In my previous article, “Do Gold Betas Point The Way To Greater Profits,” I looked more closely at the recent performance of gold mining companies. Investors who have tried to bet on gold through mining stocks have had mixed results lately. While GLD is up about 25% over the past six months, many mining companies have posted relatively disappointing results, including Barrick Gold Corporation (ABX) which was essentially flat over the past six months. While there might be perfectly logical explanations (e.g., significant hedging, poor management decisions, etc. …), the results are nevertheless disappointing to investors in the mining companies.

So when I saw several articles touting the benefits of silver mining companies, I was wondering just how correlated are these mining stocks to silver prices. Many precious metal companies mine both gold and silver, meaning that there are fewer pure plays than one might expect. So when I read “5 Silver Stocks that Could Surge Higher,” I wondered just how much of a relationship there was between silver prices, as measured by the two aforementioned ETFs, and these silver mining companies. The articles thesis is largely summed up in its opening paragraph:

The latest surge in silver prices has seen companies on this list profiting handsomely. Their revenues should continue to rise as silver production increases through new exploration programs or by acquisitions. These stocks are only suitable for investors who have the emotional and financial resources to stomach the ride that comes with holding stocks that are leveraged to volatile silver prices. – 5 Silver Stocks That Could Surge Higher

So if one is betting on silver prices, would it be better to buy silver miners and take on some additional risks or buy direct exposure through SLV or SIVR. The following securities were considered in this analysis:

Silver and Gold Securities

Source: Yahoo!Finance

For a silver miner to be a good way to bet on silver, their stock performance should be correlated to silver prices. The following table shows the companies correlation to SLV, GLD, and SPY.

36 Month Correlation to

Source: Derived from split and dividend adjusted monthly prices from Yahoo!Finance. SIVR, GDXJ and SIL do not yet have 36 months of history. Over shorter time frames, SIVR as expected offers ~100% correlation, GDXJ offers a 70-80% correlation and SIL offers a 70-80% correlation.

The first observation is that the correlations between the various mining companies and SLV is not very good, ranging from 50-73%. GDX, the gold mining ETF, offers the third highest correlation after EXK. The security with the highest correlation is ironically GLD. So for an investor betting on silver prices, picking silver mining companies might not be the best approach. Simply purchasing exposure through SLV or SIVR would be better. The next best options would probably be SIL and GDX which provide some diversification of company specific risks. However, it should be noted that several silver mining companies have had extraordinary performance over the past year with AG, EXK, and GPL all up over 200% compared to just 81% for SLV.

Disclosure: I am long SPY.

Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.

Silver was hardest hit and platinum and palladium prices came under pressure as well. December silver slid -9.8% or almost $4 to $36.50 an ounce while October platinum lost -4.9% or $87 to hover just above the $1,700/oz level. Palladium for December delivery traded down -8.1% to $655.05 an ounce.

The iShares Silver Trust ETF fell 8.2% and the SPDR Gold Trust ETF GLD fell 2.6%, while November gold futures slipped a more sharp 3.9%.

MarketWatch quotes Matt Zeman, head trader and strategist at Kingsview Financial in Chicago: “You’ve got liquidation, people are going into cash and Treasurys. Fear is dictating the gold market.”

Reuters quotes Peter Hillyard, ANZ head of metal sales in Europe: “The textbook ideas, the things we follow, the things we believe to be so are being shot to pieces for the moment and it’s very difficult to trade other than for a long-term view.”

Bloomberg quotes Lv Xiaowei, an analyst at First Futures Co: “If the global economy continues to deteriorate, there will come a point where we’ll see both gold and the dollar going higher together as people look for least risky assets.”

Base metals were not spared and the December copper contract fell 30 cents, or 8%, at $3.46 a pound – down from $4.15 a pound just two weeks ago.
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Precious metals ’shot to pieces’ as losses continue to mount

More or less all commodities had been outperforming the rest of the market, partially due to loose monetary policies and low interest rates, but silver in particular was one of the leaders gaining over 77% between February, and the end of April. In addition, the Silver market has been in backwardation and supply constraints were evident among physical products as big investors including Eric Sprott were taking record amounts in delivery.

After a two year run up in prices, the correction in silver was followed by a pullback of commodities across the board including gold, oil, and copper. The correction in silver may have been exacerbated by an unprecedented number of margin hikes in silver future contracts. The CME Group increased margin requirements for future traders by 5 consecutive margin hikes within two weeks, resulting in an 84% increase in margin requirements.

How far will silver correct?

We don’t know for sure how far silver will correct. It already made a 32% correction and erased all gains since March, 2011. To help answer this question it may be helpful to look at previous corrections. The chart shows any meaningful corrections since 2000 when the Bull Market began. The current correction is rather significant and has only been matched by three other corrections over the last 10 years. The steepest correction was by far in 2008, during the financial meltdown, which caused silver to correct by more than half.

