During the first half of September we came to the conclusion that silver had considerably more short-term upside potential than gold. As a result we bulked-up our exposure to silver during the second half of September and the first week of October by adding Mines Management (AMEX: MGN), Western Silver (AMEX: WTZ) and Coeur D'Alene Mines (NYSE: CDE) to the list of TSI stock selections. We also reiterated our bullish view on junior silver explorer/producer First Majestic Resource (TSXV: FR) three times between 2nd September and 10th October. Each of the aforementioned silver plays has done quite well over the past two months and each has the potential to do a lot better over the next 2-4 months.
But beyond the short-term we think gold has the superior risk/reward, a view that is based on our longer-term bearish outlooks for real economic growth and confidence in the current monetary system. Silver tends to outperform gold when most things appear to be right with the world and under-perform when confidence is on the decline. This, in turn, is undoubtedly due to gold's price being almost solely determined by investment/monetary-related demand while silver is more of an industrial metal than a monetary metal.
Silver's tendency to outperform gold during the 'good times' and under-perform during the 'bad times' is illustrated on the following chart comparing the silver/gold ratio with the S&P500 Index. This chart begins in 1990, but a similar pattern -- the silver/gold ratio trending in the same direction as the S&P500 -- is observable on charts that date back to 1970.
On a side note, there were two periods when the traditional relationship between silver and gold went 'out the window'. The first such period was 1979, when the Hunt Brothers' attempt to corner the silver market caused the silver price to surge relative to the gold price even though, at that time, the financial market backdrop was more positive for gold than silver. The second period of divergence occurred during 1998-2000 as a result of Warren Buffett's large purchases of silver bullion during the second half of 1997. Due to Buffett's large-scale buying and, even more significantly, the aggressive buying of silver by a few large traders who had non-public information concerning Buffett's purchases, the price of silver rocketed higher relative to the price of gold between July-1997 and January-1998. This resulted in the silver/gold ratio reaching a major peak prematurely. In our opinion, in the absence of this Buffett-related spike the silver/gold ratio would have peaked along with the stock market in 2000.
Our expectation is that the rally in the S&P500 Index from its October low will extend into the first quarter of next year, meaning that we expect the backdrop for the silver/gold ratio to remain positive for at least two more months. However, we also expect the backdrop for the silver/gold ratio to become decidedly negative by the second quarter of next year.
As far as short-term targets are concerned, the following chart shows that the silver/gold ratio has been oscillating within a well-defined channel since the middle of last year. It hit its channel bottom three months ago and we think a move up to the channel top is probable during the first quarter of 2006. With gold at $500, the silver/gold ratio at its short-term channel top would mean a silver price of $9.25.
21 November 2005
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