Two Words and Two Charts That Can Make You Rich
- Mean Reversion, a kind indicator
- A silver and gold chart
- Silver’s upside
Fellow Resource Prospector,
Today I'll discuss the most important two-word phrase you might ever hear as a commodity investor. That’s because many (if not all) commodities are tied to strong cyclical seasonal, supply and demand trends that tend to repeat themselves. Mean reversion is another one of those tools the big-shot commodity traders use - but it's simple enough that you and I can follow along with a regular brokerage account.
To break it down I’ll define these words:
Mean: the average, or normal level.
Reversion: the act of returning.
When you have a trend that continually manifests itself over a period of many years, in many different markets, you can make low-risk investments when that trend is outside of its normal range. There are about as many mean-reversion trends as there are commodities, and I’ll examine many of them as they become relevant, but for now, I’m going to focus on one of the easiest to understand and potentially most profitable.
I’m talking about the gold-silver ratio. The modern mean (ever since the 1870s when the U.S. government de-monetized silver and went to the gold standard) has been a ratio of 55.
So, in modern history, it’s taken 55 ounces of silver to buy one ounce of gold. Before that, the ratio was much lower – in the 16 range. That’s much closer to the ratio of silver to gold in the earth’s crust – and as I’ll discuss in a minute, it could revert to that ratio again.
For time being, I’m more interested in the modern ratio. That’s because the modern ratio has reverted to mean hundreds of times since the 1870s. It’s as solid a mean-reverting trend as you’ll find. And right now, it’s “out of whack” to use a colloquial term.
Invest with this ratio, and you could make the safest 10%-20% you’ll find in any market at any time.
Take a look at the chart below, and you’ll see what I mean:
Lately, the ratio hasn’t been behaving normally, but that situation will correct itself. It always has. Right now, with the ratio at about 64, silver is undervalued related to gold. The gap will close, and silver will inevitably revert to a ratio of 55 or lower. It might take a year, and the ratio might drop even lower, but I’ll conservatively estimate you could make at least 10 percent in the next year just by buying silver today. Of course that’s not the only possible scenario. Silver could stay the same and gold could go down in price. Or both could fall relative to the dollar. But I think it’s far more likely that silver will rise.
A 10 percent gain in silver prices would move the metal to the $19 range from $17.30 today. That’s not unrealistic, especially since we’ve seen $20 silver in the past 18 months.
Of course, there’s the potential for a much bigger move upwards in silver’s future, for two reasons:
1. Industrial metal uses consume 40 percent of all silver produced. The market for silver as such is somewhat inelastic in a certain price range. It does have substitutes, so if it gets too expensive, industry will cut back on silver consumption. You can see how this might make silver somewhat range-bound – or stuck between two prices. The low price being where demand is fixed by industrial use, the high price being where industrial use trails off as it becomes too expensive. As the metal becomes more expensive, industry will cut back, which lowers the price, and so on. But if monetary demand hits a certain tipping point, the price could un-tether from industrial demand. If silver stops being an industrial commodity and starts being "money" it could even revert to historical ratios of 16:1 with gold. The chart below shows how this ratio was the norm for much of the last 1,000 years.
- It's cheaper than gold. That means that in
the eventuality of a currency crisis, it will be in higher demand since
more people will be able to afford it. In that regard, it will be
more useful than gold, in terms of its use in the marketplace. A one
ounce gold coin is like a $1,200 bill. Unless you're buying a big
ticket item, that's too much money to carry around. A one ounce
silver coin is like a $20 bill. Everyone uses $20 bills. That's
walking around money. You can buy a sack of rice, a gallon of gas,
and maybe a bottle of wine, and not need any change.
So, how can you invest?
We’re planning to add a pure silver position to our Global Commodity Investor portfolio in the next couple of weeks. We’re looking for an undervalued silver miner that’s already profitable. Any bump in silver’s price will have a huge impact on the share price of this type of company. If you're desperate for exposure to silver, you could buy shares in the silver ETF (NYSE: SLV). As I said yesterday, I’m not a huge fan of these ETFs, just because they don’t offer the protection of either the physical commodity or the upside of a security. If you’re as excited about the trend in silver as I am, you’ll want to give yourself exposure to the upside in a silver miner that can boost the gains made in the metal.
In the meantime, keep an eye on the ratio. Editor Ian Wyatt will be making a formal silver stock recommendation in an upcoming issue of Global Commodity Investing. Click here to take a risk free 90 day trial subscription and you’ll be among the first to read about our favorite way to play the upside of the gold-silver mean reversion trend.
Good investing,
Kevin McElroy
Editor
Resource Prospector
