Divergence and Gold/Silver Ratio
Gold and silver both started surging in January, but silver less so. Silver has also dropped in late February, while gold has held near its 2016 high. This is called divergence. There are a couple reasons for divergence between the movement of gold and silver prices. One is the gold/silver ratio, a method traders use to assess the value of one metal to the other. Another reason for the divergence may be more fundamental, involving the demand and applications of the metals of themselves.
Divergence and Gold/Silver Ratio
Gold and silver are thought to move together, and often they do, as can be seen on figure 1. Figure 1 also shows periods where the Gold Trust (GLD) and Silver Trust (SLV) move in opposite directions, and periods where one metal outperforms the other.
Figure 1. Gold Trust (blue) Versus Silver Trust (red), Percentage Scale (right)
Gold versus silver, percentage performance
Gold is currently outperforming silver, surging higher, and staying higher, while silver has surged less and has fallen off its recent highs. Such discrepancies occur, and are monitored by the gold/silver ratio. The gold/silver ratio shows how many ounces of silver it takes to buy an ounce of gold. Since 1975 the average is near 60; right now it stands near 83 ($1258 divided by $15.17).
Figure 2. Gold and Silver Price Ratio
Gold and silver price ratio
While gold out-performance--or silver's under-performance relative to gold--is very noticeable in early 2016, this has actually been going on for a long time. Figure 2 shows that gold prices have risen relative to silver prices quite steadily for years. This is mainly due to silver price weakness since peaking near $50 in 2011 (when silver outperformed gold).
Going back to 1995 the ratio has typically topped out near 80 and then reversed. This indicates silver may start to see greater strength (relative to gold) in the coming months, possibly catching up to and overtaking gold in terms of percentage performance.
Gold and silver do diverge, but why is it so pronounced right now?
Metal Uses, Demand and Supply
Gold and silver are traded markets. There is a multi-year trend where gold has outperformed silver. As with any market, sometimes extremes need to be reached before a reversal. The gold/silver ratio near 80 is reaching one of those extremes now.
Traders are emotional; they pile into what looks good and avoid what isn't performing as well. Eventually though what is forgotten (silver) is bought up, and what was favored (gold) eventually falls out of favor. What is occurring in gold and silver is a pattern that plays out over and over in all markets.
Supply and demand also play a role though. One key driver of gold's strength has been central bank bank buying, which in 2015 was near its highest levels in decades. Silver is missing that key demand group, and could be part of the reason it's slumped relative to gold over the last several years (aside from the ebb and flow of the gold/silver ratio).
Figure 4. Central Bank Gold Buying in Metric Tonnes
Supply and demand for gold and silver are also related to economic and industrial output. Gold is primarily esthetic, as 50% of the gold purchased in 2015 was for jewelry. Approximately 38% was bought as investment or by central banks. Only 8% of gold is used in industrial processes, according to the World Gold Council's 2015 Gold Demand Trends report.
For silver, industrial fabrication consumes more than 50% of silver supply, jewelry uses up 28% and investment consumes about 20%, according to the Silver Institute's 2015 report.
The chart and numbers show that investors and central banks tend to favor gold over silver right now. That could change though if investment in silver starts to creep up. A lot of industries require silver, and but have much less need for gold. When investor demand for silver creeps up that squeezes the supply, and the big industrial players are forced to buy at higher prices, helping to fuel more people into the silver investment as prices rise. This sort of process increases silver demand relative to gold, and the gold/silver ratios starts its multi-year trek back the other way.
The Bottom Line
The divergence in gold and silver prices are not anything new. The fluctuations between the two metals are tracked using the gold/silver ratio, which is currently near extreme levels. Near extremes, and possible reversal points, market participants often see the wildest swings. This could be why the spread between gold and silver performance is so pronounced in 2016.
Right now, investment in silver is steady, but not high. Since silver is used so much in industrial processes, any increase in investment demand has a magnified impact since the large industrial players have to buy no matter what. It all comes down to supply and demand. Right now demand favors gold, but if the gold/silver starts to slip lower market participants are showing that silver is becoming more favorable again.
Gold is highly misunderstood. Conventional wisdom says that it's a safe hedge against a bear market. However, this would only be true if there are inflationary pressures. It would be difficult to find inflationary pressures right now, and they’re not hiding under a rock and waiting to shout “surprise!” at some point in the near future. In other words, there is no rampant inflation in a low-wage, slow-growth economy. It’s not even a remote possibility.
