TED BUTLER COMMENTARY

June 3, 2008

BUBBLE MANIA?

(This essay was written by silver analyst Theodore Butler, an independent consultant. Investment Rarities does not necessarily endorse these views, which may or may not prove to be correct.)

If there ever was an overused word in the current financial world, it has to be the word "bubble." It seems that everything that moves sharply up in price is now said to be in a bubble. Recently, I have read, and heard, more commentary on what item may be in a bubble than at any point in my lifetime. I’m sure you have as well.

Much of the current commentary, particularly from those whose opinions I respect, leaves me confused as to what being in a bubble means to the average investor. While there’s a debate as to whether we are experiencing a bubble in certain items, there’s much less attention on what an individual investor should do about it. Nowhere is the term currently used more than with crude oil, the most important commodity of all (save food, also said to be in a bubble). No commodity’s price rise has garnered more attention than crude oil. But if oil and other commodities are in a bubble, what does that mean to investors?

Let’s take a step back and first define the word bubble. Many say it is simply any item that gets overvalued in price (compared to its fundamental value) due to excessive speculation. That definition doesn’t go far enough. A true bubble involves widespread public participation, tacit government support and the use of leverage to buy the asset in the bubble. While the bubble is in full force, vast numbers of people appear to be winners, which in turn attracts more participants. All remain in the game. Finally, prices in a bubble eventually reach levels so much above any sane measure of supply and demand, that the inevitable price deflation is severe and long lasting. Most participants lose. However, some are lucky enough to get out near the peak and are financially set for life.

Prior to the past ten years or so, the term bubble was used sparingly. It was reserved for truly historic price events like the South Sea Bubble and the Holland Tulip Bulb Mania. But two recent financial events did qualify as historic bubbles, and that has created a propensity to label any subsequent unusual price rise as a bubble. I’m speaking of the dramatic price rise in technology common stocks in the late 1990’s, ending in early 2000, and the unusual and worldwide rise in real estate prices from 2000 to 2005. Tech stocks generally rose hundreds of percent in price, only to lose almost all those gains in the subsequent crash. Real estate is still correcting in price. Both bubbles involved widespread public participation and borrowed money.

These twin bubbles, tech stocks and real estate, were very unusual events. Most generations don’t get to experience even one genuine bubble. We got two. Money supply, credit creation and world economic conditions allowed the twin bubbles to come into existence, and then burst. Those forces still appear to be in place, setting the stage for future bubbles.

It is extremely important, investment-wise, to correctly identify a bubble in any item. Even more important, but rarely stated, is the identification of an item about to enter a bubble. That’s because there can be nothing more profitable than to correctly anticipate beforehand whether a bubble is likely to form. If one can anticipate a bubble developing in any item, and invests accordingly, that person would profit beyond any dreams imaginable. There could have been no better investment than to have purchased tech stocks or real estate before the bubble and then selling before the bubble burst. So let’s stipulate that investing in any financial item about to enter into a bubble is as good as it gets, and something we want to achieve. That’s the easy part, stating our objective. More difficult is identifying the specific item.

Let’s look at the current bubble poster child, crude oil. Even though the words oil and bubble are used in the same breath by commentators and regulators, crude oil doesn’t meet the definition of a true bubble. There is speculation in the oil futures market, as with every commodity, but there is no evident concentration suggesting manipulation. Moreover, there is no widespread public participation or borrowing to buy crude oil. No one you know is hoarding oil, and very few are winning on the price rise. Everyone is complaining about the crude oil price rise. Compare that to the day-traders, real estate flippers and get rich quick dreamers of a few years ago.

Even if I’m dead wrong, and oil is in a bubble, it’s still way too late to get in cheaply, nor is it a practical play for the average investor in either direction. I have experience in commodities for more than 35 years and I wouldn’t play oil in either direction with anyone’s money.

My point is that crude oil, at this time and price, whether in a bubble or not, is not a potential home run investment. Neither are tech stocks. When bubbles burst, history suggests they usually don’t re-inflate quickly. So, if we are in a quest to find the best potential asset that could develop into a bubble and fulfill the wildest possible investment dreams, where can we find it?

The Bubble To Be

If there is any single investment asset that is not yet in a bubble, but holds the potential to turn into one of the biggest bubbles in financial history, it is silver. More than other precious metals or commodities, stocks, bonds or real estate, silver has unique characteristics that make it the prime candidate to be the next big bubble.

Silver is still dirt cheap by any relative or absolute measurement, especially after its recent price correction. Yes, it is up four-fold from the lows of several years ago, giving early buyers an immense return, but it is still cheap compared to its own fundamentals and all other commodities, including gold. I know that some analysts I respect maintain that gold will go into a bubble of its own, greatly enriching investors. If that turns out to be true, it will enhance, not diminish, the likelihood of a bubble in silver, because silver is less than 2% of the price of gold and more rare in investment form. If gold doesn’t get to a bubble, silver may still do so, due to special circumstances unique to silver.

Silver is still off the radar of those who are capable of investing in it, namely, just about everyone in the world. Silver is a basic element, known to all cultures and in all places. In fact, it is somewhat of a miracle that silver has not entered a bubble yet. The key word is yet. Bubbles are unpredictable in their lifecycle, both when they start and when they end. My main point is that silver is prime bubble material.

