HardAssetsInvestor

Written by Brad Zigler  |

August 26, 2010

Every Silver Lining Has A Cloud

Details

A lot of people are excited by silver's breakout activity over the past two trading sessions. Rightfully so, too. Prices did bust through a critical resistance area left over from the metal's early-summer decline when spot was trimmed by $2.65 an ounce over three weeks.

Silver tested its 200-day moving average on Tuesday, setting up the two-day rally that has brought spot prices to the $19 level.

As gold prices advanced over the past year, silver's role as the "poor man's gold" has played out through the gold/silver ratio. The ratio prices gold in terms of its silver purchasing power. At yesterday's London fixing, an ounce of gold could purchase 66.4 ounces of silver. To put that into perspective, at the height of the financial harum-scarum in October 2008, the ratio climbed to 84.1. Silver was very cheap then—about half its current price—as the fears of economic collapse peaked. While gold has appreciated since then, its price hasn't risen at same steep angle as silver's.

Not surprisingly, the gold silver/ratio's declined over the past two years. But, if you look at the daily ratio chart, you'll see the ratio's moved into a tighter and tighter range. In other words, the ratio's high points have gotten successively lower while its low points have been rising. That pattern typically precedes a breakout.

Gold/Silver Ratio

A breakout to higher ratio levels would ensue if we headed back into a fearful maelstrom where silver's prospects as an industrial metal dim. Lower ratios—meaning silver appreciates relative to gold—would logically follow brightening on the economic horizon. Then, gold's fear premium would start to vaporize.

So, what's it going to be? An upside breakout or a collapse in the ratio?

Much is being made of Tuesday's 24-ton build in the bullion holdings of the iShares Silver Trust (NYSE Arca: SLV)—the first addition in six weeks. As we've seen with the larger SPDR Gold Shares Trust (NYSE Arca: GLD), though, bullion additions aren't highly correlated with price spikes (see "Clues To GLD's Price Trajectory"). The trend in the trust's money flow is a better predictor.

For the past year, capital flows into and out of the silver trust have been locked in a see-saw pattern. A breakout from this pattern should give us a clue as to the ratio's destination.

SLV Price And Money Flow Index

We'll calculate the actual odds of a ratio breakout in a future column. Provided, of course, the ratio doesn't break out beforehand.