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.
September 2, 2011
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