This
last year for silver has been awesome! After a sideways grind in the
$15 to $20 range for most of the first three quarters of 2010, silver’s
September breakout unleashed a beast that has been nearly unstoppable.
By the end of that breakout month silver blasted through its bull high from
early 2008, and has more than doubled since!
As
an investor who’s been accumulating a bunch of this metal for over a
decade, it’s been exhilarating watching my trove grow in value.
Our newsletter subscribers have also been rewarded handsomely, as at Zeal
we’ve been recommending physical silver since late 2001 when it was
just over $4. Silver bullion should be a foundational component of everyone’s
portfolio!
With
silver’s incredible gains I was even more excited for the part of my
portfolio that held silver-mining stocks. The companies that are
producing this shiny-white metal should be rolling in the dough with some
major profits leverage. And those next-generation producers should be
seeing the values of their deposits skyrocket.
But while the gains in silver stocks have been nice, they’re nowhere
near what I expected and have grown accustomed to over the course of this
bull. Considering their risks, these stocks should be delivering
positive leverage to the performance of their underlying metal, and they
don’t appear to be of recent. This is definitely a disconnect based on historic precedent.
Unfortunately
we’ve seen a similar disconnect in the happenings of silver’s big
brother, gold. Investors have been endlessly frustrated with gold
stocks recently too, and rightly so considering their performance relative to
that of the yellow metal.
Gold
stocks are easily measured as a group via the venerable HUI gold-stock
index. And it’s disheartening to see the HUI at the same level
today as it was when gold was at $1400 in late 2010, and not much higher than
where it was in early 2008 when gold was at $1000. The HUI/Gold Ratio further demonstrates this disconnect, currently at 2008 levels and
well below its pre-panic range.
While
silver stocks tend to follow the directionality of gold and gold stocks, I
was curious to see how they’ve fared in isolation relative to
silver. Unfortunately since this is such a small sector there
isn’t really a good measure of how they perform as a group.
Silver stocks don’t have a dedicated big-board index, and for a variety
of reasons the silver miners ETF that recently hit the scene doesn’t
fit the mold.
It’s
of course easy to scrub an individual stock up against silver, but this still
doesn’t give me the big picture on the health of this sector. For
this reason I decided to run some numbers and come up with my own
“index”. For the components I used 10 top silver-mining
stocks that have listings on major US stock exchanges. And to develop
some perspective I ran the data back to 2003, when silver’s bull
officially kicked off.
As
far as indexes go, the one I put together is simple and incomplex.
All I did was calculate the daily gains/losses of each of these 10 stocks,
and then averaged them together for a daily gain/loss that is applied to the
index. (Note: Not all stocks ran back to 2003 due to either lack of
listing or non-existence. The average daily index gain/loss from 2003
to 2006 is calculated from all available silver stocks of these 10. By
2006 all 10 stocks are included.)
This
hypothetical index is not a product of fancy formulas, it’s not
market-cap weighted, and it’s not price weighted. It is merely a
proxy on the collective performance of silver stocks as a sector. And
for demonstration purposes I indexed this index to the exact price of silver,
using the first trading day of 2003 as my starting point.
Even
though the starting points are the same, naturally silver and this makeshift
index are quick to diverge as their daily gains/losses differ. And as
one would expect, with the exception of the anomalous 2008 panic silver
stocks take the high road to reward investors for taking the risk. In
this example if an investor bought the metal and the index in the beginning
of 2003 and held on to current, he’d have seen gains of 913% and 1728%
respectively to the highs earlier this year (if I had chosen a different
start date, the gains and visuals would obviously be different).
You’ll
also notice that even though there is separation, the oscillations of stocks
and silver are clearly positively correlated. When silver rises, so do
silver stocks. When silver prices retreat, so do the stocks. And
this visual correlation is supported with an r-square of 93.8% over the course
of silver’s bull. This means roughly 94% of the daily price
action of silver stocks is mathematically explainable by the daily moves of
silver.
But
while this positive correlation is great (and expected), and over the long
term this chart shows positive leverage, this doesn’t eradicate that
lack-of-leverage notion over silver’s latest upleg.
Investors have short memories, and usually strut a
“what have you done for me lately” attitude.
So
what have silver stocks done for us lately? Well it has been nearly 12
months to the day since silver decisively broke above $20, over which time
silver stocks as measured by our index have gained an awesome 118%.
This type of one-year gain ought to make any investor happy! So why
aren’t we happy? Well, over this exact same span silver is up
114%. What have silver stocks done for us lately? They’ve
left investors without any leverage! 1-to-1 leverage is unacceptable
considering the serious risks inherent in these stocks.
