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Gold has historically been a safe haven in times of economic chaos, political uncertainty, and social unrest.  Such a safe haven has been very much in demand, with concerns the U.S. economic recovery is fading, worry of European sovereign debt issues, and inflationary troubles throughout the world. Thus, it should come as no surprise that gold prices recently set an all-time high of $1,423 an ounce. Other commodities have followed suit. In particular, silver prices have risen rapidly, recently reaching a 20-year high of $31 an ounce.

In spite of recent momentum, there are indications that silver is relatively undervalued – especially in relation to gold. Rising investment and industrial demand, as well as a long-followed ratio (see below) indicate silver prices have more room to run. Commodity traders follow the silver-to-gold ratio, which indicates the amount of silver it takes to purchase one ounce of gold. They have used the rate to gauge the approximate value of gold to silver. After averaging 16:1 through much of history, and reaching 100:1 in 1991, the ratio currently approximates 47:1. This suggests that silver is relatively undervalued and could forge closer to the 16:1 historical average. It is possible that the ratio could normalize is a steep drop in the price of gold were to evolve. Indeed, the following conditions show why we expect silver prices to rise. The only question remains when will the ratio revert toward this more traditional level?

One caveat: Silver prices are extremely volatile due to a relatively low level of liquidity. For example, transactions on the London gold bullion market turn over 18 times more in money than silver. Regardless, there is a confluence of factors that show the run on these two precious metals should continue.

Under the stewardship of Chairman Ben Bernanke, the Federal Reserve Board has initiated various measures of quantitative easing. Under these initiatives, monetary authorities inject money into the banking system by buying long-term bonds. This is supposed to lower interest rates and entice consumers and corporations into boosting spending, which, in turn, helps create jobs. Under such an “accommodative policy,” excess dollars eventually lead to inflation. A certain degree of higher prices would be encouraging to Mr. Bernanke, who now views the possibility of deflation as the greater pricing threat to a sustainable economic recovery. But, remember that for every new dollar printed, every dollar in our pocket losses some value.

Quantitative easing thus weakens the greenback. While this makes U.S. exports cheaper, foreigners have to pay more U.S. dollars to settle transactions. This is significant since a major portion of international trade is denominated in greenbacks. Moreover, easy money has the potential to make investments in dollars less appealing for foreigners. Inflation and weakness in the world’s most-used currency are causing investors to hedge their positions with gold and silver.

Indeed, it is probably foreign exchange risk that is leading China to accelerate purchases of Gold. In fact, the world’s most populous nation likely imported 320 tons of the yellow metal during 2010, placing China in second place behind India. After taking into account China’s domestic output (it is the leading producer of the shiny metal) the country (government agencies and private citizens) consumed more than 600 metric tons of gold in 2010 alone. What’s more, China is keeping all the gold it mines, in order to slow a growing dollar reserve. Until recently, China did not allow its citizens to buy precious metals. Now, it is encouraging its 1.3 billion citizens, whose tastes and incomes are growing, to do so.

India’s one billion consumers have long been known to have a sweet tooth for silver and gold jewelry. We expect rising demand and silver prices to encourage consumers to secure supplies, fearing prices will rise substantially. Other Asian countries are following suit. It sounds like these nations are starting to hedge against the possibility that the U.S. dollar will continue to weaken.

The aforementioned factors indicate why silver seems likely to advance with the help of gold. The following reasons show why silver may well have greater potential. First and foremost, Gold’s current high price makes silver more affordable to certain consumers and investors seeking protection.

Global demand for silver has exceeded supply during much of the last several decades, and the gap keeps growing each year. Due to this disequilibrium, world stockpiles have fallen from two billion ounces in 1990, to less than 150 million ounces now. Moreover, conditions for this commodity continue to firm. Due to technological innovation, new uses for silver are materializing. In recent years, the metal has been used in cell phones, photovoltaic cells in solar panels, and various medical applications, among other uses. Demand should further be supported by its use in silver zinc batteries, and radio-frequency identification tags.
The aforementioned factors are leading investors to include silver companies in their portfolios. In particular, Silver Wheaton (SLW, see “Silver Wheaton’s Time To Shine”) and Pan American Silver (PAAS), as well as ETFs iShares silver trust (SLV) and DB Silver Fund (DBS) are benefiting from growing Wall Street interest. It would be judicious for those sitting on the sidelines to hedge their risk with silver plays.

All told, silver prices appear primed to forge ahead. If international affairs remain more unstable than usual, investors will likely continue to gravitate toward the metal. And if the global economy continues to improve, the shiny metal ought to gain from higher industrial demand. How high can silver prices go? Based on the historical silver-to-gold ratio of 16:1, silver may well be trending toward $90 -$100 an ounce, based on the assumption that gold will continue trading at about $1,400 an ounce.
 

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.