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Tuesday, January 12, 2010

The Gold / Silver Ratio

I have a series of posts going regarding important Gold ratios. This is the third installment.

1. Gold Miner Performance: A Look Miner Cost Inputs vs. Gold Price - Dec 30, 2009
2. Gold Miner Performance Relative to Gold - Jan 11, 2010
3. This Post - The GSR
4. The Dow/Gold Ratio - forthcoming. I have written several posts on the DGR in the past, I will update those based on recent developments
5. Other Gold Ratios - forthcoming. Again, I have written several posts on these that I will update.

The Gold / Silver Ratio (GSR) is another key ratio that describes larger market trends and perceptions, much like I showed with the HUI/Gold ratio in my last post. So lets first start off with a long term chart of the GSR.

Like I pointed out in my last post, this is a chart of the Gold / Silver ratio. When a ratio is increasing, it means that the numerator is increasing faster than the denominator OR the numerator is not dropping as fast as the denominator. Outperformance means either moving up faster or not dropping as quickly. This is why I included Gold and Silver price history at the bottom of the chart so you can see the relative movement.

But first, let me talk a little bit about what Gold and Silver are.

Gold is sound money. Now you may be a gold bear, and think it is a useless shiny piece of ... metal. But the odds of someone of that mindset actually making it far down this post is probably unlikely. However, my point is, there are *many* people who feel this way, even if you don't happen to agree with them. And so it is important to understand what many other investors think. My $0.02, and take away from that what you want.

Gold is sound money, which means it represents safety. It is a safe haven move in times of crisis to go to physical gold or to funds that have claims on physical gold (there is a *very important* distinction to be made here about gold / gold funds / types of gold funds. But I have made them many times before and this is beyond the scope of this post).

Silver, however, is a different animal. Silver is another monetary metal, yet it has a very wide range of industrial uses. As such it straddles the line between a currency and a commodity. However Silver has some very interesting facts: For a long time it was not recycled (unlike gold which has been recycled for a long time in industrial applications). This is not true anymore, it is being recycled more now, but there are still many applications where it is not due to economic non-viability. As such, a large portion of silver is literally sitting in landfills in various chemical states. But because there is still so much industrial demand, the amount of silver sitting in vaults as a monetary metal is lower than the amount of gold. This makes Silver a bit of a conundrum at times. Currently Gold demand is 85% investment and jewelry (which is mostly Asian and Indian = investment) and 15% commodity. Silver is more like 70% commodity / 30% investment (rough ballpark). Yet the current above ground warehousing of Gold far exceeds Silver. Only ~500 million ounces of Silver is being warehoused, which is roughly a year's worth of global mine production. The makes Silver *especially* susceptible to demand drive spikes (more on that in a minute).

Let's discuss the chart and asset class correlation:

Remember, the GSR is a ratio. From 1980-1991 an increasing GSR signified Silver falling faster than Gold. This was actually very bullish for the market. As the spike in Silver from the Hunt brothers fiasco led to a very manic Silver Run up in the 1980s and it corrected very hard down to its lows in the early 1990s. Money moved out of safe haven investments and into stocks. So in this case, a rising GSR in a falling gold/silver environment is bullish for stocks. And stocks did indeed make a spectacular bull run during this time.

Compare this to the recent past. A rising GSR in a rising Gold and Silver Environment means that that a premium is being placed on safety / risk aversion. A rising GSR in this scenario is *VERY BEARISH* for the equity markets. This was the case in 2000-2003 (Tech Bubble crash) and again in 2007-2009 (First Credit Bubble Crash / The Great Deleveraging Crisis of 2008) and what do we have right now?

That's right, the Gold / Silver Ratio is on the rise again.

What does this mean?

Silver, like the HUI, is a more speculative play that is tied to more positive economic correlation. That is, Silver is much more correlated to positive economic activity (where we have sustainable growth in commodities as fuel for productive economic endeavors). This optimism typically occurs during times of leverage and liquidity.

Gold is much more of the stalwart safe haven precious metal. It's moves are a lot less spiky than Silver's.

The GSR currently has room to run up. Assuming that we have another credit and/or confidence crisis, Gold will be the true safe haven move. During the next leg of the crisis Gold will vastly outperform Silver (IMO). I think the GSR could challenge the triple-digit level again.

**BUT** if it does that (and gold will probably be putting on its biggest move of the bull market at that time) expect a feeding frenzy in Silver (as demand for monetary metal heightens, expect Silver to behave like money and not at all like a commodity). And due to scant warehouse supply of Silver, also expect demand to skyrocket. At this point Silver will vastly outperform gold, and expect the GSR to plummet to 30 or less.

Here is my takeaway

I am bullish on both Gold and Silver and I think shorting it, for any length of time with any large portion of your portfolio, is a very bad call. I think demand for both will increase dramatically in the coming years.

I think Gold will lead the next phase of the crisis and outperform Silver.

But at some point the Gold / Silver Ratio becomes "stretched" so far, and demand for all Precious Metals becomes great, especially undervalued Silver, that Silver will skyrocket and outperform Gold.

So, Gold outperforms for the near term, Silver outperforms about halfway through the crisis. If you go by all my logic / observations above.

Here is some further required reading on Silver:

-- Jesse: Is the Price of World Silver the Result of Legitimate Market Discovery? - http://caps.fool.com/Blogs/ViewPost.aspx?bpid=312290
-- Golden Sextant Commentary - http://www.goldensextant.com/commentary35.html


The point of this post, just like the point of any of my posts, is *not* to try to convince you of anything. I am an analyst who is sharing observations. That's all. It is immaterial to me whether you agree or disagree with my observations or conclusions. But I do hope that my observations are useful in helping you to formulate your own opinion, even if your conclusion is completely opposite of mine.
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