From the May 01, 2009 issue of Futures Magazine • Subscribe!

Why silver may outshine gold

Silver is currently underpriced relative to gold and may offer the best opportunity for long-term profit in the metals sector. While both gold and silver are safe-haven investments, particularly as a hedge against the longer-term risk of hyper-inflation, gains in silver are likely to outpace gold. The gold-to-silver ratio has reached elevated levels in recent months due in large part to a steep sell-off in silver coupled with strong gains in gold. And while gold is expected to continue higher, we anticipate a reversion in the gold-to-silver ratio to more normal levels. The supply/demand dynamics of silver present a strong case for its appreciation in the long term, specifically due to increased global industrial demand outpacing supply.

Gold benefited from a flight to quality in 2008 as the economic crisis deepened and investors fled risky assets for the safety of gold and Treasuries; two of the few assets classes to experience gains for the year. Silver, on the other hand, suffered along with most other commodities over the same time period as fears of the deepening recession mounted. For the year, gold gained approximately 6% while silver dropped more than 25%. The dispersion in performance between these two precious metals has led to a drastic widening in the gold-to-silver ratio from 50x in early 2007 to its current level of 72x, the highest level since 2004.

Despite recent concerns regarding weakening global economies and a subsequent pullback in silver’s price, the long-term supply/demand story for silver remains intact. Silver is unique relative to most other precious metals. The demand for silver not only stems from its use as a raw material to manufacture jewelry and silverware, but also from its numerous industrial applications. More than 50% of silver demand comes from the industrial sector and is utilized across a wide range of industries including imaging, electronics, jewelry, coinage, superconductivity and water purification. While we could see a slowdown in demand in the near term due to the global recession, longer-term demand should continue to rise and support higher silver prices. An additional source of demand for silver is the market for silver exchange traded funds (ETF). The iShares Silver Trust, created in 2006, has grown in popularity in recent years and has led to tremendous growth in the amount of silver backing the shares issued to investors. Growth in the silver ETF market is likely to continue going forward and will put additional strains on the supply/demand dynamics for silver.

The supply side of silver is unique as well, in that only a small percentage of mines in the world are pure silver producers; silver is typically a by-product of mines mainly engaged in extracting lead, zinc and copper. According to the 2008 World Silver Survey, supply generated due to mine production has grown 24% from 1998 to 2007, while demand from industrial applications has grown nearly 44%, creating a shortfall of approximately 20%. Similar shortfalls between supply and demand, particularly as the economy recovers and industrial demand accelerates, are likely.

With the gold-to-silver ratio at elevated levels relative to historical norms, traders have the opportunity to profit in the short- to medium-term. A play on a reversion to a more traditional relationship between the metals will allow investors to avoid some of the current volatility by initiating a long position in silver and a short position in gold. The most straightforward approach for professional traders to execute this trade would be to go long SLV, the iShares Silver Trust ETF and short GLD, the SPDR Gold Trust ETF.

Another option would be to initiate a long position in silver futures and a short position in gold futures in the same expiration date and with the same notional value. In a market where precious metals are going up, we would expect silver to outperform gold. In a down market for precious metals, we would expect silver to decline less rapidly than gold. In a precious metals market that is without direction, we would expect silver to increase relative to gold because of the distortion in the historical ratio between gold and silver prices.

Charles Gradante is co-founder of the Hennessee Group LLC, , which publishes the Hennessee Hedge Fund Indices.

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