The Gold Silver Ratio As An Early Warning Indicator [actingman]
July 7, 2012 Leave a comment
The Gold-Silver Ratio and Credit Spreads
We recently presented a long term chart of the gold-silver ratio. Traditionally it has been a leading indicator of credit spreads, as during times of declining economic confidence silver, which has a large industrial demand component, tends to fall against gold (which is what this ratio depicts, only vice versa).
Our comment below the chart went as follows:
„The ‘fly in the ointment’ chart. In spite of the big party the markets threw on Friday, the gold-silver ratio has broken through a long term downtrend line this year. This bodes ill for the medium to long term outlook for stocks and junk bonds, as the ratio tends to work as a proxy and leading indicator for credit spreads. Note in this context that junk bond issuance has recently diverged bearishly from the stock market (namely at the early April high in the SPX). This is a phenomenon that was last observed in 2007.”
This prompted a reader to ask us to clarify this comment further in an e-mail exchange. We thought it might also be of interest to other readers and our further thoughts on the matter follow below:
Per experience, major trend changes in this ratio precede credit distress with a lead time varying from a few weeks to a few months (as always, this is more art than science). It is a heads-up that ‘risk assets’ of all kinds could get into trouble as the year goes on, provided the ratio does not reverse convincingly.
Since the AU-AG ratio’s peak during the 2008 crash, it has been in a long term downtrend – since the downtrend line has recently been breached, a warning signal is currently held to be operative.
The industrial and fabrication demand for silver has remained fairly constant (or rather, has grown very slowly) over the past decade. The loss of demand from the photography sector was more than made up by demand growth in other sectors. What growth there has been has mainly come from investment demand.
One of the reasons why it makes more sense to use silver than e.g. copper or crude oil for this exercise, is precisely based on the fact that the large above-ground supply of silver held for investment purposes is providing a large supply cushion – this means that the silver market is as a rule not subject to unforeseen supply shocks.
For instance, in crude oil one could imagine a scenario where political tensions in the Middle East drive up its price in spite of declining economic confidence. In copper, it may happen that strikes at very large mines in Chile could prop the price up, a drought might influence grain prices, and so forth.
Platinum, another metal with both precious and industrial metal characteristics is also somewhat less useful for using it in this type of indicator, as its production is highly concentrated in one place (75% of it is produced in South Africa) and supply disruptions are both likely and can not be buffered easily. The platinum market is small and often highly volatile.
This is not the case with silver: for one thing, the bulk of its production is widely dispersed and mostly a by-product of base metal mining, and secondly the large stock held for investment purposes will always be available to offset any major disruptions from the supply side.