It is a commonly held belief by many precious metal investors and even a good percentage of market pundits that silver always outperforms gold during the latter stages of a precious metals rally. When the chart action goes parabolic — such as in January 1980 or May 2006 — silver is at its most profitable, or so the thinking goes. The truth, however, is that silver outperforms gold only during orderly and strong price advances that remain trend-bound. Once gold and silver prices achieve the wildfire stage, the blond metal can outshine its albino sibling both on the way up and especially on the way down (by falling less, of course). With incorrect notions in hand about gold and silver price action, both pros and amateurs can make fundamentally-mistaken allocation decisions in their precious metals portfolios that can be painful in the short and long run.
We will employ a visual construction in this analysis that essentially reconsiders the traditional market perception of gold/silver prices and ratios. At first our approach may appear a bit convoluted but even cursory study should reveal its utility. What we have done is plot the gold and silver price on the same chart, adjusting the silver price by a factor that causes a confluence with the gold price at each market top that we are attempting to analyze. For example, the market top in January 1980 occurred near a ratio of gold to silver prices of 20-to-1 so we multiplied the silver price by 20 on that chart. The gold/silver ratio has also been plotted on the chart with red arrows drawn to indicate the trend during each market phase.
Prices are COMEX daily highs for the futures contract that was active during the market top. There are no contract rolls or continuations using this method and therefore prices become sharper and more focused as time passes. This is because the contract goes from lightly traded in the outer months to heavily traded as it becomes the front month. Furthermore, plotting only the daily high removes a lot of noise and magnifies the trending characteristics of each rally. The net effect is subtle but useful in a way that would take a long time to describe in words so we’ll let the charts do most of the talking. Note that each chart is also labeled with a graphic to indicate the phases when silver is in a strong, sustained price advance. Interim price peaks and blow-offs are visually separated to help isolate price action and gold/silver ratio changes during these market events.
While it would be preferable to use spot gold and silver prices for our analysis, the lack of historical (and current) spot price granularity would blur or even obliterate many of the relational features found in charts constructed from active, exchange-based market data.
Let’s now look at the first chart, which displays the classic 1979-1980 rally in gold and silver ending with the ultimate blow-off high on January 21, 1980. The chart shows that, amazingly, the vast majority of that historic price rise occurred during just two 45 day periods. Moreover, almost the entirety of silver’s relative strength was limited to these two short intervals of time as indicated by the vertical arrows pointing down in the below chart. Note that our unique chart construction makes silver look like a machine on a mission. It is actually gold that appears to be careening out of control as the afterburners are lit during the final few days of this historic move.
Note that the gold/silver ratio spent the vast majority of its time during 1979-1980 drifting sideways or slightly up while silver was not advancing strongly. Of particular note is that during the interim price peak of early October 1979, the gold/silver ratio interrupted its ultimate decline to under 20-to-1 and did not resume it until gold and silver prices started to strongly advance again in late November. Moreover, most of the relative gains in silver were made while advancing into the interim peak in October and not the final blow-off in January.
As the rally went parabolic in early January 1980, the gold/silver ratio actually flattened out prior to turning up sharply in March (not shown). Therefore, the time to profitably own silver over gold was actually quite limited in duration and it certainly did not include the final blow-off stage, especially given that silver was back to $10 by April 1980 (not shown).
The above chart obviously shows a peak high for COMEX silver slightly over $40 whereas spot prices reached and even exceeded $50 around January 21, 1980. While this is a valid point, it doesn’t materially change the story told by the above chart. Gold at $850 and silver at $50 results in a gold/silver ratio of 17-to-1 which is exactly where the chart shows the ratio bottoming during the demarcated blow-off stage. In other words, using spot prices would still result in the same conclusion that silver did not outperform gold during the January 1980 blow-off whereas gold did substantially better during the subsequent price decline (not shown).
The only logical conclusion to be drawn from the above chart is therefore that silver should have been sold for gold at the start of January 1980 well before the famous blow-off got to its spectacular final stage. If your newsletter writer, broker, analyst or pundit doesn’t know this then how in tarnation will he or she provide useful guidance much less advice the next time such a blow-off takes place?
