'History Repeats the Old Conceits' -- Elvis Costello
Nearly five centuries ago, Europeans were caught up in a frenzy for tulips. Prices surged ever higher on hopes that the flowers could be re-sold at an even higher price. The mania crashed when a glut of tulips hit the market. And we’ve been playing the same game ever since.
Every decade or so, hordes of investors lock on to one asset, pushing its price well beyond any sort of rational value. Tech stocks in 1999 and home prices in 2006 are classic examples.
And in the spring of 2011, it happened again.
The Soaring Price of Silver
The price of silver soared from $27 an ounce in February, to above $48 by early May. By then, the crowd realized that there was no real rationale behind the sudden spike. Before long, folks who bought silver just weeks earlier made a panic move to the exits. Silver lost 11% of its value in just 12 minutes on May 6 and would eventually be down 30% on the week.
Why do we do it?
We do it because we crave any investment that may yield a very quick profit for us. Wildly popular metals ETFs like iShares Silver Trust (NYSE: SLV) and iShares Gold Trust (NYSE: GLD) make it easier than ever for individuals to pile in and out of precious metals in the blink of an eye. Yet, as experienced investors know, gains come from diligent research and plenty of patience. Get rich quick, invariably becomes 'get poor quick.' The key is to know when a mania is taking place, so you can move to the sidelines and watch the inevitable carnage play out.
The Red Flags of Weakening Silver
In silver’s case, red flags quickly emerged that should have made investors pause. First, there was the gold-to-silver ratio. Gold and silver are both used as hedges against inflation, and their prices have usually risen and fallen in tandem.
From 1978 to 2008, an ounce of gold bought about 60 ounces of silver. By this spring, that ratio fell below 30. If history is any guide, that means gold was sharply undervalued and should have been valued at closer to $3,000 an ounce. Or an ounce of silver would need to drop from its peak of $48 to $25, or about 40%.
Thanks to silver’s sell-off, the gold/silver ratio now stands at 43, still well below the historical reading of 60, implying more weakness to come for silver.
Another red flag: silver isn’t just a speculative metal that is used as an inflation hedge. It is also heavily used in a range of industries such as dentistry and coatings. Total (non-investment) demand for silver typically averages around 900 million ounces per year.
Yet as silver prices took off this past winter, a number of companies announced plans to use other metals that have other similar properties in industrial applications, known as the 'substitution effect.' That means demand for silver (at least for industrial purposes) was starting to weaken.
No asset can rise higher in price if demand for it is falling. That’s the painful lesson we’re learning in the prolonged housing crisis.
The Silver 'Mania'
Whenever you spot a mania, you need to ask whether that hot asset has a limited supply, or is in abundance. The Dutch tulip mania ended when it became apparent that an increasing number of people were getting into the tulip growing business.
In the case of silver (and many precious metals), there is ample supply, and higher prices encourage miners to step up their exploration pace. Thanks to rising prices, analysts at UBS estimate that recently initiated mining plans should push global production of silver up by 25% in the next four years.
Summing it up, rising supply and faltering demand can end a mania very quickly. The glut of unsold new and existing homes underscores that notion.
Will Silver Rebound?
Looking for silver’s Second Act? Well you should know that silver still fetches twice the price that it did in the summer of 2010. will it fall back to those levels? Not unless the global economy hits a major bump in the road. For example, if the fast-growing Chinese economy cooled down, demand for silver would likely plunge back to the summer 2010 doldrums.
What could cause silver to rebound? Either a clear rebound in the U.S. and Western European economies that boost industrial demand for the precious metal, or clear signs that the economy is starting to see a lot of inflation.
Speculators have been anticipating a spike in inflation for quite some now, and they may be waiting a lot longer. There is simply too much slack in the U.S. economy right now for inflation pressures to emerge.
The Investing Answer
You can bet we’re going to see another mania within a few years -- as Elvis Costello reminds us -- but it’s not clear where it will happen. Might stocks suddenly start surging much higher? What about oil prices? Heck, maybe housing prices will start rising and we’ll again be in a manic phase as investors spot deep bargains.
These are implausible scenarios right now, but we’ll be talking about them again one of these years. Feel free to jump on the early stages of whatever mania pops up. But if we can learn anything from the silver mania, you’ll need to take profits where you can get them because things can get pretty nutty as mania fever deepens.
