How To Make Money with Silver

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It's been going on for at least a couple of months now.

Most of the major media outlets have been publishing articles about silver - and more specifically that silver is inexpensive right now - especially relative to gold.

It's taken some time, and usually when we see a story become widespread it's time to exit the trade and move on to something else. But not in this case: there are several reasons why silver's an attractive investment right now.

The Gold:Silver Ratio: Should you Care?

A ratio that is frequently referred to by precious metal investors is the gold:silver ratio. The gold:silver ratio is calculated by dividing the spot price of gold by the spot price of silver. Doing so gives a picture of the relative value of both metals, and when viewed over time yields an average, or mean ratio. Using modern times (the last 100 years or so) as our time horizon this 'mean' ratio tends to track around 55. That means that the price of gold, on average, tends to be around 55-times the price of silver.

This is much easier to explain with the aid of a chart, so I've included a 20-year chart of the gold:silver ratio below. As you can see, the average ratio of 55 looks a bit low when viewed over this period, but over a longer horizon it is relatively accurate.

What you'll also notice if you analyze the time periods in the above chart, is that the gold:silver ratio tends to rise in periods when market risk elevates, such as in the years around the dot.com bubble and the most recent financial crisis. In periods of sustained and relatively stable economic growth, the ratio tends to be lower.

Remember that this ratio is giving us the relative value of silver and gold, so when the ratio is higher that means gold is more expensive relative to silver. And conversely, when the ratio is lower silver is more expensive relative to gold.

Right now, the ratio is around 64.5, implying that gold is expensive relative to silver. To calculate this ratio divide the price of gold ($1247) by the price of silver ($19.35) and you get 64.5.

***Part of my investment thesis for owning silver mining companies, like the one I've held in Small Cap Investor PRO since mid-July, is based on my belief that we will see the gold:silver ratio begin to revert back toward its mean of 55. For this to happen, silver must rise in price (thus lowering the ratio because the denominator increases), or gold must fall in price (the numerator falls). I don't believe gold is going to fall - but I do believe silver will rise.

To see what would need to happen for the gold:silver ratio to revert back to 55 divide the current price of gold ($1247) by 55, and you get a silver price of $22.67. This implies that the price of silver has 17 percent upside.

However, if gold were to rise to $1500 an ounce, a very possible occurrence, silver would need to rise by over 40 percent to $27.27 for the gold:silver ratio to fall back in line with the historical average.

If you believe in mean reversion, as I do, then either of these scenarios points toward higher silver prices (assuming gold doesn't fall).

***Of course, this ratio only tells half of the story since it just illustrates relative value. Nominal value is still important. And from this angle, silver looks even more attractive.

Take a look at the following chart, which plots the price of both silver (left side scale) and gold (right side scale) over the last 10 years.

Both of these precious metals are rising in price, and I believe this trend will continue. I've explained my rationale in previous articles (growing use for investment purposes, commercial uses, etc.), so I'll ask your forgiveness for not repeating them here today. But suffice to say I believe that regardless of what the gold:silver ratio tells us, there is still momentum for the nominal value of silver to rise.

***Both the gold:silver ratio and the positive momentum behind the price of silver support my investment theses for the small cap company I just recommended. The third piece of the pie is that this little company has a solid track record of performance. Results for the second quarter of 2010, (over second quarter of 2009) showed that silver production was up 41 percent, cash costs were down 15 percent, and EBITDA was up 150 percent.

This company's stock price tracks very closely to that of silver. This shouldn't come as a surprise given that it is a silver mining company, but it bears reminding. As you can see from the one year chart below, the company's stock (green line) and the price of silver don't trade in lock-step. Right now this company is trading 'below' the price of silver.

I know there is a lot to digest here. However, both the gold:silver ratio, as well as nominal values for the two precious metals should be on the watch list of all investors.

Finally, the chart below shoes that since I recommended this stock the Russell 2000 Small Cap Index (blue) and the S&P Small Cap 600 index (green) have both fallen around 10 percent - but this silver stock (red) has risen 4 percent. That's a modest gain to be sure, but a nearly 14 percentage point outperformance over this short time period.

As you can see, the stock has shot up in recent weeks, but subscribers can still capitalize on the opportunity in silver right now. I have a 'buy up to' price on shares that is rapidly approaching - so if you're interested in a great small cap silver miner you should check this company out soon. Click here to try a free subscription to Small Cap Investor PRO and find out more about this great little company.

And if you're not, you should still follow the movement of silver and gold and invest accordingly.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Stocks

Referenced Stocks: BAC

Wyatt Investment Research

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