How Silver Can Help Leverage Gold

Sep.19.07 | About: iShares Silver (SLV)

When gold is on the rise one should buy gold stocks to leverage the price of gold and hence maximize returns. Is this statement true or false? The answer depends on when and what.

For most of this gold bull market, gold stocks in general have indeed outperformed their main product. Based on a four year rolling basis, HUI stocks as a whole have leveraged gold by as much as 4 to 1. That happened back in December 2004 but since then the leveraged return on HUI stocks has increasingly diminished.

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However, while all this was going on another product designed to leverage the price of gold was quietly gaining ground on the HUI. That product is silver and since October 2006 it has been consistently outperforming the HUI. As of last week silver has been outperforming the HUI by a factor of 1.5 to 1. What does that 1.5 mean? It means that if you had invested an equal amount of money in silver and in the HUI four years ago, your return on silver would be 50% greater than that gained on the HUI.

The chart above demonstrates this reversal of investment fortunes in silver and the HUI. Back in November 2004, the HUI reigned supreme and returned 412% over and above anything silver had gained by then. But since then that leverage over silver has dropped and dropped until equality (= 1.000 on the chart) was gained in 2006 until silver began to outperform the HUI.

The theories as to why this has come about are various ranging from geopolitical aversion to mining stocks and increased infrastructure mining costs on the negative side. On the opposite and positive side, the rise of silver ETFs and the fact that silver cannot go to zero like a bust mining company make silver attractive to private and institutional investors.

The suggestion therefore is that anyone wishing to leverage the price of gold should diversify some of their portfolio into physical silver. Not only do they get some leverage on the price of gold but they hold an asset which they know cannot go bust and is not beholden to hedging, large debt, bad management or the caprice of dictators wanting a piece of the gold action.

Good mining company stocks should continue to form part of a leveraged portfolio but in terms of risk and reward, silver stands between gold and its mining stocks.