TED BUTLER COMMENTARY

October 16, 2006

RELATIVITY

(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.)

One of the soundest money principles is relative value. The true value investor is always on the hunt for that which offers the best intrinsic value when measured against comparable choices. This is a common sense exercise for all of us when buying anything, from groceries, to gasoline, to clothing on a daily basis, or big-ticket items like cars or computers or houses. We instinctively seek out the best relative value, the best buy. It’s all about getting the most bang for your buck.

Nowhere is this principle more important than in the investment world. We want to put our money into not only the best investment class, but also the best choices within that investment class. If one decides to invest in bonds, then the search begins for the very best bonds. Same with stocks, or real estate, or anything. Yes, this is very basic stuff, but rock solid.

The beauty of relative value is that, once you have decided which asset class to invest in, finding the best value within that class is fairly straightforward. Once you have decided to invest in common stocks, for instance, your search is then narrowed to finding the best stocks. While it is always possible to choose wrong, the relative choice between which computer stock to buy is easier than deciding if computer stocks are a good investment in general. That’s because the criteria for decision are greatly narrowed. Basically it comes down to how comparative stocks will do against each other, and not broad macroeconomic concerns.

There’s nothing complicated about finding the best relative specific investment once you decide on an asset class. You simply want to buy the cheapest item; the one that offers the biggest price discount from comparable intrinsic values.

I think natural resources are the best long-term asset class, due to demographics and world economic growth and future mineral production constraints. I’ll tell you a bit more why in general, and then why I feel that silver is the best possible relative choice in that asset class. Even if you disagree that natural resources are likely to be the best asset class for the long term, there’s always still merit in deciding what single component may be the best relative value in any asset class. That’s because if you pick the best relative bargain in any asset class, it can turn out well even if you picked the wrong asset class.

Within the natural resource asset class I choose to focus on the major non-ferrous metals, including copper, aluminum, zinc, nickel and lead. Many of these metals have been hitting new all-time price highs as I write this article. I’ve excluded tin (because it is financially insignificant compared to the others), but have included gold and silver from the precious metals group. Silver is, of course, considered both industrial and precious, and I am including gold because it is the logical and obvious precious metal companion of silver. I’ve excluded the other precious metals, including platinum and palladium, for a variety of reasons.

This comparative look at metals is not a new concept and I’ve written about it before in articles such as, "Friedman’s Theory" http://www.investmentrarities.com/01-04-05.html which discussed relative amounts of below ground resources and "The Relative Value of Silver" http://www.investmentrarities.com/04-13-04.html which compared production ratios of copper, gold and silver versus price. (If you want to do something interesting update that article by substituting current prices for copper and gold and see what new silver price is projected. Hint- it’s a lot higher than in the original examples) While the concept may not be new, I’ll look at some new methods of comparison, in the quest to determining correct relativity.

Before the specific comparisons, let me explain why I have chosen natural resources, and specifically, the non-ferrous metals as my preferred general asset class. The total world economic output (GDP) runs more than 45 trillion dollars annually. It has been growing at close to 5% annually, for the past few years, or more than $2 trillion per year. Without natural resources (energy, foodstuffs, all metals and other commodities), there wouldn’t be a world economy. Just like there wouldn’t be life without air, water and food. Natural resources are a necessary and vital component of the world economy.

Further, there would be no modern world economy without the industrial metals. How could there be? Yet in a $45 trillion world economy, the total annual cost to the world for all the copper, aluminum, nickel, zinc, lead, and silver consumed (plus gold, although gold is not industrial) is only $315 billion. Please think about that for a moment. The cost of these metals is less than 1% of the total world economy. Yet, without these metals there would be no world economy. And this is after all of these metals have at least double from low price points, with some up 3, 4, and 5-fold.

My point here is simple – the price tag to the world economy for the metal in question, even after the dramatic increases over the past few years, is small. That is not to say prices can’t or won’t come down at some point, but at less than a 1% cost to the world economy, they don’t have to come down because the total cost is excessive or onerous. Add in the growing demand, for as far as the eye can see, and you have the basis for this being my choice for the best asset class.

