Silver Poised For A Breakout

Summary

• Gold and silver are both seen as “safe haven” investments to a degree, with a moderately strong correlation between them as measured by a coefficient of determination (or “R-squared”) of 0.64.
• Despite the correlation, the gold-to-silver price ratio can vary significantly over time, but logically should be mean-reverting, and generally has been.
• The ratio is currently at a 100-year extreme, skewed toward gold.
• Many have argued that despite gold’s recent appreciation, it still has upside. They have a point. Silver appears to have even more upside and less downside.

Investment Thesis

Silver is poised for a potential 40%+ breakout to the upside based on the uncertainty caused by the COVID-19 pandemic and its historically low price relative to gold. Both metals performed very well in the years following the Global Financial Crisis, and while not a perfect analogy, there are enough similarities to support a bullish outlook for both metals today, especially silver.

Background

There’s a lady who knows, all that glitters is gold, and she’s buying a stairway to heaven. When she gets there she knows, if the stores are all closed, with a word she can get what she came for.

- Led Zeppelin

If the aforementioned lady walked down Fifth Avenue today, she would surely notice that the stores are, in fact, all closed, and might wonder if she had finally found her way to heaven. If she managed to find someone to ask, they would likely tell her to put on a face mask. But her more important misconception to us investors is the belief that “all that glitters is gold.” As our mothers taught us, many things that glitter are not good stores of value. But a corollary may also be true today. One thing that glitters like gold, but in a different hue, namely silver, might be a superior investment. This article explores the medium-term upside potential for the white metal and explains why incorporating it into your portfolio could a provide a strong return with limited downside.

Gold and silver are often employed as safe haven assets and are readily available as exchange-traded funds (ETFs) such as the SPDR Gold Trust ETF (GLD) or the iShares Gold Trust ETF (IAU) for the yellow metal and the iShares Silver Trust ETF (NYSEARCA:SLV) and the Aberd Std Silvr Shs (SIVR) for the white metal. SLV is an ideal instrument based on its size and liquidity ($6 billion AUM and ~68x the average daily dollar volume of SIVR). It also has a plentiful and highly liquid options market, which provides the opportunity to offset the fund's expense ratio and generate income by selling out-of-the-money calls. One such strategy is discussed here.

To a degree, both metals are seen as a hedge against inflation, although, in moderate-inflation environments, their actual record as a hedge is questionable. The iShares TIPS Bond ETF (TIP) and the iShares 0-5 Year TIPS Bond ETF (STIP) are less-volatile alternatives with returns explicitly tied to the US CPI. The precious metals' more important feature is their perceived role as a safe haven in uncertain financial environments. I think it is safe to say that the current environment qualifies as such a scenario. And while no analogies are perfect, a look back at the lessons of the Financial Crisis and its aftermath provides a useful context for today.

The scale of the Federal Reserve’s monetary response to the coronavirus pandemic has led many to suggest that inflation will surely result, and gold is therefore a wise investment. Many others will note that the same was said after the Financial Crisis of 2008, but it never happened. Both positions have elements of truth. While broad-based inflation never did take hold, the data we will examine in this article shows that gold certainly proved to be a solid investment for the next 2-3 years. From late-2008 to mid-2011, GLD approximately doubled (from ~$80 to ~$160). A near-perfect market timer could have made >160% from a low of $70 to a high of $184. For its part, silver performed a little better for the first year and a half of this period, doubling in under two years. And then it performed a lot better. It doubled again in just seven months. It’s fair to say, the silver market turned into a bubble. It would be foolhardy to make an investment assuming that the silver bubble will repeat in the near future.

But a bubble redux is not necessary to make silver a strong play now. The main phenomenon at play is that the gold-to-silver ratio has reached a 100-year high (maybe longer). This ratio has been studied for some time, and while it can certainly get out of balance for stretches of time, logically it makes sense for the ratio to be somewhat mean-reverting - and historical data shows that it has been.

