The No. 1 Way to Profit When Silver Upstages Gold

While prices of gold don’t necessarily affect silver prices or vice versa, history has demonstrated that when gold rises or falls, silver usually follows suit.

This time around, silver has failed to match the gains that gold posted in recent months, spawning a widespread believe that silver is poised for a bull run. Such factors as a decline in supply and a weakening U.S. dollar have buttressed that bullish belief. And so has the fact that China’s government is strongly encouraging that country’s residents to buy the white metal.

With Beijing’s plan to inject $587 billion (4 trillion yuan) into China’s economy, and a growing desire to diversify away from the U.S. dollar as its key reserve currency, the Asian giant could increase its reliance on such precious metals as gold and silver – especially if global inflation takes hold.

China’s central bank “could use gold, silver or even a basket of commodities” to diversify away from the dollar, said Money Morning Contributing Editor Peter Krauth, a recognized expert in metals, mining and energy stocks. “It’s impossible to know how they’d go about it.”

This wouldn’t be the first time that silver played an important economic and transactional role in Mainland China. Nearly 2,500 years ago, the Red Dragon was the first to use silver as money. While China invented paper money in the ninth century, silver made its way back several dynasties later as legal tender until the government again prohibited its ownership in 1935.

Now, 75 years later – in the wake of the worst economic downturn since World War II – China has reversed its stance on silver.

In July, state-run China Central Television (CCTV) began a campaign that pushes the purchase of silver bullion as investment opportunity. Analysts say silver has been undervalued in the last few years, and is a good investment for individual investors, according to CCTV.

“The investment threshold [for silver] is not high, and is more suitable for the general public,” said Want Chunli, GM of Beijing’s Caibai Shopping Mall, the first to offer silver as an investment opportunity. “Silver is much cheaper than gold.”

Silver’s investment potential is best measured by the silver-gold ratio, or the price of gold divided by the price of silver. Over the past five years, the ratio has held fairly steady, requiring 55 ounces of silver to buy an ounce of gold. Earlier this year, as gold increased at a faster rate than sliver, the ratio skyrocketed to 70 to 1. It has since corrected to around 60.

Money Morning’s Krauth says that when this relative price ratio does correct, it tends to overshoot.

“I see it going to 50 at least,” Krauth said. “With gold at $1,000, that means silver could trade to $20 or even higher, which is another 20% from [the current price].”

Silver closed Friday at $16.06, while gold closed at $991.10 – implying a silver-to-gold ratio of 61.71.

Krauth sees China returning to an asset-backed currency and says ownership of silver could help the average citizen, even if its central bank is unable to diversify out of the U.S. dollar fast enough.

The more Chinese citizens who own silver, “the stronger the country will be in the eventuality that the world establishes a new world reserve currency backed by (most likely) precious metal(s).”

China’s middle class is estimated at 300 million – roughly equal to the entire U.S. population. And that consumer group in China is growing. As those incomes continue to rise, so, too, will the demand for silver.

China’s use for silver goes beyond jewelry or as a safeguard against inflation. Thanks to the antibacterial properties of silver ions, the white metal is used for everything from socks to wash machines, to name a few.

Silver Supply is Falling

The world once had 2.2 billion ounces of silver above ground, but that figure has plummeted 86% to the current 300 million ounces, according to Addison Wiggin, a best-selling author and an executive publisher at Agora Financial LLC, which, like Money Morning, is part of the Agora Inc. group of companies.

However, above-ground silver accounts for only 25% of the silver produced today, says Money Morning’s Krauth. The other three-quarters is actually a byproduct of such mined base metals as iron, nickel or lead.

When the financial markets nearly collapsed last fall, base-metals producers weren’t spared. As demand forecasts were cut, they quickly throttled back on production, expansion and exploration.

“More has to come from mine production, which can only grow so fast,” Krauth said. “The fact that base-metals producers have cut back a lot hurts silver production because it’s a byproduct of base-metal mining.”

Once the recovery begins – and it’s already under way in China – supplies will be hard to come by as demand for base metals returns, resulting in higher prices for silver.

Gold’s “Lap Dog”

The price of gold doesn’t necessarily affect the price of silver, but when other economic factors such as the U.S. dollar falter, prices traditionally rise at the same pace. But when the global financial crisis took hold last year, the silver-to-gold ratio shot up to 84.

Much like a “nervous little lapdog,” the price of silver follows gold closely, Krauth says.

Since its mid-July low of $12.46 an ounce, silver has rebounded roughly 30% to current levels. But if gold supplies run short, silver may have even more room to run.

When gold hit its all-time high of $1,033.90 per ounce in March 2008, silver prices soared as high as $20.92. But when gold hit its 18-month high earlier this month, silver stayed in check.

“Silver has lagged the rise in gold prices since 2000,” said Money Morning Contributing Editor Martin Hutchinson, a former investment banker with more than 25 years’ experience in the global financial markets. “If gold really takes off and the big money finds there isn’t enough of it, there should be spillover into silver.”

Famed commodities investor Jim Rogers also noted the lag in silver and gold’s prices.

“I’m looking at all commodities, but some commodity prices are very depressed,” Rogers told China International Business. “Silver is 70% or so below its historical highs, coffee is 70% or so, as is sugar, while gold is only 10% off its all time high.”

Making the Investment

While buying physical silver is an option for investors, the simplest way to get in, Krauth says, is via the iShares Silver Trust (NYSE: SLV) exchange-traded fund (ETF). In the three years since its inception, SLV has accumulated $3.91 billion in assets, and the share price – which is the equivalent to one ounce of silver – is up more than 50% this year.

During last fall’s market crash, SLV’s holdings remained nearly flat, around 220 million silver ounces. Since then, it has grown a further 22% to about 280 million ounces.

“That’s a testament to investor commitment,” Krauth said.

Hutchinson calls SLV “quite a good vehicle” over the big silver miners – such as Coeur d'Alene Mines Corp. (NYSE: CDE).

Coeur d'Alene has a large silver deposit in Bolivia. But Hutchinson characterizes Bolivia as a country that he “wouldn’t touch,” thanks chiefly to the Venezuela-like nationalization of the country’s other commodities, including oil and natural gas.

[Editor's Note: If you're new to the commodities-investing arena, and are uncertain about the landscape - or even if you're an "old hand" at natural-resource stocks, but want some insights into the new profit plays and new players - consider hiring a guide: Money Morning Contributing Editor Peter Krauth, a recognized expert in metals, mining and energy stocks, is also the editor of the Global Resource Alerttrading service, which ferrets out companies poised to profit from the so-called "Secular Bull Market" in commodities. A former portfolio advisor, Krauth continues to work out of resource-rich Canada, which keeps him close to most of the companies he researches. Against the global financial malaise, Krauth says that commodities are among the most-profitable and least-risky investments available, and notes that this may well be the most powerful bull market for commodities we'll see in our lifetimes. He makes a strong case. To read more about his strategies, and the sector plays he likes the most, please click here.]

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