Canada’s Dr. Doom Likes Silver

04/30/2012 10:00 am EST

Focus: COMMODITIES

Gordon Pape

Editor and Publisher, The Income Investor and the Internet Wealth Builder

If a well-respected market analyst hates everything but one sector, it pays to know what that sector is, writes Gordon Pape of The Canada Report.

Money manager Eric Sprott has gained a reputation as an implacable bear, Canada’s version of Nouriel Roubini (aka Dr. Doom).

In fact, that has not always been the case. Back in the 1980s, Sprott was bullish on the stock market. But that’s ancient history. Since 1999, he has been Canada’s highest-profile doomsayer. To hear him tell it, the markets are in long-term decline and everything is going to hell.

He was in his usual end-of-the-financial world-as-we-know-it form when he spoke to an audience of financial professionals in Toronto recently, at the kick-off of his company’s annual national road show. In a presentation titled "Mania. Manipulation. Meltdown."

Sprott predicted the collapse of almost everything. "There is nothing positive in Europe," he intoned, noting that the continent’s banking system is only being kept afloat by massive 1% loans from the European Central Bank.

China has shown negative manufacturing growth for five months in a row, which has not happened in recent memory. A hard landing could be in the cards.

The US is weighed down by an impossible debt burden of $100 trillion in present value terms when Social Security, Medicare, and public sector pensions are factored in. He quoted a recent report that predicts a US recession by mid-year.

As for the stock market, he points out it went up in the first quarter on decreasing volume. "It’s a BS rally," he tells the audience, who would like to believe it’s anything but. "We have a system that is breaking down," he concludes.

What’s the answer for the investor who, after listening to all this, is in a state of near-panic? Surprisingly, not gold. "It was the investment of the last decade," he says dismissively.

The answer is silver. Eric Sprott has become Canada’s Silver Bull. And he says his conviction has nothing to do with a new fund his company is launching, the Sprott Silver Equities Class. He’s a true believer. "It’s the investment of the decade," he proclaims.

Why? Let us count the reasons.

1. Demand exceeds supply. Annual production is about 900 million ounces per year, including recycling.

Industrial usage alone will rise to 660 million ounces by 2015. That leaves only 240 million ounces for coinage, central bank purchases, and investment. The latter category is huge; as of 2010 holdings of physical silver to back up exchange traded funds was 577 million ounces.

2. Silver is undervalued compared to gold. The historic silver to gold ratio is 16 to one.

The geological silver-gold in situ reserve ratio is 17.5 to one. The silver-gold price ratio is 52.87 to one. The implied price if silver reverts to its historic ratio with gold at $1,600 an ounce is $100 an ounce. The actual closing price on April 13 was $31.49.

3. The silver price is artificially low. There has been speculation for some time that the price of silver has been kept deliberately low by market manipulation.

Historically, silver has a bad reputation in this regard. In the late 1970s and early 1980s, the Hunt Brothers (Nelson and William) borrowed heavily to buy silver futures, and at one point held the rights to more than one-third the world’s non-governmental supply.

During that time, the price of the metal rose from $6 an ounce to almost $50 an ounce in January 1980. The bold move prompted drastic changes in margin rules. When the Hunts were unable to meet a margin call for $1.7 billion, panic set in and the price of silver fell 50% in four days.

When it was all over, the Hunts lost more than $1 billion, and several years later were found guilty of conspiracy in a civil case and slapped with a $134 million penalty. They declared bankruptcy.

We haven’t seen anything that dramatic in the current market, but Sprott pointed out that a huge short position of 250 million ounces in early 2011 exposed some powerful institutional investors to big losses if the price of silver rose. Those positions are being unwound and recently stood at 75 million ounces.

However, he believes the manipulation is still going on, pointing to the sale of 137,000 ounces of silver in a one-hour period on February 29, which resulted in a drop of 5.2% in the price. A further unwinding of short positions is needed to free the metal to rise in value.

Although the rationale is persuasive, I view predictions like this with skepticism, mainly because I have heard it all before.

But if you want to make a bet on silver, one way to do it is by investing in some shares of Silver Wheaton (SLW) which is on our Recommended List. The Bank of Montreal brokerage arm projects a three-year increase of 75% in the company’s earnings per share, based on an average silver price of $33 an ounce.

Another stock that Sprott likes right now is First Majestic Silver (AG), which operates three mines in Mexico and is projected to have EPS growth of 110% over three years. A more speculative position is SilverCrest Mines Inc. (Toronto: SVL), a small company with positive cash flow and plans to increase production.

Keep in mind that the current trend in precious metals prices is down, and that is likely to continue until the latest rush to US Treasuries runs its course. Watch the market closely and be prepared to act when the gold and silver prices show signs of bottoming.

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