Global Debt
The world is awash in debt. According to National Debt Clock.org, that total is $60 trillion. However, the real total is likely to be much higher. In the United States alone, government debt is north of $18 trillion and private debt is estimated to be approximately $45 trillion. Even if that estimate is high, if you look at data from the Bureau of Economic for 2014, you will see that private debt was at an all-time high and that it has likely increased since that time. (For more, see also: What Drives the Price of Gold.)
Interestingly, Japan’s private debt was at an all-time high in 1989, just prior to its infamous crash. What followed in Japan? Deflation. A similar pattern will take place in the United States. As massive deleveraging occurs, deflation will reign supreme. This will take down equities, lead to more defaults in the high-yield bond market, bring oil down even further than it is now, and send gold below $1,000 an ounce – likely much lower at some point over the next 1-3 years.
Short-Term vs. Long-Term
Here’s the tricky part. When markets begin to crater, investors rush to gold, which should send gold higher in the short term. This could make for a good trade, but you would need to have impeccable timing. When the rush of buyers cease and deflation is upon us, the U.S. dollar will continue to appreciate due to deleveraging and gold will begin its descent. If you don’t believe in this theory, then consider going back in time to witness a similar pattern. (For more, see: The Best Ways to Invest in Gold Without Holding It.)
Stoking Inflation
When the financial crisis hit in 2008, gold actually performed poorly. That’s because we had a short stint of deflation. When the Federal Reserve stepped in, it was to prevent deflation and stoke inflation, which then led to a bull market in precious metals. This bull run peaked in mid-2011. Over the past two years, gold hasn’t performed well because the Federal Reserve hasn’t been able to drive inflation like it had in the past.
None of this information factors in China – the second-largest economy in the world – where total debt to gross domestic product (GDP) is above 280%. Deleveraging will need to occur here as well, and deleveraging is deflationary. (For more, see: China's GDP Examined: A Service-Sector Surge.)
No Kryptonite for Deflation
If you want the simplest version: Gold did not perform well during the last deflationary crisis until the Federal Reserve brought out its economic bazooka. All the Federal Reserve did was prolong the inevitable and allow for debt-fueled growth, which has led to a bigger problem. Deflation will eventually win. It always does.
Trading Opportunities
If you’re looking for a gold trade on the long side, or if you don’t believe in this theory and you think gold will continue to appreciate during the next crisis, then the most liquid way to do so is with the SPDR Gold Shares (GLD) exchange-traded-fund (ETF). (For more, see: GLD vs. IAU: Which Gold ETF is Better?)
Key metrics for GLD:
Purpose: Tracks the price of gold bullion.
Net Assets: $23.75 billion
Volume: 5,690,160
Expense Ratio: 0.39%
Price on Feb. 1, 2008: $96.18 (pre-crisis)
Price on Oct. 1, 2008: $71.34 (midst of crisis)
Price on July 1, 2011: $177.72 (well after accommodative Federal Reserve policies)
If you’re looking for a trade on the short side and you don’t want to use margin while seeking liquidity, then look at the DB Gold Double Short exchange-traded note (ETN) (DZZ). (For more, see: Defend Against Deflation With Gold Short ETFs.)
Key metrics for DZZ:
Purpose: Tracks 2x the inverse performance of the Deutsche Bank Index – Optimum Yield Gold Excess Return.
Price on July 7, 2008: $24.55 (pre-crisis)
Price on Oct. 27, 2008: $39.52 (midst of crisis)
Price on Feb. 16, 2009: $18.99 (well after first Federal Reserve quantitative easing announcement)
Over the past year, GLD has depreciated 16.59% and DZZ has appreciated 35.78%.
The Bottom Line
Is shorting gold the best trading opportunity out there at the moment? Absolutely not. There are a myriad of opportunities out there that won’t be nearly as stressful. Gold should see a tug-of-war, which means it should be left to professional traders. I think gold will end up lower than where it is now one year from now, but please do your own research prior to making any investment decisions. As a side note, I have been bearish on gold for years. But I do think there will be an exceptional buying opportunity several years from now, when organic growth and inflation return. (For more, see: Has Gold Been a Good Investment Over the Long Term?)