Silver is conducive to becoming a bubble. By that, I mean it is of the form that vast numbers of the world’s population, from the very richest to the not so rich can participate in direct ownership. Plus, silver has an existing worldwide distribution and investment infrastructure in place which can accommodate the largest institutional investor buying 1000-ounce bars to local village brides in India or Asia buying silver bracelets. Crude oil, grain, copper, sugar or zinc can not be held in their elemental physical form by the world’s investors. That precludes these items from entering into a bubble mania. Vast numbers of people can’t buy and hold them for investment. We witnessed bubbles in the past because they were doable, just like silver.

One of the characteristics of prior financial bubbles is that there was an initial sound economic rationale for investing in the item in the first place. There was a good story to begin with. Whether it was the profits that a company could earn through some new technology, or the rarity of a beautiful flower, or the demand for shelter, the initial story made sense. A bubble develops when the emotions and great numbers of people overwhelm the initial good story. And make no mistake, there is no better story than silver. The silver story is so good that I couldn’t make it up if I tried. No one’s imagination could be that vivid. No one could fabricate a story of how an age-old revered precious metal, sought in every land and culture and accumulated for thousands of years, could suddenly develop into a vital modern material capable of more varied industrial applications than any other metal. And how, in the course of just a half-century, the world could deplete the accumulated inventory of thousands of years, in pursuit of vital applications.

What better story could there be? Because of the depletion of the world’s silver inventories, silver is rarer than gold and its price doesn‘t reflect that fact yet. If a bubble develops in silver, it will probably occur because enough people recognize silver’s rarity and new investors will chant the mantra that silver is rarer than gold. They will justify the purchase of silver at any price less than gold’s price, and perhaps equal to or more than gold’s price.

While I don’t think most world governments would welcome a silver bubble, the amount of silver owned collectively by world governments is the lowest in hundreds of years. They are incapable of dousing any price fire from a silver bubble (unlike gold).

Silver is used in tiny amounts in most applications. Dramatically higher silver prices will not bring the pain to consumers like increases in oil and food. Hence, there will be less widespread political pressure from constituents to fight a silver price rise (save the Silver Users Association).

It’s not certain that vast amounts of leverage would fuel a silver bubble, but it could, particularly when it involves large institutional investors, such as hedge funds. But, importantly, no leverage is needed to fuel a silver bubble. That’s because silver is so cheap and there is so little remaining in existence, that borrowed money is not needed to drive prices sharply higher. With perhaps a billion ounces of investment silver in existence, there is less than $20 billion worth of silver in the entire world. That is truly a small amount of money for the entire worth of an important world asset. There are individuals, and certainly many investment pools, with more than that. Please keep in mind that the more silver that is held on a fully paid for basis lessens the chance of a leveraged induced sell-off, like the kind we have seen regularly on the COMEX. As more investors buy for cash, shaking them out will be harder. Even the thought that big leveraged money might flow into silver should boggle the mind.

Don’t assume for a moment that just because a billion ounces of silver may exist, as small as that is in actual material and money, especially in per capita terms, that somehow that small amount of silver is available for purchase at anywhere near current prices. Every ounce of that silver is owned by someone and only that person will decide at what price to sell. If the vast majority of owners of that silver have done their homework, as I suspect they have, that silver will not be coming to market any time soon. That greatly reduces the amount of silver that could be bought, and juices up the case for an investment bubble.

While I have not made it the focus of this article, I would be remiss if I did not mention the obscene short position of silver, both on the COMEX and in unbacked silver certificates. As you know, I consider the concentrated short position on the COMEX to be prima facie evidence of a silver manipulation. I am not so much concerned that you embrace my manipulation thesis, as I am for you to be aware of the unusual nature of such a documented short position. At the very least, hundreds of millions of ounces have been pre-sold, by just a few entities, and can’t be sold again. In a world destined to be chronically short of silver for investment demand, hundreds of millions of ounces already sold, but not yet delivered against or bought back, is bullish beyond description.

The purpose of this article is to add to all my prior research by suggesting the possibility that silver could enter into an investment bubble. This is on top of my prior analysis pointing to sharply higher prices, which stands by itself. Permit me to summarize the significance of the bubble possibility. I had previously pegged silver as perhaps hitting $50 or $100 per ounce. This prediction was made when silver was below $5, and seemed outlandish at the time. Today it doesn’t seem so extreme. But the possibility of silver developing into a bubble mania phase radically changes the equation.

Such a bubble phase in silver could easily lift the price into the hundreds of dollars price range. And in some ways, silver may not appear at that time to be excessively valued. For instance, at $200 per ounce, the 1 billion ounces of real investment silver in existence would be worth $200 billion. Assuming that gold was only priced at that time at $1000 per ounce (an admittedly very low number), that would make all the gold in the world worth $5 trillion, or still 25 times what all the silver was worth. And if gold were much higher, as is likely, the comparison would be more favorable for silver. With potential new investors realizing silver is rarer than gold, silver could still look cheap to them.

This is not a promise that silver is going into a bubble and will trade at hundreds of dollars per ounce in the next few years. It is intended as an additional thought process for you to consider. Don’t you wish someone hinted at such a possibility in tech stocks or real estate before those bubbles developed?