The Silver/Gold Ratio Is Approaching A Record Level

by: Andrew Hecht

A long history for the spread.

The highest level in a quarter of a century.

Silver has been stubborn, and the trend is bearish.

Is the ratio telling us a rally in silver is coming and mean reversion in the spread is on the horizon?

USLV turbocharged silver volatility if a correction is on the horizon.

Last Friday, on May 10, the trade dispute between the US and China escalated with sent a wave of uncertainty through markets across all asset classes.

Source: Barchart

The chart of the VIX volatility index shows that the metric that moves higher when stock prices move to the downside traded up to $23.38 on Monday, May 10 and was around the 20 level at the end of the session as all of the leading share indices in the US posted significant losses of between 2-3% on the session. Since China has suffered more under the wave of protectionism over the past year, Chinese large-cap stocks fell after the latest exchange of protectionist measures as talks hit a roadblock.

Source: Barchart

As the chart shows, the ETF that reflects the price action in Chinese large-cap stocks fell from a high at $45.96 on April 5 to a low at $40.32 on May 13, a decline of 12.3%.

Most asset prices fell on Monday, May 13 after the optimism over trade turned pessimistic. The uncertainty when it comes to the global economy caused only two leading assets to post substantial gains on Monday as gold and Bitcoin moved to the upside. Bitcoin could be serving as a haven for capital in China as the nation devalues the yuan in the current environment.

The price of Bitcoin has doubled since mid-February as the price moved above the $8000 level on Monday. After trading to a low at $1267.30 on May 2, the price of June gold futures rose to settle at $1301.80 on May 13. Despite the rally in the price of the yellow metal, silver settled the session art $14.777 down 1.3% on May 13, and the precious metal continued to lose value against gold. Market participants are going for the gold and ignoring silver in a continuation of the trend that has been intact throughout 2019.

A long history for the spread

The silver/gold ratio dates back 5000 years to 3000 BC when the first Egyptian Pharaoh Menes stated that two and one-half parts silver equal one-part gold. In modern days, since 1974, the average for the price relationship has been around 55:1 or 55 ounces of silver value in each ounce of gold value.

Source: CQG

As the quarterly chart highlights, the range over the past forty-five years has been from 15.47 to 93.18 with an average of 54.325. When the price relationship moves below 55:1, silver tends to be historically expensive compared to the price of gold. The last time the ratio was below the midpoint was in 2012. When it is above the midpoint level, silver is historically cheap compared to gold and these days, what is cheap is getting cheaper by the day.

The highest level in a quarter of a century

The quarterly chart shows that as of the close of business on May 13 with gold at $1301.80 and silver at $14.777 the ratio stood at over 88:1, a new high and the highest level since 1992 or twenty-seven years. The price relationship reached its modern-day peak at 93.18:1 in 1990. In 1990, the price range in gold was from $346 to $428 and silver traded in a band from $3.93 to $5.445 per ounce.

In 1990, like in 2019, gold performed like a star compared to silver which acted like a financial dog, not to insult our best and most loyal friends. The silver/gold ratio made a new high on May 13 as silver refuses to keep pace with the price action in the gold market.

Silver has been stubborn, and the trend is bearish

In 2018, the prices of both silver and gold tested the downside. Gold fell to a low at $1161.40 in mid-August under the weight of rising US interest rates and a strengthening dollar. The low was $115.20 above the December 2015 low and level of critical technical support in the gold market at $1046.20 per ounce. Silver waited until November to make its low for 2018, but it came a lot closer to the late 2015 and level of technical support than gold. Silver fell to $13.86 in November which was only 22.5 cents above its December 2015 bottom at $13.625.

Meanwhile, both gold and silver rose to highs in July 2016 at $1377.50 and $21.095 per ounce respectively. At their settlement prices on May 13, gold was just $75.70 or 5.8% below the line in the sand on the upside, while silver was $6.318 or 42.8% below its resistance level. Silver has been bearish, and the trend in the precious metals remains bearish as it has made lower highs and lower lows since July 2016.

Is the ratio telling us a rally in silver is coming and mean reversion in the spread is on the horizon?

Inter-commodity spreads like the silver/gold ratio often provides clues about value and if the price of one commodity or the other is cheap or expensive. The current reading on the silver/gold ratio is screaming that either silver is cheap, gold is expensive, or a bit of both on a historical basis.

Over time, these types of spreads in markets that are closely related tend to revert to the mean or average over time. Silver and gold are both precious metals. They both have long histories as a means of exchange, and both have industrial and fabricated applications. However, central banks around the world hold gold as a reserve asset, and they have been net buyers, while silver moves higher or lower on speculative sentiment. In the current environment where protectionist policies are causing market turbulence, the risk-off activity has lifted the price of gold and caused market participants to avoid the speculative silver market, for now. However, the silver market always loves to provide surprises. Silver is undervalued on a historical basis, and the weekly chart could be telling us that the market will run out of selling sooner rather than later.

Source: CQG

The weekly chart shows that open interest or the total number of open long and short positions in the silver futures market is flatlining around the 200,000-contract midpoint level. However, price momentum and relative strength metrics are both in oversold territory, and weekly historical volatility at 5.57% is far too low for the silver market. The weekly chart has been in a bearish trend since July 2016, but a relief rally is long overdue. Moreover, the extreme deviance compared to the price of gold is highly supportive of a corrective rally in the silver market if gold can hold its recent gains.

USLV turbocharged silver volatility if a correction is on the horizon

Aside from buying silver futures or ETF products like SLV on dips, trading the precious metal by buying USLV during periods when the price is under pressure and taking profits on a recovery rally can offer leveraged returns if price action alleviates the current oversold condition. The fund summary for the ETN product states:

The investment seeks to replicate, net of expenses, three times the S&P GSCI Silver index ER. The index comprises futures contracts on a single commodity. The fluctuations in the values of it are intended generally to correlate with changes in the price of silver in global markets.

USLV has net assets of $224.18 million and trades over 204,000 shares each day making it a liquid product. However, the leverage comes at a price which is time decay. If silver moved lower or sideways, USLV will quickly lose value, and the ETN is always susceptible to reverse splits which destroy its value. Therefore, triple-leveraged products like USLV are only appropriate for short-term forays on the long side of the market. On May 2, July silver futures hit a low at $14.57 per ounce, and on the next day, it traded to a high at $14.995, a rise of 2.9%.

Source: Barchart

Over the same period, USLV moved to a low at $57.81 and rose to a high at $62.82 per share or 8.7% which was triple the percentage move in the silver futures market.

The silver/gold ratio is at the highest level in twenty-seven years, and the price action on the weekly chart displays an oversold condition. If a short-term rally is in the cards for the silver market, USLV could be a tool that enhances your results, but make sure to take a profit before time decay turns a profit into a loss.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author always has positions in commodities markets in futures, options, ETF/ETN products, and commodity equities. These long and short positions tend to change on an intraday basis.

The author is long precious metals