My December 5, 2011 commentary concluded with a prediction for silver and gold as last year drew to a close:

Positive correlation of gold not only with silver but other key commodities, silver’s high-beta, and a declining trend in the gold-to-silver ratio are bullish signs for a yearend rally if prevailing market pessimism proves overdone. $36/oz silver could ride quite comfortably in the saddle with $1,800/oz gold for a sunset ride. Alternately, tomorrow’s dire headline might send them both packing to a cheap hotel.

Unfortunately, our precious metal high rollers chose the alternate and closed 2011 in low rent accommodations. After making all-time highs earlier in the year, it didn’t take a dire headline but persistent yearend liquidations to push COMEX gold down 19% to $1,566.8 per ounce from its Sept. 6 peak of $1,923.7. COMEX silver’s fall was more dramatic, stumbling 44% from its $49.889 per ounce high on April, 25 to $27.915.

Liquidations aside, the bullish fundamentals of gold’s positive correlation with commodities, silver’s high-beta and a compressing gold-to-silver ratio kicked off a January rally for both. The pair moved quickly uptown closing the month at $1,740.4 per ounce for gold and $33.20 per ounce for silver – arriving in the neighborhood of my December prediction. February brought the two even closer to ritzy digs but Friday’s surprisingly good U.S. labor report returned gold and silver to within pennies of their January close.

Tracking the performance of silver relative to gold can reveal and anticipate where precious metals may be headed next. A scatter plot of their journey in 2011 is an effective way to visualize their often changing relation and provide clues to what may lie ahead for 2012.

Figure 1 U.S. Debt Downgrade is a Market Tipping Point

In Figure 1, COMEX silver price is plotted versus COMEX gold for the most active futures contracts last year. The silver triangles represent the price pair in U.S. dollars for all the market days in 2011. The gray lines connecting the data points represent their price trajectory throughout the year. The bifurcation of their path into two distinct price domains (circumscribed by dotted ellipses) stands out when compared to more normal years that lack the drama of highly accommodative monetary policy, western economy debt crises and the erratic political reactions that result.

Aug. 5 (big red triangle) proved to be a critical tipping point for both base and precious metal markets; the day credit-rating agency Standard & Poor’s downgraded U.S. debt for the first time in the nation’s history. The downgrade followed a dysfunctional U.S. debt ceiling debate amidst a gravely worsening European sovereign debt crisis. Aug. 5 is the single intersection of the two price domains

“Price Domain A” within the upper-left ellipse marks a period where commodities were buoyed by a second round of U.S. Federal Reserve quantitative easing and COMEX silver made its April all-time high; spot prices exceeded levels not seen since the Hunt Brother’s bubble in 1979-1980. Gold gradually rose in U.S. dollar price over this period as an early May crash in silver prices ushered in the May-June malaise for the metals complex.

 “Price Domain B” in the lower-right corner includes a second crash in silver prices and gold’s surge to a new-record high on Sept. 6. At that time gold was in safe-haven mode and silver fled to bear country. As the year closed, the yellow metal returned to mid-$1,500 per ounce territory joining silver with the bears.

Table 1 uses the gold-to-silver price ratio to illustrate the wild swing from silver-bullish to silver-bearish conditions for domains A and B.


Table 1 Gold-to-Silver Ratios

At the April silver high, an ounce of gold bought only 31 ounces of silver; in late December, an ounce could fetch as much as 58 ounces. The highest (i.e. most bearish) ratio during the 2008-2009 financial crisis was an amazing 86 ounces of silver per ounce of gold.

From the beginning of Great Recession to the present, Nov. 26, 2010 stands out as a date when key commodities copper, oil and silver all approached historical ratios relative to gold. It is reasonable then to use the gold-to-silver ratio of 51.0 on that day as a contemporary “norm” to gauge price performance relative to the yellow metal. The gold-to-silver ratio crossed through this norm in early November before expanding to the more bearish level of 57.7 on the second to last market day of 2011.

The plot in Figure 2 combines the ratio data in Table 1 with the previous chart. Gold-to-silver ratios of constant value appear as straight lines whose slope is the inverse of the ratio:


Figure 2 Bull/Bear Constraint Boundaries

Price Domain A falls between the “Ag-Bullish 2011” green line and the dotted-orange “norm” line. Price Domain B begins above the norm, crosses through it and lingers at or near the “Ag-Bearish 2011” red line during the period of liquidations. The dark red “Ag-Bearish 2008” line is included to indicate a low-price constraint boundary given the recent history of the Great Recession. Reassuringly, the norm falls roughly near the geometric mean of the bullish extremes of 2011 and the bearish bottom of 2008 (i.e. a norm ratio of 51.0 versus a mean of 51.97).

Analysis In mid-January Goldman Sachs reaffirmed their 2012 gold price target at $1,940 per ounce. SEB Commodity Research predicted $2,050 per ounce for 2012 in December. The high-side for gold could be sparked by a conflict in the Persian Gulf or disorderly sovereign defaults in Europe. On the low-side, the recent Federal Reserve extension of very low interest rates to late 2014 may very well put a floor in for COMEX gold at $1,615 per ounce. Given these endpoints, Figure 2 is useful to estimate a range for silver prices in 2012. Assuming the “Ag-Bearish 2011” boundary is not breached this year, $1,615 per ounce gold suggests a $28 per ounce floor for silver. Friday’s robust jobs report diminishes the chances for a third round of quantitative easing so it is unlikely that the highs in gold for 2012 will push silver prices very close to the “Ag-Bullish 2011” line. Assuming a more normal silver market for this year, the dotted “Norm” line indicates a silver high of $38+ per ounce for Goldman Sachs’ $1,940 gold and $40+ per ounce for the SEB $2,050 prediction. To date, there is growing evidence to support using ratios closer to the norm for high-side silver predictions. Figure 3 is a chart of the gold-to-silver ratios for 2011 extended to include last Friday’s closing prices, Feb. 3, 2012.


Figure 3 Gold-to-Silver Ratio Converges to the Norm The 2012 data (blue diamonds) shows convergence to the norm (51.56 versus 51.0 norm) with a notable degree of stability (the three-month standard deviation normalized by the mean is 2.97% - less than 3% is considered “very stable”). By contrast, 2011 data (gray diamonds) moved from the extremes of April lows to September highs through two very different price domains. Is it time for gold and silver to move further uptown? The 3-month moving average of the gold-to-silver ratio has flattened at 53.58 and is expected to descend to the “Norm” line in coming weeks. The present 3-month silver beta with respect to gold is a respectable 1.61 with a very high correlation of 0.97 over the same period – all bullish indications for the white metal in a gold market that is expected to resume its trend to higher prices. However, surprises in precious metals markets have trumped the norm in the last four turbulent years. Silver prices in a range of $28 to $40+ per ounce appear consistent with a convergence to the norm in 2012 given a range of $1,615 to $2,050 per ounce for gold. Calamitous headlines or dramatic central bank accommodation in Europe or the U.S. could move silver above the Hunt Brother’s penthouse or remind us why it traded down to $9 per ounce during the darkest days of the financial crisis. By Richard Baker, CP Value Analytics