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Will silver do better than gold?

Many analysts are convinced that silver is going to outperform gold this year and for years to come. Are they right?

We don't know. What we do know is that: a) most of the recent silver-related commentary has focused on silver's upside potential and has not mentioned, or has glossed over, silver's downside risk, and b) silver bulls are generally ignoring the relationship between the silver/gold ratio and the economic growth theme. These two points go together in that silver's downside risk is linked to the potential for the 'growth trade' to collapse.

By way of further explanation we present, below, a weekly chart comparing the silver/gold ratio with the copper/gold ratio (in green) and the S&P500 Index (in blue). This chart shows that over the past 12 years silver has out-performed gold during periods when copper has been out-performing gold and when the broad stock market has been trending upward; in other words, when growth-oriented speculations have been gaining in popularity. The chart also shows that silver has performed very poorly relative to gold when growth-oriented speculations have been falling in popularity, especially when there has been a financial/banking crisis.

The chart's message is that you should be intermediate-term bullish on silver relative to gold if you are bullish on the economy, and intermediate-term bearish on silver relative to gold if you are bearish on the economy and/or the financial system. Strangely, though, some of the most vociferous silver bulls are bearish on the economy and the financial system.

We have always said that silver stood a good chance of out-performing gold over the course of the long-term precious metals bull market, simply because silver is a vastly smaller market than gold and therefore has the potential to make disproportionately large gains in response to increasing investment demand. However, we have also said that we favoured gold over silver due to gold's lesser downside risk. It's the risk relative to the potential reward -- not just the potential reward -- that determines the merits of a speculation. The risk is that a future banking crisis and/or major deflation scare will have the same effect on the silver/gold ratio as the last three such episodes (the early-1990s, the early-2000s, and 2007-2008), when silver cheapened relative to gold to the point where it took 80-100 ounces of silver to purchase an ounce of gold.

If you believe that there is almost no chance of a banking crisis or major deflation scare happening over the next few years then you should definitely favour silver over gold.

The Stock Market

The stock market has recently been quiet. Too quiet.

Here are a few of the observations we made over the first three trading days of this week:

1. The Brazilian and Indian stock markets continued to weaken and ended Wednesday's session at new 5-month lows.

2. The Hong Kong stock market, an important indicator of the global trend, weakened a little but hasn't yet done anything definitively bearish. Hong Kong's Hang Seng Index has short-term support at 22500.

3. The major mining stocks were noticeably weak on Wednesday. BHP made a new high as recently as Tuesday 8th February, but FCX and VALE have been declining for the past few weeks.

4. The senior US stock indices continue to trade as if there is absolutely nothing to worry about.

Gold and the Dollar

Gold and Silver

A point we've tried to make over the past couple of weeks is that there has been nothing in gold's price action to indicate that the decline since the December peak is anything more serious than a routine short-term correction. In particular, we noted that the US$ gold price had reversed upward in late January after touching its 150-day moving average, which is exactly what happened during every other short-term correction of the past two years.

The following daily chart shows that March gold has rebounded from its late January low of $1307 to short-term resistance in the $1360s. The fact that gold has made it back to the $1360s doesn't mean much because the first leg of a rally to new highs and a counter-trend reaction to the January decline would both be expected to take the gold price up this far. It's what happens next that should provide some useful information. For example, a pullback from resistance followed by a move above this week's high would suggest that gold was on its way to a new all-time high.

The silver/gold ratio made a new multi-year high earlier this week, an event that increases the probability of both gold and silver making new multi-year highs within the next few weeks. However, we would continue to be cautious and only accumulate new positions on weakness. Our concerns are that the silver/gold ratio never dropped enough to properly correct last year's moon-shot, and that while sentiment in the gold market is constructive the same can't be said of the silver market. There is a lot of froth in the silver market and this froth will have to be eliminated by a sizeable price decline that either begins from near the present level or begins from a higher level a few weeks from now.

