Play The Spread: Short Gold And Long Silver

 |  Includes: AGQ, DGZ, GLD, GLL, IAU, SLV
by: Nico Inberg

The collapse of gold prices last week triggered a sell-off in almost every other commodity. The question is whether this is a normal correlation. Or is gold not just a commodity but has it a more important function: as a replacement for paper money. Let's look at the differences between gold and the most important other commodity, little brother silver.

When we look at the material itself, gold is a raw material mostly used in jewelry. People, for some reason, like to hang it around their neck, replace loose teeth with it or wear it on their fingers. When we make a promise to stay with another person for as long as we live, we seal it with a golden ring. This all is the main use of material gold. There is no great other use for industrial purposes.


Then there is silver. If we compare silver with gold there's one big difference. Along with gold it is jewelry, actually in the eyes of many a classier one. But more important, silver is being used in many industrial applications. Roughly 70% of silver demand is used for manufacturing. Not just electronics, but also solar and healthcare industries are sectors where silver is expected to play an important role in the near future.


The gold price is this high just because people believe it has this value. Here we see some similarity with the Tulip rage in the Netherlands in the years 1634 -1637 (although Central Banks in that time did not use tulips to back their paper money). People think gold is scarce, but it isn't. There's plenty of gold, but most if it is locked in safes under the ground by central banks. Furthermore, it pays no dividend and the cost of storing physical gold is quite substantial.

Both gold and silver are rather costly to extract from the earth. Compared to the supply already in use and above the ground, there is again a big difference between the two commodities. Gold looks scarce, but people tend to forget that Central Banks are sitting on huge amounts of gold. As we recently experienced, Cyprus played with the thought of selling (some of) it in order to restore their balance sheet. Silver on the other hand is not in possession of the Central Banks.

Demand purposes

In recent years, around a third of demand for gold came from investors who saw gold as a hedge against a possible monetary collapse. These investors are not using gold; they just hold it and see it as an insurance. Gold is also seen as an inflation hedge, although research has shown that the correlation between gold price and inflation just isn't there.

Silver is, as stated, mainly used in industrial processes. For future demand, the solar industry is very important. Considering the expected growth of solar energy, silver demand could rise by 30% the coming years.

The correlation between gold and silver has always been there. In recent history, gold/silver ratio has fluctuated between 32 and 88. With the rise of the credit crunch back in 2008, gold rallied away from silver because of the extra investment purpose - insurance against monetary Armageddon. At this moment, with gold at $1406.00 and silver at $23.48, the ratio hovers around 60.

Conclusion: Two simple reasons for silver vs. gold

There are in the end two simple reasons why investors should prefer silver over gold.

1 Application of silver in various kinds of industries will boost silver demand in the coming decades. Gold has little use in industrial purposes.

2 Gold has had a tremendous run-up because of belief in gold as an insurance against a monetary disaster. Once fear of a monetary collapse is fading, gold bugs will substitute their gold for other assets.

With a ratio of 60, gold is still quite expensive towards silver. In trading, timing is everything.

Right now seems like a nice time to set up this spread.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.