Silver/Gold Ratio Reversion 3

By: Adam Hamilton | Fri, Apr 16, 2010
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Silver's recent rallying action is starting to catch traders' attention. Since the end of its latest correction in early February, this white metal has surged 23% higher. It has well outperformed gold, which only climbed 9% over this same 9-week span. And based on silver's strong historical relationship with gold, odds are today's silver rally is only beginning. Silver's gains should accelerate in the months ahead.

The primary reason is silver remains seriously undervalued relative to gold. While it sounds strange to apply valuation concepts across metals, in the case of silver and gold it is very appropriate. The gold action utterly dominates silver traders' sentiment and hence silver price action. When gold rallies, they get excited and aggressively buy silver. And when gold sells off, they get scared and swiftly dump silver.

Over the decades as silver traders watched gold for silver-trading cues, naturally silver's behavior converged to mimic gold's ever more closely. This became a self-fulfilling prophecy. The more that silver traders watched gold and followed its lead, the closer tactical silver action mirrored gold's. This led even more silver traders to monitor gold and elevated this yellow metal to the dominant driver of silver sentiment.

Silver's ironclad relationship with gold is easily quantifiable through the Silver/Gold Ratio. The SGR simply divides the silver price by the gold price and charts the result over time. Thanks to late 2008's epic stock panic, the SGR today is still way out of whack compared to historical precedent. While silver has already recovered greatly relative to the gold price, it still remains nowhere close to rectifying the panic-driven gap.

This persistent-yet-gradually-closing valuation anomaly of silver relative to gold continues to create excellent opportunities for silver traders. As silver continues to normalize with prevailing gold prices, its price will rise driving all silver-related investments including silver stocks much higher. To understand these SGR-reversion opportunities, we have to first consider the stock panic's impact.

This first chart is not the SGR, but simply raw silver and gold prices over the last 5 years or so. It establishes the usual historical relationship between these two precious metals, how the apocalyptic fear generated by the stock panic threw this relationship into chaos, and how silver has been recovering relative to gold on balance ever since. This necessary reversion has yet to fully run its course.

Silver and Gold 2005-2010

Prior to the stock panic, silver's very-tight correlation with gold is readily apparent visually. Silver rallied when gold was strong and fell when gold was weak. And this critical relationship is even stronger mathematically than our eyeballs can perceive. On a day-by-day basis between January 2005 and August 2008, silver had a stellar pre-panic correlation r-square with gold of 94.7%!

This means almost 95% of silver's daily trading action over this entire span was directly explainable mathematically by gold's own. Silver, as has always been the case in history, was acting as a leveraged proxy on gold itself. Silver has always mirrored, and usually amplified, underlying moves in gold. Silver traders watch gold like hawks, hence prevailing gold action at any given time creates silver psychology.

But during 2008's once-in-a-century stock panic, silver radically decoupled from gold. The silver traders were watching gold as always, but it was the least of their concerns. They got caught up in the unbelievably-intense general fear gushing from the plunging stock markets. Silver has always been a highly-speculative asset, and those overwhelming panic fears collapsed the universal appetite for speculation in all risky assets. Silver was collateral damage.

The heart of the stock panic was an insane 21-trading-day span ending on October 27th, 2008 where the flagship S&P 500 stock index (SPX) plummeted 30.0%! Gold didn't fare as well through this fearstorm as its investors had long hoped, falling 16.7%. Yet even though it held up much better than general stocks, silver traders still freaked out. They drove a 32.6% silver plunge over this 4-week span, brutal.

And provocatively in October 2008, silver hit new lows on days the SPX did (and gold did not). Silver followed the stock markets. The SPX fear temporarily eclipsed gold as silver's primary driver. During that 4-month panic span (September to December 2008), silver's correlation r-square with gold plunged to a once-unthinkable 52.5%. Merely just over half of silver's daily action was statistically explainable by gold's own, a surreal anomaly without precedent.

