Despite the massive outflow of capital from commodities, a leading indicator suggests that silver prices are about to skyrocket. The last time silver priced approached $50.00 per ounce, it was preceded by a corresponding rise in this key metric.
The grey metal has depreciated by over 30% in the last 12 months. It’s a steep fall for silver, especially in light of the NASDAQ gaining nearly 15%. The pattern seems to indicate a clear direction for capital; out of commodities and into stocks. However, following the trend is the exact opposite of what investors should be doing.
We’ve all heard the maxim “buy low, sell high,” but most investors still end up doing the opposite. They forget that making money demands a willingness to move against the crowd and keep a steady hand during times of crisis.
Yes, silver’s in a rut. But there are some optimistic signs showing a positive run in the near future. Let’s take a look.
The Last Time This Happened, Silver Prices Soared 420%
One of silver’s fundamental relationships is with gold. The two metals have a shared history that’s evident in their conversion rates, with an above average silver-to-gold ratio signaling a rise in silver prices. Bear in mind that the silver-to-gold ratio represents how many ounces of the grey metal can be traded for an ounce of gold.
When investors are bearish on precious metals, both silver and gold suffer a pullback—but the declines are not necessarily equal. And when the decline in silver is greater than gold, our conversion ratio gets overinflated.
But this is a good thing. Over the last 25 years, the tipping point for silver prices usually occurs when the ratio is above 70. Investors stood to gain huge returns when the ratio crossed the 70 point benchmark as it did in 1995, 2003, and 2011. Those who got in at the right time made 70%, 200%, and 420%, respectively. But investors who took advantage of that opportunity had to—forgive the cliché—swim against the tide.
ETFs: A “Silver Bullet?”
Over the last 40 years, an ounce of gold cost an average of 42 ounces of silver. However, the ratio can swing far from the mean. Gold fell far less than silver in the last 12 months, down just 16% compared to silver’s 30% decline. In the best of times, gold gets far more attention than silver, so there’s no surprise that the yellow metal is more insulated from pessimism.
Yet, reality doesn’t match with investor perception. When all physical deposits of gold and silver are measured, there are roughly 17 ounces of silver for every ounce of gold. By holding the price of gold steady at its current level and calculating with the natural rate of silver to gold, we find a silver level of $64.36.
Even if markets don’t reorder to reflect the true conversion ratio, a partial correction makes sense. Silver prices edged one percent higher on Monday July 27th, but are still at $14.65. That’s well below the breakeven point of most miners. Even the silver streaming company, Silver Wheaton Corp. (NYSE/SLW), will find its margins squeezed by such low prices. The firm owns no actual mines, choosing instead to finance smaller mining firms in return for part of their yield. (Source: Financial Post, March 25, 2014.)
Low prices, and subsequently low profits, will force many miners to scale back operations or even close up shop. When they do, a supply shortage is going to put upward pressure on silver prices, resulting in a more balanced silver-to-gold price ratio. In this scenario, owning actual silver bullion or an exchange traded fund like the iShares Silver Trust (NYSEAcra/SLV) is a smart play for investors. Owning miners is a little more risky because many will not survive the low revenue environment.
On the other hand, silver exchange traded funds (ETFs) are mandated to keep their holdings in bullion. It’s simply the best way to gain exposure to a precious metal without actually owning it. Ultimately, we know three things. Firstly, a bellwether of rising prices is when silver trades at more than 70 times the value of gold. We also know the ratio is at 74 right now and supply is contracting. All these signs converge to a single proposition: silver prices are ready for a comeback.