a selection of second-tier mining shares, companies that are near producers who are expanding ore bodies. I also have no problem with really early-stage explorers. I don't know many of the silver companies as well, but I would prefer the growing second-tier silver companies to the very large, more mature ones that are consuming capital. Silver is volatile so I am happier owning a greater proportion of metal relative to mining stock there.

TGR: Many people call precious metals an insurance policy and recommend it be about 10% of a balanced portfolio. What do you see as a reasonable level of physical precious metals?

JT: It depends how much cash is in your portfolio. And that depends on a variety of factors, including comfort level, age and goals. The historical norm is that you should have 10% of your portfolio in the precious metals. But since gold and silver are so undervalued and national currencies are being destroyed by central bank policies around the world, I think at the minimum you probably want to have 25% of your portfolio in gold and in silver. I am talking about physical gold and physical silver. But the general rule is the older you are, the less willing you should be to take risks, which means that you want to have even more liquidity in your portfolio. So, as you get older, you should be well above that 25% of your portfolio in physical gold and physical silver.

TGR: What percentages of physical gold and silver are in your portfolio?

JT: I have about 80% in gold and silver. Off the top of my head, I would say it's probably about 60% physical metal. The rest would be mining shares. Then the remaining 20% is in oil and a little bit of timber land.

IM: I have invested slightly higher than 50/50 in gold and silver, but it is because I have a high risk-tolerance level because I don't have any dependents. To me, it's as much a philosophical decision as anything else. For people who are less familiar with what they are doing, I urge a balance between gold and silver. For those who are trying to be more aggressive, essentially if you are going to win on gold, you are going to win on silver by a factor of two or three.

TGR: The silver equities, as with the gold equities, have not increased at the same rate as the metals. Why do you think that has been? Do you see that changing?

JT: I think it is changing. Mining stocks were in a bear market from the time of the Bre-X mining scandal in the late 1990s until the collapse of Lehman Brothers in September 2008. The negative sentiment during that period was due to both the allegations of fraud and the emergence of hedging programs that turned people off of the industry. Rising input costs also squeezed mining margins during that time, resulting in declining profits despite rising precious metals prices. All of that has changed since 2008. It first started changing slowly, and now it is changing more rapidly. You can see the change particularly in the cash flow that the mining companies are starting to generate. Some mining companies are even announcing dividend increases because of the strong cash flow.

We are in stage one of the mining company shares. Over the past couple of weeks, as the precious metals came back to retest support, the mining shares have come back to retest support as well. The second stage of the mining shares bull market is, I think, about ready to begin. We can expect much higher prices in the months immediately ahead for all the gold mining and silver mining shares.

AK: Increased capital and operating costs, along with concerns about production disruption, have really led investors to be concerned about equity margin expansion. However, based on higher average silver prices over the third quarter, earnings should be very positive. That hasn't been factored into the market yet. That means that right now the equities are on sale relative to the metals.

The risk is moving into the fourth quarter. The reality is most investors are looking at the fourth quarter and beyond into 2012. While we will probably see significant margin expansion during the last quarter for silver companies, the risk is that the market is skeptical of higher silver prices because of macroeconomic conditions.

TGR: Thank you for your insights.

James Turk is the chairman of GoldMoney, a company he launched in 2001 to help investors buy gold and other precious metals. Turk began publishing the Freemarket Gold & Money Report in March 1987 and changed the name to the Free Gold Money Report in 2009 with additional commentary.

Andrew Kaip is vice president of Precious Metals & Mining at BMO Capital Markets. Previously, he worked as a mining analyst at Haywood Securities, most recently covering gold and silver junior exploration and mining companies. Prior to that, he served as a project and consulting geologist for more than 10 years. Andrew received his Bachelor of Science degree in geology from Carleton University and his Master of Science degree in economic geology from the University of British Columbia, and is a professional geologist.

Ian McAvity has been involved in the world of finance for more than 40 years as a banker, broker, independent advisor and consultant. He has produced
Deliberations on World Markets since 1972. He specializes in the technical analysis of international equity, foreign exchange and precious metals markets, and has been a featured speaker at investment conferences and technical analyst society gatherings in the U.S., Canada and Europe over the past 36 years. He is one of the founders of the Central Fund of Canada.

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