Let the Gold Surge of 2011 Begin

Guess what: It's happening again. Gold broke out above $1,450 Tuesday in convincing fashion and quickly moved above $1,460 early Wednesday before stopping to catch its breath.

It seems like only yesterday I was heralding the onset of a powerful new surge in gold and silver, a surge that made the second half of 2010 a memorably profitable one for well-positioned precious metal investors. Given that remarkable year-end run in 2010, initial price weakness early in 2011 came as no surprise.

Following a swift correction, I pleaded with Fools on Jan. 21 to take advantage of their last best chance to acquire long-term positions in gold and silver. One week later, the year-to-date lows for both metals trickled in. Even megacap miner Goldcorp (NYSE: GG  ) has tacked on more than 30% since then, while the real superstars have been the silver miners. Silver Standard Resources (Nasdaq: SSRI  ) and Silvercorp Metals (NYSE: SVM  ) have gained more than 50%, and my top 10 pick Great Panther Silver (AMEX: GPL  ) has two-bagged -- all in less than three months' time.

Market commentators were quick to suggest an array of real-time drivers responsible for gold's breakout surge, collectively offering: Portugal's credit downgrade and overall eurozone distress, the budget impasse on Capitol Hill and associated unease over a potential government shutdown, persistent unrest in the Middle East, and of course the evidence of inflationary concerns observed both in China's rate hike and Fed Chairman Ben Bernanke's rhetoric.

Of course, each of these factors likely plays some role in the metal's recent strength, and precious metal investors are well advised to track all relevant geopolitical and macroeconomic events worldwide. However, on a more fundamental level, gold continues to correlate quite reliably over time with prevailing trends in the U.S. dollar and the euro (often alternating its correlations between the two leading reserve currencies with surprising ease). But there is a third currency that boasts an unbreakable correlation to gold, and I believe its role in gold's latest breakout has been entirely overlooked.

How silver is leading gold by a leash
To understand gold's dramatic breakout move Tuesday in its proper context, a Fool must carefully consider the undeniable role played by its rival precious metal: silver. The fascinating relationship between these two metals is being fundamentally reforged by the incredible degree to which silver has outpaced gold so far in this new decade. Back in February, I discussed the potential for silver's price momentum to provide a catalyst for gold, and that is precisely what has proceeded to play out before our eyes.

I have made consistent mention over the years of the "slingshot effect," a term I find helpful for visualizing the variable pulling force that one metal often exerts upon the other. Dynamic stretches and contractions in that metaphorical slingshot tether, joining gold to silver, are manifested in the variable price ratio between the two. Over a very long historical time frame, covering several centuries, that relationship coalesced around a gold-to-silver ratio of about 16-to-1, which happens also to approximate the estimated relative geological scarcity of the two metals within the entirety of the Earth's crust. Aside from a pair of glancing blows at that historical price relationship -- the most recent occurring during the infamous gold and silver spike in 1980 -- the ratio has trended above 40:1 through much of our modern financial era. Since the mid-1980s, in fact, the ratio has only delved below 50:1 a couple of times.

Lately, of course, powerful upward price momentum has taken hold of silver, and it shows no signs of letting go. Silver has surged an astronomical 120% over the past year, vaulting the iShares Silver Trust (NYSE: SLV  ) in similar fashion. During February and March of this year, silver recorded scores of successive 30-year highs, launching nearly 50% from its late-January low even as gold struggled to break out convincingly. Something had to give, you see, as silver's surge has stretched the elastic tether until the gold-to-silver ratio dropped beneath 37:1 ... a level not seen since 1983.

With the tension that was building in the slingshot tether, either gold's failure to break higher would increasingly pull downward against silver's impressive momentum, or silver would retain the lead and pull gold into a more convincing breakout. The latter occurred, of course, and I believe that the immense fundamental strength supporting silver's price advance has handed silver the leash in terms of which metal is leading the other. I expect that to continue, with possible pauses along the way, until silver reasserts its long-term historical price relationship to gold ... just as it did in 1980 at 16:1.

