I'm filing this idea under SLV but my full recommendation is to go long silver using your favorite vehicle and hedge with a short of either gold or your favorite equity index, depending on view of gold vs. equities. The thesis here is that silver's recent outperformance of gold will continue until the two are better aligned. For gold bulls, there's the added thesis that silver is a better choice and will offer better protection if there's a sell-off in risk assets. I am implementing this with futures

Intro to Silver

Unlike gold, silver mining hasn't peaked yet. However, according to the U.S. geological survey, silver has less years of world production than most other commodities. Silver is a 'hybrid' commodity - it is both an industrial commodity and a precious metal. On one hand, is it a top choice to conduct electricity, transfer heat, reflect light and kill bacteria. On the other, it has a long history of being used for currency. The words 'silver' and 'money' are identical in multiple languages. Silver is largely a byproduct of the mining of other metals (gold, zinc, copper, lead...) and is therefore more inelastic. If silver were to shoot up, there wouldn't be an exact corresponding reaction in the mining industry to increase supply. If the economy tanks and demand for base metals declines, silver demand will decline less because of the precious metal component of demand will hold up better. And as mines of other metals are shut down, silver supply will be choked, providing support for its price.

Gold/Silver Ratio

The gold/silver ratio has been in the teens for most of money's history, often fixed by authorities.

As the 19th Century ended, though, the fixed ratio of 15-16 was discontinued as governments sought to eliminate silver's role as money. At first this was met with popular rejection but eventually it stuck. Then, during the 20th century the ratio was much higher, averaging around 50 and peaking near 100. The ratio is now 50. A brief episode in 2008 drove it to 80 temporarily (more on 2008 below).

It seems that the new price range reflects the supply-demand dynamics when silver is disregarded for its role as money. In any event, the industrial revolution has changed these dynamics for both silver and gold and it would be logical to think that the old ratios don't apply anymore. However, ratios in this ballpark appear all over the precious metals space:

- The most recent Commitment Of Traders report showed a ratio of about 12x less gold, measured in ounces.

-  in COMEX warehouses, the ratio of silver to gold inventories has been close to 12.

- in the earth's crust, silver occurs at 0.07 ppm and gold at 0.004 ppm. The ratio is 17.5

- looking at the ratio of all gold and silver ever mined, the ratio is estimated at 10.5 by the website silverinscripture.com which compiled data from various sources.

Of course, volume of trading and storage isn't everything and despite the funny coincidences, x more silver doesn't necessarily imply a price of x times less. What is certain, though, is that if sovereign crises continue (Japan, UK, U.S.) and silver and gold grow their role as currencies, investment demand for those metals will mask the industrial supply-demand dynamics. What would then happen? I refer to recent interview with Eric Sprott who recently launched an ETF with physical silver. Sprott has $7B AUM and a good record of understanding bubbles and predictions regarding precious metals and equities. Sprott knows the precious metals markets on a large scale and at a high level. Here are his observations:

- There's $1 of SLV demand for every $7 of GLD demand

- In mint sales, there's $1 of silver demand for every $2 of gold demand

- In various funds including Sprott's funds these ratios are below 5

- People around the world are attracted to silver

- But the availability of silver is closer to 2:1

- Not much more silver available for investments. SLV + central fund + our fund = a few hundred million ounces. The approximately 600mm ounces left have a market value of $18B which is nothing.

- It's impossible for the ratio of gold/silver to remain at 50 with these kinds of investment flows

Target price of silver (as function of your target gold price and gold/silver ratio)

Manipulation of Silver

CFTC commissioner Bart Chilton recently declared that silver prices are being manipulated, something which has been alleged for years by various people. There is an ongoing investigation and many lawsuits related to this issue. Various silver experts including Eric Sprott believe that this manipulation will soon end, that there will be a short squeeze of the 1.1B oz short position on the COMEX and that silver prices will rise as result. Recent outperformance of silver is believed to be the beginning of this process. Here is a prediction of an eventual short squeeze right from Sprott's silver ETF prospectus:

"In addition, the total physical silver bullion inventory held by the COMEX (as defined by COMEX's Registered and Unregistered Inventory in the COMEX Inventory Daily Report) is equal to 117 million ounces as at June 24, 2010. The open positions are approximately six-times as large as the total physical inventory of the COMEX. The Manager believes that the future settlement of the significant short position "overhang" will create significant incremental demand for physical silver."

