As you can see in the following chart, the last few months have been somewhat challenged for shareholders of the Global X Silver Miners ETF (SIL) with shares off from the peak set earlier this year.

Source: TradingView

In my opinion, it is time to buy the pullback in SIL. I believe that the fundamentals for the ETF remain strong and in the following sections I’ll discuss reasons why I believe investors should buy the product.

About SIL

To start this piece off, let’s take a quick look at SIL’s methodology and scope. Put simply, SIL is a straightforward ETF which is tracking the Solactive Global Silver Miners Total Return Index. This index essentially targets a basket of holdings of firms primarily engaged in silver exploration, mining, or refining. It is a market-cap weighted ETF and it charges a moderate 0.66% expense ratio.

At present, the fund is holding 41 different firms with $932 million AUM. Market caps shift through time which means that this will change, but at present here are the top 10 holdings:

Source: Global X

One of the key benefits of trading a fund like SIL is that it allows investors broad exposure to themes rather than specific firms. For example, if you or I desired to invest in any of the individual stocks held by the fund, we would need to conduct a fairly robust fundamental analysis of the positioning, margins, and corporate developments occurring at the company. We also would need to assess management’s qualifications and their stated corporate plans and objectives to understand how cash flows may evolve in the future. Put simply, individual stock analysis requires a significant dedication to researching a specific firm’s positioning and financials prior to deciding the worthiness of a firm for investment.

This is the beauty of a product like SIL: it allows us to reduce this process to simply assessing the overall driver of cash flows for the basket of firms rather than any specific firm. Since this product holds a diverse basket of 41 different companies, we can examine the firms in aggregate rather than individually.

For example, each of the above firms is subject to the fluctuations of silver prices. Individual firms may pursue various hedging strategies or sales agreements to mitigate risk, but in aggregate, the 41 stocks held by SIL will generally rise or fall with the price of silver since silver’s prices are directly correlated to revenues and therefore cash flows.

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But don’t take my word for it. Here is a chart in which I’ve correlated all available pricing for SIL with the price of silver.

Source: Author’s calculations of LMBA and Yahoo Finance Data

We only have about 10 years of data, but what we do have paints a very clear picture: SIL is highly correlated to changes in the price of silver.

What interests me about the above chart is the correlation under different pricing regimes of silver. What I mean by this is that if you look at the correlations between SIL and silver on the downside, the data is fairly grouped around the trend-line. That is, when it comes to downside movements, in general there is a linear relationship between silver’s movements and SIL.

However, on the upside, there’s an interesting trend in which returns in SIL can strongly outpace the actual gains in silver (to an extent). What this tells me is that when silver prices are rising, investors have historically become fairly bullish on silver firms which results in the basket of firms held by SIL to actually outperform silver. Here’s another chart to show this point.

Source: Author’s calculations of LMBA and Yahoo Finance Data

I find the above data very interesting. What this essentially shows is that under most price appreciation environments of silver, an investment in SIL has actually outperformed. In other words, if you knew that silver was likely to increase in a given year, the historic data shows that you would have generally been better off buying SIL rather than the underlying commodity – in terms of absolute return that is.

What this data means is this: if we can understand where silver is likely headed, then we can have a good idea of how SIL is likely to perform. This said, let’s turn our attention to silver’s fundamentals to gauge where the market is likely headed.

Silver Fundamentals

Over the past year, silver has performed fairly strongly with the price of the commodity rising by around 30-35%. This figure changes on a week-to-week basis, but for the past month or so, we have consistently seen year-over-year gains in this vicinity.

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From a classic “buy low and sell high” perspective, traders may be tempted to think that silver’s rally has run its course. After all, most markets which increase by nearly a third in the course of a year tend to be primed for a reversal. However, this is not the case with silver. Indeed, in the following chart I have calculated the average future 1-year return in silver grouped by past 1-year returns. This chart answers the question, “given silver’s past performance, how is it likely to perform in the future?”

Source: Author’s calculations of LMBA data

Put simply, silver markets exhibit strong momentum. That is, past periods of strong performance tend to lead to future performance. Interestingly, this relationship tends to only be on the upside – downside movements tend to peter out while upside movements tend to carry forward into the next year.

From a numeric standpoint, we’ve seen silver’s 1-year return fluctuate between 30-35% for the past few weeks. There’s been noise around this figure, but in general, history shows that rallies have historically occurred in the year following readings of this level with average movements between 15-69%. These figures are just averages of all returns, so to get an idea as per the spread between upside and downside movements, I’ve calculated average gains and losses in the same format.

Source: Author’s calculations of LMBA data

This chart shows the average gains and losses seen in the year following a movement in silver by a certain magnitude. For example, historically speaking, when we’ve seen silver rally by between 30-35%, the next year has either seen gains in the territory of 46-115% or losses in the territory of 13-24%. If you’re familiar with statistics, this data is essentially showing a very strong skew to the upside with gains tending to vastly outpace losses seen under similar regimes.

From a probabilistic standpoint, the data is also quite bullish. For example, history shows that when we’ve seen silver make a move similar to what’s been seen over the past year, the next year tends to rise about 60-75% of the time. The past does not perfectly guide the future, but this data is certainly suggesting further upside.

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So what is happening here? Why is there a clear relationship in this data and what does it mean? This is a very important question to ask because this helps us understand if we are just looking at noise in the data or if there is a fundamental relationship at work.

In my opinion, this data captures the tendency of investors to chase returns in silver. What I mean by this is that investors tend to group into silver after it has been performing well which leads to a virtuous cycle of further periods of upside (until the end of the trend of course). This tendency is also captured through momentum-based traders who buy silver after it has been performing well leading to further strong performance. On this basis, I believe that silver momentum is a strong tendency around which to base a market outlook for silver prices.

I believe that this data is suggesting that we will see silver rally over the next year by anywhere from 15-30% based on the clear historic averages. For SIL traders, this type of rally actually is very bullish for the ETF with history showing the product increasing by 40-80% during this type of price appreciation. In other words, based on this expectation for silver’s price gains, SIL is likely going to remain the better alternative and deliver a stronger return than silver itself. For this reason, I suggest that investors purchase SIL at this time.

Conclusion

SIL’s diverse basket of holdings allows investors to focus on the drivers of cash flows rather than any specific firm-level strategy. Momentum effects suggest that silver is going to rally by 15-30% over the next year. History shows that when silver rallies by this amount, SIL tends to outperform by a strong degree.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.



Via SeekingAlpha.com

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