Are Gold and Silver Ready for Their Next Substantial Leg Up?

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Includes: GDX, GLD, IAU, SLV
by: Przemyslaw Radomski, CFA

I like gold and the whole precious metals market which is why I follow it, invest in it and base my professional life around it. Warren Buffett, one of the world’s savviest investors, doesn’t like gold at all. He doesn’t believe in it. In fact, in a speech he gave at Harvard University in 1998 this is what he had to say about gold:

It gets dug out of the ground in Africa or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it.

As an investor Warren Buffett is in a class all of his own. There is a reason why he is called the Oracle from Omaha. However, when it comes to gold, perhaps he has missed the point. Gold doesn’t generate dividends like the stocks that Buffett favors. However, gold has a role in balancing a portfolio and hedging against the worst of times, like the recent global financial meltdown we have witnessed. For those fortunate to have had it in their portfolio, gold helped preserve wealth that would have otherwise been eroded.

In his last shareholders’ meeting Buffett gave some good news about gold, although indirectly. He warned his investors about inflation and predicted that the dollar would be heading down. Both of those are positive indications for gold.

Precious metals tend to appreciate during inflationary periods (under the current financial system) and outperform other assets; therefore, this chart is very bullish for gold and silver. Most likely, even Warren Buffett would agree.

Gold

As indicated last week, the situation in the gold market has developed similarly to the scenario at the end of April when I wrote the following:

As you can see, the areas marked with blue rectangles look alike. Generally, it is common to see certain patterns on a particular market repeat themselves in a different scale (the so called fractal nature of markets.) This may be the case here.

The price action that followed has been remarkably in tune with what happened previously in the marked time frame. Please take a look at the chart (charts courtesy of http://stockcharts.com) below.


After publishing last week’s essay, we have seen gold go lower, bounce, and move lower again. This is also what happened in the end of April. The implications are positive for gold, because in the past the analogical price action marked the beginning of the new upleg. As always, caution is necessary because there are no sure bets in any market. However, the odds favor higher prices in the short term.

Silver


Silver’s performance has been far from stellar, disappointing those who included the white metal in their portfolios in hopes of higher rates of return. The good news is that silver tends (general tendency of silver) to underperform gold during the initial phase of a rally, and vastly outperform it during the late stage, more than making up for the initial lagging. In other words, silver’s underperformance to gold is nothing to worry about, as we are still in the early part of the second stage of the bull market. On the contrary - we should expect it. Assuming that the major bottom for the precious metals sector is already in place (during the last months of the previous year) and we are still below the previous high (substantially below it, in case of silver), we may infer that the following rally will be accompanied by a massive silver catch up. How can I be so sure that we will eventually rally, and most likely, soon? Because of the favorable fundamentals that determine the market’s long-term direction.

The silver catch up to gold has been visible several times in the past during this bull market. Please compare the following charts for details.


Clearly, in most cases, the final stage of the massive upswing was characterized by an even bigger rally in silver. Since we are not in the final stages of an upleg, but rather at its beginning, silver’s underperformance may be viewed as normal and should not overly concern you.

However, due to silver’s large (and growing) amount of industrial applications, it is correlated with the general stock market to a much greater extent than gold. Don’t forget that silver is both a precious metal and an inexpensive industrial commodity. While Warren Buffett is right that gold is hoarded and “we pay people to stand around guarding it,“ silver is consumed in industrial applications at a frantic pace. (While all the gold ever mined is basically still around in one form or another, that is not true for silver. It gets consumed. Like gold, silver has a finite supply. There is only so much of it under ground, and we use it up faster than we can replace it.)

While correlation coefficients are based on the average values (they tell you what happens on average), the same silver-stocks link is also visible during particularly violent price swings. By that I mean last year‘s plunge in the general stock market and the corresponding massive drop in the value of silver. Gold declined as well, but silver’s fall was much more painful. The point is that if the values of main stock indices move sharply lower, silver may temporarily follow them. If this were to happen, it will most likely be temporary and should not concern long-term investors who hold silver.

Summing up, silver seems to be a great buy today with the medium- and long-term in mind. However, the short-term situation is somewhat unclear.

Summary

The outlook for the precious metals sector remains bullish. We have seen several confirmation signals that the bottom is in, so it seems that this week’s price action is a consolidation during an upswing. put the pressure on the precious metals market. Silver has been disappointing lately, but that is within the historical norms and should not cause worry at this point. The situation in the general stock market is now rather bearish, which may be a factor here, but I will leave this part of the commentary for my Premium Subscribers.

Disclousure: I own gold and silver.