Silver/Gold Ratio Reversion 4

Silver has been a rock-star in recent months, rocketing higher to dazzling gains. After such a blistering near-vertical ascent, technicians understandably fear this metal has become wildly overbought. Nevertheless, an alternative perspective on silver's recent levels counters its extreme technicals. Compared to gold, its primary driver, silver actually looks reasonably-priced today.

After a stupendous 72% rally in just over 4 months, considering silver fairly-valued seems like quite a stretch. I predicted silver's autumn rally back in mid-August when it traded under $18, but the magnitude of this year's typical seasonal advance was greater than I expected. This was wonderful, of course, as our silver-stock investments and speculations leveraged this awesome silver surge to huge gains.

But by mid-November, silver had soared so far so fast that its technicals were stretched to serious extremes. Based on bull-to-date precedent, these levels shouldn't have been sustainable for long. Silver's absolute price levels weren't a problem at all, simply the speed with which they were attained. But since gold didn't correct (unlike silver it was nowhere close to being overbought), silver didn't either.

While there is no doubt silver's technicals remain extremely overbought on a short-term basis, always a risky situation, this week I decided to see how silver is looking relative to gold. Technically in price-action terms, silver is gold's little lapdog. Speculators only flood into silver and drive its characteristic sharp rallies when gold is strong enough to ignite interest in the precious metals. For decades now, we haven't seen any sizable silver rallies until gold first leads the way by seeding bullish psychology.

But since silver is so hyper-speculative, it is buffeted by broader sentiment winds beyond what gold alone generates. In particular, silver speculators are very sensitive togeneral-stock-market selloffs. Even if gold is up, silver is often sold aggressively on big stock-market down days. And there has been no longer series of big down days in our lifetimes than 2008's epic stock panic. Silver prices were obliterated by the frantic terror-laden psychology spawned by that once-in-a-century event.

Peak to trough, gold fell 27% in about 4 months culminating in that panic. But silver, being far more speculative in the best of times, fared far worse than gold in that maelstrom of fear. It plummeted a gut-wrenching 53% at worst thanks to the panic! This left silver severely undervalued relative to gold, as you can see in this chart. The stock panic threw a giant monkey-wrench into silver's secular-bull progress.

Prior to the panic, silver's secular bull had enjoyed a very tight correlation with gold's. This was typical, silver has always rallied when gold rallies and corrected when gold corrects. But silver traders freaked out during the stock panic, driving the biggest freefall I've ever heard of in the midst of an ongoing secular bull. By the time the dust settled, silver had plunged from over $19 to under $9. This was a 34-month low in silver prices, compared to gold only retreating to a 14-month low in its own panic-induced swoon!

These levels were utterly ludicrous fundamentally, the selling was radically overdone as I argued in an essay published the very day after silver hit its panic lows. So we and our newsletter subscribers aggressively bought silver stocks, fighting the irrational panic fears. One long-term investment we made then in one of the world's elite silver stocks was recently up over 1000%, fantastic returns for just 2 years!

The biggest clue that silver simply couldn't stay so low was its relationship with gold, its primary driver. Prior to the panic, silver's correlation r-square with gold ran a very-high 94.7%. In other words, nearly 95% of silver's daily price action was statistically explainable by gold's own. But during that panic span this relationship imploded, plunging to 52.5%. The horrendous general-stock-market action eclipsed gold to become silver's primary driver on many trading days, a peculiar development to see sustained so long.

But sooner or later, silver's strong decades-old relationship with gold had to reassert itself. After our subscribers had a couple months to aggressively buy silver stocks to capitalize on this buying opportunity of a lifetime, I wrote my original Silver/Gold Ratio Reversion essay in February 2009. Though silver had recovered above $12 by then, it was still radically undervalued relative to prevailing gold prices.

Before we dive into the SGR specifically, you can really see this gap in the straight silver-and-gold chart above. Though silver was rallying sharply after the panic, for the most part it was merely pacing gold. It wasn't regaining lost ground, so the panic-driven gap between these metals persisted for 2 entire years. Provocatively, 2010's big autumn rally is merely an overdue normalization! Silver has finally caught back up with gold, regaining its pre-panic levels relative to its primary driver.

Though I didn't zero this chart's vertical axes (in order to offer better resolution on this relationship), the silver and gold lines are not distorted. They are truly proportional and have the same relationship on zeroed-axis charts. Silver prices closely followed gold's in 2005, 2006, 2007, and 2008 before the panic. And finally now in autumn 2010, silver has normalized to regain its historic levels compared to gold.