Let’s now move along and look at the next chart, which shows the 2003-2006 period. Here was a long rising market with at least two interim peaks and a very exciting blow-off that had both COMEX silver and gold going parabolic. This particular stage of the precious metals bull market was marked by long advances during which silver maintained a relentless climb and the gold/silver ratio fell. Once again, the declines in the ratio correspond directly with strong but trend-bound advances by silver. As price peaks and the blow-off stage are approached, however, silver no longer outperforms gold and in fact surrenders much of its relative gains during the subsequent price decline. The May 2006 blow-off is particularly interesting as it marks an obvious low in the gold/silver ratio prior to the top in prices. In fact, gold continues to rally even as silver’s first parabolic rise fails. Remember, we are looking at daily highs here and so it is quite possible that other charting methods will not reveal this relative price action in such obvious detail.
As the Q&A embedded in the chart suggests, there is a fundamental difference between the behavior of prices and the gold/silver ratio during the interim peaks compared to the final blow-off stage. Interim peaks are marked by an almost inverse relationship between gold and silver prices and the gold/silver ratio whereas the blow-off is associated with a sudden correlation between the gold price and the gold/silver ratio as a result of gold turning on the afterburners in a late bid to outshine its monochromatic kin. If we look back at the 1979-1980 chart, we can make a similar observation with some caveats. Namely, the October 1979 interim peak shows a sloppy inverse relationship whereas the January 1980 blow-off suggests a sloppy direct correlation. Note also that it is gold finally going vertical that seems to mark each blow-off, which of course is consistent with the idea that silver literally loses its edge right before the rally ends.
Another point that may be worth considering is that interim peaks seem to be accompanied by more gradual rallies in the price of silver and steeper declines in the gold/silver ratio. Blow-offs meanwhile appear to be preceded by steeper advances in the silver price and more gradual declines in the ratio. Let’s keep this in mind as we look at the final chart in this analysis, the period from 2009 to today.
By now all of the relationships should be familiar: strong but trend-bound advance in silver associated with declining gold/silver ratio, interim peaks with stalling or reversal of the fall in the ratio, no blow-off without gold going vertical. Note that the most recent price advance was much stronger and steeper than during the preceding interim peak but the ratio also declined more sharply in the Sep-Dec 2010 period. This actually doesn’t look all that different from the period immediately preceding the 2006 blow-off. The conditions apparently required to fulfill such an outcome include gold going vertical while the gold/silver ratio turns up.
Other possibilities outside an imminent blow-off could include:
(1) Interim peak preceding 1979-1980 or 2006 style blow-off.
(2) Interim peak with no blow-off to follow (2003-2005 style).
(3) 2008 style topping (multiple peaks, high level consolidation).
The best comparative fit in our opinion is an interim peak before a 1979-1980 or 2006 style blow-off because both the price and gold/silver ratio exhibit similar geometry compared to those prior events. For this thesis to hold, any pullback in the gold price should ideally be shallow and immediately followed by basing action during which the gold/silver ratio remains steady.
The following chart is basically the same as the previous one but some of the markings have been removed and the confluence factor has been recast to 35 under the assumption that the next blow-off will happen near a 35-to-1 gold/silver ratio.
In our opinion, the current price advance in the above recast chart appears analogous to the interim peak in October 1979. The hypothesis would be negated by a strong rise in the gold price accompanied by an upturn in the gold/silver ratio.
In summary, the two favored scenarios in the current precious metals market according to our unique reconsideration analysis of gold/silver prices and ratios are an interim peak or a blow-off. Further price evolution is required before either theory gains credibility but it should be noted that the modeled relationship between gold and silver prices and the gold/silver ratio suggests silver will not outperform gold by a substantial margin in either case. One may wish to consider the investment implications and portfolio allocation factors resulting from such a conclusion derived from the foregoing analysis — but not before also evaluating the possibility that the strong recent advance in silver prices will simply resume in short order and thereby provide impetus to a substantial further decline in the gold/silver ratio. Trend-wise we are getting long in the tooth for resumption in the price advance and therefore we will assume for now that failure to achieve new highs in silver by mid-January brings into play the scenario involving “interim peak preceding 1979-1980 or 2006 style blow-off”.
There are a number of other obvious conclusions that can be reached from this reconsideration analysis. We’ll reserve our own interpretations and integration with other analyses (such as the gold basis) for the benefit of Metal Augmentor subscribers. The last few Founding Memberships are going fast and we will probably never offer this premium level of subscription after we close the sign-up window on January 12, 2011 — and certainly not at the ridiculously-low current price.