ETFs: How Investors Can Play The Plunging Gold/Silver Ratio

Sumit Roy:  At a time when commodities across the board have surged to multiyear, even record, highs, it’s hard for any one individual commodity to stand out. Oil’s spiking, sending retail gasoline prices spiraling toward $4; floods in Australia have lifted coal prices to new heights; corn’s hovering near record highs; and cotton is in the stratosphere. Let’s not forget about gold, which, week after week, has steadily climbed to new all-time highs.

Yet somehow, one commodity that isn’t even at a record high yet has managed to steal the spotlight. I’m talking, of course, about silver.

Now granted, silver may not be the most crucial commodity out there. Relative to crude oil, silver’s impact on the economy is inconsequential. And when it comes to safe-haven investing, the metal is dwarfed by its far-more-prominent cousin, gold. But when it comes to the one metric that counts most to investors—performance—silver has the rest beat.

Year-to-date, the white metal is up a whopping 30 percent, well ahead of the pack. It’s bested only by cotton’s 40 percent return.

What’s most pertinent for precious metals investors is the significant divergence between silver and gold. While, yes, gold is clearly in an uptrend, striking a fresh record this week, its recent performance pales in comparison to that of silver. Since the beginning of the year, the yellow metal is up a mere 2 percent.

But gold’s underperformance (and silver’s outperformance) actually started well before now; in fact, you can see signs of it as early as the middle of last year.

Reading The Gold/Silver Ratio

The clearest way to visualize this is using the gold/silver ratio. For those who aren’t familiar with it, the ratio literally measures the relative value of gold and silver; in other words, how many troy ounces of silver it takes to buy one troy ounce of gold.

The ratio itself is a snapshot of a moment in time, but if we look at movements in the ratio, we can see the relative performance of the two precious metals. An increase represents either gold outperformance or silver underperformance (or both), while a decrease represents silver outperformance, gold underperformance or both.

 Gold/Silver Ratio: 2006 - 2011

Source: Bloomberg

Since about June of last year, it’s been straight downhill for the ratio, which fell from close to 65 then to 35 now. That’s an enormous decline—historic even. In fact, at 35, the ratio is at the lowest level since 1983—28 years ago.

 Gold/Silver Ratio: 1950 - 2011

Source: Bloomberg

How Investment Demand Affects The Gold/Silver Ratio

Invariably when it comes to commodities, price fluctuations always come back to supply and demand, and movements in the gold/silver ratio are no different. What we’ve seen recently is a massive influx of investment demand—bars, coins, ETFs and so on (as opposed to industrial demand, where silver is used as a manufacturing input).

Last year we saw a significant portion of this capital entering the market through exchange-traded funds. This year, we witnessed outflows from ETFs at the beginning of the year, but those have quickly reversed, and holdings are now once again at record levels.

Silver ETF Holdings
Source: Bloomberg

Simultaneously we’ve seen huge investment demand for physical silver, too. The U.S. Mint reported that sales of silver American Eagle coins hit a record 12.4 million troy ounces in the first quarter of this year; that’s compared with the 34.6 million troy ounces minted in all of last year. While we can only speculate how much silver is being purchasing through other channels—such as private mints and so on—all signs indicate that this year’s investment purchases should easily surpass last year’s 279 million troy ounces.

However, silver investment demand alone does not explain the gold/silver ratio’s plunge; you must also consider the smaller size of the silver market. Using last year’s supply and demand figures from the World Silver Survey, annual silver output is valued at about $43 billion at today’s prices—less than a quarter of the value of gold’s output of $180 billion. Thus incremental speculative purchases have had (and will continue to have) a disproportionate impact on silver prices relative to gold prices.

Moreover, if we take a look at gold itself, we see that investment demand for the metal remains fairly lackluster. Using exchange-traded fund holdings as a proxy, the picture is quite clear:

Gold ETF Holdings
Source: Bloomberg

Clearly, speculators and investors have much more enthusiasm for silver than gold. And as prices have climbed higher, that enthusiasm has only increased.

Where The Gold/Silver Ratio Heads Next

So will the gold/silver ratio continue to plunge? It all boils down to whether investment-minded buyers are willing to bid prices even higher from here. The fundamental underpinnings of the precious metals bull market—inflation fears and sovereign debt worries – have not gone away. But at the same time, prices have skyrocketed, suggesting that many of those fundamentals have already been priced in.

As the gold/silver ratio falls, it makes silver less of a bargain vs. gold than it was only months ago. Yet this parabolic drop somehow doesn’t feel complete, given that silver has not yet surpassed its record-high near $50/oz set back in 1980. At that time, the gold/silver ratio fell close to 17, or nearly half of its current levels.

Playing The Ratio

For traders looking to play the current move in precious metals but with less risk than an outright long position in silver, betting on the gold/silver ratio may make sense. If silver continues to rise, the gold/silver ratio will likely continue to fall; since the beginning of 2010, the monthly correlation between the two has been a near-perfect -0.99.

Thus, a bullish precious metals bet using the gold/silver ratio would involve going long a certain dollar amount of silver, while simultaneously shorting an equal dollar amount of gold. (Conversely, a bearish position would be to short silver, while going long gold.) Such exposure could be gotten through exchange-traded funds such as the SPDR Gold Trust (NYSE:GLD) or the iShares Gold Trust (NYSE:IAU) and the iShares Silver Trust (NYSE:SLV). More-aggressive traders could use futures to leverage their positions quite substantially.

Written by Sumit Roy From Hard Assets Investor (HAI) is a research-oriented Web site devoted to sharing ideas about hard assets investing. The site has been developed as an educational resource for both individual and institutional investors interested in learning more about commodity equities, commodity futures and gold (the three major components of the hard assets marketplace). The site will focus on hard assets investing without endorsing or recommending any particular investment product.

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