You see, the fundamental forces driving silver higher are simply stronger than those for gold. The degree to which the ratio between the two remains elevated from a long-term historical perspective is but one of many facets of silver's superior outlook. Investment demand for both metals is strong, but history suggests that a relative preference for silver, as the cheaper alternative to gold, is likely to emerge as a precious metal bull market matures. Moreover, industrial demand for silver -- which is already very strong, and expected to expand by 37% through 2015 -- grants a very compelling two-pronged structure to the demand side of the equation.

Over on the supply side, meanwhile, the outlook for silver becomes almost unimaginably bullish. For starters, we have a silver market dominated by high-volume trade in paper contracts and proxies that appear completely divorced from the reality of scant physical supply of the metal. Hedge fund manager Eric Sprott witnessed the physical shortage first-hand when attempting to procure silver for his firm's Sprott Physical Silver Trust, and attributed the long delays incurred to "the disconnect that exists between the paper and physical markets for silver." Silver futures on the COMEX also remain in a rare state of backwardation, and many veteran commodity investors have been astonished by the sheer persistence of this condition over nearly two months. We've witnessed the dropping of the silver manipulation bombshell, and the Presidents Day silver short squeeze.

Everything I see, from the specter of QE3, to a seemingly inevitable standoff between the holders of physical silver and the peddlers of unbacked paper, suggests continued gains for silver. Gold enjoys its own powerful suite of fundamental drivers, of course, but I submit that to some meaningful degree it is also riding on the coattails of silver at present. I am not suggesting that Fools ditch their top-quality gold stocks like my top pick Gammon Gold (NYSE: GRS  ) , but nor would I consider any precious metals allocation complete without at least some representation from a quality silver miner like Hecla Mining (NYSE: HL  ) .

If the never-boring silver mining industry piques your Foolish curiosity, be sure to add these stocks to your free, personalized watchlist and follow all the precious news to come:

Fool contributor Christopher Barker can be found blogging actively and acting Foolishly within the CAPS community under the username TMFSinchiruna. He tweets. He owns shares of Gammon Gold, Goldcorp, Great Panther Silver, Hecla Mining, Silvercorp Metals, and Silver Standard Resources. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool's disclosure policy has never been in backwardation.


Read/Post Comments (9) | Recommend This Article (42)

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  • Report this Comment On April 07, 2011, at 1:02 PM, vkmo wrote:

    Gold is high, but so's Silver. CEO of Silver mining company Great Panther GPL had predicted a few months ago that Silver will reach $40 before year-end. Well, it's almost that today, Apr 7 staying between $39.50 and $39.60.

  • Report this Comment On April 07, 2011, at 4:59 PM, rfaramir wrote:

    “a gold-to-silver ratio of about 16-to-1, which happens also to approximate the estimated relative geological scarcity of the two metals within the entirety of the Earth's crust.”

    I’ve been hearing this a lot, so I decided to look into it (without doing actual original research).

    http://en.wikipedia.org/wiki/Abundance_of_elements_in_Earth'...

    2007 figures from 3 different sources:

    Ag 0.070 ppm - 0.080 ppm (23,000 tons/year)

    Au 0.0011 ppm - 0.004 ppm (2,800 tons/year)

    ratio of occurrence: 63:1 - 20:1 (silver to gold)

    ratio of production: 8.2:1 (silver to gold)

    another page, http://en.wikipedia.org/wiki/Abundances_of_the_elements_(dat...

    puts the ratio of occurrence between these limits:

    20:1 - 25:1 (silver to gold)

    But we must understand that relative occurrence is a secondary determinant of relative price. It really only matters when the two are good substitutes for each other. For example, if we were talking corn and wheat, or better, white marble and black marble. For feeding animals and building structures they are substitutes, for human needs (food and art), less so.

    Gold and silver are interchangeable for monetary uses (with gold always being more valuable due to higher density and higher resistance to corrosion), but NOT for many other uses. Jewelry is a case where they sometimes are substituted under duress, but not by preference. But in electronics or medical applications, they definitely are not substitutable.

    *IF* they were highly substitutable, then the relative frequency of occurrence would directly affect their relative value. The more frequent, the less valuable. Like dollars, the more you print, the less each is worth. But unlike the near-perfect substitutability of paper currency, gold and silver have a very imperfect relation. So on the whole, I think the argument from occurrence ratio to value ratio is not worth bringing up. Interesting to look into, but not very valuable to rely on. The production ratio makes a case for the rise of silver (only an 8.2:1 ratio?), as does the fact that much silver is actually lost when ‘used’ industrially, while much gold is still recoverable (from jewelry, at least, sometimes from other industry).