When the dust settled from this unparalleled panic period, silver had plunged 53.4% from its July highs a few months earlier while gold lost 23.4%. Although gold only fell to a 14-month low at its panic nadir, silver went much deeper to a 34-month low. As I told our subscribers at the time in the heart of the panic, it was very clear that silver was radically undervalued relative to gold. So we aggressively bought and recommended elite silver stocks in late 2008 to ride this anomaly's unwinding.

And silver has indeed recovered sharply as you can see in this chart. Whenever you see a market anomaly driven by an extreme emotion, realize that once this emotion abates the anomaly will not persist. Extreme fear crushed silver, so as this fear evaporated silver bounced back. Between its panic low under $9 in November 2008 and its latest interim high above $19 in early December 2009, silver has already rallied over 115% at best. Yet despite these big gains, silver's post-panic recovery is still far from over.

You can see why in this silver and gold chart. Even though silver has rallied mightily out of the depths of panic despair, it is now only nearing its pre-panic levels. Meanwhile its primary driver, gold, has surged to new highs well over its pre-panic levels. And silver's joined-at-the-hip day-to-day relationship with gold has been largely restored since the panic. Since January 2009, its r-square has surged back to 88.5%. In the post-panic timespan, 89% of all silver action has been mathematically explainable by gold's own.

With silver mirroring and amplifying gold again on a daily basis, the odds are overwhelming that silver will continue normalizing back to its historic price relationship relative to gold. And even with this chart, it is readily apparent silver tracked gold very well prior to the panic. If the blue silver line was to mirror the red gold line again, silver would have to be trading at new bull highs in the lower $20s. We aren't even close yet.

And this is where the Silver/Gold Ratio comes in. The SGR precisely quantifies the relationship between the silver price and the gold price. This next chart shows the SGR in blue, along with its key 50-day and 200-day moving averages. Technically the SGR leads to difficult-to-understand decimals, so I usually take the inverse of it (Gold/Silver Ratio) and invert the axis so a rising blue line indicates silver strengthening relative to gold and vice versa. The raw silver price is shown in red.

Silver/Gold Ratio 2005-2010

For many years prior to the stock panic, the SGR averaged 54.9. An ounce of silver tended to trade at 1/55th the price of an ounce of gold. This 55 ratio naturally became widely accepted in the precious-metals mining industry. When primary silver producers converted byproduct gold to silver-equivalent ounces for their SEC financial reports, they used 55. Primary gold producers used the same number for their byproduct silver. In today's silver bull, a 55 SGR was established normality prior to the stock panic.

And interestingly, the SGR was actually in a secular uptrend before 2008's stock panic crushed silver traders' resolve. As the silver bull marched on, silver gradually gained ground relative to gold. This made a lot of sense. As more investors learned of the secular gold bull, their interest in deploying capital in it grew. And silver, since it is much more affordable and leverages gold's gains, is a perfect precious-metals investment for the masses. As silver's popularity with investors grew, it rallied faster than gold.

But the stock panic was a bullet to the skull of normality, and the resulting silver plunge drove a massive SGR breakdown. Since silver fell much faster than gold during the stock panic, the SGR naturally plummeted. This key ratio ultimately fell to its lowest levels of this entire secular bull. At the height of fear in the stock panic, you could by an ounce of silver for just 1/84th the price of an ounce of gold! It was truly the silver fire-sale of a lifetime, a fantastic opportunity I told our subscribers about in real-time.

Over the entire 4-month panic span, the SGR averaged 75.8. Silver remained far too cheap relative to gold based on historic precedent. After our subscribers had had plenty of time to lay in their own silver-related positions, I first wrote about this anomaly publicly in early February 2009 when silver had just climbed back over $12. Since then as expected, silver has indeed regained much ground relative to gold.

Today, the SGR's recovery uptrend is now well-established as you can see in this chart. No one has to take it on faith anymore. Silver has been rallying much faster than gold during the latter's uplegs, regaining lost ground. And as usual when gold corrects, silver falls faster than its primary driver. But over time these flowings and ebbings have clearly carved higher lows and higher highs in SGR terms, a textbook-perfect recovery uptrend.

