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The Gold to Silver Ratio - Alternative Look

By Przemyslaw Radomski      Printer Friendly Version
Jul 9 2008 10:05AM

www.sunshineprofits.com

In our previous essays we often used the R-square coefficient to measure particular gold or silver stocks’ exposure to the price of respective metal. Some of the featured companies were both gold and silver producers. The problem with this analysis was that it implied rising gold / silver ratio. We said that we will research this topic further and here we are. For details of this analysis please see articles available in the Researchsection on our Website.

Gold to silver ratio is a topic often covered in various analyses and essays. As you probably know, we strive to provide you with articles that differ from all other essays you might find on the web. This is why we decided to look at this matter from an unusual perspective. In this essay we apply similar methods as we used when analyzing gold/silver’s influence on the prices of precious metals stocks. We will therefore use a chart which lets you see the whole structure of the correlation without using the time axis. Please take a minute to understand the chart, used scales and the shape of the trend lines.

Each point on the graph represents the combination of silver’s and gold’s price at a particular date. Looking at this chart instead of standard gold/silver and time axis does not give you clear idea about extreme levels this ratio goes, but it’s clearer if you want to see general tendencies. As we all know, looking at various things from different aspects usually leads to making better decisions, especially the investment-related ones.

All trend lines on the above chart are rising. That means that if we took the first stage of the bull market, the second stage or even the whole bull market (please refer to our previous essays to find out what we mean under these terms), we would see that on average price of silver increases along with the price of gold. Not much of a news, up to this point. What is interesting is that in all these time frames this correlation is best described using different trend lines. What is not that obvious is that all these trend lines have different shape. First, we will focus on the long term trend line and what implications it has on the current situation on the metals market.

Data for the whole bull market is best represented by a linear trend line, so the trend line is rising and the slope is constant. This suggests that the gold / silver ratio could average around 43 level in the future. If this trend line is to be taken into account, silver is currently undervalued to gold and therefore it might make sense to add to your silver positions by selling gold (if you are inclined to trade this ratio) or making additional purchases of metals by buying silver instead of gold. This trend line may change its shape in the future as it will be calculated by using combination of more prices than we currently can use. Although it is possible that this trend line will be held, we expect that the slope of this trend line start to decline at some point, consequently changing long term direction of the gold/silver ratio in favor of the white metal. There are numerous fundamental reasons, which were deeply covered in many essays, so we won’t go into details here. Even according to current trend line with gold at $930 the fair (not long-term under- or overvalued) price for silver would be $18.65. Silver has some catching up to do.

Term 'catching up' was not used by a coincidence. Silver, just like junior mining companies, tends to 'take its time' before finally starting to rise really significantly. However, when it finally does move, then it’s 'up, up and away' for silver and its relative performance to gold. Some of our readers have already experienced these absolutely stupendous upswings in the price of the white metal, for example in the first months of 2004 and 2006. We have seen this type of performance on very long term charts that go back to the previous secular bull market in precious metals. Silver’s catch up materialized mostly in the final stage of the bull market. Scale was far greater than in more recent examples, but the fact remains that the most of the rise took place in its last part.

The trend line for the first stage of this bull market (thin, dotted, logarithmic line on the chart) seems to confirm our initial assumptions.

One of the main principles of the technical analysis is that history repeats itself. Let’s say that it rhymes at least, so we might infer that the second stage of this bull market will probably be characterized by a huge ‘silver catch up’.

Using the word 'will' is definitely accurate, as it was not the case up to this moment of the second stage of this bull market. For now, the second stage is best reflected by the exponential trend line, which means that gold tends to outperform silver so far. If history is to repeat itself once again (which we expect) silver might be in for a huge rise in the future. As you may see, changing the trend line to logarithmic would require the gold to silver ratio to decrease significantly. Please note that during the first stage of the bull market the gold / silver ratio fell significantly below the trend line during silver’s local peaks. Applying this to more recent prices would cause us expect silver to rise above $18.65 with gold at $930. Of course gold is in an uptrend itself, so the price of silver might get a lot higher than $21 at its next peak. This would also cause the slope of the long term trend line to decrease, and as we indicated above, we expect that to take place.

The main point is that silver’s underperformance to gold is nothing to worry about, as we are still in the early part of the second stage of the bull market. On the contrary - we should expect it. In our view, this situation will change but not necessarily right away. Current tendency has influenced our leverage model for some gold / silver companies (see our previous essays for details). It was based on data from the second stage of the bull and did not take into account the fact that the change of the gold / silver ratio is likely to decrease in the future. As you may see, using pure numbers for your analysis and looking at the short term price swings without relating to the bigger picture might lead to making wrong and costly investment decisions. Therefore, we strongly advise you to understand the way a particular number was calculated, before you decide to manage your money taking into account a particular ratio or coefficient.

In summary, the Gold / Silver ratio is declining along with the rise in the price of metals. Sometimes silver lags and sometimes it laps gold. It tends to accelerate its rise in the last part of particular upswing, rather than at the beginning. Since we are still early in the second stage of the bull market, silver’s rather poor performance in comparison with gold is pretty natural and we expect it to change in the future. Stay alert for strong moves in the price of the white metal, especially those connected with minor changes in the price of gold. They may signal that we are on the brink of another spectacular, parabolic rise.

On our website you can access tools dedicated to evaluating trend lines and calculating leverage for most popular precious metals stocks. Register today and you will gain access to all our Tools and much more. We use the methodology described in this essay as well as many other techniques to forecast market’s moves and discover unique opportunities for profit. When you register, we will send you occasional, brief market alerts, based on our research, whenever situation requires it. Registration is FREE of charge and you may unregister anytime.

P. Radomski
Editor
Sunshine Profits

 

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