Now, to the specific comparisons. Here’s a breakdown of the dollar cost to the world annually for the metals’ mine production in question, based upon current prices compared to four years ago. (Sources – LME, Silver Institute, World Gold Council).

In Billions of Dollars–

Aluminum -     65        35

Copper -         115       22

Nickel -          36         7

Zinc -              34         7

Lead -             9           3

Gold -              48         24

Silver -             8          3

TOTAL           315       101

A few observations about this data, before my conclusions. The annual cost to the world economy, from 4 years ago, as a result of these price increases has grown by $214 billion. Compared to the $8 trillion growth in the world economy over that same period, this means the increase in these metals is less than 3% of just the growth in the world economy. As stated above, the total current cost of these metals makes up less than 1% of the $45 trillion world GDP.

To put the increase in these metal costs to the world in further perspective, the current cost to the world for crude oil has grown by almost $1 trillion from 2002, or almost 5 times the increased current cost of these metals combined.

My first conclusion is that it would appear that the world has and can "afford" the price increases in these metals. Certainly, I am aware of no credible assertions that the increase prices of these metals threaten world economic growth. Further, considering that the easy inventories and scrap has already been consumed over the past few years, those already-consumed supplies are no longer the price depressant they once were. From this point forward, it’s going to take plain vanilla increased mine production and decreased consumption to balance supply and demand. Only price incentives can accomplish that. This is at the heart of why this asset class looks attractive to me.

Another point is that it has been increased demand and world economic growth behind the surge in prices of these metals, versus any serious supply disruptions. There has been a demand-push theme to the price increases to date. There is no way that these industrial metals could all be subject to simultaneous tightness and dramatic inventory drawdowns without strong world economic growth.

Specifically regarding silver, there is no way that all the base metals could be experiencing across the board demand and inventory drawdowns without the same thing occurring in silver. After all, the one thing you can say about the base metals is that they are demographic and GDP-sensitive. This is even truer with silver, since the industrial applications for silver are more diverse and varied than all the base metals combined.

Further, on the supply side, since silver is principally produced as a by-product of the very metals being discussed, any suggestion that silver production is growing while copper, nickel, zinc, lead and gold production is stagnant is absurd. The link between silver and the rest of these metals is as close as it gets, from both a production and industrial consumption basis.

My principal conclusion regarding the information in the table is straightforward. Simply stated, the world economy cannot exist in its current form without copper, zinc, nickel or lead, or any important industrial commodity. It will pay what it has to pay in order to have these materials. There is no other choice. The same goes, in spades, for silver. So ask yourself - if the world can afford an increased annual cost of $93 billion for copper, or $29 billion for nickel, or $27 billion for zinc, or $24 billion for gold with no obvious dislocations, what could the world afford to pay for silver? Based upon those examples, it would appear that the world could afford $50 to $150 ounce silver.

Therefore, on a total affordability basis, silver would appear to have a great deal of catch up to the other metals. That makes it, in my opinion, the best relative value among the industrial metals (ex gold) by this calculation. But there are other, even more important considerations that mandate silver as the best relative choice. Chief among them are practicality.

How the heck does the average investor buy real copper, zinc, nickel or lead? The short answer is he can’t. He can buy common stocks in mining concerns, but that involves extra complications (which is why I don’t publicly recommend them). He can buy pure paper contracts with no metal backing, including the LME nickel contract currently in delivery default. But this is not the same as buying real metal. In silver, he can buy real metal.

Sometimes, the choice is very easy. This is the case with buying silver versus the other industrial metals. Not only is silver the best relative investment from a pricing basis, but it is also the only practical possibility on a real metal basis. If someone chose to participate in the natural resource asset class and wanted the very best component of that class, I am hard-pressed to see how that choice wouldn’t be silver.

The Real Gold/Silver Ratio

Obviously, investors can also buy real gold as a natural resource asset class choice. As I have written, I think gold is currently a good buy on a risk reward basis, due to the favorable COT structure. But since gold is not considered an industrial metal, it’s hard to justify buying it as a substitute for copper, nickel, zinc or lead. Silver, yes, but not gold. But on a precious metal basis, gold does represent an easy alternative to silver. It’s not as bulky and the bid/ask spreads are much tighter. And gold is certainly more popular than silver.

