Well first off, I want to thank Tim for hosting this space and allowing me to bludgeon you with some theory on the Gold-Silver Ratio (GSR), assuming he approves and publishes :-). I found Slope a while back and really appreciate the quality with which Tim presents his ideas on a daily basis.
My name is Gary and I have been trading the markets quite actively for about ten years. I run this blog and the website biiwii.com. My primary focus is not on being bearish or bullish, but as a trader, on being right. As a human being I, like Tim, am bearish due to the unhealthy and crooked dynamics that go into keeping this bloated construct afloat.
But keeping a disciplined psychological profile is important in the effort not to micromanage or try to control the markets. There are also many tools that can be used ('signposts' as I call them) as well, to help filter the noise. One of those is the all-important GSR. I got the idea to highlight this after reading one of Tim's posts regarding Robert Prechter and a coming USD rally.
The GSR is one signpost that can give us a leg up on impending market events. The lower panels on the above chart show what I mean.
You will hear all manner of cheering by gold bugs when silver is leading gold, and as the first panel shows, when gold began to out-perform silver, the gold miners (HUI) gave a clear indication that all was not well. To this day, many gold bugs seem to think that the gold stocks will escape the coming carnage when the GSR turns up again. Pardon me if I do not go along with this idea in the short term, although beyond a coming correction, I believe this sector is the place to be for reasons I will explain a bit later in the post. But here is the nugget, if you will: The gold miners need the USD to strengthen and the GSR to turn up in order to establish the next leg up in their positive fundamentals and in order to become distinguished from the general commodity/inflation trade that is positively correlated to the economy.
We all remember how well-gamed crude oil was in the summer of '08. This was the final high profile bubble of what was in my opinion, a series of rolling bubbles that made up the commodity (and inflation) mania which led directly to the crash of Q4, 2008. This bubble did not get the memo that the end was near as sincere 'peak oil' believers were about to be hit with the reality of an epic deflationary impulse. Oil was just another play, positively correlated to the economy.
The next two panels are industrial metals and the stock market, which are of course, also items of positive economic correlation. They had their bubble tops previously and acted as we might expect leading into the upturn of the GSR and onset of the crash; they diverged negatively.
The GSR signals the draining of liquidity as the mass speculative urge begins to fade. It rises with the same dynamics that make the USD rise in a bout of deflation. In other words, it rises with the collective need to get liquid, get safe and get the heck out of the casino. So, any bottoming or bullish activity in the GSR can be looked upon as an early warning system on a USD rise and accompanying decline of nearly all asset markets.
But here is what I love about the GSR. While it can give signals to get short certain bloated and hope-fueled markets, the rising GSR also signals that things like oil, industrial metals and even human hopes for prosperity will be declining in terms of gold. I find Prechter's analysis that gold will decline in a deflation therefore so too will the gold mining stocks, to be too simplistic. Gold will probably decline in a deflation, but here are two vital points to be considered beyond the short term:
1) Gold will decline much less than positively correlated items – like silver, like oil, like copper, etc. Gold will decline less than gold mining cost inputs, which means margins at the companies that dig the yellow stuff out of the ground will expand as their product out-performs relative to their costs. The best part is that another epic buying opportunity is likely to present itself even as the miners' fundamental picture improves. Now that's risk/reward I can deal with. I am getting my HUI downside targets prepared, just as was the case in Q4, 2008.
2) I do not believe that a real deflation is going to take hold. Pull up a monthly chart of the 30 year bond and you will see that the 100 month exponential moving average has not been broken. This condition has gone on for decades and it means that inflation expectations have not broken out despite the best hopes of the inflation alarmists. What this actually means is that while deflationists and inflationists duke it out, policy makers are allowed to continue to inflate at will as inflation hysterics inevitably swing back to deflation hysterics. I tried to get this point across recently in this article entitled Yin/Yang, Deflation/Inflation.
My main point is that as long as confidence by the majority remains intact, policy makers will continue their macro game of hide the cheese. They need a deflation event right about now, which will likely be used as an inflationary lever yet again. The GSR is one tool to watch constantly going forward because if that is a bullish consolidation of last year's hysterical upside, the ratio will find support – and a higher low – in the noted zone and that will not be good for any markets in the short term. In the intermediate term it will signal that gold mining companies will be one of the few flourishing sectors as the 'real' price of gold continues its rise, as indicated first and by the GSR and gold's ratio to many other assets.
I hope this post is not too dry. This is a blog with a very entertaining publisher who writes in a clear and concise manner. As I review what I have written above, I realize this stuff can be a tough read. But I hope it helps add some perspective to the ongoing debates on inflation, deflation and gold's role amid the noise.
Best to you all, and thank you again Tim!