Gold and silver both started surging in January, but silver less so. Silver has also dropped in late February, while gold has held near its 2016 high. This is called divergence. There are a couple reasons for divergence between the movement of gold and silver prices. One is the gold/silver ratio, a method traders use to assess the value of one metal to the other. Another reason for the divergence may be more fundamental, involving the demand and applications of the metals of themselves.
Divergence and Gold/Silver Ratio
Gold and silver are thought to move together, and often they do, as can be seen on figure 1. Figure 1 also shows periods where the Gold Trust (GLD) and Silver Trust (SLV) move in opposite directions, and periods where one metal outperforms the other.
Figure 1. Gold Trust (blue) Versus Silver Trust (red), Percentage Scale (right)
Gold versus silver, percentage performance
Gold is currently outperforming silver, surging higher, and staying higher, while silver has surged less and has fallen off its recent highs. Such discrepancies occur, and are monitored by the gold/silver ratio. The gold/silver ratio shows how many ounces of silver it takes to buy an ounce of gold. Since 1975 the average is near 60; right now it stands near 83 ($1258 divided by $15.17).
Figure 2. Gold and Silver Price Ratio
Gold and silver price ratio
While gold out-performance--or silver's under-performance relative to gold--is very noticeable in early 2016, this has actually been going on for a long time. Figure 2 shows that gold prices have risen relative to silver prices quite steadily for years. This is mainly due to silver price weakness since peaking near $50 in 2011 (when silver outperformed gold).
Going back to 1995 the ratio has typically topped out near 80 and then reversed. This indicates silver may start to see greater strength (relative to gold) in the coming months, possibly catching up to and overtaking gold in terms of percentage performance.
Gold and silver do diverge, but why is it so pronounced right now?
Metal Uses, Demand and Supply
Gold and silver are traded markets. There is a multi-year trend where gold has outperformed silver. As with any market, sometimes extremes need to be reached before a reversal. The gold/silver ratio near 80 is reaching one of those extremes now.
Traders are emotional; they pile into what looks good and avoid what isn't performing as well. Eventually though what is forgotten (silver) is bought up, and what was favored (gold) eventually falls out of favor. What is occurring in gold and silver is a pattern that plays out over and over in all markets.
Supply and demand also play a role though. One key driver of gold's strength has been central bank bank buying, which in 2015 was near its highest levels in decades. Silver is missing that key demand group, and could be part of the reason it's slumped relative to gold over the last several years (aside from the ebb and flow of the gold/silver ratio).
Figure 4. Central Bank Gold Buying in Metric Tonnes
Supply and demand for gold and silver are also related to economic and industrial output. Gold is primarily esthetic, as 50% of the gold purchased in 2015 was for jewelry. Approximately 38% was bought as investment or by central banks. Only 8% of gold is used in industrial processes, according to the World Gold Council's 2015 Gold Demand Trends report.
For silver, industrial fabrication consumes more than 50% of silver supply, jewelry uses up 28% and investment consumes about 20%, according to the Silver Institute's 2015 report.
The chart and numbers show that investors and central banks tend to favor gold over silver right now. That could change though if investment in silver starts to creep up. A lot of industries require silver, and but have much less need for gold. When investor demand for silver creeps up that squeezes the supply, and the big industrial players are forced to buy at higher prices, helping to fuel more people into the silver investment as prices rise. This sort of process increases silver demand relative to gold, and the gold/silver ratios starts its multi-year trek back the other way.
The Bottom Line
The divergence in gold and silver prices are not anything new. The fluctuations between the two metals are tracked using the gold/silver ratio, which is currently near extreme levels. Near extremes, and possible reversal points, market participants often see the wildest swings. This could be why the spread between gold and silver performance is so pronounced in 2016.
Right now, investment in silver is steady, but not high. Since silver is used so much in industrial processes, any increase in investment demand has a magnified impact since the large industrial players have to buy no matter what. It all comes down to supply and demand. Right now demand favors gold, but if the gold/silver starts to slip lower market participants are showing that silver is becoming more favorable again.
Gold is highly misunderstood. Conventional wisdom says that it's a safe hedge against a bear market. However, this would only be true if there are inflationary pressures. It would be difficult to find inflationary pressures right now, and they’re not hiding under a rock and waiting to shout “surprise!” at some point in the near future. In other words, there is no rampant inflation in a low-wage, slow-growth economy. It’s not even a remote possibility.
