Score one for the bulls. When I recommended shares of Couer D’Alene Mines Corp. (NYSE: CDE) back in late January, there was a raging debate about whether silver prices would rally to new highs or finally come back to earth. I thought the bulls had a stronger case, and Couer D’ Alene was a solid play on any silver rally. The shiny metal has risen in price from $28 to $41 and shares of Coeur D’ Alene have come along for the ride, surging more than 60% in just six weeks.

Yet for a host of reasons, some or all of those gains may be lost in coming weeks and months. It’s time to take profits and even think about establishing a short position in this highflying name.

 

A bubble in the making?
To understand why silver has rallied so quickly, you need to understand the psychology behind investor sentiment. Silver’s 80% gain in the past year has made it a darling of the inflation hawk crowd (as gold had been in prior years). Demand for silver to be held purely for investment purposes has increased 40% in that time. Trouble is, the more appealing silver becomes as an inflation hedge, the less appealing it becomes in the real world, where it is used in a wide range of industrial applications.

As silver becomes more costly, the “substitution effect” occurs whereby other less expensive metals get swapped in and replace silver in industrial uses. We’re already seeing signs of demand for silver start to cool among industrial buyers.

Meanwhile, the high price of silver is leading to what always happens when a commodity surges in price: increased mining activity that boosts supply. Analysts at UBS estimate that recently initiated mining plans should push global production of silver up by 25% in the next four years. Barrick Gold (NYSE: ABX) and Goldcorp (NYSE: GG), a pair of yellow metal plays, actually have the most ambitious silver mining expansion plans. (Most of the world’s silver is produced from non-silver mines; i.e. from lead/zinc, copper and gold mines as a by-product.)

UBS estimates supply will stay just ahead of demand, as this chart shows. Yet it’s important to know these assumptions were derived in late February when silver fetched $32 an ounce. In fact, UBS’ demand estimates assume that silver will end the year at $33 and then steadily slide in price to less than $20 by 2014. Instead, silver has pushed past the $40 mark and, before long, you could start to see industrial demand being affected. (Supply is likely to continue to grow as miners need to complete projects once they’re underway and can’t simply close a mine as end-market prices start to drop.)

#-ad_banner-#Industrial demand averaged 800-850 million ounces from 2004 to 2008, slumped badly in 2009 and rebounded to a record 915 million ounces in 2010. Yet expectations that demand will keep rising now look much riskier. As traditional drivers of demand such as photography and dentistry start to use alternate materials, then demand is likely to flatten rather than rise, even if the global economy keeps growing. Any rising gap between supply and demand would surely blunt silver’s price momentum.

Gold vs. silver
As gold and silver are both used as hedges against inflation, it’s helpful to see how the two metals compare to historical levels. From 1978 to 2008, an ounce of gold bought about 60 ounces of silver. Thanks to silver’s strong surge, that ratio has shrunk to 36. To return to historical levels, gold would need to rise 75% to around $2,500 an ounce or silver would need to drop from a current $41 to $25, or about 39%. Unless inflation spirals out of control (which still seems unlikely as of now), gold is unlikely to rise that high, so the logical conclusion is that silver must fall to return back to that historical ratio.

Production ramping, then peaking
Couer D’ Alene has benefited from rising silver prices and the nice uptick in production at a major mine known as Palmarejo. Output could rise even more this year, but then start to fall in subsequent years as some of Couer D’Alene’s other mines start to produce less and less. That’s why UBS expects revenue to drop 16% in 2012 to $808 million and another 15% in 2013 to $683 million. EBITDA (earnings before interest, taxes, depreciation and amortization) is likely to peak at around $600 million this year, but slump to $300 million by 2013, according to UBS. Again, that forecast assumes rising industrial demand that undergirds silver prices, though it’s unclear if that will really pan out.

Action to Take –> As inflation concerns persist, investors have shifted their sights toward silver. Yet the speculative end of the market is creating real pressure on the industrial end of the market. For Couer D’ Alene, it’s been a perfect alignment of positive factors. With silver now looking very pricey in relation to gold and in relation to other industrial metals, the coming quarters are likely to be far less supportive for this stock. A move back to $30 appears in the cards once the frothy silver market starts to cool. So if you’ve mad money on this trade, now appears the time to get out.

P.S. — I don’t know if you’re aware of this or not, but a 20-year energy agreement between the United States and Russia is about to expire. The problem is, this deal supplies 10% of America’s electricity. When the Russians refuse to renew the agreement, the U.S. will face an entirely new kind of energy crisis. This disruption could send a handful of energy stocks through the roof. Keep reading…