Correlation And Likely Trend For Gold And Silver

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Includes: AGQ, DBS, DGL, DGLD, DGP, DGZ, DSLV, DZZ, GEUR, GLD, GLDI, GLL, GTU, GYEN, IAU, OUNZ, PHYS, PSLV, QGLDX, SGOL, SIVR, SLV, SLVO, UBG, UGL, UGLD, USLV, USV, ZSL
by: Disruptive Investor

In several articles in the recent past, I have opined that I am bullish on gold not just for 2016, but for the next decade. While gold has trended higher by 17% for YTD16, silver has surged by 24% during the same period and there are analysts who opine that silver has bottomed out and is set for renewed rally.

This article addresses the following questions to conclude on the likely trend for silver in 2016 and in the coming years.

1) What is the closely watched gold-silver ratio telling an investor?

2) What is the correlation of returns between gold and silver?

3) Why silver has underperformed gold in the last five years?

As this article from Business Insider shows, the gold-silver ratio is currently above the average level seen in the last 20 years. It is entirely likely that the gold-silver ratio will trend towards the average in the coming months.

This would imply gold correcting in the foreseeable future or silver generating returns that outperform gold returns. In my view, the first scenario is unlikely considering the point that the global economic activity remains uncertain, central bankers are prepared to pursue renewed expansionary monetary policies and an increasing value of government bonds trading at negative yields.

Therefore, as witnessed for YTD16, I expect silver returns to be higher than returns for gold in the foreseeable future and that will take the gold–silver ratio closer to long-term averages.

As the chart below shows, gold-silver ratio has declined in the recent past and this trend is likely to sustain.

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Source: MacroTrends

In connection with this point, I also want to mention here that there is a strong positive correlation between gold and silver returns with the chart below showing 3-year and 5-year weekly return correlation for gold against silver and other commodities.

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It is clear that silver shares a strong positive correlation with gold and it is very unlikely that silver trends higher and gold corrects. Importantly, in terms of fiat money factors, both gold and silver are likely to trend higher in the long-term.

However, the point that I am trying to make on the gold-silver ratio trending towards the long-term average will be clear from the chart below that gives the 3-year and 5-year price performance (OTCPK:CAGR) for gold and silver.

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While both precious metals have generated negative returns, silver has underperformed gold during this period. In the coming years, it might not be surprising to see gold underperform silver. However, gold can still generate annual returns of 15% to 20% if silver returns 25% or 35% in the coming years. These are just rough numbers and the point that I am trying to make is that gold underperforming silver does not imply gold does not provide robust returns on a standalone basis.

For silver, I must specifically mention that there are two factors that determine the price trend –

First, a weak dollar or expansionary monetary policies are likely to be positive for silver. According to the Silver Institute, the demand for coins & bars has increased from 51.2 million ounces in 2007 to 196 million ounces in 2014. In my view, this factor will continue to boost silver prices.

Second, industrial demand for silver peaked out in 2007 at 659.2 million ounces and the demand for 2014 was still lower at 594.9 million ounces. In my view, demand from developing Asia is the key factor and silver will trend higher if demand remains robust in China and India. I see application of silver in the solar panel industry as a key demand driver in the coming years.

In conclusion, I remain bullish on gold as well as silver for the foreseeable future as well as for the coming years. In my view, precious metal allocation to portfolio should be at least 15% to 25% in the current economic scenario.