Is Silver Bubbling Or Just Doing What It's Supposed To?

04/25/11 12:48:14 PM

by Matt Blackman

Given the meteoric rise of silver over the last year, many pundits have proclaimed the gray metal in bubble territory. But there is interesting evidence to indicate this is probably not the case.

Security: AGQ
Position: N/A

As Mike Carr pointed in his April 20, 2001, Traders.com Advantage article, "Bubble Watch: Silver," silver has gained more than 130% in the last 12 months. It is interesting to note that its bullish cousin, the Proshares Ultra Silver ETF (AGQ), is 480% higher that it was in mid-April 2010!

This kind of performance is enough for any sane trader to suspect a bubble. And while silver may indeed suffer some sort of correction in the coming days, weeks, or months, this author does not expect a major reversal anytime soon unless the current inflationary trend is magically reversed and the dollar starts to rally with a vengeance.

Recently, Eric Sprott of Sprott Management firm offered an enlightening view on the subject. He sees silver going a lot higher for the simple reason that it is significantly undervalued relative to gold based on current supply and demand.

Over the longer term, silver has traditionally traded to gold at an average of 16-to-1. As of the close of April 21, this ratio was north of 32-to-1. To return to its historical norm and assuming gold prices remained unchanged, silver would have to soar to more than $94 per ounce. However, Sprott believes the real ratio based on supply/demand should be closer to single digits. If he is right, a ratio of 9-to-1 would put silver at nearly $170 an ounce!

FIGURE 1: SILVER/GOLD RATIO FROM 1980 TO TODAY

Graphic provided by: Trade Navigator by http://www.genesisft.com.

As Figure 1 demonstrates, silver has made significant gains relative to gold in the last year but it is still little more than half of the price relative to gold in 1980 when silver shot to just under $50 per ounce.

And although that was the result of an attempt by the Hunt brothers to corner the market so therefore not indicative of the usual market factors, here are some interesting numbers to consider.

Using the official BLS Consumer Price Index (CPI), today's US dollar buys 34.8 cents worth of goods so it is now worth roughly one-third its 1980 value. Using this inflation estimate, the January 1980 silver high of $49.48 an ounce translates to $142.18 an ounce today.

But any trader worth his salt knows that this estimate (as well as other official stats like unemployment and GDP) must be taken with a huge grain of salt (please see "Getting Real On Inflation" and "The Inflation Story: Separating Fact From Fiction" in the Suggested Reading section). Using a more realistic average inflation rate of 7.75% per annum based on the work of John Williams (ShadowStats.com) gives a truer value of the dollar today at around $0.10 in 1980 terms. The math is easy and puts the current 1980 silver high in real inflation-adjusted terms at $495 an ounce after rounding.

So maybe the target of $50 per ounce silver isn't really all that high after all, especially as long as the US government and Federal Reserve do everything in their power to undermine the greenback.

Suggested Reading

Follow the Money - Eric Sprott and Andrew Morris
http://www.sprott.com/Main3.aspx?id=54

The Inflation Story: Separating Fact from Fiction
http://premium.working-money.com/wm/display.asp?art=808

Getting Real on Inflation
http://technical.traders.com/tradersonline/display.asp?art=5839

Bubble Watch: Silver
http://technical.traders.com/tradersonline/display.asp?art=5917

Matt Blackman

Matt Blackman is a full-time technical and financial writer and trader. He produces corporate and financial newsletters, and assists clients in getting published in the mainstream media. He is the host of TradeSystemGuru.com. Matt has earned the Chartered Market Technician (CMT) designation. Find out what stocks and futures Matt is watching on Twitter at www.twitter.com/RatioTrade

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