What now for gold and silver?

Gold closed on April 21 at an all-time high of US$1,504.38 an ounce. Despite all the buzz about bullion recently, that represents an increase of only 5.6 per cent from the 2010 year-end price of US$1,420.78.

Silver finished the trading week at US$46.56 an ounce. That’s not an all-time high — silver hit US$55 an ounce in 1980 when the Hunt brothers tried to corner the market. But it’s a huge jump of 51.6 per cent from the price of US$30.72 that prevailed as we entered this year. Gold may have the glamour but silver has the momentum right now.

The dilemma for investors is how high can precious metals prices go from here? How high the moon?

There are two diametrically opposing views on this. One is that gold and silver are in a classic bubble phase and that both are overdue for a major price correction. The other is that with inflation on the rise, there is a lot of upside potential remaining for both. The real answer may be somewhere in between.

It’s important to remember that although gold and silver are often viewed in tandem, the forces that drive their spot prices are actually quite different. Silver is primarily an industrial metal, with about 60 per cent of consumption used in the manufacture of a wide range of products.

A report released in March by the Washington D.C.-based Silver Institute, a non-profit international association of miners, refiners, wholesalers, and manufacturers, focuses specifically on the industrial side of the silver business. P repared by GFMS Ltd., a highly respected London-based precious metals consultancy firm, the report says that 47 million ounces of silver were used by the photo voltaic industry in 2010, 36 million ounces by the automotive sector, 22 million ounces in the production of computers, and 13 million ounces in cell phones.

Silver is also used in a variety of products that may surprise readers including face creams, washing machines, flat screen TV sets, water purification, food packaging, and, believe it or not, socks. GFMS believes that overall industrial demand will increase by 180 million ounces between now and 2015 at which time it will reach 665.9 million ounces.

You would logically conclude from this that the price of silver will continue to rise. That’s true in the short term says GFMS, which predicts prices will remain high through 2012 with the average for 2011 “comfortably eclipsing the 1980 record high” in nominal terms (but not inflation-adjusted terms). But once this run is over, prices will start to drift lower “in reflection of less robust investment in the silver market”. The report also notes that as the metal becomes more expensive, manufacturers will look for cheaper alternatives.

Investors should pay close attention to this report, which is the most comprehensive and analytical study I could find on the prospects for silver. The implication is that there is still more upside in the metal, and the shares of the companies that produce it, but don’t overplay the hand. Within 18 months or so, this party will be over.

Gold consumption follows a very different pattern. GFMS released its annual gold survey on April 13 and it showed that 52 per cent of existing above-ground gold is held in the form of jewellery, 19 per cent by private investors, 16 per cent by central banks, 11 per cent in “other fabrications”, and 2 per cent “lost and unaccounted”. So unlike silver, gold is used mainly as a store of value and for decorative purposes.

The report predicts that gold production will increase by 6 per cent this year compared to only 0.4 per cent in 2010, which would normally have a depressing effect on the price. However, demand will be strong, especially from investors and governments, due to rising inflation expectations and the on-going sovereign debt crisis in Europe which, says GFMS, will eventually spread to the U.S. and Japan (this report came out before Standard & Poor’s downgraded the U.S. debt rating). The result “will further undermine faith in government paper,” says GFMS.

Looking ahead, the report warns that we could see a retracement in the gold price to the high US$1,300s range in the next three months, which will bring out the bargain hunters. After that, investors will drive bullion prices higher “with a breach of $1,600 in the second half still a strong possibility”. (Coincidentally, that is the price I set as my 2011 target in my January predictions.)

This forecast may help to explain why gold stocks have been laggards this year, despite the rise of bullion to a record high. As of the close of trading on April 21, the S&P/TSX Global Gold Index was down 1.9 per cent year-to-date. Many precious metals funds are in a loss position year-to-date, especially those that are heavily weighted to gold. RBC Global Precious Metals Fund, which is one of my newsletter recommendations, is off 0.38 per cent so far in 2011 although we’ve enjoyed an average annual compound rate of return of 22.2 per cent over the past five years.

If GFMS is correct, expect the prices of gold stocks and funds to drift lower over the summer. Use that as an opportunity to add to your positions so that you will be able to profit from the rebound that should begin in August or September.

Of course, international events could change this outlook. However, based on what we know right now, silver looks like a strong buy while gold is a hold/buy on weakness.

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