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ETF’s: How To Play The Gold/Silver Ratio

October 27th, 2009

goldandsilverJulian Murdoch From Hard Assets Investor Writes:  Whether you’re a gold bug or a silver buff, you’ve been a happy camper so far in 2009. As of Friday’s close, gold was at $1,056.40, up 20 percent year-to-date. Silver has done even better; it was up 56 percent to settle at $17.723.

The upward trend has many investors going long in both metals, but there’s more you can do with gold and silver than just buy and hold. You can also play the two metals off one another—but to do it successfully, you must first understand the ever-changing gold/silver ratio.

The gold/silver ratio tells you the number of ounces of silver it would take to purchase one ounce of gold at a specified date. If you examine gold and silver prices reaching back 100 years or more, the historical ratio most commonly quoted is 30:1, where 30 ounces of silver would buy you one ounce of gold.

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But if you change the time period, that average changes. In the last 12 years, for example, the ratio has held closer to 60:1, meaning that it takes lots more silver to buy one ounce of gold. And in just the past three years, the ratio has fluctuated from 45 to 85, driven by the volatility in the prices of the metals themselves.

As of Friday’s close, the gold/silver ratio was sitting slightly below 60, at 59.72:

 

 hai_how_to_play_10262009_chart1

Of course, looking at the ratio in a vacuum tells you nothing—it’s just a number, after all. It’s only after you factor in the dimension of time and the price movements underlying the number that you can make sense of the gold/silver relationship.

 

What’s Driving The Ratio Down?

The gold/silver ratio will drop if either: a) gold decreases more than silver does, or b) silver increases more than gold does.

This latter case is what we’ve seen so far in 2009. Since the beginning of the year, both metals have had great returns, but silver has outperformed gold, increasing 56 percent year-to-date while gold only increased 20 percent:

 

hai_how_to_play_10262009_chart2

 

Consequently, that has pushed the gold/silver ratio down: 

hai_how_to_play_10262009_chart3

 So just how low could the ratio go? Could it ever, say, return to its historical average of 30:1?

If so, we’d have to see one of the following occur:

  • Gold would need to plummet to $531.67/oz., with silver remaining stable around $17.55/oz.
  • Silver would need to almost double to $35.21/oz., while gold held steady at $1056.40/oz.
  • In perhaps the most likely scenario, gold would need to see some retrenchment, combined with continued strength in silver.

The idea of gold plummeting back below $600 without affecting silver, or silver doubling to $35 with gold holding steady, is pretty outrageous. But there is some support for the possibility we might see silver gains decoupling from gold’s coattails. Back when gold broke the $1,000 mark for the first time, in March 2008, silver was trading above $20/oz. Now, it’s trading in a $16-$18 range. The disparity could indicate silver may be undervalued right now by historical standards.

In addition, silver’s fundamentals are improving. With around 50 percent of silver demand coming from industrial applications such as batteries, electrical switches and other components, analysts have predicted that as the economy recovers, so will demand, thus pushing silver prices higher. In an article on Bloomberg, David Thurtell, an analyst with Citigroup in London, said:

“Silver is set to benefit from stronger gold, but also the improving outlook for global industrial production.”

Meanwhile, the other side of the ratio—gold—may not be able to sustain its current price levels, say some in the industry. In Harmony Gold’s 2009 annual report, CEO Graham Briggs told shareholders recently that gold was still being affected by consumer and investor uncertainty. And in a recent Forbes article, David Wilson, an analyst with Societe Generale, stated that gold’s weak fundamentals simply couldn’t support last week’s high of $1070.40/oz.

Yet we still see experts like Jim Rogers predicting gold will soon hit $2,000/oz. Weak fundamentals combined with forecasts of high prices—does anyone else smell a bubble?

So the ratio play right now is: Silver’s strong for fundamental reasons, while gold might be verging on bubble territory. I’ll leave it to you to decide whether you believe that story, but for the near term at least, it looks like the gold/silver ratio will stay on its downward path.

 

Playing The Gold/Silver Ratio

Investors looking to play the continuing collapse have several options available.

Some die-hard precious metals aficionados approach the ratio literally, managing physical stores of the two metals based on ratio targets. This is a strategy for those who are fortifying their bunkers, preparing for the end of the financial system as we know it and the subsequent return of the gold standard.

Under this strategy, the ultimate goal is simply to increase the number of ounces of gold held, without any real regard for price. For example, let’s say the gold/silver ratio is currently at 60, but I think it’s going to 30. I can then sell one ounce of gold for 60 ounces of silver, and when the ratio hits 30, I can use my 60 ounces of silver to buy two ounces of gold. Voila! I have doubled my physical gold holdings.

Of course, if the ratio goes to 120 instead, my 60 ounces of silver only buy me half as much gold as I’d originally held. In some ways, this style of trading feels a bit like playing the child whose older brother convinced him to trade his quarter for two dimes.

A more traditional financial strategy would be to make a precious-metals-neutral play: Short shares of the SPDR Gold Trust (NYSE Arca: GLD) and invest, dollar-for-dollar, in the iShares Silver Trust (NYSE Arca: SLV). Then it becomes a simple matter of adjusting your holdings depending on which way you feel the ratio will move. In this trade, you only lose money if gold continues to ramp up and silver stays flat, or if silver collapses. Should both metals rally, you end up even.

For investors with an even bigger appetite for risk (perhaps we should say speculators), you can carry out the same play using options. Both (GLD) and (SLV) offer active options, and for the low, low price of $9.50, you can buy the right to sell GLD for $100 in January of 2011. Likewise, for $3.50, you can get the right to buy SLV at $17.

Such plays are not for the faint of heart, of course, but if you’re a true believer in the ratio and its continued collapse, it’s definitely possible to put a lot of money to work that way. As always, caveat emptor.

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