Silver’s historical relation with gold has changed character dramatically throughout 2011. There are technical signs that December will close with both returned to their more traditional relation with potential upside for silver investors.
As in the title of the Ray Charles tune, gold and silver are thankfully “together again.” 2011 has weathered both the highs and lows of their stormy relation including a complete breakup in July. Gold, the usual cool head of the quarrelsome couple, became more volatile than silver following their separation from mid-August through mid-September. By my Oct. 6 IBTimes commentary, What is Up (or Down) with Silver and Gold? , the two were showing signs of reconciliation. As this year closes, they may yet ride into a golden sunset rally.
A close relation historically
The October commentary explained silver’s historical relation with gold as typically having high-correlation, high-volatility and high-beta. These three attributes reveal much about silver but also about gold; when they are behaving normally as a pair – and when they are not.
Typically, as gold price goes; so goes silver. Since gold and silver are both precious metals, it is reasonable to expect silver to have a high positive price correlation with its lustrous companion (i.e. a correlation close to + 1.0). However, the price volatility of silver can be quite exaggerated compared to more stable gold.
Beta measures the price sensitivity of silver relative to gold. Silver is often characterized as a “high-beta” metal because its price sensitivity is usually greater than 1.0 – a gold-silver beta of 4.0 implies one can expect a 4% change in silver price for a 1% change in gold price. This makes silver a “higher percentage-gainer” than a bet on bullion in a rising market. Unfortunately, the opposite is true when fortunes reverse and price declines in silver become dramatic when compared to more steadfast gold.
High-beta is a consequence of silver’s high-volatility and high-correlation. The three metrics for silver performance are related – beta (β) is simply the product of correlation (ρ) and volatility (VOL):
β (Au, Ag) = ρ (Au, Ag) x VOL(Au, Ag)
A positive correlation close to unity combined with high relative volatility results in high-beta performance for the white metal.
Long lonely nights
Here is an updated one-year chart of the price volatility and beta for silver relative to gold* through Friday’s close:
(*Both volatility and beta are computed over a moving 3-month window. Volatility is defined as the ratio of the 3-month standard price deviation of silver to the 3-month standard deviation of gold. The standard deviations are normalized by their respective means)
In late April, spot silver topped the 1980 high of the Hunt brothers’ speculation bubble and COMEX silver touched $49.880/oz on April, 25. Before that peak the two precious metals behaved as expected historically. Silver volatility (VOL, blue line) was greater than 1.0 (dashed black line) in a range of 2.3 to 5.0 and around the 4.0- level during the highs of late April. The beta curve (red line) tracked volatility fairly closely over this time since silver-gold correlation was high and positive in a range of 0.64 to 0.98.
A violent reversal for silver price followed the April highs falling from its near $50/oz April peak to mid-$30/oz territory. By late June silver beta was not only less than 1.0 but near zero on June 28 marking the “the breakup” of the precious metal pair.
As silver beta and correlation courted zero, silver volatility soared hitting a peak of 6.9 on July 12. By the “long lonely nights” verse of our headline tune, COMEX gold trudged alone uphill in July from the low- $1,500/oz to the low-$1,600/oz level.
By August it was time for gold to forget his sorrows and party merrily to much higher highs hitting an impressive $1.917.9/oz on Aug. 23. That record was replaced Sept. 6 when COMEX gold reached its all-time high of $1,923.7/oz. After each of these two highs, gold price took a greater-than $100/oz plunge falling all the way to an intraday low of $1,793.8/oz on Sept. 7.
These wild price swings proved gold more volatile his estranged partner, a no less curious development than the zero-correlation breakup. On Aug. 12, silver beta again dipped below 1.0 soon to be followed by a less-than-unity volatility ratio (i.e. gold more volatile than silver, dotted circle). Rolling into September, silver had re-established high positive correlation with gold but still lacked two of its other “high” attributes.
Silver and gold resumed their more normal relationship during October and November closing Friday, Dec. 2 with a 3-month correlation of +0.889, a volatility ratio of +2.67 and corresponding beta of +2.37. These are all very near the values one year ago as shown in Table 1.
Table 1 – One-Year Gold & Silver Attribute Comparison
Attribute Dec. 2, 2010 Dec. 2, 2011
Correlation - ρ(Au, Ag) 0.917 0.889
Volatility - VOL (Au, Ag) 3.32 2.67
Price sensitivity - β (Au, Ag) 3.05 2.37
The gray skies are gone?
Most troubled relations have some financial basis for their turmoil. Gold and silver are no different, just on a grander scale – they’ve squabbled over an impending global financial crisis. At least that was the perception for the latter part of 2011 as the U.S. debt ceiling debate, ensuing credit downgrade and escalating European sovereign debt worries flip-flopped precious metals from cherished safe havens to easily liquidated assets in ‘risk-off” markets. Arguably, the crash of silver following record highs in late April presaged the May-June malaise for base metals, the spike in gold prices in September followed by a crash in copper prices shortly thereafter.
The coordinated efforts of central banks and European politicians more seriously addressing fiscal union prior to their summit Dec. 9 bring new sunlight to the gray skies of our song’s second stanza. 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. In either case our lustrous hero will no doubt sing to his white metal companion, “…nothing else matters baby, we’re together again.”
By Richard Baker, CP Value Analytics