    Overall, I certainly agree with you.

  • Report this Comment On April 07, 2011, at 5:54 PM, SB11 wrote:

    Any idea why Silver Wheaton and Endeavour are soaring to new all-time highs, but GPL has been struggling a little bit the past week or so?

  • Report this Comment On April 08, 2011, at 1:04 AM, mhy729 wrote:

    I was wondering about that too. I think it is due to the financing deal, which is expected to close on or about April 12th. <From GPL's website: "The Company intends to issue 5,000,000 common shares at a price of $4.20 per common share ("Offering Price") for gross proceeds to Great Panther of $21 million (the "Offering")."> After that, I would imagine that GPL will resume its ascent, assuming silver does not experience a correction by that time. Right now might be a good opportunity to accumulate, if you believe in the bullish case for silver.

  • Report this Comment On April 08, 2011, at 4:43 AM, subdriver683 wrote:

    Saw this pop up and was curious if any of you have looked into Aurcana Corp as another silver play.

    http://www.aurcana.com/s/NewsReleases.asp?ReportID=450724

  • Report this Comment On April 08, 2011, at 8:43 AM, XMFSinchiruna wrote:

    rfaramir,

    Thanks for sharing your thoughts on that. The occurrence ratio is relevant because over the deep well of history it did inform and influence the price ratio. It was no accident that the 1980 move spiked neatly to that ratio. The more precious metals reassert their monetary roles over the course of this bull market, the more likely silver becomes to seek that very long-term average price relationship. The fact that silver in our modern era enjoys industrial uses that gold does not, only strengthens the case for a lower price ratio.

    I have confirmed the figure I employ for the natural occurrence ratio with multiple geologists over the course of my research, but I will inquire with my sources whether a 25:1 or 20:1 ratio might be plausible. There are two figures that must be considered, of course: first the relative distribution in the Earth's crust, and then the relative distribution within the sorts of near-surface mineralized structures that are likely to be explored/extracted while targeting a range of coveted metals.

    SB11,

    What mhy729 said. :)

    subdriver,

    I do consider Aurcana quite interesting, and I do own a modest position in the stock. I give credit to fellow Fool speedybure for bringing Aurcana to the attention of the Motley Fool community.

    Fool on!

  • Report this Comment On April 09, 2011, at 7:57 PM, silvermind wrote:

    Hey Chris,

    As always - great commentary and "recc'd"!

    After Hecla's (90% of this loss of about $230M was recognized on their 2010 books) settlement with EPA/Couer D' lene Indian tribe you said you were really disappointed and although you were keeping your shares it was kind of like you suggested let's not buy HL for now. That's one reason why I didn't buy HL when it went to $8.00/share. I personally thought that the current management was not fully responsible for what HL did clear back to 1960 and that maybe they were not such bad guys. I think you were mostly disappointed with them for not warning investors it was coming - but as a business owner I can tell you that announcing Bad Things coming (prior to certainty of how bad things will be) can sometimes make things worse for investors.

    So you are ready to move on with HL - even recommending it as a Foolish purchase? Looks like it.

    PS - you could have mentioned to newer readers that GRS has a Substantial Silver aspect to their future fortunes.

  • Report this Comment On April 12, 2011, at 6:10 PM, XMFSinchiruna wrote:

    silvermind,

    HL traded above $11 when I wrote that piece -- although it slipped intraday to close at $10.15 -- and silver was below $34. Yes, I was sorely disappointed that management saw fit to spring a much larger settlement on investors than they had been prepared for by prior estimates of total liability, but the weakness in shares since that time (especially in the context of an 18% surge in silver prices) in my opinion represents a major overshoot to the downside.

    My indication that I would remain a shareholder despite the unfortunate surprise would most properly have been interpreted as a statement of retained confidence in management and the excellence of Hecla's current operations.

    With silver prices above $40, I consider Hecla Mining near $9 a screaming bargain.

  • Report this Comment On April 16, 2011, at 2:11 AM, silvermind wrote:

    Chris,

    Cool, thanks a lot for the reply!

    Yeah - and now at $43.05 silver has escalated by 26.5% (from the $34 mark).

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