TED BUTLER COMMENTARY

                                                       July 17, 2007

THE PRINCIPLE OF SUBSTITUTION

(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.)

We are all familiar with the concept of substitution. This principle holds that, given no dramatic fall-off in quality, it is rational to replace one item with another based upon a cost advantage. In other words, we all try to get the best bang for our buck. We substitute as retail consumers, constantly seeking out the best product or service. Whether shopping for big or small ticket items, we seek the best over-all value.

Businesses adhere to the concept of substitution to gain bottom-line results. The commercial buyer will choose the superior value, quality or service if similar results can be achieved. In commodities, the concept of substitution reigns supreme. It’s an integral aspect of our free market economy. If it’s cheaper to feed one type of grain to cattle, or if pork is cheap relative to chicken, or if natural gas is a bargain relative to crude oil, those that can substitute for the cheaper item will do so. This is particularly true with the industrial metals. If one metal climbs too high in price, compared to other materials or processes that can achieve the same results, you can be sure of substitution. There’s no escaping the principle of substitution. It can have a huge bearing on the future price of silver.

As for substituting other metals for silver when the price gets too high, some of that will happen. However, silver is generally used in such small quantities per application, it’s often claimed to be price insensitive. It makes up such a small amount of the price of the final product it can rise a long way before substitutes are sought. Most importantly, the statistics for silver show that new uses and growing worldwide demand are outdistancing any reduction from substitution. Silver has the best story of virtually every metal when it comes to the principle of substitution.

Based upon this iron clad rule of substitution, I ask you to consider yet another bullish factor that has the potential to profoundly impact the price of silver. I believe that there is one substitution that could launch the price of silver to the heavens. I am speaking about substituting silver for gold as an investment.

You’ve heard silver referred to as "the poor man’s gold." I have always disliked that phrase and never use it. It implies gold is better than silver. My decades’ long study of silver tells me that is not true. Further, some of the personalities who have invested in silver, like Warren Buffett, could hardly be considered poor. On July 15 there was a front-page story in the New York Times about the truly wealthy in the US over the past 150 years. While Buffett and Bill Gates were the only contemporaries to make the list of the 30 richest, along with Rockerfeller, Vanderbilt, Astor, Carnegie and the Mellons, two of the 30, whose names I was unfamiliar with (Fair and Flood), owed their wealth to silver. Poor man’s gold, indeed.

However, there is always some truth in age-old phrases. It is precisely that truth that accounts for what I feel is a new and potentially powerful bullish factor in silver – substitution. At some point and at some price, some investors are going to substitute silver in place of gold for investment purposes. Most of those investors will be new to precious metals investing. Their prime motivation will be that they are excited by price action.

Recently, the venerable market analyst and editor, Richard Russell, wrote about something that I have also been "feeling in my bones." He wrote that it was his sense that, due to various trends in place, the world was headed for a blowoff in asset prices that would be one for the record books and take our breath away.

There has been recent commentary by some that there is a bubble in metal prices. Two of the principal characteristics of any price bubble are widespread public participation and excessive leverage, or borrowing to buy the asset. Neither of those two ingredients appears to be present in any metal today, but I believe they will come into play at some future point.

If and when this blowoff in asset prices takes place, there is little doubt that gold would participate. After all, gold is the most widely held investment commodity of all. There are millions of investors holding billions of ounces. Collectively, the dollar value of all the gold held runs into the trillions. Gold is big and visible. It is also expensive. There are not many commodities priced in hundreds of dollars per ounce. If the price of gold participates, it will get much more expensive. Here is where the principle of substitution should kick in, to silver’s great advantage.

For thousands of years the world’s population has come to think of gold and silver in similar terms. They are an easy to understand matched pair. It’s not gold and platinum, or gold and palladium, it’s gold and silver. This didn’t happen through any deliberate research or from anything that any analyst may have written. The pairing of gold and silver is ingrained in the minds of the majority of people.

If and when the gold price surges upward, there would be a spillover effect on silver. Since gold is already considered expensive compared to silver, any escalation in the price of gold will accentuate that perception. Let’s say gold rises to $900 an ounce. Even if silver rises to $30, it will still be viewed as cheap compared to gold. This is a key point. New metals buyers, influenced by price alone, would reason that they could buy 30 times as much silver for the same dollar amount of gold. Such buyers will be interested in how much bang for the buck they could get with silver.