A more precise way to analyze this relationship is through the actual Silver/Gold Ratio. The SGR simply divides daily closing prices in silver by those in gold and charts the resulting multiple over time. Unfortunately the true SGR (0.021 today) yields tiny fractional decimals that are difficult for our minds to process, so I use an invertedGold/Silver Ratio (47.9 today) as a proxy. It is a lot easier to think in terms of ounces of silver per ounce of gold, even when approaching this relationship from a silver perspective.

Prior to 2008's stock panic, this silver bull enjoyed an average SGR of 54.9. It took about 55 ounces of silver to equal the price of a single ounce of gold. And this ratio was deeply ingrained in the precious-metals-mining industry. When you examined financial statements of silver miners converting gold byproducts to silver-equivalent ounces and vice versa, a hard 55 ratio was always used. It was well-established and appeared in every SEC report where a conversion occurred.

In this chart, a rising SGR means silver is outperforming gold while a falling one means silver is lagging gold. Note above that the SGR was actually rising in a well-definedsecular uptrend before the stock panic scared silver traders into scattering like frightened schoolgirls. This uptrend was logical, and it may very well resume in the coming years.

The longer a secular gold bull powers higher, the more investors become aware of it. And nothing begets new investment like persistent, strong performance. As gold impresses more and more people and starts growing in popularity even among mainstream traders, naturally they get interested in silver as well. And silver has some unique attributes that contribute to its outperformance in such a precious-metals-bull environment.

Most importantly, the global silver market is very small compared to gold's. Far less silver is mined than gold in terms of market value each year. Global silver production in 2009 ran about 700m ounces, and at last year's average silver price ($14.70) this equates to $10.3b. Meanwhile around 75m ounces of gold were mined worldwide last year, and at 2009's average gold price ($974) this was worth $73.0b. In addition to being a far-smaller market, silver is generally not stored in massive hoards by institutions like central banks.

A smaller market means any given amount of new investment capital flowing into silver will have a wildly-disproportionate impact on its price compared to gold. So it is not surprising to see silver prices rally faster than gold's over the course of a secular precious-metals bull because smaller assets move faster than larger ones. On top of this market-capitalization-like comparison, silver enjoys a special investor affinity.

Buying an ounce of silver is within the reach of far more investors than buying an ounce of gold due to these metals' vast price differential. And we all know investors prefer owning more "shares" of anything rather than fewer. So since silver feels more affordable than gold, small investors often prefer it over gold. This is magnified by silver's reputation for massive gains. These psychological factors tend to drive silver outperformance as disproportionately-high amounts of capital are attracted to this speculative metal.

Interestingly this tendency is increasingly affecting the flagship gold and silver ETFs as well. Remember the mined market-value ratio of silver to gold is about 1/7th. Today GLDis worth around $56.4b while SLV is worth about $10.2b. This is well better than a 1/6th ratio, which is even more impressive considering SLV was born in April 2006 which was considerably later than GLD's November 2004 birthday. Even stock investors buying these ETFs shunt disproportionately more dollars into silver!

A much smaller market with a bigger psychological draw makes silver outperformance totally normal, which is relevant today because the SGR's pre-panic secular uptrend could definitely be regained. This makes silver's anomalous plunge during the stock panic seem even crazier. Silver plummeted so far so fast that the SGR shot up to an average of 75.8 during the panic months. Instead of the traditional 55 ounces, it took a whopping 76 ounces of silver to equal the price of a single ounce of gold!

Ever since that totally-irrational extreme, silver has been gradually recovering on balance. The SGR actually carved a nice post-panic uptrend, although before 2010's autumn rally it was nowhere close to regaining pre-panic levels. Back in mid-August when I wrote about the coming autumn silver rally, I used this very chart (SGR 68 then) to argue that silver was "very undervalued relative to gold" with a high probability of rallying back up to a 55 or lower SGR. And indeed it came to pass.

The SGR lingered in its post-panic-recovery uptrend until mid-October when this critical ratio saw an upside breakout under 58. Ever since then, silver has just kept on rallying much faster than gold as more and more traders get interested in chasing this volatile and highly-speculative metal. But despite all the sound and fury, and silver's own overbought technicals, it has merely regained pre-panic levels relative to gold!

Believe me, $30 silver feels high to me too. I first started recommending physical-silver coins to our subscribers as long-term investments in November 2001 when silver was just over $4. But this chart doesn't lie. Compared to gold, its primary driver, silver's stunning autumn rally this year has simply carried it back to its normal historical relationship. The SGR finally returned to its pre-panic average in early November.

This revelation has all kinds of implications, and can certainly change the way we view silver today. Yes, by its own bull-to-date standards silver's technicals remain extremely overbought. A short-term correction would be totally normal and very healthy. Yet from this longer-term perspective compared to gold, silver doesn't look excessive at all at today's prices. All that has really happened is the panic losses have finally been fully recovered, a very overdue and welcome development.

