Commodities and currencies are complicated because the supply and demand mechanisms aren't nearly as obvious as a dividend company. If Johnson & Johnson dropped by 50%, I'd buy it regardless of any worries about future stock prices -- that income alone would make me a happy camper.
Not so for commodities which are pretty much based on when you unload the asset. There's nothing wrong with this, of course -- a savvy investor can do just fine, and those of us with silver and gold over the last several years don't have much to complain about.
Still, there's always going to be controversy. Earlier, I posted an article about why I think that silver "scarcity" in the sense of above ground silver (SLV) supply isn't what people think it is in terms of industrial demand, and is just silver's "commodity" side that isn't bullish for the long-term, essentially rejecting every silver article I've read over the last couple of years.
The reason is simple: silver's industrial demand is certainly strong, but roughly the same as it was 10 years ago when prices were much, much lower, and in 2011, industrial demand even dropped a little.
And yet silver prices and "supply" -- of coins and bars -- took a beating. Why? The answer is below.
Let's Be Blunt About Silver
Silver has three basic demands: industrial demand, monetary demand, and speculation demand. The lines between the three types of demands are fuzzy at best, and are extremely interconnected. But they're not identical, and making some sort of distinction is necessary.
In 2011, we saw silver prices peak due to supply concerns, and then drop strongly for different reasons including margin requirements being changed. I know plenty of people who were burned because of the drop, including folks who had no business making such bets -- and they should have just bought the physical stuff, which is all I own.
But the "supply" concerns weren't for consumption -- they were for speculators and people looking to use it as money at least in the future.
For some reason, most people don't emphasize this difference in demand, which is mindboggling. It's the most important aspect of understanding the difference between gold and silver, and is why silver prices have skyrocketed so much faster than gold.
Copper, for example, is hooked up almost exclusively to industrial demand and speculation regarding the relatively short-term forecasts of industrial demand.
Gold (GLD), for example, is hooked up almost exclusively to the notion that it's an alternative currency for crisis, which explains most of its fluctuations. For the purpose of this article, we'll consider jewelry part of that demand, because plenty of people, especially in other countries, buy the jewelry for the long-term wealth storage as well as just because it's pretty.
What this has to do with silver is important, because each of the above metals behaves differently depending on what drives the market.
Silver is a bit weird, because it's a little bit of all markets. Unfortunately, its price is now mostly determined by raw speculation of future prices -- that's why its price is so incredibly volatile even while demand stays far more steady than the price.
Evidence For Silver-Prices Being Speculation Driven
Silver industrial consumption is roughly the same as it was in 2002, only up, according to The Silver Institute. In fact, overall "consumption" not including coins and metals and such was actually down slightly in 2011. Even industrial consumption was down slightly in 2011 compared to 2010.
Obviously, silver mining production must be down for the supply shortage, correct? Not quite. Silver mining production has been up these last couple of years. So, the only answer according to the "scarcity" school would be that we're just running out of scrap, right? Again, not quite -- according to Monex, scrap supply is growing right now. It's even growing for 2012.
And yet silver prices are up something like 800% during this same time frame. Even most estimates using modest price forecasts believe that we still have decades of silver mining left before we hit "peak silver," and by that time new technology and innovation will make silver mining easier. Many of the people reading this sentence will literally be dead before that's even a noticeable influence.
The lack of demand that has existed has no just been for silver existing -- it's been for silver that has been minted into actual silver coins and/or bars. That's gone up only roughly 300% in the last decade, even though the demand is likely much higher. That's not a structural problem so much as just how minting works -- it's not incredibly fast and there are often delays in coining and sales. This is why there's been a lot of silver backwardation over the last several years, most noticeably in early 2011.
Unfortunately, most people -- including almost everyone reading this -- has been led to believe that we're in a consumption-demand driven market, and we're just not. The price of silver is leaping and dropping because of people who are trading silver because they want to sell it to others. And yes, speculation and hoarding can absolutely drive up prices, especially when we account for people who lose a lot of money when prices drop suddenly, like they did in early 2011.
What All of This Means
I'm not buying silver because of industrial demand, because that has been extremely overstated and has mostly become less of a long-term issue over the last ten years. Instead, I'm buying silver because of investor demand.
I'm also not buying for monetary demand, because gold is a far better monetary source than gold these days because of the industrial demand and the fact that silver is speculation driven right now, and if there is some sort of crash, it'll behave more like a commodity than gold. Not that I wouldn't be happy to have some silver if the dollar crashed -- of course not. I'm just going to be happier with gold.
In the end, hopefully this explains what's really going on in the silver market. It's a great asset, I think there's a lot of fight left in the metal, and I plan on making money from it in the coming years. But not for one minute will I forget that it's a market driven far, far more by speculators and other investors like me than its driven by industrial consumption or some sort of "lack" of silver out there.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I own physical gold and silver, and will be adding to my position regularly.