There is some talk about silver being in backwardation, but based on the quote table displayed HERE it is more accurate to say that silver's forward price curve is flat. There is almost no difference between the nearest futures price and the prices of longer-dated contracts, so silver is neither in contango nor in backwardation. The flat forward price curve suggests some tightness in the silver market, which doesn't imply that the price is about to move higher -- since the tightness is already discounted in current prices -- but does suggest that the market will be more sensitive than usual to a bullish change in the near-term supply/demand balance.

Gold Stocks

Current Market Situation

The HUI's recent rebound took it from support at around 500 to the vicinity of its 50-day moving average. This is the minimum that would be expected from either a counter-trend rebound or the first leg of a rally to new highs.

We don't have any opinion on what will happen over the next several days, other than we don't expect a sustained break below the recent low. The HUI is not yet close to being 'overbought', so it wouldn't surprise us if the rebound continued. However, it also wouldn't surprise us if there were a pullback to re-test support.

As mentioned last week, on a very short-term basis we think that the HUI in the low-500s constitutes a sector-wide buying opportunity while a rise to 550 or higher creates a selling opportunity.

Financings Galore

There is obviously a lot of money sloshing around the financial system at the moment, and junior gold/silver miners are taking advantage of the 'excess liquidity' by stampeding towards the financing trough. For example, five of the gold/silver stocks in the TSI List have announced sizeable (relative to company size) financings over the past three weeks.

Some of the financings have been well managed in that the companies involved have done deals that substantially add to cash reserves without significantly diluting the interests of existing shareholders. Other financings, however, have been poorly timed/executed. Examples of the latter include the Jaguar Mining (JAG) convertible note financing discussed in the latest Weekly Update and the Catalpa Resource (ASX: CAH) equity financing announced late last week. The CAH financing was problematic from the perspective of existing shareholders because a) it was arranged after the stock had just dropped to a 5-month low, b) it involved selling new shares at a 10% discount to the current low price and at a huge discount to full value, and c) the company did not have an urgent need for additional funds. CAH's management subsequently boasted that there was very strong demand for the new shares, to which we respond: of course there was -- there will always be plenty of demand if you set the price low enough. At the other end of the financial management spectrum, on Tuesday of this week Sabina Gold and Silver (TSX: SBB) announced that it was raising money by selling new shares at, or near, an all-time high.

Anyway, the point we wanted to make is that the extremely accommodative financial backdrop is bringing about a large increase in the supply of shares at the junior end of the gold/silver sector. This increase in share supply should be kept in mind because it WILL weigh on stock prices during the second and third quarters of this year.

Currency Market Update

Over the first three days of this week the Dollar Index gave back about half the gains it made during the final three days of last week.

With regard to chart-based support and resistance, here's the situation as we see it:

1. Consecutive daily closes above its 50-day moving average would be a warning sign that the Dollar Index's bottoming process was about to end.

2. A solid daily close above 81.5 would remove all doubt that an intermediate-term advance began last November.

3. A daily close below the early February low would suggest that an intermediate-term bottom was NOT put in place last November.

Update on Stock Selections

(Notes: 1) To review the complete list of current TSI stock selections, logon at http://www.speculative-investor.com/new/market_logon.asp and then click on "Stock Selections" in the menu. When at the Stock Selections page, click on a stock's symbol to bring-up an archive of our comments on the stock in question. 2) The Small Stock Watch List is located at http://www.speculative-investor.com/new/smallstockwatch.html)

Gryphon Gold (TSX: GGN). Shares: 88M issued, 99M fully diluted. Recent price: C$0.215

GGN announced on Monday that it was in the process of arranging a $10M equity financing. The details haven't yet been finalised, but our guess is that the financing will involve 50M $0.20 units with each unit comprising one share of common stock and one-half of one $0.30 warrant. This would make the terms of the current financing the same as the terms of the $1.3M private placement that was done last month.

If the abovementioned financing is 'put to bed' within the next couple of weeks then GGN will have enough money to complete the first phase of the two-phase development process outlined in its "Road to Production" presentation. Phase 1 involves small-scale gold production from the old dump sites at the Borealis project (Nevada), and at a gold price of $1200/oz is expected to generate a gross profit of about $7M over 6 months. Phase 2 involves an expansion of the leach pad and the mining of an existing pit, and is expected to generate a gross profit of about $15M (at $1200/oz) over 12 months. Combined, Phases 1 and 2 are expected to result in gold production of around 40,000 ounces over the next 18 months, providing GGN with gross profit of around $22M. The plan is for this profit to be used to ramp up the production rate to 50K ounces/year by mid-2012.

