I believe in assessing the fundamentals of a market before even considering whatever trading opportunity it represents. In the case of silver the fundamentals are well known to anyone who has done even the barest due diligence on it. Both from an industrial and monetary perspective, silver represents one of the most under-valued assets in the markets right now.
Silver has literally no chemical substitute for many of its antibacterial properties as well as the value proposition its electrical conductivity presents relative to its price. Everything we use on a daily basis now uses a little silver. Markets don't always trade on their fundamentals and silver - being tied to gold - is a politicized market as well as a unique industrial commodity. Discussing the demand profile for silver is itself a major undertaking, so here I'm going to focus on what I think will be the biggest driver for silver in 2013, its tie to gold. I'm bullish on gold and, by extension, bullish on silver.
The Golden Ratio
While the gold/silver ratio is not the greatest of indicators when looked at over a long time horizon it can have its uses. Since the peak in gold in September 2011, the gold-to-silver ratio has traded in a range between 50 and 60 with the 40-month moving average trending down.
The way I prefer to look at this ratio is not versus its natural abundance, which I feel is a very lazy argument because it ignores market demand and need, but rather in terms of silver's tug of war between its industrial and monetary character. If natural abundance meant anything, then Rhenium would be more expensive, by far, than Gold. It isn't.
Gold is functioning right now as a currency and until this super cycle in credit money comes to a head movements in, the price of gold will be based on its demand as a currency. Therefore the gold-to-silver ratio becomes a good barometer of how much marginal demand silver is seeing for its monetary characteristics versus its industrial ones. A rising gold-to-silver ratio has silver, at the margin, trading more like a commodity and a falling one like a currency - seeing spillover inflation hedging when gold gets too expensive. The 40-month moving average is clearly telling us that silver is reasserting itself as a currency over the past 20 years, albeit slowly and with great volatility. Hence, all bearish arguments for silver based on its commodity character are inherently weak at current gold-to-silver ratios.
While the ratio between gold to silver is itself volatile, the directional correlation between their price moves are highly correlated. As measured by the Pearson statistic, gold and silver trade in sympathy with one another (since December 1992) to a 97.0% correlation. So, anything that is going to happen to gold is going to happen to silver. What is different is their relative volatilities. This correlation says nothing about causality. In essence, changes in either's fundamentals manifest in the other. One does not lead the other per se - sometimes gold leads and sometimes silver does.
Hail, Hail the Helicopter's Here
If the Fed and the rest of the major central banks are successful in inflating the world economy and creating not only higher GDP growth across the board but also higher money turnover - more flow compared to stock - then silver's industrial fundamentals improve dramatically which then feed back into its monetary fundamentals along with gold.
More money flow - i.e. a higher M1 multiplier and money velocity - will also create upward pressure on the price of gold (AMEX:GLD) because that is what gold is, an inflation hedge and more money flow in this ultra-liquid environment is an inflation firestorm waiting to happen. The M1 multiplier has been rising for more than a year now, so has total bank credit. Even if inflation does not explode, it will be difficult to contain and considering the Fed is inviting inflation to stoke money flow, it seems reasonable to assume higher gold prices will ensue. This is what the Fed means when it says it is pursuing monetary policy to achieve certain macroeconomic goals like 6.5% unemployment.
The Fed still has a problem with money velocity and this is what is giving the precious metals bears their wings, so to speak. The counter argument to that, which is essentially a low-CPI is bad for gold, is simply that since gold has risen proportionately to the size of the Fed's balance sheet, the degree of that proportional rise in gold is affected by the money velocity.
- Slowing money velocity and a flat balance sheet equals no rise in gold.
- Slowing money velocity and an expanding balance sheet equals a steady rise in gold
- High money velocity and an expanding balance sheet equals a parabolic rise in gold.
Why do you think Bernanke and the FOMC have been so reluctant to actually let the money they printed in 2008 loose into the economy?
It is beginning to, by the way. Excess reserves at the Fed are down to $1.4 trillion. Bank credit rose to nearly $10 trillion last week. The inflation is coming however you want to measure it.
Now let's add the E.C.B. not lowering interest rates this meeting, which gave the all-clear signal for capital to flow out of the U.S. Dollar and back into the Euro, pushing the Euro (NYSEARCA:FXE) towards its highest weekly close in nearly a year at $1.326. A close above $1.33 this week would clear the path to $1.35 and take gold, silver and oil along with it. This is different than what had been happening since November, when Euro strength was inversely correlated with gold.
If Gold and the Euro are back in lock-step as U.S. inflation expectations take over and the threat of the E.C.B. inflating similarly has receded sufficiently, then the Euro, Gold, Silver and Brent Crude should all move directionally together until the next crisis or policy meeting. I showed the correlation between Brent Crude (AMEX:BNO) and Gold in a previous article here. Fundamentally, it all boils down to inflation being baked into markets. The 5/30 TIPS spread is holding above 1.82% and TIPS yields are dropping again after last week's spasm, also supportive of gold prices.
Above is a monthly chart of the iShares Silver Trust ETF (AMEX:SLV). From a price perspective silver is bounded by the two lines on the chart. There is very strong support around $26 per share, thanks to multiple months where traders bid the price back up before the close. Monthly closes are extremely important, especially ones that happen on a Friday as they represent weekly closes as well.
In short, the support between $25.34 and $26.65 is, frankly, massive.
So, that defines the bottom of the current trading range while the top of it is defined, quite clearly, by the 6 monthly peaks which intersect the line I've drawn on the chart above around $34.30 per share. Last week's volatility violated the low from December and that creates a low probability that December's high will be breached this month. So, while the fundamentals are lining up after nearly 18 months of the Fed holding its balance sheet flat, silver is not quite ready to take off yet.
Until some other signal is given, there is a low probability of a breakout or breakdown from the consolidation in silver this month. Silver is range-bound until further notice regardless of what the latest changes in the monetary statistics are saying. Eventually the fundamentals in silver reassert themselves and the price spasms higher, only to over-correct again. It's a thin and volatile market. It will be interesting to watch if that happens during this next leg of the bull market or will silver trade more freely than it has in the past.
For long-term bulls, any further weakness in January will present a good opportunity to accumulate either shares of SLV, physical silver or your favorite silver stocks like Silver Wheaton (NYSE:SLW) or Pan American Silver (NASDAQ:PAAS). The support near $26.50 is strong enough that at those prices your probability of a large loss is minimal.
Disclosure: I 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.
Additional disclosure: I own physical gold and silver and a few goats.