Staying the Course in Gold and Silver

Includes: GDX, GLD, SLV
by: Wyatt Investment Research

The rally in precious metals is leading to massive takeover speculation in gold and silver mining companies.

All media outlets are talking about it. And analyst price targets on gold are now pushing $1,500 within the next 12-months. The fact that gold is up around 20 percent so far in 2010 and is poised to make its tenth consecutive annual gain only appears to be adding fuel to the rally.

And silver has pushed nearly 30 percent higher this year too - the 'poor man's gold' is set to post gains for the seventh consecutive quarter. If it does, it would be the best streak for silver since 1974.

The million dollar question is clear - should you believe this rally and buy at these levels?

Nobody wants to be the last one to the party, putting capital to work right when the 'smart money' starts to head for the exits.

My short answer is simple. I believe gold and silver both have room to run from here. But that doesn't mean you run blindly into gold and silver stocks on the assumption that all will rise indefinitely.

And it also doesn't mean that gold, and mining stocks, can't pull-back significantly from current levels. The five year chart of gold below shows that yesterday's close of $1,380 is pushing the upper end of a fairly well established channel. The relative strength indicator (RSI) is also showing that gold could be getting extended at current levels. Of course, trading ranges are broken all the time, so there are no hard and fast rules here.

Based on RSI silver is also starting to look a bit extended near $22. The recent dramatic spike higher from $18 was nothing short of spectacular, but in my opinion was more about silver 'catching up' with gold than an independent move. Silver around $18 was too cheap by historical standards.

To get a better picture of where these too metals are we need to compare them to each other. Check out the gold:silver ratio over the last ten years and you can see exactly what I mean. The ratio has finally touched 60 again, a level it hasn't seen since late 2009. This ratio divides the price of silver into the price of gold and gives investors an idea of the relative value of these two precious metals.

The long-term historical average gold:silver ratio is closer to 55, indicating that silver still has room to run (or that gold should fall from here, all else being equal).

What you'll also notice if you analyze the time periods in the above chart, is that the gold:silver ratio tends to rise in periods when market risk elevates, such as in the years around the bubble and the most recent financial crisis.

In periods of sustained and relatively stable economic growth, the ratio tends to be lower. Remember that this ratio is giving us the relative value of silver and gold, so when the ratio is higher that means gold is more expensive relative to silver. And conversely, when the ratio is lower silver is more expensive relative to gold.

***Right now one of the catalysts pushing gold higher is investor demand for a safe haven asset. Typically gold is purchased as an inflation hedge, and with monetary stimulus still on the Fed's menu, the consensus seems to be that gold is the place to be.

With an uncertain outlook for the U.S. economy, silver is stuck in the middle. It tends to rise in price with economic growth and stability, but fall when market risk rises. Right now, investors don't know which is more likely.

So what to do? Again, the answer is simple: stay the course.

I've said over and over that small cap investors should have exposure to both gold and silver mining stocks for all of the above reasons. Buy both on the dips, and make sure to invest in the best companies that are already in production and with significant reserves.

Right now these stocks are rallying. Takeover speculation is rampant, and prices are rallying. I think we'll see a pullback soon, and that will be a great time to add another miner, or increase exposure to one that you already own.

Be patient, and don't get too caught up in the hype.