Why Silver Belongs At 30

Includes: GLD, SLV
by: Spencer Knight

Commodities and hard assets will be debated for an eternity and an agreement will never be reached. On the one hand, some argue commodities and hard assets are overvalued and overpriced like technology equities in 2000. On the other hand, some argue hard assets such as gold and silver are the safest place for an investor's money in an unstable economy.

A common counter point to that argument is gold, and to a lesser extent silver, are an ancient form of currency that serves no purpose in the modern economic system. As you can see in a matter of seconds it is simple to light the embers of a fire that will not be extinguished anytime soon.

One of the positives with investing in commodities, such as the iShares Silver Trust ETF (NYSEARCA:SLV), is the possibility of strength during U.S. dollar weakness. A second positive about investing in silver is that volume has increased 3-4 times since 2009 and most of 2010. However, it is important to note that the increase in volume is a double edged sword because as the number of traders trading silver increases, the higher the chances that the ETF will soar and become overbought, which directly increases the likelihood of a severe downward move.

Another issue with silver, and other commodities, is that during severe equity market weakness, traders are forced to sell hard assets to cover margin losses. This often can cause sharp declines, such as the 22.3% two day drop in silver from September 22nd to September 23rd.

This brings us to the question of when should investors view silver as overvalued. Many view the gold to silver ratio to determine whether silver is overpriced. I will get to this point, however I feel it is more informing to simply view the silver ETF's chart to identify how investors phsycologically react to the silver ETF's price fluctuations.

As promised, the 125 year ratio of gold to silver is roughly 1:46 and the 25 year ratio is around 1:67. The current ratio between the SPDR Gold Trust ETF (NYSEARCA:GLD) and the silver ETF is around 1:52. Therefore, the current ratio is stable between the two historical values. This shows that the current level of the silver ETF, which is 30.23, is fairly reasonable.

With that in mind, another question arises: is 30 a stable level for silver based upon the increase in daily volume and the recent historical resistance points. Before getting to the current market situation, it is important to rewind to 2009 and review how investors and traders have become more attached to buying silver's ETF.

Beginning in September 2009, the price of silver was around the 17 level. Eleven months later, the ETF price increased a mere 5%. The lowest point during these eleven months was a 14% decrease that saw a bottom in February of 2010. The real fun began after August 20, 2010 as investors began to view the silver ETF as a viable source for substantial returns. From August through December 31, 2010 the ETF returned over 70%.

An important note to make regarding this 70% run is the resistance seen at the 30 level. Some say the 13% retreat was simply a healthy pullback before another big run can take place. While this may be true, the importance of this resistance being at 30 is infinitely important.

As you can see below, December 6, 2010 was a signal that the ETF was going to stall at the 30 level as the ETF was able to reach 30.00; but it was unable to push past that resistance until almost four weeks later. Another important note to make is that the ETF was able to hold above 30 for about four days before breaking down. This shows that investors were uncomfortable with the silver ETF being above 30 during that period of time.

[Click all images to enlarge]

(Silver ETF chart from August 20, 2010 through February 1, 2011.)

After the 13% pullback, the silver ETF made an incredible 84% run through April 28th of this year. This run took the ETF up to 48.35 before plunging 34% over the next four days. This retreat took the ETF down to 31.97 at one point. Some may argue that this was due to the equity markets taking a nosedive, but the equity markets declined roughly 2% during that same period.

Therefore, the dip in the silver ETF can be attributed to investors and traders taking profits and realizing silver was vastly overvalued. The main reason that silver did not retreat under 30 was because the equity markets and economy were to some extent thriving and investors were willing to buy commodities, hard assets and equities at premium prices.

(Silver ETF chart from April 1, 2011 through May 31, 2011.)

Even after this initial sign of weakness, bullish investors and traders continued to send silver higher. Prior to the September 22nd plunge, the ETF was hovering along a temporary resistance level of 40. The ETF was unable to break above or below the 40 level for any sustained period of time. That is until the 22% two day descent I mentioned previously.

At one point, the ETF touched 27.41 before it closed back above the 29 level. This decline indicates two features of the silver ETF I aforementioned. First, over 160 million shares traded hands those two days; which explains the incredible downward momentum. Secondly, and most importantly, the ETF caught resistance at 30 and the further the ETF price deviated from 30, the stronger the resistance. In other words, the resistance at 30 was essentially a shock cord, or bungee cord, that caught the free falling ETF price and brought it back near a comfortable level.

(Silver ETF chart from July 1, 2011 through October 7, 2011.)

This brings us to the present to address the current valuation of the silver ETF. As you can see in the more refined chart, the price has fluctuated above and below 30 since September 23rd. This is another indication that the price of the silver ETF is fairly comfortable at 30. Some argue the drop in price is due to market volatility and this is a great time to buy the silver ETF, as it will take off to the 40 level and even possibly 50 in the near future. There is no doubt in my mind that the increased volatility has caused the ETF price to fluctuate rampantly. However, the exact resistance points are not coincidental. For instance, it is not a coincidence that the ETF slid 25% and almost instantaneously found strength at 30.

(Silver ETF chart from September 20, 2011 through October 7, 2011.)

One final important question remains: will the silver ETF spike to the 40 and 50 levels? Yes it will. The chances of future spikes are more possible than ever with the increased volume and volatility. Keep in mind that silver has a tendency to spike during equity market rallies. Therefore, if the equity market rallies and the U.S. dollar shows weakness, we may see a big rally in the hard asset ETFs. And with the upcoming earnings season, this exact scenario may come to fruition.

However, investors must keep in mind the silver ETF will return to 30 at some point, therefore the best advice I can give is take profits going up and get out as the ETF returns to 30.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.