The Silver-To-Gold Ratio May Pullback, Providing An Entry Point; Silver Likely Outperforms Gold Thereafter

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Includes: GLD, SLV
by: Robert P. Balan

Summary

Silver severely underperformed Gold, and we previously noted it was just matter of time before the relationship between silver and gold adjusts to less extreme levels; that opportunity is nigh.

Indications show that the US dollar, short-term, may make a move higher after being sideways bound in past quarters. That may provide a time-window for a long-silver, short-gold trade.

Growing industrial demand, a weaker dollar, the Fed's shallower policy trajectory, and supply constraints should all play their part in supporting higher silver prices over the near term at least.

In previous articles about the Silver-to-Gold Ratio (SGR), we noted that Silver had severely underperformed Gold, and it was just a matter of time before the opportunity arises as the relationship between silver and gold adjusts to less extreme levels. We believe that this opportunity is upon us -- silver should start outperforming gold soon, and adjustments in their relative value via the Silver-to-Gold ratio present a solid investment opportunity for investors.

Since April 1, the price of silver has rallied by 14.4%, and gold rose by 2.47%, allowing silver to close some of the recent valuation gap with gold. The common trough in these two metals also marked what could be the cyclical trough for the SGR. From a ratio of 1.199 SGR closed at 1.375 on Friday, last week. We believe that, bar a so-called "test of the low" in coming weeks, the SGR will continue to rise over the medium-term, as cyclical assets outperform defensive assets. If our thinking proves correct, the SGR could rise to near 2.00 ratio over the next 18 months or so (see the chart below).

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Why should we care about the Silver-to-Gold Ratio, and why does it make a difference? SGR measures the amount of silver required to purchase an ounce of gold and it is one important metric of the value of silver relative to gold. Basically, it indicates whether gold or silver is undervalued or overvalued relative to each other. When the ratio is high ("high" being above the historic mean) it indicates that silver is overvalued relative to gold, and the opposite is true when the ratio is "low". The SGR had fluctuated widely during and after the Great Financial Recession of 2008, as investors bought Gold (and dumped Silver) during the height of the GFR in 2008, and did the opposite (bought Silver and dumped Gold) in the sharp reflation of risk assets from early 2009 to the 2011 top of the SGR.

US Dollar changes impact the SGR in a big way

There are indications that the US dollar may move higher in the short-term after having been generally sideways bound over the past several quarters. That may provide a good entry into this trade by late May to mid-June this year (see chart below).

To track this US Dollar-Gold and Silver directional pricing model, go here:

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In the longer-run, the US currency is probably due for further declines, and this will help support further rises in the value of silver and the SGR, as silver outperforms gold, during the general uptake of all major commodity sectors. This outperformance has historically happened during instances of broader global growth, rising interest rates, and a relatively weak US dollar environment. In other words, that is when cyclical assets dominate defensive assets. As the US dollar is negatively correlated with Global growth, then it follows that the Silver is highly sensitive to the inverse changes in the USD TWI valuation -- even more so than Gold (see that relationship in the chart below):

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There are still issues that are preventing a quicker recovery of silver over gold. There is still a tremendous volume of paper silver, a glut in silver futures contracts, still in place. Some analysts estimated that there is about one ounce of physical silver to over 250 ounces of paper silver (Caiman Valores, here). These paper contracts have effectively created a virtual silver supply without putting pressure on the physical silver market. This has helped depressed the price of silver, and is also creating considerable volatility in the silver price - Caiman Valores says the large volume of futures contracts is creating a considerable disconnect between paper and physical silver.

Silver industrial demand is growing again

Nonetheless, even as silver industrial demand grows, there is an increasingly constrained supply situation with miners in recent years investing substantially less in exploration and development. Most silver stock comes as a by-product of base metals mining, and so the depressed prices of copper and nickel have recently moved miners to slash capital expenditures as they seek to shore up balance sheets and protect their cash flows. Caiman Valores reported that there has been a steep reduction in exploration and mine development activity among some of the world's largest silver producers such as Rio Tinto (NYSE:RIO).

Moreover, of the world's largest producers of silver, global miner BHP Billiton (NYSE:BHP) (which has also slashed capital expenditures), is still battling the fallout from the recent Samarco issues in Brazil. Primary silver miners, on top of slashing capital expenditures, are also contemplating shuttering uneconomic production. This has improved the output profile for silver, laying the groundwork for the recent up move in prices (see chart below).

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The outlook for silver is beginning to turn positive, after a few years of being the unwanted cousin of gold. Growing industrial demand, a soon-to-be weaker dollar, the Fed's shallower trajectory towards tighter monetary policy, and supply constraints should all play their part in supporting higher silver prices over the near-term at least. Bar a short-term correction in May-June time frame, the SGR should continue to power ahead for the rest of the year. As a virtual cyclical asset, the SGR is sensitive in a positive sense to the impact of Headline CPI inflation. And here lies the link of the SGR with Crude Oil, as oil leads the Headline CPI by a month (see chart below).

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There are still niggling issues, like the large volume of paper silver contracts still extant, which distorts silver's price discovery process and promotes unwanted volatility. But the market should balance out over the longer term, and those issues should be resolved over time, making now the appropriate time to start acquiring exposure to silver. And if the factors that make this trade very attractive align well, the upside potential of the SGR could be huge.

I will illustrate this with a little personal story: My boss and I spoke about the silver/gold ratio in detail last December, and we both agreed at that time that a bottom will likely come in H1 2016, the approximate date still unknown at that time. We have been discussing SGR a lot because of our in-house outlook of significantly higher oil prices over the next 3 to 5 years, or even longer. And we were looking for the right vehicle that takes both the Oil and CPI elements without any direct market exposure (sort of), and we thought one promising way is through the SGR spread trade. It is true that the silver-gold ratio does not totally remove the market beta risk, but the spread may minimize it, and yet it does not curtail the upside potential. This trade really appeals to my basic trading instincts. Here is how it looks like, if everything goes according to hope -- a rally back to circa 5.0 in the SGR in less than 5-7 years (see the chart below). The pink rectangle is where I believe we are in the context of the 1970s environment.

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One final note:

One frequently reads articles at Seeking Alpha or elsewhere underlining the primacy of real interest rates as movers of precious metals (gold, silver) prices. That is not exactly right. It is better to look at the US Dollar as the Big Kahuna in SGR and precious metals price discovery. Real rates lag too far behind the evolution of the Dollar and PM prices, so they are useless as forecasting variables for future PM prices. The determination of real rates require CPI inflation as the modifier of interest rates (as subtrahend in the mathematical operation). Since changes in the CPI can easily be proven to lag behind the changes in the USD, or even PM prices, there is no need to resort to real rates in forecasting the likely trajectory of the SGR and PM prices (see those correlations in the chart below) -- understanding what the US dollar will do is sufficient.

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Disclosure: I/we 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. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The company the author represents may have outstanding long or short positions in the commodities discussed in the article. The company may also initiate new positions, long or short, in any of those commodities mentioned, within 72 hours of publication of this article.