Silver Wheaton & The Fiscal Cliff

Douglas is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Despite a respectable rise in the price of silver during Wednesday’s trading session, Silver Wheaton (NYSE: SLW) and other silver miners experienced significant drops. Using the iShares Silver Trust (NYSEMKT: SLV) as a proxy for silver, the commodity gained 0.76%, while Silver Wheaton was off by 6.7%; using the Global X Silver Miners ETF (NYSEMKT: SIL) as a proxy for miners as a whole, that group was down 4.9%. The divergence between the price of the metal itself and those companies that help to bring it to the market is an important phenomenon that can provide a great buying opportunity if properly managed.

Powerful Catalysts

There are two powerful catalysts currently at work in the market that are driving the price of silver and the price of silver mining stocks in opposite directions. The price of silver is being driven higher by ongoing concerns over inflation. On Tuesday, the Federal Reserve’s Vice Chair, Janet Yellen, said that interest rates may need to be held near zero for at least six months longer than had been expected, placing the target period as running through early 2016. Many see Ms. Yellen as the heir apparent to take over the Fed at the end of “Helicopter” Ben Bernanke’s current term in January of 2014.

The extended forecast by Ms. Yellen was accompanied by discussion of her belief that Fed policy may need to be directly tied to employment goals moving into the future. What all of the political maneuvering amounts to is one simple truth: the Fed will be in full blown printing mode for the foreseeable future. While the inflation that this will create may take time to be properly reflected in various economic indicators, it is inevitable. In inflationary periods, precious metals are an attractive store of wealth.

The other side of this duality is the looming fiscal cliff, which refers to various automatic spending cuts and tax hikes that are set to take effect in the early part of 2013. Most economists agree that unless these measured are at least tempered by new compromises, they will have the collective power to push the U.S. economy into another recession. It is under these recessionary pressures that silver mining stocks are trading more like stocks than as proxies for appreciating commodities.

Historically, during recessions there have tended to be disconnects between the prices of these two types of investments. Given the significantly larger size of the gold market, this phenomenon is easier to see there, but it holds true for silver as well. The divergences may continue for an extended period, but when they reverse, they can create significant profit potential. Before you choose to allocate capital to such a trade, it is important to decide if you can handle, both financially and emotionally, a long period in which the trade may suffer. If so, this trade can provide very handsome returns.

An Allocation to Silver Wheaton

Given its position as a silver streaming company, Silver Wheaton often has an amplified reaction to significant shifts in the market. While these usually occur in the same direction as silver prices, with the moves simply magnified as a result of the company’s leveraged position, the principle equally applies to divergence.  Under the company’s business model, it contracts with miners to purchase silver production at a predetermined and fixed price. The company then earns the spread between the contract price and the prevailing market price. Silver Wheaton’s current average cost of silver is $4.04 per ounce.

Silver Wheaton remains my favorite play in the silver market. As the fear over the fiscal cliff mounts, the company may suffer and its stock price decline. Given the potential for an extended period of underperformance, scaling into a position is the most prudent approach to achieve an attractive average entry price. Over the medium and longer-term, however, Silver Wheaton continues to look very attractive.

Mr. Ehrman has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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