Data and Analysis

Turning to the data, the chart below from Macrotrends (with axis labels added) shows the nominal prices of gold and silver dating back to 1915.

The two most significant events over the last century for gold and silver were the formal end of the gold standard in the 1970s and the Financial Crisis of 2008. The first was a period of relative high inflation and was an excellent time to own both gold and silver. As inflation oscillated in the 4-14% range, the prices of silver and gold both rallied by about 10x in real terms. That said, long-term investors should recognize that for the next quarter century, gold and silver were lousy investments. As the U.S. economy expanded and private sector innovation created progress in leaps and bounds, equities (SPY, VOO, VTI) were the place to be.

Thus, while the harsher critics of fiat money will surely disagree, I am not suggesting that an overweight position to gold and/or silver should be maintained for decades on end. Rather, I am suggesting that in periods of financial and economic uncertainty, the precious metals shine. I believe we now find ourselves in such times. In the Financial Crisis of 2008, gold was the first mover, but silver soon followed and eventually surpassed gold in relative terms. That pattern may be repeating.

We now turn to the relative price levels. The next chart shows the gold-to-silver ratio over the last 105 years.

To be sure, the ratio can vary significantly, but for over a century, it has averaged around 60 and has spent the overwhelming majority of the time in the 30-90 range. On two prior occasions the ratio approached 100, but it never crossed that milestone. As I write today, it stands at 113.

For the remainder of this article, I will turn my focus to the GLD and SLV ETFs as the basis for more detailed numerical analysis considering that most readers will prefer these “paper” vehicles to holding physical gold and silver. The shortcoming is that SLV only dates back to 2006, so most subsequent comparisons are limited to the last 14 years, but the charts above tell a similar story over a much longer period. Setting the stage for the analysis that follows, the next chart shows the price levels of SPY, GLD, and SLV and also a “normalized” SLV that has been scaled based on the average GLD/SLV ratio over the full period starting in May 2006 when SLV began trading. This helps compare the relative performance of GLD and SLV more directly.

(Source: Yahoo Finance and author's calculations)

Two observations jump off the page. First, SLV went on an absolute tear in two years following the depths of the Financial Crisis. This ended in a bubble which burst spectacularly in May 2011. Second, SLV is more volatile than GLD. This can be quantified via regression analysis and is illustrated in the chart below, which shows the correlations of the monthly change of both SLV and SPY relative to GLD. All series are sampled monthly on the 1^st.

(Source: Yahoo Finance and author's calculations)

SLV’s coefficient of determination, or “R-squared”, is 0.64, meaning that 64% of SLV’s monthly change can be “explained” by the movement of GLD. In addition, the magnitude of the correlation, given by the slope of the trend line, is 1.46. Said differently, SLV has a beta of 1.46 with respect to GLD. On the other hand, GLD has essentially no correlation to SPY. Not shown graphically, SLV has a slight positive correlation to SPY, but not much. That R-squared is 0.06 with a beta of 0.51. In other words, if you are bullish on GLD, you should generally be bullish on SLV as well. And that’s before we accounting for the GLD/SLV ratio, which is currently indicating that SLV is an absolute bargain relative to GLD.

Conclusions

The first conclusion is that both gold and silver should do well in the COVID-19-related downturn and the ensuing recovery.

There is a raging debate about the shape of the recovery that will follow the Great Lockdown. I’ll not rehash any of that here except to say that relatively few seem to think that all the volatility is behind us. The most bullish seem to be relying fairly heavily on a Fed that is not shy about throwing liquidity around and driving real rates below zero. As explained by Eric Basmajian, declining real rates are bullish for gold. And if the last downturn is any guide, gold figures to do well not just when fear is peaking, but also for 2-3 years into the recovery phase. The chart below shows SPY, SLV, and GLD indexed to 100 on 2/1/2009 just before stocks bottomed.