Global Debt
The world is awash in debt. According to National Debt Clock.org, that total is $60 trillion. However, the real total is likely to be much higher. In the United States alone, government debt is north of $18 trillion and private debt is estimated to be approximately $45 trillion. Even if that estimate is high, if you look at data from the Bureau of Economic for 2014, you will see that private debt was at an all-time high and that it has likely increased since that time. (For more, see also: What Drives the Price of Gold.)
Interestingly, Japan’s private debt was at an all-time high in 1989, just prior to its infamous crash. What followed in Japan? Deflation. A similar pattern will take place in the United States. As massive deleveraging occurs, deflation will reign supreme. This will take down equities, lead to more defaults in the high-yield bond market, bring oil down even further than it is now, and send gold below $1,000 an ounce – likely much lower at some point over the next 1-3 years.
Short-Term vs. Long-Term
Here’s the tricky part. When markets begin to crater, investors rush to gold, which should send gold higher in the short term. This could make for a good trade, but you would need to have impeccable timing. When the rush of buyers cease and deflation is upon us, the U.S. dollar will continue to appreciate due to deleveraging and gold will begin its descent. If you don’t believe in this theory, then consider going back in time to witness a similar pattern. (For more, see: The Best Ways to Invest in Gold Without Holding It.)
Stoking Inflation
When the financial crisis hit in 2008, gold actually performed poorly. That’s because we had a short stint of deflation. When the Federal Reserve stepped in, it was to prevent deflation and stoke inflation, which then led to a bull market in precious metals. This bull run peaked in mid-2011. Over the past two years, gold hasn’t performed well because the Federal Reserve hasn’t been able to drive inflation like it had in the past.
None of this information factors in China – the second-largest economy in the world – where total debt to gross domestic product (GDP) is above 280%. Deleveraging will need to occur here as well, and deleveraging is deflationary. (For more, see: China's GDP Examined: A Service-Sector Surge.)
No Kryptonite for Deflation
If you want the simplest version: Gold did not perform well during the last deflationary crisis until the Federal Reserve brought out its economic bazooka. All the Federal Reserve did was prolong the inevitable and allow for debt-fueled growth, which has led to a bigger problem. Deflation will eventually win. It always does.
Trading Opportunities
If you’re looking for a gold trade on the long side, or if you don’t believe in this theory and you think gold will continue to appreciate during the next crisis, then the most liquid way to do so is with the SPDR Gold Shares (GLD) exchange-traded-fund (ETF). (For more, see: GLD vs. IAU: Which Gold ETF is Better?)
Key metrics for GLD:
Purpose: Tracks the price of gold bullion.
Net Assets: $23.75 billion
Volume: 5,690,160
Expense Ratio: 0.39%
Price on Feb. 1, 2008: $96.18 (pre-crisis)
Price on Oct. 1, 2008: $71.34 (midst of crisis)
Price on July 1, 2011: $177.72 (well after accommodative Federal Reserve policies)
If you’re looking for a trade on the short side and you don’t want to use margin while seeking liquidity, then look at the DB Gold Double Short exchange-traded note (ETN) (DZZ). (For more, see: Defend Against Deflation With Gold Short ETFs.)
Key metrics for DZZ:
Purpose: Tracks 2x the inverse performance of the Deutsche Bank Index – Optimum Yield Gold Excess Return.
Price on July 7, 2008: $24.55 (pre-crisis)
Price on Oct. 27, 2008: $39.52 (midst of crisis)
Price on Feb. 16, 2009: $18.99 (well after first Federal Reserve quantitative easing announcement)
Over the past year, GLD has depreciated 16.59% and DZZ has appreciated 35.78%.
The Bottom Line
Is shorting gold the best trading opportunity out there at the moment? Absolutely not. There are a myriad of opportunities out there that won’t be nearly as stressful. Gold should see a tug-of-war, which means it should be left to professional traders. I think gold will end up lower than where it is now one year from now, but please do your own research prior to making any investment decisions. As a side note, I have been bearish on gold for years. But I do think there will be an exceptional buying opportunity several years from now, when organic growth and inflation return. (For more, see: Has Gold Been a Good Investment Over the Long Term?)
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