Silver Sheds Light On World Economy And Outlook

| About: iShares Silver (SLV)

The PM (precious metals) sector is recovering nicely today. From Spider Gold (NYSEARCA:GLD) and iShares Silver (NYSEARCA:SLV) to physical-backed Sprott Silver (NYSEARCA:PSLV) and gold bullion ETPs (NYSEARCA:PHYS) to gold miners like Goldcorp (NYSE:GG) +2.31% at noon, to silver mid-tier miner First Majestic (NYSE:AG), +4.31% to major streaming Company, Silver Wheaton (NYSE:SLW), +3.04% the board is green. This is great news for holders in this beaten down sector. While the positives accord with many fundamentals in the macro situation and are welcome, it is by reviewing the latest hard sell-down that we may learn most about the PM sector and what it tells us about global economies and markets going forward.

At the close of trading June 26, the spot price (the difference between bid and ask) for silver bullion was $18.63. Like gold, in the past ten weeks silver has crashed far below its 200-day moving average. Its former frequently tested support level at $26.50 seems a distant memory. Because silver, unlike gold is primarily an industrial and high-tech commodity its plunging price offers insight on the actual status of global economies as well as on sentiment, trading practices and silver's worth in a portfolio.

The points discussed here are essential not only to current or potential investors in the PM sector. Silver's collapse (45% since the October 2012 high at $35) affects all investors whose holdings are in the S&P (NYSEARCA:SPY), Total Market (NYSEARCA:VTI), Total World Markets (NYSEARCA:VT) or international equities (NASDAQ:VXUS). That is, the action in silver has lessons and impact on everyone.

The narrative is that the American economy is in recovery and that price performance shows that precious metals are losers. This is the rationale for the latest Goldman Sachs lowered estimate for gold prices for 2013-14. Economic recovery also is cited by various members of the Fed as a reason they might, repeat "might" begin reducing the pace of QE (debt creation) and de-leveraging the Fed's balance sheet from its massive position in MBS (mortgage backed securities).

The "historic 16-1" gold/silver price ratio is often cited by PM and silver proponents particularly. The ratio has grown from 54:1 last summer to 65:1 today. However, like most other things that ratio means little in times of hyper-stimulant fiscal policy and other forms of Sovereign market interventions in all major economies. Moreover, the past few months have indicated that precious metals pricing does not clearly reflect fundamental measures like supply and demand, utility, the degree of economic growth or their value as supports or substitutes for fictive fiat currencies.

Silver's industrial uses span the gamut of modern society. Because of its unique conductivity, silver is used in cell phones, car and jet engines, home appliances, flat screens, circuit boards and solar panels.

It has anti-bacterial qualities that are finding increasing medical applications (silver sulfadiazine). Overall, industrial use of silver 2012-14 will be 483 million oz/year, 54% higher than the 310 million oz used in the 1990s. So if the American and world economies are growing, the demand and price of silver should be rising, perhaps rising substantially.

Certainly retail demand for silver is very strong: Recent price declines have led to 800% increase in sales for retailers like Provident Metals. The US Mint has sold record amounts of silver eagle dollar coins YTD and demand for precious metal coins, jewelry and bars is high in Asia, too. Though the rate of Asian buying has slowed in June, by early May, Heywood Cheung, President of the Hong Kong Gold and Silver Exchange said late in April (see previous link) that dealers had exhausted physical stockpiles in trying to satisfy surging demand, the highest in thirty years. How then to understand what is being taught by the radical decline of silver prices, 37% YTD and counting?

China's version of QE has seen them create the equivalent of $1.6 trillion in the past six months in an economy a third the size of ours. They now are tapering. Also hitting commodities is a radical tightening of China's easy-money major bank lending policies. The Shibor, or special Shanghai interbank interest rate available to their own "too big to fail" banks have been raised from 3 - 13% to rein in their shadow-banking system. Strong hands in China have been borrowing low from the PBOC and other major banks and lending out at much higher rates, creating distortions and credit crises throughout their system. It is roughly analogous to companies here borrowing at artificially low rates to buy back shares, or to banks or investment firms borrowing at Fed-suppressed rates to invest in depressed real estate areas or MBS. Any rise in rates shivers such maneuvers and prompts massive risk-off trading which impacts precious metals most among commodities and asset classes. China is now in a whiplash between "perma-stimulus" and mal-investment, which may crash their housing markets and damage their economy and those interlinked with it. China may be experiencing or about to undergo a version of the credit crunch of 2008, which will hit all entities that trade with it. Words like "crisis" and "panic" are being used to describe Asian markets.

Thus, part of the massive 2Q sell-down in silver results from distortions in the global banking system and Sovereign monetary interventions in economies. The problem is not intrinsic to precious metals but affects them disproportionately since they are among the first risk-off asset to be sold for cash. However, as this continues it will affect PMs less than other asset classes because of PMs' intrinsic monetary value and, in the case of silver, its essential role in many sectors of the economy and commerce. Cell phones, stoves, refrigerators and cars still will be made.

There are several messages sent by the radical collapse in silver prices (on American markets) YTD. Firstly, the global economy is in worse shape than usually acknowledged. The big bad fact is that the four major world economies, America, Europe, China and Japan are contracting, their fiscal policies are creating extreme distortions in their own and each other's markets and their currencies are devalued and unstable, most obviously in Japan. The Japanese economy is so damaged that its Central Bank has adopted inflation as a growth strategy. Interest rate manipulation in China is even greater and less carefully managed than in America and Europe. Convulsions in China's economic and fiscal situation will undercut their growth and imports, which will shake resource-exporting giants like Australia, Canada and Chile. Copper is the third worst performing commodity YTD (falling from $3.60 to $3/lb) after silver and gold. As a side note: Chile, the world's largest copper exporter may help push forward Barrick Gold's (NYSE:ABX) huge Pascua Lama project as Chinese commodity demand sags or collapses.

Secondly, as Dr. Philippa Malmgren plainly stated, the PM market is affected greatly by strong hands with enormous positions. This makes it difficult for retail investors to weather turbulence resulting from the fact that the sector, despite its relatively small size in fact is very important to world markets and economies. So expect volatility and try not to be shaken out of your PM positions. The absolute bottom may not yet have been reached but the values now invite participation and the upside is enormous.

Thirdly, those able to ride out the current collapse in PM prices likely will be rewarded. It is difficult to be precise about the world system formed from current instability and systemic distortions. While I would not advise anyone already in the sector who does not have secure and ample income to invest further in PMs, it is likely that in the mid-long term they will retain their value and portability better than most asset classes and that their prices will rise.

Be cautious with your allocation and vigilant in monitoring your holdings. Those who can be patient with the sector in the ongoing and extreme downside volatility will come out shining.

Disclosure: I am long PSLV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I own precious metal companies in two mutual funds.