Why Gold and Silver Will Rise

Includes: FXE, GLD, SLV, UUP
by: Mark Thomas

The primary and overarching reason you should have a significant percentage of your investable assets and wealth in precious metals is very simple: To protect your real purchasing power. Governments have abused their privilege of excessive printing currency and easy credit creation on a magnitude and scale not seen for decades. This is the only investment that both protects your wealth and even prospers from the inevitable destruction of purchasing powers in all major currencies -- the US dollar, the euro and others.

The US dollar has lost 31% of its real purchasing power since 2000 and 72% since 1990. Since the US was taken off the gold standard in 1971, the dollar has lost a staggering 82% of its value. Since the Federal Reserve was created in 1913, the dollar has lost 95.6% of its purchasing power. When you compare the historical appreciation and more importantly the retention of its purchasing power of precious metals versus the dollar in those same time frames, those facts should convince you that significant exposure in precious metals will protect your wealth against these irresponsible government policies.

In 1980, gold prices reached $850 per troy ounce, which in today's inflation-adjusted dollars equals approximately $2,325. We think it will exceed that prior level and continue to rise. This is based on the vast expansion of money in credit in all the years since 1980. In 1980, silver prices briefly traded above $50. That in today's equivalent, inflation-adjusted dollars would be at least $135.

Gold and silver are such unique elements with so many unique properties; therefore, the chance of a gold or silver substitute being developed is almost impossible. It hasn't happened in thousands of years and it probably never will. That is what makes gold and silver unique elements to the worldwide monetary system. They can't reproduce or create out of thin air more gold or silver, unlike paper currency. Backing a currency with gold (having a gold standard) is what restricts countries from excesses over the longer term. It forces them to balance the federal government budget and restrains deficit spending. There would be periods with less boom and bust cycles in the economy. The convertibility of a currency into gold inevitably restrains government spending, creates no sustained big federal deficits and makes you run a positive trade balance over time.

Most of the world central banks have been selling gold for two decades. They sold literally all of their silver reserves to meet excess demand, which helped keep prices artificially low from 1981-2001. That had made mining so marginally profitable for so long that there is a shortage of new mining capacity developing over the next few years. When you combine that fact on the supply side with the exploding demand from more investors all over the globe at the same time, you have the recipe for strong and sustained bull market in precious metals. This process has now reversed and central banks of the world -- including those in China, Korea, Russia, Brazil and Middle Eastern countries -- are again net new purchasers of gold.. These purchases by central banks are by the metric ton, which equals 32,150 troy ounces at a time or $56.75 million per one metric ton purchased.

As confidence in currencies like the US dollar and the euro fade quickly, money will flow into gold and silver. China which is a top producer of gold and went from being a net exporter to a net importer. It's buying gold to diversify its foreign reserves away from such a reliance on the US dollar. It's even encouraged its citizens to buy gold and silver.

The largest gold mines, operated by almost all of the major gold mining companies in the world, currently are responsible for a very large percentage of world production each year and are all starting to get less gold per ton of ore mined. The mining industry is literally on a treadmill that keeps speeding up but it doesn't have the potential to keep up with the increasing speed of higher demand.

The gold mining companies, especially the major ones, have little ability to more rapidly expand their production because today's production is the result of decisions made years and multi-billions dollars of investment ago. As a result, it makes it more difficult for them to sustain any significant production growth. They have to devote much more capital, time and resources in order to maintain existing production levels and have total industry output up maybe 3-4% per year. This is one of the reasons that gold mining stocks have so underperformed the physical bullion itself. The thing you have to remember about mining stocks is they are still stocks and, as you saw recently when all stocks were being sold, they get sold too. They can go lower even when higher gold prices and moderating costs should be increasing their stock price.

If the Golden Mean process is occurring now, mining stocks will eventually soar in value. However, in the end you always must remember they are stocks and will act more like a stock than the metal itself. We personally currently own no miners but do have a model portfolio of them to give you some ideas of our favored companies in the sector if you choose to have some exposure to them. Our favorites in the mining sector are not the companies that most investors in the group favor. The mining sector is difficult to evaluate because it trades at 3-7 times current annual revenue, so valuation is the sector is difficult to analyze the potential reward to risk. Then you combine the specific company and mine operational risk and it is even more of an investment minefield. There are various primary silver miners that still offer value and growth. Silver stocks, because they are still mid cap as opposed to large cap gold miners, still have production growth that can reward shareholders with capital gains. However, you have to research these companies and pick the top performers relative to their risk.

You need to understand that gold and silver are longer-term investments, not short-term trading vehicles. You have to ask yourself, "If I really believe gold and silver have the potential to rise 300-500%, do I really need to get greedy and use an individual mining stock or derivative like a leveraged ETF, option, or even futures that are even significantly more leveraged but also simultaneously exposes me to much more risk?" When you own derivative instruments that equal gold and silver, you have added counter-party risk which is the risk the other party in transaction will have the ability to actually pay you, which defeats the best thing about gold and silver. Unlike an account at a bank which is both an asset and liability to the bank and every other financial instruments man has created in history has this feature.