In the current environment a 50K oz/yr gold-mining operation in Nevada would probably be worth at least $100M. Assuming no change in the market environment and a share-count increase to 170M, this suggests a valuation-based 18-month upside target of about $0.60/share for GGN.

As a result of what happened in 2008 -- when the demand for the stocks of micro-cap mining companies evaporated to the point where it was impossible to sell even small stakes without driving stock prices downward -- we decided that future inclusions in the TSI Stocks List would have to be sufficiently liquid that we could suggest buying or selling the stock without having a big effect on its price. Also, we established the Small Stocks Watch List for the purpose of tracking high-potential stocks that weren't liquid enough to be members of the TSI List.

Based on its size and liquidity, if we were introducing GGN to our readership today we would put it in the Small Stocks Watch List rather than the Stocks List. It has good upside potential (assuming that the just-announced $10M financing is completed as planned), but on most days it can only be traded in very small parcels.

    Andina Minerals (TSXV: ADM). Shares: 108M issued, 129M fully diluted. Recent price: C$1.73

After the close of trading on Wednesday, ADM announced that the results of the Pre-Feasibility Study (PFS) for its Volcan gold project will be published on Monday 14th February. The PFS will tell us (and the market) whether the company has been able to re-engineer the mine plan in a way that makes the project economically robust, despite the metallurgical issues previously discovered. It is therefore a critical milestone.

The bounce in the stock price over the past two days, which led to a mini upside breakout on Wednesday, is most likely due to anticipation of positive PFS results.

The following chart shows that ADM has substantial resistance in the low-C$2 area. A break above this resistance would suggest a short-term target of C$3.00, a price level that would be more than justified by the stock's valuation IF the PFS proves to be positive.

    Duoyuan Global Water (NYSE: DGW). Shares: 25M. Recent price: US$8.35

DGW's decline accelerated this week on higher-than-average volume. We aren't aware of any new developments that would explain the decline.

DGW is now trading at about 5.5-times its trailing 12-month earnings and at less than 5-times what it should earn this year, assuming that its accounting can be trusted. Of equal importance, the company has no debt and working capital of $7.44/share (including $6.08/share of cash). This means that if DGW's stock price is pushed down much further, its fast-growing, profitable water treatment/purification business will be valued by the stock market at zero.

There is an unusually large short interest in DGW's shares. Specifically, as at 14th January the stock's short ratio was 15.5, which means that the number of shares sold short was equivalent to 15.5 days of average trading volume (note: a short ratio of more than 6 is considered to be high). And the recent price action suggests that the short interest would now be even higher. This short selling could be due to traders betting on accounting problems, or it could be due to traders making bearish bets on China by shorting the most vulnerable US-traded China stocks regardless of company-specific fundamentals. The latter possibility is suggested by the fact that quite a few US-traded China stocks have unusually large short ratios. Examples, with the associated short ratio shown in brackets, are: YONG (8.5), DEER (13.6), SNDA (13.0), CHBT (10.3), CAGC (8.5), FSIN (7.6), LFT (11.1), ACH (13.5), CBPO (14.5), HRBN (15.6), GFRE (12.7), CRIC (39.3), GSH (24.0), MR (18.0), CMED (17.2), and CSR (8.3).

For information purposes, this is how we are handling DGW in our own account:
  - We bought half of what we would consider a full position in the mid-$12 area
  - We bought another 25% in response to this week's pummeling
  - We plan to buy the final 25% following a stock price decline to the vicinity of cash value, or evidence of a turnaround in the stock price, or the company receiving a clean bill of health from its independent auditors, whichever happens first.

Chart Sources

Charts appearing in today's commentary are courtesy of:

http://stockcharts.com/index.html
http://www.futuresource.com/