The big whistleblower regarding this issue is Andrew Maguire, a former Goldman trader who's been in touch with commissioner Chilton since 2009, walking him through the mechanics of the manipulation and making predictions that came true with intra-day precision (February 5th 2010). Basically, the allegation is that JPMorgan and HSBC hold huge short positions to unwind and they hammer down the price every so often so that they could then buy. JPM inherited that position from Bear Stearns. The silver market is much smaller than the gold market and doesn't have too many traders; Maguire alleges that traders from these banks have been in constant contact for their mutual benefit. The fear is that eventually some big outside traders (Asians or others) decide to produce a massive short squeeze in the COMEX, where the amount of paper silver is a couple of orders of magnitude higher than the amount of physical silver.

In March 2010 Maguire publicly disclosed his whistleblowing activities. The various lawsuits filed against these banks have based themselves on his information. Most lawsuits are seeking class action and the plaintiffs tend to be traders who lost money in silver in the summer of 2008. Here is a link to one complaint (out of about 25 in total)

http://www.hbsslaw.com/cases-and-investigations/jp-morgan-silver-futures

The details in this complaint should be regarded as a supplement to this write-up. The details are very interesting but too much to repeat in full. Here is an excerpt from the complaint:

"In connection with its acquisition of Bear Stearns in March 2008, defendant JPMorgan acquired massive short positions in the silver futures market. Thereafter, JPMorgan, with HSBC, artificially depressed the price of silver dramatically downward. The conspiracy and scheme was enormously successful, netting the defendants substantial illegal profits. The conspiracy and scheme has been corroborated by a 40-year industry veteran and former employee of Goldman Sachs (the "Informant") who was told by representatives of the defendants about the conspiracy and scheme. The Informant has stated that he had been told first hand by traders at JPMorgan that JPMorgan manipulates the silver market. The JPMorgan traders would brag to the Informant about how much money they were making as a result of such manipulation. The informant reported the defendants' activities to the CFTC which has opened an investigation into the manipulation of the silver market."

A second person to have notably scrutinized this alleged manipulation over the years is Ted Butler, a silver analyst who used to trade futures for Merrill and Drexel over 15 years before becoming independent. When he worked as a trader, Butler was issued a challenge by a client: to figure out why silver is stuck at $4-5 despite a growing supply/demand imbalance. Butler found that open interest in silver was huge compared to other commodities and that there was a big short position, and theorized that there is manipulation. In 2008 Butler urged people to write to the CFTC about position concentration on short side and Chilton reacted by calling for a prompt investigation so that a final answer could put the issue to rest. It is after Chilton made this public move that the legal community stated spitting out the lawsuits. CFTC chairman Gary Gensler hasn't spoken out on the issue. Butler, who has been in touch with the CTFC over the years, opines that Gensler is different than previous chairmen and wants the truth to come out. The CFTC is currently seeking comments on how to deal with manipulation in any commodities of finite supply. The most common proposal is to have a position limit of 1% of total world production which is about 1500 contracts.

So in summary the situation is this:

- over many centuries, the ratio of silver/gold was stable

- at the end of the 19^th century governments squashed silver's role as money

- three credible parties have alleged COMEX manipulation to an extent that has prompted public admission of a problem by the CFTC and various lawsuits

- publicity of this issue has coincided with the beginning of a recompression of this ratio

- this recompression is now itself being made public as market participants notice silver's amazing outperformance

- more people are finding out about this whole affair

- the CFTC is expected to act forcefully and fairly

- investment flows into silver are already very strong and they complement the pressure from any short squeeze

Any way you cut it, the pressure from investment flows and the squeezing of this huge short position should pressure silver upward. My personal guesstimate is for gold to rise further and therefore I'm going long silver vs. short stocks. But I think that even if there's a crash, stocks will decline 25-50%, gold will decline 20-35% and silver will decline perhaps 0-20%. The trade should work.