Any rise in the price of gold causing people to buy silver as the only legitimate substitute, would have a disproportionate impact on the price of silver. Because there is so much more investable gold in the world than silver, both in ounces and dollar terms, an equivalent amount of money flowing into each would impact the price of silver far more. This disproportionate impact on the price action in silver would likely stimulate additional buying.

This concept of substitution differs from the various other reasons I have championed silver over gold. Those reasons include the depletion of silver inventories compared to growing inventories of gold. Also there’s the growing importance of silver as a vital industrial commodity, versus gold’s non-utilitarian nature. I also see an inevitable attempt by industrial consumers to stockpile inventories in a silver shortage, exacerbating tight physical conditions. In addition, there’s the powerful fact that silver is much more manipulated than gold, due to the unique and historic concentrated short position on the COMEX.

The ultimate investment quest is to position yourself in the assets that you feel will perform the best percentage wise. It’s really as simple as that. Because of this fact, I’ve never owned an ounce of gold. I do speculate on gold’s short term price directions and do have interests in companies that explore for gold, in conjunction with silver and other minerals. And I study the gold market more closely than most. If there were no such thing as silver, I would own gold.

The conclusion of the powerful principle of substitution should be clear. In the event of a gold price boom, the investor of tomorrow will likely also rush to buy silver, creating a disproportionate impact on price. The silver buyer of today holds a huge advantage in anticipating the price actions, but only by buying silver today and not waiting until the principle of substitution kicks in.

ASSET INFLATION

Newsletter editor Richard Russell recently wrote, "I believe we are going into an international third phase of the bull market. The third phase is the highly speculative phase. In the third phase of a bull market, stocks may rise faster and farther than what they did during the first and second phases combined…..

"This third phase will not be confined to stocks alone. It will include commodities, gold, silver, diamonds, art, collectibles, selected real estate with an emphasis on commercial real estate, hotels and homes on all coasts everywhere -- and, of course, stocks.

"The third phase will be fed by masses of fiat currency, abnormally low interest rates, modern communications and advanced technology -- plus a mass psychology of greed and "feel good" aided by a speculation-gambling sentiment on the part of not only the big money interests but also the masses. It will be a once-in-a-generation event -- on a scale never seen before in history.

"In every great bull market there is usually one area that serves to surprise everyone. Will there be such an area or an item which will surprise as this third phase moves into "high gear"? One item (this is simply a guess) comes to my mind. That item is silver, which now sells at an absurdly low price of under thirteen dollars an ounce."

A SHORT ANSWER

Dear Mr. Cook:

"I have been reading Mr. Butler's commentaries as published in Investment Rarities Market Updates.

"I do not understand how and why the alleged manipulators drive down the price of silver by going short. These people are not stupid. Do they not believe Mr. Butler's statements about how the silver reserves have been exhausted and that the usage of silver exceeds its production. If they do, why don't they buy silver, keep it, and watch the price soar?

"Mr. Butler writes convincingly, but I just don't understand the alleged manipulation by the short sellers.

"Please help me to understand this situation. I imagine there must be other readers in the same fix. I know of at least two others. If what I have described could be clarified, I think you would have buyers."

Mr. Butler’s response –

"I would call the manipulators many things, but stupid is the last thing I would call them. For many years, they have been able to control the market because they knew that the key group of opposing traders, the technical funds, could be tricked into and out of the market. The manipulators (commercial traders) collusively engineered prices up and down through key price points (moving averages). The manipulators made a fortune doing so. However, they stayed short too long and in amounts too large to cover easily. All this can be confirmed by studying the COTs.

"These commercial traders/manipulators would love to buy silver and let the price soar, if they could. But they can’t, for the simple reason that there is no one who could sell to them in any significant quantity. Who could possibly be expected to sell to the manipulators, at near current prices, the hundreds of millions of ounces they normally deal in? It’s like the old Wall Street joke, "sell to who?" In this case, it is "buy from who?"