Silver: Short-Term Risks Vs. Long-Term Rewards

Silver prices have fallen 15% over the past month since their February 2 spike, and in the near term the selling pressure is likely to remain as continued upside pressure on real US bond yields keeps precious metal demand muted. However, from a long-term perspective silver is likely to outperform most other assets, with 10% annual returns likely from current undervalued levels.

Bearish Trend And Rising Real Yields Suggests Near-Term Weakness

Silver’s technical picture looks precarious in the short term as last month’s failure to break above the USD25/oz area keeps the bearish trend from the February highs intact. There is no notable support until the USD17/oz area which suggests we could see considerable further downside, particularly with high and rising real yields putting downside pressure on gold.

US 10-year inflation-linked bond yields are trading back near their cyclical highs, with the yield currently at 1.6%. This has put downside pressure on gold demand due to its use as an alternative store of value, and by extension this has undermined monetary demand for silver. As the chart shows, both gold and silver have been pressured by rising real yields over the past year and the correlation suggests both precious metals may have further to fall.

10% Annual Long-Term Returns Likely

While the near-term outlook for silver remains precarious, the long-term outlook is highly positive and has improved over the past month as a result of the recent weakness. Over the long term silver prices tend to track an equally-weighted basket of gold and the broader commodity complex due to the metal’s use as a monetary and an industrial metal. As the following chart shows, despite recent weakness in gold and the Bloomberg Commodity Index, silver is deeply undervalued based on this correlation.

Over the past 40 years silver has returned just 1.7% annually in nominal terms, dramatically underperforming most other assets. However, when the metal has been as undervalued as it is today, it has returned just over 10% annually.

How To Play It?

I believe the best way to play the silver market at present is to sell put options, which give the holder the right to sell silver at a specified price by a specified date to the writer of the put. This way, bullish long-term investors can generate a premium in compensation for taking on near-term risk, and any further near-term weakness would provide an even better opportunity to capture long-term gains.

As shown above, silver puts expiring on August 28 at the current spot rate of USD2,100 trades at USD132, which equivalent to an annualized return of 14%. Silver prices would have to drop below USD1,968 by end-August for ATM put sellers to lose money, while any rally in silver over this period would generate gains of USD132. While put sellers would see losses on any drop below USD1,968, any such decline would further improve the long-term outlook for the metal.