Trading the Precious Melt-up

Trading the Precious Melt-up

Precious metals have a long history of being used as money.

The Roman Empire formalised the first gold standard…because of the silver standard it inherited from the Athenian Empire.

Furthermore, the Roman Empire was the first official government to debase its currency…whereas the Athenian Empire refused to when times got tough.[1][2]

Both empires created precious metal standards for their respective economies.

Over the years, many empires came and went. Bolivia, India, Spain, China and Germany have a history of silver standards.

Yet it was only at the start of the 18th century that Sir Isaac Newton introduced a mashup of the gold and silver ratio.

And that ratio could be a useful predictor for what the silver price will do next…

Gold goes up and silver does nothing

I rarely talk about silver.

And I should.

Silver — more so than gold — is a crucial metal for modern society.

It’s everywhere.

In your phone, laptop… In fact, pretty much in any electronic device you own.

Scratch that.

Anything with a circuit board will have a small component of silver.

Your microwave, washing machine, oven and camera equipment.

All those new, shiny trucks driving past you on the freeway? Yep, their circuit boards contain silver too.

The ‘other’ precious metal is easily forgotten about.

At roughly AU$28 per ounce, you can buy two ounces of the stuff for less than 60 bucks.

And let’s be honest. The moves in gold are much more exciting than moves in the silver price. Gold can jump US$20-30 per ounce in a day.

Heck, there’s been times when it moves US$100 in an hour.

But silver would be lucky to move a buck or two in response.

The lack of volatility — or excitement — is one of the reasons why many people never cover it.

In US dollar terms, the yellow metal is up 21% this year alone.

Until two weeks ago, silver had only gained 10% over the same period.

Yet as of this morning, silver is 26% higher since the start of the year. The other precious metal has had a sudden two-buck rally and its gains could see it outpace gold.

So where did this price rally for silver come from? And was it predictable?

The ‘other’ precious metal

The silver price rally seems to have the market talking.

Where did it come from, and is there more to come?

You see, up until recently, silver was behaving like a commodity rather than a precious metal.

The biggest drag on the silver price today is that the price performance of silver is tied to global growth.

Industrial use of silver accounts for 60% of consumption of the metal, against 10% of gold in industrial demand.

So when global growth slows, or is forecast to slow, that means the demand for silver will decline.

That’s why analysts say silver is behaving like a commodity, as its price is reacting to news of global growth or decline.

When the grey metal reacts to financial instability, that’s when silver will be behaving like a precious metal.

And that’s exactly what we have just witnessed in the past two weeks.

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Silver has shaken off its commodity behaviour…

…and is starting to reflect the tetchy global backdrop.

Essentially, silver ‘switches’ between the two points. It’s either a reflection of global demand or a reflection of global instability.

Historically, silver seems to surge out of nowhere and spike higher, before the price collapses once again. This makes it difficult to benefit from it.

The problem is, predicting silver’s ‘switch’ is actually very hard to do.

However, there is one tool you can use to help forecast the ‘switch’ playing out…

Trading silver’s switch

The gold to silver ratio has evolved in the few centuries it has been around.

The ratio was formally created in 1717 by Isaac Newtown, and was a fixed ratio at 15.5:1. That is, it would take 15 ounces of silver to buy one ounce of gold.

Of course, over the following centuries, the amount of silver required to buy one ounce of gold increased. Then, with the creation of the US Federal Reserve, a fixed amount of silver for gold was abandoned.

This means the ratio is no longer fixed and is free floating…

…leaving the market to determine silver’s worth against gold.

As a result, the gold to silver ratio is extremely volatile.

Check this out…

Gold to silver ratio: 1915-present

Source: Macro Trends

Essentially, you’re looking at the ‘worth’ of silver against gold over the past century.

In that time, the ratio has been as low as 18 and as high as 97.

However, when former US president Richard Nixon took the world off the gold standard, the new long-term average became 58.

In other words, over the past 48 years, it has taken an average of 58 ounces of silver to buy one ounce of gold.

Let’s compare that to now.

In early July, the gold to silver ratio was sitting at 91.

Only three times in the past century has the ratio been this high.

However, as of this morning, the ratio has dropped to 79.

That tells us the value of silver is rising faster than the gold price.

That creates investment and trading opportunities in one move…

Silver still looks cheap compared to gold

Knowing how the gold to silver ratio works makes you a better bullion investor.

While it’s a clunky tool, it can be useful to point out times when the silver price movements aren’t keeping up with gold price movements.

We can even use the last eight weeks of trading as an example.

When the gold to silver ratio was sitting at 91, it was a signal that the yellow metal gains have far outpaced silver, meaning silver is looking like the cheaper option when compared to gold.

So now that the ratio has fallen to 79, we can see that the silver price is catching up to gold.

Perhaps more importantly, the gold to silver ratio is still far outside historical norms.

And when you look at the chart closely, you can see that the gold to silver ratio tends to fall rapidly, but rises at a steady pace.

That suggests that spikes in silver tend to catch the market off guard.

Tracking the ratio will help you take advantage of the ‘switch’ (when silver stops acting like a commodity and starts trading like a precious metal).

Perhaps the way to play the gold rally isn’t to rush out and buy physical gold…

…but start off with silver and then ‘convert’ those silver ounces to gold when the ratio falls back to the long-term average.

Until next time,

Shae Russell Signature

Shae Russell,
Editor, The Daily Reckoning Australia