So is easy and popular the way to go? Not to me, but you have to decide for yourself. The key to investing, once again, is to get the most bang for your buck, not to do what is easier or more popular. It amazes me to hear many pundits acknowledge and actually predict that silver will outperform gold, and then turn around and suggest people buy gold instead of silver. It makes no sense to put your money in anything other than what you think will perform the best. If one believes gold will outperform silver in the long term, then, by all means, he should invest in gold over silver. But is that a well-founded belief? You decide.

Just about all the "fundamentals" attributed to gold, like it being a currency or inflation hedge, or as some type of money, apply to silver as well. There are obvious differences, like color and price and physical and chemical properties and the amounts held by world governments, but these are fairly well known. Much less well known are other important differences.

There is more above ground gold than silver. There is more above ground gold created everyday, while there is less silver everyday. There is fewer years’ production below ground of silver than gold, according to the US Geological Survey. Since silver is an industrial metal, it is needed by the world economy, like copper or nickel. That means the world will pay any price necessary to get silver for industry Gold is not an industrial commodity, but a highly desired item. Silver is needed and may be wanted, gold is only wanted. Need and want are qualities that can result in higher prices. I think industrial need is the more powerful, particularly if industrial users go into an attempted inventory-building panic, but the key point is that silver has both qualities, need and want, while gold has only want.

Perhaps the greatest difference between gold and silver is the "market capitalization" of each. While this factor is as widely unknown as is how rare silver is compared to gold, when just a small number of gold-only investors grasp this concept, there will be a profound impact on the price of silver.

By market capitalization, I am referring to how much all the gold in the world is worth, versus how much all the silver in the world is worth. It’s a very simple concept that is widely used in the investment world for relative measurements. All you do is multiply the amount thought to be in existence by the current price.

In gold, there is said to be more than 4 billion ounces in above ground existence that could possibly be available to the market near current prices. At $600 an ounce, the market cap comes to $2.4 trillion. In silver, there is thought to be less than one billion ounces available, near current prices, giving a market cap, at $12 an ounce, of 12 billion dollars. The gold market cap is 200 times the market cap in silver.

There is 200 times more gold than silver in the world, in dollar value. Dollar value is the basic measuring yardstick in the investment world. I would submit that 200 to 1 is the real gold/silver ratio Stated in the reverse, this means that all the silver in the world is worth one half of one percent of what all the gold in the world is worth. Please think about this for a moment.

What this means, to me, is that this is a one-way trade. (It is also why I have recommended a switch from gold to silver for many years.) Because there such a large market cap in gold compared to silver, even if all the owners of silver decided simultaneously to sell their silver and buy gold, it would only amount to 0.5% of the market cap of gold. But if only one half of one percent of gold owners decided to switch into silver, that would represent 100% of the silver market cap. This would impact of incredible proportions on the price of silver.

I am absolutely convinced that very few grasp this concept. The truly remarkable aspect is that it is completely unnecessary that many grasp it in order for it to have a profound impact on silver. Just let a few big holders of gold try to make the switch into silver and you will see real fireworks.

If you are looking for a reason as to why and how something like this go unnoticed for so long, I have a one-word answer – price. The world’s investors get their main clue from price. That’s not real analysis, but it is reality. Because gold has traded 50 times or more the price of silver, the investors of the world assume that gold is more rare than silver. They haven’t the slightest clue that the market cap of gold is 200 times greater than silver. They haven’t the slightest clue how vital silver is to industry and their own modern standard of living. Or that there is more gold being created everyday, while the amount of silver in existence is shrinking daily. They only know the price of gold is so much higher than the price of silver.

But price is a two-edged sword. It cuts both ways. Just like the (manipulated) low price of silver convinced investors how it must be super-abundant compared to gold, as the price of silver gains on the price of gold, the world’s investors will take notice. If history and human nature is any guide, the relatively stronger price of silver will beget silver investment, creating a self-fulfilling momentum of silver buying. The real opportunity is, as always, positioning oneself before the masses react.