(Source: Yahoo Finance and author's calculations)

While stocks initially lead the pack (having fallen substantially more than GLD or SLV ever did), for all intents and purposes, while SLV was absolutely crushing it, GLD and SPY were tied four years on. And achieving that tie would have required spectacularly good timing finding the bottom for stocks. You could have bought GLD or SLV pretty much any time in 2008 or the first half of 2009 and enjoyed similar gains. The takeaway is that one need not be bearish on stocks to have a constructive view of gold and silver, whatever the shape of the recovery.

The second conclusion is that silver is an absolute bargain relative to gold.

As argued by Samuel Smith, there are several reasons to like SLV now. Digging deeper into the GLD/SLV ratio, the chart below shows the ratio going back to 2006 with dashed lines showing the mean and 1-, 2-, and 3-sigma (standard deviation) bands from the mean. Note that to make share prices reasonable, GLD trades for approximately one-tenth of the value of an ounce of real gold, whereas SLV trades for nominally the same value as real silver. The mean value of the GLD/SLV ratio is 6.6 with a standard deviation (sigma) of 1.4.

It is clear that silver is on sale. The ratio sits 3.5 standard deviations from the mean. If we suppose that the ratio conforms to a Gaussian distribution, that extreme of a deviation would be expected to present about 0.03% of the time. That percentage of the ~5,000 days this data set spans works out to about a day and a half. To be sure, there are no guarantees here. There are no laws of physics dictating that this ratio cannot get further out of balance, nor is there any set time limit on how long it will take to revert to the mean (if ever). But 100+ years of history indicate that staying outside the 2-sigma bounds tends to be a temporary condition. This provides SLV with significant upside on top of whatever upside GLD has from where it sits today.

Price Targets

Just how much upside can we expect in GLD and SLV? Given the unprecedented monetary actions being undertaken by the Fed and other central banks the world over, I find it entirely plausible for gold to re-test its all-time inflation-adjusted peak which occurred at the start of 1980, which was $678 in nominal terms but equates to $2,250 today. This would equate to about $210 for GLD (the spot gold-to-GLD ratio is currently ~10.7). A slightly less ambitious target is for gold to simply retest its much-more-recent nominal high achieved in August 2011, which was $1,825 for gold and $184 for GLD. More conservative still, one could assume that the gold price is currently “right” and simply play for a silver “catch-up” based on the ratio reverting toward the mean.

What does that imply for the white metal’s prospects? It depends a lot on how much mean reversion gets baked into the cake. Your author’s humble opinion is that a regression back inside the 3-sigma bound within a few months is almost a slam dunk. Pulling back to the 2-sigma by the end of the year is reasonably likely. And a pullback to the 1-sigma line within 2 years, while far from certain, is more probable than not. The table below provides price targets for GLD and SLV based on the three targets for GLD described above and integer-sigma levels of ratio mean reversion.

(Sources: Yahoo Finance, Macrotrends, and author's calculations)

Of course, each investor should choose their own target entry and exit points. My modestly optimistic SLV target is $20 based on the Nominal Gold High scenario and a ratio reversion to the +2-sigma line (+43% from today’s level right around $14). A more aggressive target is $26 based on the Real Gold High scenario and a reversion to +1-sigma (+86% from today).

What about the potential downside? We certainly could see a full risk-on shift that sends the safe haven precious metals back to pre-COVID-19 levels. This was around $148 for GLD in the first part of the year. This, coupled with ratio reversion only to the +3-sigma level, would put SLV around $13.50 - a negligible decline. A revisit of SLV’s 52-week low of $10.86 represents a 22% decline. The most pessimistic scenario I see as plausible is a retest of SLV’s all-time low of $9.58 (a 32% decline), which occurred in 2008. These potential upsides and downsides present an attractive risk-reward profile.

Perhaps that “lady we all know, who shines white light...” actually wants to show us the it is time for the white metal to shine.

Stay safe out there!

Analyst’s Disclosure: I am/we are long GLD, SLV. 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.