Drilling
down on silver stocks’ relationship with silver, I can use this
hypothetical index to run a Silver Stocks/Silver Ratio. The SSSR is
exactly what it sounds like, the index’s daily
close divided by silver’s daily close. And charted over time,
this ratio indeed shows how silver-mining stocks are performing relative to
the performance of their underlying metal.
This
first SSSR chart offers us a bull-to-date view of how silver stocks have
performed relative to silver. And not surprisingly they’ve
delivered positive leverage. One of the reasons I indexed this
silver-stock index to the price of silver at inception is it gives us an SSSR
starting point of 1.00x. Though crude, it’s fair to deduce that a
ratio greater than 1.00x shows bull-to-date positive
leverage.
More
importantly is the SSSR gives us an idea of where silver stocks should be
relative to silver based on historic precedent. And one thing
that’s important to distill from this analysis is the effect of the
infamous 2008 stock panic. As you can see, the panic had a huge
negative impact on the SSSR.
With
the panic such a rare anomaly, it’s prudent to consider the SSSR in a
state of normalcy prior to this historic event. And in the 5 years
preceding the panic the SSSR averaged 1.64x,
fluctuating between about 1.30x on the low side and 2.00x on the high
side. Another way to look at this ratio is the silver-stock index
closed each day about 64% higher than silver’s prevailing price.
Well
this normalcy was thrown out the window in the panic. By the time the
dust settled the SSSR had plummeted well below 1.00x,
to an insane bull-to-date low of 0.60x. A falling SSSR can mean one of
two things. Either silver stocks are falling faster than silver, or
silver is rising faster than silver stocks. And with both stocks and
the metal aggressively sold into the panic blood bath, the former scenario
was the case in the SSSR’s decline. Silver stocks got creamed!
Eventually
investors realized the world wasn’t coming to an end, and they gobbled
up silver stocks at bargain-basement prices. At Zeal we were
aggressively buying, and in our November 2008 monthly newsletter we
recommended that our subscribers add a high-quality yet beaten-down silver
stock to their long-term investments. Today this stock is championing
our investment portfolio with a staggering 1001% unrealized gain!
Not
surprisingly silver stocks mounted a massive rally out of their panic
lows. And as you can tell by the directionality of the SSSR, they
greatly outperformed silver over nearly the entirety of 2009. By the
end of that year the SSSR had climbed all the way back into its secular trend
channel. This is quite impressive considering the extreme panic damage.
Even
more impressive is the SSSR continued to rise, exceeding 2.00x
and touching secular resistance. Silver stocks were rocking in the
second half of 2010, decisively outperforming their underlying metal.
But it was at this point that the SSSR was repelled by its trend-channel
resistance. And this is when investors started raising their fists in
fury. Secular trend channel be damned, how could silver stocks lag
considering the action in silver? This next chart clearly conveys this
“what have you done for me lately” mentality.
Through
about the first three quarters of 2010 the SSSR was slipping marginally
lower. And this shouldn’t come as a surprise considering the
state of silver at the time. Following its post-panic surge this metal bounced
around in the $15 to $20 range for the better part of a year. And this
sideways action usually leads to investors pulling out of speculative plays
like silver stocks and putting their capital to work elsewhere.
But
once silver caught a bid in September 2010, investors came back with a
vengeance. Silver’s breakout saw it blast through its March 2008
bull-to-date high and enter into a massive upleg.
And it took a nearly-straight line to $30 before finally taking a breather.
This
type of action warms the hearts of investors and risk-junkie speculators, and
they aggressively bought silver stocks as silver continued to hit prices that
had not been seen since the brief super-spike of 1980. And as you can
tell by the directionality of the SSSR, silver stocks were handily
outperforming the metal. Investors were being rewarded for the risk
they were taking in owning these stocks.
But
provocatively upon silver’s challenge of $30 the stocks ran out of gas,
and in December the SSSR hit its post-panic apex of 2.24x.
The SSSR’s initial leg down coincided with a brief silver pullback in
January that dropped it down under $27. And in this situation stock
weakness was to be expected. If silver prices pull back, it’s
usually risk-off and time to sell the stocks. Investors can’t
expect only one-sided leverage.
But
silver’s moderate pullback was indeed brief, and before long the metal
was back at $30 with its sights set a lot higher. Amazingly silver
proceeded to go parabolic, not looking back until it challenged all-time
nominal highs near $50. But as you can see, silver-stock investors
weren’t as enthusiastic about these record highs.
