Silver prices continue to languish, rising a modest 6% for the year to date compared to gold’s surge of 10% over the same period. Historically, there has been a strong correlation between the prices of both precious metals and coupled with other supply and demand indicators, this move suggests that silver is set to rally. 1. The gold-to-silver ratio indicates silver is undervalued A key indicator of whether silver is undervalued is the gold-to-silver ratio, which represents how many ounces of silver are required to buy one ounce of gold. This is because of the historical correlation that has existed between the two metals,…
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Silver prices continue to languish, rising a modest 6% for the year to date compared to gold’s surge of 10% over the same period. Historically, there has been a strong correlation between the prices of both precious metals and coupled with other supply and demand indicators, this move suggests that silver is set to rally.
1. The gold-to-silver ratio indicates silver is undervalued
A key indicator of whether silver is undervalued is the gold-to-silver ratio, which represents how many ounces of silver are required to buy one ounce of gold. This is because of the historical correlation that has existed between the two metals, with silver prices typically following gold prices.
In the past, a number of analysts have argued the ratio should be somewhere between nine and 19, which is an average of both where the ratio has historically existed and the natural occurrence of silver compared to gold. However, for some time now this ratio has been well in excess of this range, climbing as high as 67 earlier this year and only last week narrowing to 62, seeing the ratio remain relatively unchanged for the year to date.
More astonishing is that the ratio has widened by seven points over the last two years. As a result, I expect the ratio to continue to narrow as silver prices continue to appreciate.
2. Demand for silver continues to grow
An important factor supporting a sustained rally in silver is growing global demand, particularly for non-industrial uses including jewelry and physical investment through coins and bars. By the end of 2013, global demand for silver had reached its highest point in 10 years of just over one billion ounces. The key drivers were a massive surge in coins and bars, which shot up 76% compared to the previous year, and jewelry, which spiked a healthy 10% for the same period.
This growing demand for physical silver is expected to continue as it becomes increasingly popular for the manufacturing of jewelry and among investors. While the demand for silver in these categories may have surged, industrial demand for silver — the single largest market, making up over 54% of total demand — has declined significantly over the last four years.
It is this factor that makes the price of silver far more volatile than gold. However, with the global economy, and in particular the consumption of technology products, expected to grow better than initially expected, industrial demand is set to increase.
I also expect to see investment demand grow as growing inflationary concerns caused by surging crude prices and recently implemented economic stimulus packages in Europe and China make silver more attractive to investors because of its perceived status as a hedge against inflation.
3. Supply continues to fall
Global silver supply is at its lowest level since 2009, and by the end of 2013 had fallen by 18% since then to under one billion ounces. Much of this can be attributed to silver miners winding down or putting costly and uneconomic projects on hold because of softer precious metal prices.
Given the long lead-in time required to develop silver mines and boost production, it is likely this will remain a problem for some time to come. As a result, it is unlikely that supply will be able to keep pace with growing demand, therefore pushing the price higher.
How can investors cash in on this rally?
All of these factors clearly indicate that silver is set to rally, but it is important for investors to determine how to effectively cash in on this. Since the price of silver crashed, the miners have taken a battering, making major producers Pan American Silver (TSX: PAA)(NYSE: PAAS) and First Majestic Silver (TSX: FR)(TSX: AG) appear attractive. Silver Wheaton (TSX: SLW)(NYSE: SLW) remains the outstanding pick.
This is because Silver Wheaton is a streaming company rather than a miner, providing funding to miners in exchange for the rights to purchase silver produced at a set price. As a result, it does not have the same operational or development costs as a silver miner and is able generate a higher profit margin. It has also amassed a significant pile of cash totaling almost $82 million, leaving it well positioned to make further investments in miners as they seek to expand their silver reserves and production as silver prices grow.
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Fool contributor Matt Smith does not own shares of any companies mentioned. Silver Wheaton is a recommendation of Stock Advisor Canada.