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
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
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
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.
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