When
silver hit its high in late April the SSSR had actually trended down to 1.65x, a 26% drop from its high. Silver
was well outperforming the stocks, and this really had folks scratching their
heads since the metal was going nuts and the stock markets were strong (the
S&P 500 hit its year-to-date high the day after silvers). It was
seemingly the perfect environment for silver stocks to gain fanfare and
leverage the metal to the high side.
Silver
stocks were rising, and the gains were still great, but they ran at a slower
clip than the metal. This SSSR weakness really showed that stock
investors didn’t believe in these high silver prices. And as
contrarians expected, the metal fell sharply on the back side of its
parabola.
Silver
eventually found its interim base around $33, and has since launched higher
with gold in what has turned out to be a strange summer precious-metals rally.
So what have silver stocks done in this latest surge higher that has silver
back up over $40? Well according to the sinking SSSR, they continue to
lag. This time they’ve faced big headwinds amidst a sharp
stock-market correction.
So
what have silver stocks done for us lately? Unfortunately, not
enough! At $40+ silver these stocks should be tearing it up. But
for whatever reason, whether a lack of confidence that these levels can hold,
the stock-market correction, or an adherence to historic ratio levels, silver
stocks have not given investors the leverage they deserve and need recently.
Amazingly
some folks have trouble understanding why we need leverage considering the
still-great gains in silver stocks. And indeed this sector has been
among the best-performing of recent. In reality though it is easy to
understand this leverage requirement when you take into account the inherent
risks involved in owning these companies. Just to name a few, mining
companies are subject to geopolitical, geological, operational, and financial
risks. Silver has none of these.
In
order to give investors incentive to own these stocks there must be the
allure of positive leverage. With higher risks investors usually demand
higher rewards. Besides, if the gains aren’t outsized then there
is no reason to own stocks when you can get the same or better returns owning
the much-less-risky physical metal.
And
speaking of risk, this high-risk unbalanced-reward trend is very risky for
the silver-mining industry. These companies heavily rely on retail
investors to buy shares of their stocks and thus fund development and
expansion. If conditions like what we are seeing lately in the SSSR
persist, and investors do lose interest, this could be very dangerous for
today’s and tomorrow’s silver companies.
So
what are we to make of this period of silver-stock underperformance?
How long will it last? When will things turn around? Of course as
mere mortals all we can do is game probabilities for
what the future has in store. And as a prudent investor it’s
critical to pay attention to the many different driving forces that can
influence silver’s interim and long-term moves.
This
makeshift silver-stock index and resulting SSSR can act as a secondary
indicator that can be used to observe behaviors and perhaps support
buying/selling decisions. And as a long-term investor who holds both
bullion and stocks, and a trader who likes to speculate in stocks, such
metrics are indeed important to consider.
One
thing that the SSSR tells me for certain is that we are in an environment
where individual stock picking is increasingly important. Feeding this
ratio is an index where the gains and losses are averaged across a large
group. And as is usual in averaging, there are some big outliers.
Some of the individual silver stocks greatly underperform the average, and
some greatly outperform.
I
want to own the stocks that greatly outperform. I want to get bang for
my buck and have confidence that the hand-selected basket of stocks I own
will give me leverage to silver even though the sector as a whole may
not. Silver is still likely only in the middle of a secular bull where
prices ought to eventually eclipse those highs seen earlier this year.
And at these high prices the miners will be printing the Benjamins.
I have no doubt that investors will take a liking to silver stocks once
again. It’ll be hard not to considering their profits leverage.
Even
though gold is currently overbought, we are entering into a historically
strong season for precious metals. Perhaps the SSSR is poised to break
out of its downward trend and head back up towards secular resistance when
these opposing forces work it out. For this reason it is important to
have your silver-stock shopping list ready. And perhaps it is also time
to trust Zeal to guide your navigation of these crazy volatile markets.
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The
bottom line is silver stocks as a group are
performing quite well amidst silver’s spectacular run to historic
highs. But as the SSSR shows, these high-risk stocks currently
aren’t giving investors the positive leverage that is needed to make
owning them worthwhile. This is likely just a temporary disconnect, but
it has still caused some angst amongst investors.
To alleviate some of this angst, it would behoove investors to find
some outliers that are capable of delivering leveraged gains even when the
sector can’t. And though silver is in a state of limbo with the
crosscurrents of entering into a seasonally-strong time of year with gold
overbought, investors need to be ready to deploy at the drop of a hat.
Scott Wright
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Thoughts, comments, or flames? Fire away at scottq@zealllc.com . Depending on the volume of feedback I may
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