Silver is highly correlated to gold, with increased volatility
Silver, iShares Silver Trust (SLV), and gold, SPDR Gold Shares (GLD) or its equivalent iShares Gold Trust (IAU), have moved in lock step over the past seven years, with an 81% correlation in price movements. The difference lies in the volatility of the two metals, with silver’s annualized volatility of 33% dwarfing gold’s at 21%. This combination of a high correlation with gold and higher volatility means silver tends to outperform gold when sentiment turns positive for precious metals, as it did in June. On the other hand, the VanEck Vectors Gold Miners ETF (GDX) has been consistently under-performing both commodities due to the poor capital allocation of its constituent miners.
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Precious metals are closely tied to monetary policy
One way to think about gold and silver is like currencies, with two differences from government-issued currencies. The first difference is that gold and silver can’t be printed. So, all else equal, increased inflation in flat currencies is bullish for precious metals. The second difference is that currencies pay interest, unlike gold and silver. This means that—again, all else equal—increases in the interest rate received on currencies are bearish for precious metals.
In June, domestic factors in China led to short-term interest rates spiking. This move precipitated a sell-off in precious metals, which reversed once SHIBOR, the Shanghai Interbank Lending Rate, reverted to a more stable level.
Investors should allocate a small portion of their portfolios to precious metals
The low correlation between precious metals and equity ETFs such as SPDR S&P 500 (SPY) makes gold and silver a good diversifier for a portfolio. However, investors should only allocate a small percentage of assets to precious metals. Any more than a 5% allocation will begin to eat into the growth and income provided by other asset classes.
In a diversified portfolio, the volatility of individual assets matters less than their correlation with one another. Investors interested in higher upside can get a similar diversification benefit by investing in silver as they can in gold.
© 2013 Market Realist, Inc.