August 19, 2002 – There is an old Wall Street adage that bull markets climb a ‘wall of worry’. Having been through a large number of bull markets in stocks and commodities, I can attest to the accuracy of that statement. There is always plenty to worry about when you have your cold, hard cash on the line.
The recent performance of the gold/silver ratio is a case in point. As I’ve discussed with increasing intensity in these letters in recent weeks, it has been worrying me that the ratio was climbing, but now there is even more to worry about, as I’ll explain in a moment. But first I would like to provide some background information.
The gold/silver ratio measures the relative performance of these two precious metals. Their ratio falls when silver is outperforming gold, i.e., if silver’s price is rising faster or falling more slowly than the price of gold. In these instances it takes less and less silver to buy one ounce of gold. Conversely, the ratio rises when the table is turned, i.e., gold is performing better than silver.
On the surface it would seem that the relative performance of these two precious metals is inconsequential. But the reality is quite the opposite. Their relative performance is indeed very important, and consequently, we can learn a lot by watching what the ratio is doing.
For example, in precious metal bull markets, the ratio falls, whereas it rises in bear markets. It’s beyond the scope of this commentary to explain in detail why this pattern repeats. But briefly, the demand for silver is more volatile than the demand for gold. Therefore, in bull markets the purchasing power moving into the metals has relatively larger impact on silver, causing the silver price to rise more rapidly than the price of gold. Conversely, in bear markets, the impact of silver’s demand on the margin causes its price to fall more rapidly and further than the price of gold.
To put some numbers to this analysis, the ratio fell throughout the precious metals bull market of the late 1970’s. The ratio reached approximately 17 when the price of the metals peaked in January 1980. In other words, at their peak price (approximately $850 and $50) it took only 17 ounces of silver to buy one ounce of gold. In the bear market that followed, the ratio then rose to 105, as can be seen on the accompanying chart.
In the early 1990’s the ratio started to fall once again. Importantly, in 1997 it fell through support in the 66-67 area. The ratio continued to drop precipitously to 41.3 on February 5th, 1998 on the frenzy of silver buying that took place on news that over the previous six months, Warren Buffett had acquired 130 million ounces of silver.
Since then, we have been watching the ratio climb relentlessly. And no one can deny that the precious metals have been in a bear market since 1998, providing more evidence that the gold/silver ratio climbs in precious metal bear markets. But the recent action of the ratio has been particularly unnerving.
Last year I noted how the ratio was attempting to break through its 11-year downtrend line. Though this downtrend line was eventually broken, the result was undecided because the ratio was unable to clearly climb over resistance at 67 (the dotted horizontal line on the chart). That has now changed.
It is clear from the above chart that resistance at 67 is now giving way. The ratio touched as high as 70.2 this past Thursday, before backing off a little on Friday to close at 69.9. The technical damage to this chart has been done. While of course nothing is certain when it comes to markets, it appears that the ratio will continue to climb, which is for me the source of concern. A rising gold/silver ratio is historically bearish for the precious metals. The ratio rises in precious metal bear markets.
We therefore have some serious thinking to do, as well as some important decisions to make. Are the precious metals going to work their way lower as the gold/silver ratio climbs higher? Or is it ‘different this time around’?
Those are dangerous words, but I will stick my neck out by saying that this time it will indeed be different. Silver and gold are about to part company. Gold will continue to outperform silver, particularly as gold rallies into the Fall.
Readers know that I expect gold to remain in its $300-$320 trading range until September or October, at which time I then expect gold to challenge and break through resistance at $325. Thereafter, gold will rally to $400 sometime in Q1 2003. If this projection is correct and if silver does underperform, my expectation is that if gold trades at $400, silver will be at $5, putting their ratio at 80.
Clearly this projection will no doubt disappoint the silver bulls. Though I project silver to rise (based on Friday’s closing prices) 11.4% over the next six months, I expect gold to rise more than twice as fast at 27.5%. Therefore, the ratio will rise 14.4% over the next six months.
Do you find that growth in the ratio hard to believe? Well, then consider recent history. In the 4½ years since bottoming at 41.3, the ratio has risen at an average rate of 12.4% per annum. So while a 14.4% growth rate over the next six months is above trend, the important point is that I am projecting a growth rate in the ratio that is consistent with the current trend in the ratio.
Moreover there have been 6-month periods when the ratio has increased at my projected rate or even greater. For example, in the six months from August 1999 to February 2000, the ratio jumped 25.6% as gold rose from $257 to $308, while silver sat almost motionless. It had a lackluster jump during this period from $5.12 to $5.25.
Therefore, take this previous result to heart if you are looking for great things in silver over the next six months. You may be disappointed. Silver may rise, but I expect that gold will do better.
Because there has been significant out-performance by gold before, it is very reasonable to expect that it could happen again over the next six months. Indeed, that is the message from the chart of the gold/silver ratio. The ratio looks sets to rise, but this time it will rise in a precious metals bull market. In other words, it will be different this time around. A rising ratio will not be bearish for the precious metals. But why?
Well, I have a theory. This underperformance by silver over the past few weeks and the rise in the ratio to 70 is in my mind an indication that Warren Buffett is dishoarding his silver position. This is pure speculation on my part. I’m only suggesting it because it provides a plausible answer to explain why the chart pattern says that the ratio’s trend is headed higher.
We’ve not yet seen any huge increase in silver inventories, which would be a clear signal of dishoarding by Mr. Buffett. But look at this decision from a macro point of view. His decision to buy silver instead of stocks in late 1997, early 1998 was a good one. He preserved his purchasing power, while the stock market has tanked. It would be quite logical to expect that Mr. Buffett may be selling silver to put that money back into stocks. He has done a number of acquisitions recently, suggesting that he is finding the value he needs to make stock purchases. I guess we’ll find out the answer in time.
There is one last thing about the Page 1 chart that I would like to bring to your attention. I find it intriguing that line A-B is exactly parallel to line C-D. Here you have two trendlines many years apart, with no apparent reason why they should be exactly parallel to one another. But I take an important message from this result.
Because line A-B was a powerful trend indicator that directed the ratio for many years, assume that line C-D can do the same. Assume that the ratio can climb much higher, even perhaps back to over one hundred over the next few years.
So what do we do? There are two answers to that question. The easy answer is to focus on gold in preference to silver. When we’re ready to load up for the big Fall rally that I am expecting, load up with gold, not silver.
The second answer is somewhat worrying. What we need to do is watch both gold and silver here carefully to look for signs of weakness. If that weakness shows up, it may be an indication that I have it wrong and that a rising ratio means the metals are in fact in a bear market. In other words, it won’t be ‘different this time around’ and a rising ratio will prove this time – as it has historically proven – to be bearish for the precious metals.
What are those signs of weakness? It would be a big warning signal if silver falls back below $4.38 and gold falls back below $300 per ounce. I don’t think it will happen, but be prepared to stop out your positions if it does.