Assuming the traditional gold-to-silver ratio holds some water, there are two ways for a correction to take place. We could see silver prices fall, or gold could continue its upward tear.
For the latter to play out, gold prices would need to climb to new highs of around $1,480 per troy ounce, a move of roughly 6%, or $80, from today's prices. A correction on the silver side would remain well within the metal's 52-week range, and near the upper bound at that. Given silver's aforementioned 88% gain versus gold's 19%, the former case seems likelier.
The downside risks
SPDR Gold Shares has seen sizable outflows every month since October 2010. Last month alone, the fund bled $3.7 billion. During the same period, iShares Silver Trust saw just a single month of moderate outflows. It would seem that the silver-over-gold play has become increasingly popular. Last month, SLV saw $263 million of inflows.
While silver's run-up has been influenced by global demand, there has been controversy surrounding physically backed precious metal ETFs such as SLV because investors were taking supply out of the market, thereby increasing the likelihood that price increases were a self-fulfilling prophecy.
At current prices, SLV's $263 million inflow last month translates to approximately 7.7 million ounces of silver. That allocation represents just under 11% of total mined silver production in 2009, highlighting the significant portion of supply that is being stored rather than consumed.
Annualizing that fund flow figure might not be realistic, since that would mean the ETF would add more silver to its vaults than is produced by miners annually. But it clearly illustrates that the silver ETF is demanding an extremely large portion of all silver pulled out of the ground. In fact, the silver ETF today holds more of the bullion in its vaults than all other storage sources combined did just five years ago.
The performance expectations of the various precious metals are often painted with a very broad brush. The first metal to come to mind is gold, and for good reason. Throughout history, gold has proved time and again to be the asset of choice for those looking for a reliable store of wealth. Gold is still likened to a monetary metal by many today. In line with popular perception, industrial demand makes up a relatively small fraction of overall demand.
This isn't quite the case for silver. Despite its grouping as a precious metal, the lion's share of demand for silver is accounted for by industrial activity.
In 2009, industrial demand accounted for 41% of silver demand, and GFMS, a prominent precious metals consultancy, forecast that figure to grow to 46%.
While at first glimpse, recent flows seem to indicate continued interest in physically backed silver exposure, they set the stage for a significant correction. Unlike gold, silver historically has not been stored. Rather, as its demand allocations would indicate, the vast majority of silver produced annually is consumed. Not surprisingly, the entrance of physically backed funds and the outsize draw on production that they created made for substantial positive price pressures.
The potential for a correction comes on the basis of a substitution effect. As prices of silver continue to increase, industries that use the metal will, at some point, find it economically viable to turn to other metals to fulfill their needs.
While the price at which substitution becomes feasible differs from one industrial application to the next, the outsize allocation toward industrial demand for silver creates the potential for a significant correction.
Many attribute the run-up in silver and gold prices to extremely loose monetary policy by several developed nations. Based on that, some argue that fundamental drivers for the metals are still positive and leave room to run. Examining silver on a more granular basis, however, seems to point to a level of overheating in its own performance and with respect to gold, as prices have gone virtually vertical.
We initially recommended the position because a number of drivers -- including price, flight to safety, broad inflationary fears and the gold-to-silver ratio -- aligned to set the stage for a positive run. We've been pleased to see quite an upward tear, and while there still may be a bit of room to run as the market adjusts to potentially long-term structural changes in both the global economy and our monetary-policy backdrop, it may be time to pocket some of that hard-earned coin.
This article was reported by ETF analyst Abraham Bailin for Morningstar.
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