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Does This Buffett Axiom Favor Silver?

Thursday - 3/14/2013, 11:00pm  ET

Warren Buffett, the Oracle of Omaha, is credited with many investment axioms that have been developed over a career of spectacular success. One that applies today, as various markets test various highs, deals with being skeptical of the crowd: "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful." More and more investors are flooding into the market, suddenly afraid of being left behind, as the stock market grinds higher, the U.S. dollar strengthens, and retail sales are strong.

Despite all of these positive signs for the economy -- all of which are negative for precious metals -- there are still plenty of reasons for concern. A recent report showed a spike in Chinese inflation, the Federal Reserve has shown no signs of slowing down the printing presses, and the sequestration situation has not been resolved. Furthermore, the action in the stock market is becoming overdone and a correction is needed. If Buffett's axiom is to be believed, the rapid inflow of capital into stocks is a sign that it is time to be fearful.

Since the end of January, silver, as represented by the iShares Silver Trust , has come under considerable pressure, particularly as other markets have shown increasing strength. In a recent webcast, institutional asset manager Jeffrey Gundlach advised the purchase of silver and other non-stock assets. He specifically singled out silver as being at a favorable entry point relative to gold because its "high beta" offers a more attractive return profile. Even as other assets look strong, therefore, silver is a reasonable hedge against a marker correction.

The run up in multiple indexes
Just as all three major stock indexes are hitting new 52-week and all-time highs, U.S. retail sales grew at the fastest pace in five months in February, increasing by 1.1%. When coupled with strong employment data last week, and other favorable signs for the economy, signs point toward increased stabilization moving ahead. The combined data was sufficient to drive the U.S. dollar index to a seven-month high, as dollar-denominated assets grew in favor.

In response to this data, several analysts raised their growth estimates for the overall economy as measured by the gross domestic product (GDP). Goldman Sachs raised its annual GDP projection by 0.3%, to 2.9%, while JPMorgan raised its forecast to 2.3%, an increase of 0.8%. To put these figures in context, a Reuters survey of several economists that was conducted prior to the release of the retail sales figure placed the average GDP growth estimate at 1.8%. 

Precious metals catalysts
Given the overall strength of stocks, and the apparent firming of the global economy, you might wonder why anyone would be considering purchasing precious metals. While there are many positive signs, things are not as clear as they may seem. Over the weekend, it was reported that a 6% increase in food costs drove Chinese inflation up from the 2% observed in January, to a 10-month high of 3.2% last month. The spike creates some concern that the Chinese government may act too quickly, thus stifling economic growth. China has become an increasingly integral part of the global economy making a threat of contagion very real.

Inflation has remained a very real concern in the U.S. as the Fed marches mercilessly down its path of quantitative easing, currently adding roughly $85 billion to the economy on a monthly basis. Despite the fact that domestic inflation appears to have remained in check, as long as the Fed is printing money, it remains a concern. While the U.S. employment position has showed early signs of improvement, it will require several months at higher levels before the Fed is likely to change course.

The last issue to keep in mind is the reality that sequestration cuts are still in place. Despite the fact that early signs suggest that the economy remains on solid footing, it is simply too early to be sure. As lawmakers continue to squabble, willful blindness is not a solution.

Why silver is the best play
In addition to the higher volatility mentioned by Gundlach -- which means it will increase faster if a rotation back to precious metals occurs -- silver has the advantage of increasing industrial demand. As I have recently discussed, HSBC raised its 2013 and 2014 price target, largely as a result of increased estimates for industrial demand. Silver is used in health care and technology applications that are themselves experiencing significant growth.

Additionally, while silver miners like Pan American and First Majestic have continued to face increased production costs, other options exist. First Majestic reported record productions and led the industry on cost, but still saw major declines. Pan American achieved similar results, but had an even less favorable cost structure.  On the other hand, plays like Silver Wheaton offer investors leveraged exposure to silver -- and the company's 800 million ounces of reserves -- without the same cost pressure. As a streaming company, Silver Wheaton buys the production of other miners at a predetermined, fixed price, leaving it less exposed to production costs.

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