What Does The Gold/Silver Ratio Tell Us Now?

| About: SPDR Gold (GLD)

Gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV) have proven to be extraordinarily volatile over the past few months and in particular, the past couple of weeks, with both metals enduring selloffs of historical proportions. Given the fact that the metals have become "cheaper" in terms of their nominal prices, I thought it would be interesting to revisit the Gold/Silver ratio in order to see how the two are valued relative to each other. Perhaps this will provide some clues as to where the metals' respective prices are headed in the coming months.

In order to perform this analysis, I pulled the daily closing prices of GLD and SLV, the ETF alternatives to futures contracts for these two metals, and graphed the relative strength of GLD versus SLV from 2006 to present. The result is below.

Since the inception of the SLV in 2006, it has traded in a very wide range of prices in comparison to GLD, with the ratio bottoming when GLD was at just over three times the price of SLV in the Spring of 2011 and topping out at about 8.5 during the depths of the financial crisis in 2008 when panic gold buying was in vogue.

Excluding those two outliers in the data, we see that for the first two years of SLV's existence, prior to the financial crisis, GLD was worth five to six times SLV pretty reliably. We see this tight range in the chart before the spike during the financial crisis.

After the financial crisis ended, we saw the ratio plummet all the way down to just above three, indicating massive outperformance of GLD by SLV in that period. After the overreaction to the ratio's low, we saw the steep uptrend that is framed in the chart end in early 2012. However, just because that uptrend ended does not mean a period of SLV outperformance is at hand again.

We can see that a second uptrend has been in place for about a year now, with the ratio slightly trending up from five to six, indicating GLD is once again outperforming SLV. I have framed this uptrend as well and the most important point of this chart is that we see the ratio break out from its uptrend. This implies that, once confirmed, another period of GLD outperformance is likely on its way. Indeed, given that GLD saw a waterfall selloff just a couple of weeks ago means you can initiate a position in GLD far more cheaply than was possible at the beginning of April.

In terms of a target, 2008 to 2010 saw the ratio bounce between six and seven and if this range holds once more, the up move in GLD relative to SLV is just getting started. Keep in mind, this is not a reason to buy or sell one of these metals, the idea is to initiate a pairs trade, taking advantage of the outperformance of one asset over the other. In addition, the ratio could increase from GLD moving up, SLV moving down or a combination of the two. You don't need to be totally right with a pairs position, you just have to know which one will outperform.

Given that gold is simply used as a form of currency and as a fear hedge, any number of events could set off a strong bull run in gold versus silver. For instance, in 2008, we saw the GLD/SLV ratio spike from 5 to 8.5 in just a couple of months. For investors who were long GLD and short SLV, massive gains were reaped. The point of this data is to show that investors have shown a very clear preference for gold over silver in the past year and you have a very simple way to take advantage. If you are uncomfortable simply being long GLD for fear of another gigantic selloff, you can pair your long GLD position with a short SLV position in order to hedge and take advantage of what the market is giving you. This pairs trade can be initiated and held for long periods of time as "trading" around these positions is more difficult than taking advantage of a protracted, longer term move such as the one I have highlighted here. This is as close to investing in an inanimate object as one can get.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in GLD over 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.