The best precious metals trade for the next three years

Today we consider gold and silver.

We suggest that you should buy one and sell the other.

We then advise walking away for a couple of years…

Silver and Mother Nature’s ratio

There is, say the wise old men of geological lore, something like 15 times as much silver in the Earth’s crust as there is gold. Received wisdom is that in days gone by, the value of silver relative to gold reflected the amount of metal Mother Nature has given us: gold was, for hundreds of years, about 15 times the price of silver.

Last year 27,579 tonnes of silver were produced (according to my most reliable of precious metal data sources, Nick Laird of Sharelynx) and about 3,000 tonnes of gold. In other words, just over nine times as much as silver as gold was produced.

However, the gold price – about $1,270 an ounce – is about 75 times silver’s price of $17 an ounce. What gives?

I’m not a great believer in reasons for a market price. People always demand reasons. Why did the market go up today? Oh, because of Brexit fears, or the latest China data, or whatever the issue du jour is. Usually, the issue du jour or even the issue of the week or month has very little to do it with it. People are just attaching their own narratives onto a price move after an event.

A market moves in the way it moves because it does. There are more buyers than sellers, or vice versa.

So it is with gold and silver. Silver may not be 75 times as abundant as gold, but gold is 75 times the price of silver because people want gold more than they do silver. They prize it more and so they’re prepared to pay more for it.

The diehard silver bug is waiting for the day when silver returns to its “true price” – the price Mother Nature set. He is waiting for the day when silver is just 15 times the price of gold. When that day finally comes, he will jump and sing and crow. He will shout from the rooftops, “I told you so” and he will forget to sell.

Were the gold price to remain where it is today, by the way, a silver-to-gold ratio of 15 would mean silver at $85. Hmmm. Yummy.

However, while that day may well come, in terms of market probability, you are as well off speculating on the arrival of Godot. I am 46. We have seen a gold-to-silver ratio of 15 once in my lifetime – for one day in 1980. What if your eye was on other things? You missed it.

We also hit this number for a glorious day in the late 1960s (due to the deliberate suppression of the gold price for political reasons) – and once again in 1920.

I’m not saying that day will not come again – it probably will – and when it does you will, I hope, see much of La Famille Frisby’s silverware advertised on eBay – but such events are so rare they are not worth betting on.

Below, courtesy once again of Nick Laird, is the ratio of gold versus silver since 1720. (How Laird can get data for the 1720s is beyond me. I can only assume he has some kind of special power.)

Gold/silver ratio chart

We’re in the zone

Now let’s zoom in a little – as per the chart below.

Gold/silver ratio chart

If you look at the ratio over the last 30 years, you can see that there is a fairly well-defined range.

When silver went to $50 in the spring of 2011, gold was 32 times the price of silver. That month of excitement aside, the $40 to $52 area has marked the bottom of the range. That is when you want to be moving out of silver and into gold. I’ve drawn a golden band on the chart to mark this.

The top of the range I’ve defined with a silvery-grey bar. That is when the ratio goes above 80 – when silver is 80 times the price of gold. That is the point at which you want to be moving out of gold and into silver.

We visited the buy-silver, sell-gold zone earlier this year. And it now looks to me as though we have entered a period in which silver is set to outperform. During such periods – when this ratio falls – silver, silver miners, gold and gold miners all tend to do well. It’s a bull market for all such assets. And, overbought though we may now be, it’s a bull market.

If you’re looking for a different slant, you could simply rotate out of gold and into silver. You then wait for that ratio to come back into the gold zone, at which point you want to be getting out of silver and getting back into gold. (In fact, when the gold/silver ratio is rising, you often want to be out of all things precious and in cash.)

The ratio only goes into the silver zone once every few years. The last time was 2008, the time before that was 2003 – both presaged fantastic, multi-year bull markets. Similarly, it only goes into the gold zone every few years.

To be clear, I’m not recommending you sell your “in case of emergency, fetch shovel” physical gold. But not all people are so wise as to have such a stash. My buy-silver-sell-gold idea is something separate.

Silver is volatile. It goes down a lot, as well as up. By selling gold as well as buying silver, you are hedged. If you’ve been holding “paper” gold (via an exchange-traded fund, say) then switching to “paper” silver makes sense.

It’s a trade that might take a few years to play out, but if you can give it three, I’m as sure as any market participant can be – there’s no such thing as a sure thing – that you’ll make handsome profits.

The many ways to buy silver (and sell gold)

If you are a spread better, then a simple pairs trade that plays this ratio is to sell gold and buy silver. (A pairs trade is when you buy one asset and short another, with the expectation that the one you are buying will outperform the other. It means that the price of both assets can fall, but you’ll still make money as long as the one you are short falls harder and faster than the one you are long). But unless you’re already au fait with the workings of spread betting, I wouldn’t start with this.

If you are feeling greedy and impatient, miners are the place to be. But I’d be wary in the short term. By some readings, the miners are now even more overbought than they were in 2011.

If you want to buy physical silver, our friends in Dublin, the precious metals dealers GoldCore, have a new scheme whereby you can buy silver coins VAT-free. They’ll also, as most dealers will, buy your gold. Other ways to buy silver online include BullionVault and GoldMoney.

And if you own gold via an ETF and want to play this trade, sell it and use the proceeds to buy the London-listed exchange-traded fund, ETFS Securities Physical Silver (LSE: PHAG). Then, ignore the volatility – there will be lots – and wait for the ratio to fall back into the gold zone.