Technically an ETF is a derivative; however, with the ETFs we own and suggest, we are sure they are physically backed and the gold and silver is physically stored outside of the United States for more security. It is always best to own physical gold and silver that you have easy access to. For those of us with assets in retirement accounts, ETFs are a good option. You should seek out the best , physically-backed ETFS to get exposure to precious metals this way. When you feel the urge to trade or market time gold and silver don't, stay focused on the big prize and the underlying reasons these events are occurring, not the world's various misinterpretations and uninformed panics in reactions to events you will already understand.

The main difference between gold and silver is that silver is mostly consumed in industrial uses within one year of being mined. Gold is mainly used only in jewelry and electronics but most is hoarded in order to store wealth. Therefore unlike gold, most silver it is consumed every year instead of hoarded like gold is. Silver is therefore a precious metal with a store of value quality like gold but it is also primarily an industrial metal. That gives it an inherent useful value in growth industries like cell phones, computers, solar power, medicine, production of chemicals.

The risk in being more of an industrial metal is that silver is then more exposed to severe downturn in the economy than gold. The total silver available in the physical silver market is only about $50 billion versus the total gold market that now exceeds about $8 trillion and that fact alone is why silver is so much more volatile in its trading. Notice from the numbers just quoted above about the total market size of the silver market is only one sixteen the size of the entire gold market.

The average historical gold to silver ratio is approximately 15 to 1. The current gold to silver ratio is around 45 to 1. In other words, it takes the value of 45 ounces of silver to equal the value of one ounce of gold. We think the gold to silver ratio will eventually return to approximately 25 to 1 which is a very conservative relative estimate of others who expect that ratio to fall to 10-15. That reversion to a mean which would just by itself, make silver worth approximately $70 at today's gold price of $1750. That is also why since we think gold will eventually reach $5000 per troy ounce, our target for silver is then $200 ($5000) divided by 25). This could take three to four years to occur but could occur in the next two years.

Since World War II, the US government has sold over five billion ounces of silver and currently has no reported stores. They probably have one for the military but they won't release that information and it wouldn't be that significant anyway. The US government had billions in ounces because we used to literally have silver dollars that were made of silver but removed from circulation. Now that vast stockpile is gone and the supply demand equation has changed dramatically.

The gold and silver ETFs (mainly GLD, IAU, SLV, SGOL, AGOL, GTU and CEF) and more recently in new ETFs and even bank savings accounts denominated in gold in Asian countries like China have democratized precious metals investing to the average investor like never before because they didn't exist. There are a new staggering number of potential new investors in precious metals worldwide. This includes worldwide now China, India, Brazil and Russia. Combining those facts with how much easier these investment vehicles have made it purchase, own and sell own precious metals with much more reasonable expenses for commissions and storage fees. Now for the first time when the golden mean process is occurring and unfolds, small investors worldwide can purchase exposure to precious metals quickly, cheaply and don't have to worry about delivery, storage and a higher annual expense for storage.

Most importantly, this has made it much easier for retirement and tax deferred accounts to purchase precious metals. Basically for the first time you don't have to use a precious metals dealer or futures broker to buy metals for the first time. Anyone with a regular brokerage or IRA account can easily and cheaply get exposure to gold and silver. This increase in demand from new investors is removing almost 40% of new current production in silver and probably 20% of all new gold mined. Today the physically backed silver ETFs hold over 50% of the deliverable bars of silver off the market. That is a big positive as long as investors continue adding to their ETF holdings and new investors add to their holdings for the first time.

The exchange traded funds more importantly have opened investing in gold and silver to traditional stock, bond, and pension fund institutional investors to acquire significant positions in gold and silver over time without going through the futures markets. These are the real players who move financial markets and probably control a hundred trillion dollar equivalent of buying power worldwide. If institutions that only have 1.5% of assets increased that small current exposure up to just 5% of investable assets, prices would have to soar higher by 300% higher. If they switched more additional assets and increased precious metals exposure to just 8% of total worldwide investable assets under management into gold and silver, the prices could potentially go up 500%. This is because the total gold and silver held worldwide is only about $8.5 trillion and worldwide investable assets in other investments like stocks, bonds and commodities is a staggering $225 trillion so even a move of a small percentage of those assets (3-6%) into the existing precious metals markets would cause prices to explode higher. Imagine another $14 trillion forcing its way into a $8.5 trillion total market and you have a recipe for a short squeeze and soaring prices. This is what the future will probably look like.

Disclosure: I am long LD, IAU, FSG, SGOL, PHYS, GTU, CEF, SLV, PSLV.