And there is no reason not to expect this post-panic SGR-reversion normalization to continue. Investors and speculators, terrified of silver's volatility during the panic, are gradually returning to this popular white metal. As awareness of these powerful precious-metals bulls filters from contrarians out into the mainstream, countless investors will add positions in silver and silver stocks. Just as before the panic, silver's popularity profile will once again continue to grow among investors.

For all kinds of sentimental, technical, and even geological reasons, I fully expect silver to eventually resume its historical relationship with gold. This means one of two things. Either the SGR will return to its pre-panic average of 55, or this ratio will climb back into its secular uptrend where support is now running near an SGR of 47 or so. And this recovery could accelerate sharply from the pace we've seen so far when investors start really getting excited about silver again. It is overdue, as we haven't seen serious silver excitement since early 2006.

If you start plugging various gold prices into these fully-recovered SGRs, you quickly understand why I am so bullish on silver today. At today's $1150ish gold and the pre-panic average 55 SGR, we are talking about almost $21 which is considerably above today's $18ish levels. If you think the silver stocks you own or want to buy look stronger now, imagine where they would trade with silver well over $20.

And at the 47 SGR necessary to get this ratio back into its secular uptrend, and today's $1150 gold, this fully-recovered projection leaps to $24.50 or so! Silver's best price seen so far in this bull was only $20.77 in March 2008. New bull highs will spark widespread excitement in silver like nothing else can. Last autumn after gold broke decisively above $1000 for the first time ever, investors got so excited they quickly bid it up another 20%+ in just a couple months. New highs jumpstart investment demand.

And for a variety of reasons including its bullish fundamentals and seasonal spring rally, gold itself is likely to power much higher in the coming months and years. The higher gold goes, the higher silver will ultimately go as well. When you plug higher gold prices into the recovery SGRs, the potential of silver is even greater. At $1200 and $1300, the 55 SGR yields about $21.75 and $23.50 while the 47 SGR yields around $25.50 and $27.50. The "normal" silver targets relative to gold quickly climb higher as gold rallies.

Each time I've written publicly about the reversion of this panic-driven SGR anomaly, I get hammered on my conservative assumptions. But that is the whole point of this analysis. Sure, gold could and probably will go much higher and the SGR could very well climb well above these baselines next time traders really get excited about silver. So plug in whatever numbers you want, conservative or aggressive. The core point here is silver is undervalued relative to gold, regardless of one's assumptions, offering great opportunities for traders.

For years I read financial newsletters, trying to get an edge in the markets and improve my own trading. But I could never find one concentrating on what was important to me. What is driving the markets today, and why? And how can I position my capital to ride today's prevailing trends over the key 6-to-12-month time horizon that encompasses major uplegs and corrections? I wanted practical unemotional analysis leading to high-probability-for-success trades, not emotional rants. So I founded my own research company.

A decade later, our subscribers continue to thrive. While we have plenty of silver-stock positions deployed today in anticipation of the coming silver rally, silver is just one of many markets we track, analyze, and actively trade. If you like logical and practical analysis like this essay, you'll love our acclaimed monthly newsletter. In it I integrate our vast and endless market research into current market developments, distilling it all down into actionable real-world trades as opportunities arise. Subscribe today to greatly expand your market knowledge and investing success!

The bottom line is silver remains far too cheap relative to gold. 2008's stock panic severed silver's historical relationship to the dominant precious metal, and ever since silver has been recovering on balance. But despite silver's great gains since the panic, its price still has a long way to go before it fully normalizes relative to gold. The reversion to its pre-panic relationship remains very much underway.

Thus the same anomaly that offered such amazing opportunities in silver and silver stocks over the past year and a half or so largely still exists. While the initial easy profits have already been won, silver still has big gains ahead of it. Its recovery relative to gold that had to be taken on faith emerging out of the panic is now established fact. Get deployed in silver and silver stocks and ride the rest of this reversion.

 


 

Adam Hamilton

Author: Adam Hamilton

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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