Is Silver in a Bubble?

Over the past five years, silver as represented by the iShares Silver Trust is up roughly 75% on the type of steady march higher that investors dream about, despite being down about 7.5% over the past year. Earlier this week, Silver Wheaton CEO Randy Smallwood told CNBC that he saw precious-metals pricing going much higher from current levels. The comment led me to consider what alternative Smallwood might have to that position, if any, and to consider whether the long-term uptrend could continue.

While there are many typical hallmarks of a bubble scenario, most are not present in the silver market -- I hesitate to say none for fear of a barrage of examples. Ultimately, I agree with Smallwood and remain bullish on silver. Let's look at four common features of a bubble that aren't present in the silver market.

Disconnect from reality: Perhaps the greatest hallmark of a bubble is the ability of investors to ignore reality. For example, during the housing bubble, banks continued to lend on the theory that "housing prices cannot go down." From 2007 to 2009, the Case-Shiller Home Price Index collapsed from 225 down to 150.

The recent decline in the price of silver has been under control and driven by negative catalysts. Recently, the Bureau of Labor Statistics released data that indicated that jobless claims had hit a five-year low. This is negative for silver on two fronts. First, it may suggest that the economy is strengthening, making the safe-haven nature of precious metals less attractive. Secondly, the Federal Reserve, as a part of the current round of quantitative easing, has made clear that its current actions and policy initiatives are tied to the labor market -- the Fed it will keep rates near zero until unemployment dips below 6.5%. Smallwood cited the actions of various central banks and the primary positive catalyst he currently sees for silver prices.

A parabolic move higher. If you go back and study some of the previously celebrated bubbles, one common feature is that before the bubble bursts, buying became so frenzied that the asset prices climbed in a nearly vertical path. When these bubbles then burst, prices tend to crater. That's particularly true in precious metals and even more pronounced in silver.

Yet the move lower has been gradual and not what one would expect in a bubble scenario. You could argue that we are in a bubble, but that the really big up move has yet to come. If this were true, an investment would still be safe. Even so, I do not believe this is the case.

Structural breakdown. In the midst of a bubble, any asset even loosely tied to the hysteria begins to trade as if it were the same thing. In the case of silver, miners such as Pan American and First Majestic would be expected to trade alongside silver. In the past month, however, while SLV is up nearly 4%, Pan American is down nearly 4% and First Majestic is down 6.5%. The move lower for Pan American comes even as the company reported record production for the most recent quarter.

Part of the reason for this divergence is that when recessionary forces exist in the economy, miners may be treated as companies rather than as commodity plays. Ongoing cost pressures, global macroeconomic weakness, and the debt crisis have each contributed to pushing down on mining stocks. Trading the miners can be tricky because of these often competing forces. As some of these recessionary pressures are alleviated, if the upward impetus on silver remains, the miners may outperform in the immediate term.

Groupthink. The final common feature of a bubble that bears mention is the tendency of investors to suffer from the blind need to think alike. The good news for silver bulls is that the news has been fairly balanced of late, on both a commodity- and company-specific level. While many institution traders are focusing on bearish outside markets -- specifically falling crude prices and a strong U.S. dollar -- news from the Fed is mixed.

As I recently discussed, Chicago Fed Chairman Charles Evans made mention of the fact that the Federal Open Market Committee may be able to raise rates before expected. A careful reading of his comments, however, suggests that the remark was aimed at the precious-metals markets -- his detailed analysis suggests the Fed will not move rates until well into 2015. The point is that there is a healthy debate at work and groupthink is decidedly missing.

The conclusion
While this isn't a exhaustive list of the features of bubbles, it includes some of the most important signals and offers some reasons silver doesn't currently qualify as being in a bubble. Silver has enjoyed an extended positive run, but there doesn't appear to be reason for huge concern. The major macro factors remain neutral to positive, and I think silver has plenty of upside remaining.

If you're looking for a company whose success is determined by the metals market, but without involving itself in the risks of physically mining the metals, then Silver Wheaton provides a unique play on the future of silver. Silver Wheaton chooses to finance the mining of silver; it has grown sales and net income every year since 2008 and also has increased competitive advantages over its limited peer group. More details about our outlook for Silver Wheaton can be found here in our Motley Fool analyst report.

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