With the SGR averaging 48.1 so far in December, well below the 54.9 pre-panic average, the argument can certainly be made that silver needs to back off a bit relative to gold. And indeed we've seen some of that, silver falling much farther than gold on a percentage basis whenever the yellow metal edges lower. But once again zooming back out to the strategic perspective offered by the SGR shows a different picture.

Long-term averages tend to exist for solid fundamental reasons. In the case of the SGR, relative levels of mined supply and investment demand for each metal have forged this average. And one of the most important tendencies traders have to watch for in gaming long-term averages is overshoots on mean reversions. After the SGR spent 2 years well over this average, there is a good chance it needs to shoot well under it for a considerable period of time.

There are all kinds of physical analogies for this tendency. A child's swing on a playground has an average position of hanging straight down, right? If you pull it back to swing it, a deviation from its mean, it is going to overshoot in the other directionproportional to the distance you pulled it back. Markets often behave similarly, the bigger a deviation from a historical average the bigger the overshoot in the other direction after the original anomaly is resolved. So a sub-55 HGR for some time is probable.

In addition, the SGR's pre-panic secular uptrend may very well be regained. With silver a much smaller market with a considerably greater investor affinity, it should continue to attract a disproportionately-large fraction of the mainstream investor capital flowing into precious metals. And even today, the SGR still has yet to regain the lower support of this uptrend around 46. And resistance is way down around 34!

If the SGR regains the midpoint of its pre-panic uptrend, we are looking at 40 or so today. At $1400 gold, this implies a silver price of $35. And of course as gold continues to march higher in its own bull, the silver price necessary to hit any given SGR level grows accordingly. Even though the SGR has powered back above its historical average, that doesn't necessarily mean it needs to stop there.

Either way, whether silver continues higher relative to gold in the coming months or not, we can safely say that today's silver prices aren't excessive at all compared to their primary driver's. And this fact alone has very bullish implications for silver stocks. $30 silver seems so overextended technically that silver stocks today haven't even begun to reflect these levels as being normal.

July 2008 was the last normal month for silver prior to the bond panic which led to that stock panic. That month silver prices averaged just over $18. A little earlier during Q2 2008, the average was $17.16. But so far in Q4 2010, silver has averaged $25.86. This is 51% higher! Yet believe it or not, many silver stocks today are actually still trading at levels near or below where they were in the early summer of 2008!

Silver stocks have barely started to reflect the massive fundamental profit impact today's silver prices will generate. In the commodities-mining business, higher commodities prices leverage into much higher profits. If you can mine silver at $12 per ounce, at $17 you make a $5 profit. But at $26, your profit balloons to $14. In this example, a 53% increase in the silver price yields a 180% increase in profits! It doesn't make any sense at all for silver stocks to be trading under July 2008 levels with silver 50% higher.

But which silver stocks have the best fundamental prospects? At Zeal we started working on this very question back in mid-September. We painstakingly analyzed the entire population of silver stocks trading in the US and Canada, nearly 100 companies. Over 3 long months, we gradually whittled down this universe to our dozen favorite silver stocks fundamentally. It took several-hundred laborious hours wading through SEC reports and comparing companies, but the fruits of our hard work will yield great profits.

As usual, we've summarized our latest deep fundamental-research campaign in a comprehensive 34-page report profiling our dozen favorite silver stocks. The companies profiled range from large world-class silver miners to small juniors with amazing projects. This is the pool of elite silver stocks we will draw from as we continue to trade this silver bull in the coming years. For just $95 (or $75 for subscribers), you too can learn about the world's best silver stocks. Hot off the presses, buy your report today!

Of course we also publish acclaimed weekly and monthly subscription newsletters. In these I analyze the markets on an ongoing basis, with the explicit goal of finding high-probability-for-success trades in commodities stocks. Since I started doing this over a decade ago, our subscribers have been richly-blessed from our world-class research. All 222 stock trades made in Zeal Intelligence since 2001 have averaged annualized realized gains of +43.2%! Subscribe today and start thriving in the markets!

The bottom line is despite silver's massive autumn rally, it has merely regained pre-panic levels relative to gold. This means today's silver prices actually have a solid fundamental underpinning despite the very-stretched silver technicals. While silver will flow and ebb as always, today's levels are likely a lot more representative of silver's new norms than the summer-doldrums prices leading into this recent rally.

And for a variety of reasons, silver could very well continue to outperform gold before their ratio stabilizes again. Either way, if silver holds today's levels or heads higher, it is super-bullish for silver stocks. Many continue to trade under summer-2008 levels despite silver being 50% higher. As investors gradually recognize this unsustainable anomaly, much capital should flood into silver stocks and drive big gains.

Adam Hamilton, CPA

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