How long will this correction last?

Silver trades in a thin market, which results in high volatility and large prices swings. Previous corrections have lasted between a month to well over a year. The chart shows how long it took for silver to make a new high after a correction. It has previously taken anywhere between 7 months to 17 months for silver to make new highs after similar magnitude corrections. Although the past is not indicative of the future it may provide us with some guidance.

When will a bottom be established?

During previous corrections it has taken anywhere from 1 to 5 months for the market to find a bottom. The chart compares the size of each previous correction with the time elapsed for a bottom to have been reached. A 2 to 4 month period seems to be the average.

Despite a significant correction in silver prices the long term outlook is still very bullish. It is important to remember that the fundamentals that have been driving the market are still intact. We still will have record deficits, a weakening dollar and a horrendous debt problem that is not going away. In addition, limitations of supply of physical silver persist, and backwardation has widened to almost a dollar according to James Turk.

This correction has presented a buying opportunity for investors who felt that they were being priced out of the market with silver close to $50. SLV and SLW in addition to physical metal are all attractive silver plays.

iShares Silver Trust (SLV) is one of the most popular silver ETF’s. The trust holds physical silver in a custodian bank, and is designed to reflect the price of silver on the market less expenses and liabilities. Although you are subject to the risk of relaying on a custodian to actually hold your silver, this EFT is a very cost efficient instrument and an excellent trading vehicle.

Silver Wheaton Corp. (SLW) is a mining company and the largest metals streaming company in the world. It generates its revenue primarily from the sale of silver. It buys streams at low fixed prices and sells the metal at market prices. The streaming strategy allows the company to significantly reduce its operating costs, and keep its capital expenditures at a minimum, while still having access to a large amount of silver. The company at present has fourteen silver purchase agreements and two precious metals agreements where, in exchange for an upfront payment, it has the right to buy all or a part of the silver production, at a low fixed cost, from high-quality mines located in various geographical regions. In 2010, the company generated sales of $423 million, and with an impressive 69% margin, SLW made $290 million in net income. As the price more than tripled since its low last year the current correction may present a buying opportunity in to this very profitable company.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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A look at how far silver might correct

That is some very hungry demand. Which raises the question, how long can this pace continue?

This is important for various reasons, starting with how demand contributes to price. If demand falls off, our investments could, too.

While I’ve discussed the concern regarding the lack of supply before, which has its own implications for the silver market, let’s focus on investment demand. Frankly, is there room for it to continue to grow? After all, how long can investors continue to set records?

There are a number of ways to measure this – the amount of money available to invest, its percent of total financial assets, its contrast to demand in the last bull market, etc. – but I think the bottom line to answering the question is to compare the biggest silver investments to some popular equities. If they rival that of the stocks we always see on the news and analysts constantly talk about and every fund manager wants to own, then it might be reasonable to assume demand could be nearing its pinnacle.

So how do the world’s largest silver ETF and one of the biggest silver producers compare to the more fashionable equities?

The largest silver ETF, iShares Silver Trust, has net assets of $9.6 billion (as of February 4). This pales in comparison to the more popular stocks trading in the U.S. In fact, SLV has roughly 3% the market cap of Apple. It would have to grow over 43 times to match Exxon Mobil.

Pan American Silver, the largest pure silver producer trading on a major U.S. exchange, has a market cap of $3.72 billion. This is 4.7% the size of McDonald’s. The market cap would have to increase more than 53 times to match Walmart. It is over 62 times smaller than Microsoft.

This isn’t to suggest SLV and PAAS will match the market cap of these other companies, but clearly the masses are still demanding much more of them than the biggest of silver’s investment vehicles.

So how much more demand can silver handle? As much as it takes to make it the household name I’m convinced it will be before this is all over. When SLV is a favorite of fund managers. When Silver Wheaton is a market darling of the masses. When Pan American is Wall Street’s top pick for the year.

Imagine what those bars on the right will look like when most everyone you know is talking about poor man’s gold. The rise could be breathtaking.

Remember that silver rose over 3,646% from trough to peak in the last precious metals bull market; it’s up about 630% in our current run. A return matching the 1970s advance would push the price to $152. This price level is further supported by the fact that this is about where it would be when inflation-adjusted for its 1980 peak.

When you look at the potential growth in market cap of the world’s biggest silver investments, it becomes easy to view any downdraft in price as nothing but a buying opportunity. I know I do.

[The current edition of BIG GOLD includes naming the cheapest one-ounce bullion coin on the market right now, plus a new gold stock pick that has incredible growth potential. Get all this and more for only $79 per year, including a 3-month trial with full money-back guarantee. Details here.]
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How much more demand can silver handle?