Silver-To-Gold Ratio Bottomed, Is Set To Take-off Soon; Silver Likely To Outperform Gold During H1 2017
(This updates a previous SGR article published at Seeking Alpha on April 27, 2016: "The Silver-To-Gold Ratio May Pullback, Providing An Entry Point; Silver Likely Outperforms Gold Thereafter". See that article here.)
Silver started to outperform Gold since March 2016, and we believe that this outperformance will continue, and indeed accelerate over the months ahead. Cyclical assets have significantly outperformed defensives over the past few months, and Silver/Gold Ratio (SGR) is likewise set to explode to the upside soon. Indications show that the US dollar, after being boosted sharply higher by expectations of Fed policy tightening and the election of Mr. Donald Trump, is due for a significant pullback in months ahead - SGR outperforms under such conditions. Growing industrial demand, significant supply constraints and rising inflation expectations, should all play their part in supporting higher silver prices over the first half of 2017 at least.
In previous articles about the Silver-to-Gold Ratio (SGR), we noted that Silver had started to outperform Gold since March 1, 2016, and it was just a matter of time before the bottoming out process will be done with. We also posited then that the ratio between silver and gold will subsequently rise to significant levels, following the upside breakout from the very long descending triangle in the price pattern that started in late 2012.
Our SGR outlook: Silver outperformance over Gold in H1 2017
We believe that new opportunities to gain from this silver outperformance to is upon us. Paced by the outperformance of cyclical assets over defensive since early in the year, silver should start outperforming gold very soon, and adjustments higher in their relative value via the Silver-to-Gold ratio present a solid investment opportunity for investors towards at least the middle of 2017.
We believe that the ratio of silver over gold completed a correction bottom in November 21, after a long consolidation period since the late July top of the ratio. This low point could be the starting point of sharp gains of silver over gold in the months ahead, as cyclical assets continue to outperform defensive assets. Changes in the SGR follow the lead of changes in the equity defensive/cyclical ratios after a delay of 9 to 10 weeks. Following the sharp gains in equity ratios in the run-up to and following the election of Mr. Trump as US president, we believe that the SGR is just days away from a sharp revaluation. If our thinking proves correct, the SGR could rise to at least 2.00 ratio over the next 6 months or so from current 1.45 value (see the chart below).
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 start to give back some of its recent sharp gains in the run-up to and following the Fed's tightening of monetary policy and the election of Mr. Trump. We expect the US Dollar to be lower over most of Q1 2017 at least (see chart below).
In the slightly longer-run (over Q1 and Q2 2017), the US currency valuation is probably due for some moderation, 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 stronger global growth (relative to US growth), rising interest rates, and a relatively subdued 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):
There had been some issues that were preventing a quicker recovery of silver over gold. There is still a significant volume of paper silver -- a small "glut" in silver futures contracts (relative to gold contracts) is still in place. Some analysts estimated that there is about one ounce of physical silver to over 250 ounces of paper silver. These paper contracts have effectively created a virtual silver supply without putting pressure on the physical silver market. This has been helping depress the price of silver, and is also creating considerable volatility in the silver price which is creating a considerable disconnect between paper and physical silver. 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.
Silver industrial demand grows even as supply diminishes
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 over the past few years moved miners to slash capital expenditures as they seek to shore up balance sheets and protect their cash flows. There had been reports (e.g., in Bloomberg) that there had been a steep reduction in exploration and mine development activity among some of the world's largest silver producers such as Rio Tinto during the multi-year metal price downturn, although recent improved tone of recent base metal prices generated news items of plans to increase capex. Nonetheless, the previous episodes of underinvestment should continue to boost silver prices over the next few quarters.
Moreover, of the world's largest producers of silver, global miner BHP Billiton (which severely slashed capital expenditures), is still battling the fallout from the recent Samarco issues in Brazil seen early in the year. Primary silver miners, on top of slashing capital expenditures, had also shuttered some uneconomic production. This had, and continues to, reduce the output profile for silver, laying the groundwork for further move up in prices (see chart below).
Caiman Valores is a Seeking Alpha contributor who has written extensively on the outlook of Silver outperformance over Gold. I used some of the data that he has published regarding mine capital expenditures and production issues. His recent articles on the subject may be found via these links:
SGR as a leading indicator
The Silver/Gold Ratio is itself a leading indicator. As a virtual cyclical asset, changes in the SGR actually lead the onset of the changes in Crude Oil and in Headline CPI inflation. The SGR leads changes in Crude Oil by 2 months; Oil in turn leads CPI changes by 1 month (see chart below).
This knowledge is extremely useful if one investment concern you have over the long-term is unexpected and unwanted rise in inflation. Instead of focusing on Gold as an inflation hedge, we believe that the SGR is a more stable and a more reliable hedge instrument. Let me illustrate this with a short personal story: my boss and I have been studying the silver/gold ratio in great detail since December last year, and we both agreed then 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 Precious Metals and CPI elements without any direct Oil market exposure (or at least minimize it), 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 oil market beta risk, but the spread may minimize it, and yet it does not curtail the upside potential. This trade really appeals to our 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 1970's high-inflation environment.
One final note: real rate impact is over-rated in PM analysis
One frequently reads articles in the media 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 Precious Metal 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 in the future is sufficient guide.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.