Boiling Point: Gold At A Crossroads

April 01, 2011

With gold at record highs and silver on a tear, one wonders where things are heading.


Many traders, including this one, took note of the disappointing price action in the SPDR Gold Trust’s (NYSEArca: GLD) highly anticipated breakout attempt last week. This has caused investors like John Hathaway of Tocqueville Funds to label the next couple weeks a “moment of truth” for the future direction of the yellow metal as it’s been consolidating around record highs for about six months.

Chadd BennettAs I wrote early this year, it’s been my view that GLD and the iShares Silver Trust (NYSEArca: SLV) could be in for a hefty pullback as inflationary speculation cools down and the dollar catches a bid. While gold did have had a mild pullback to the $1,390 area, both SLV and GLD found aggressive buyers that pushed the precious metals higher again, taking them back to new highs last week.

Tightness in the physical silver market noted by Eric Sprott of Sprott Asset Management continues to drive prices higher in the near term. Silver, unlike gold, has seen a parabolic move in the past few months, more than doubling in price since August. For some perspective, that’s an average increase of 12 percent a month. Silver’s ascent has actually been faster than what we saw in oil from February 2008 to its peak in July of that year.

John Hussman, of Hussman Funds, has an interesting analysis that highlights the characteristics of bubblelike price action. He refers to observations by the physicist Didier Sornette that, as parabolic moves reach their peak, short-term fluctuations become more chaotic, and corrections become shallower as buyers act with increasing urgency.

It’s interesting that the price of silver has fit Sornette’s description perfectly, while GLD is acting like it may move one more leg higher as it consolidates near highs. SLV’s recent outperformance can be seen in the chart below through the lens of the gold to silver ratio.


GLD: 4/09 to 3/11


Gold closed at $1,438.90 on March 31—a record, while silver settled at $37.67. That puts the closely watched price ratio between the two metals at about 38:1. For truly long-term perspective, that’s considerably higher than the ratio of around 15:1 that has prevailed for much of the past several hundred years, and yet is lower than the range of 50:1 to 60:1 that has prevailed over the past decade. Whether silver keeps “catching up” to gold, as the chart above shows it doing, is a crucial question for investors.

Fundamentals: Gold And Silver Are Insurance

I agree with Nassim Nicholas Taleb, author of “The Black Swan,” who has argued that the current debt-based monetary system is inherently unstable and fragile. The further policymakers push the issue of credit expansion in a weak economic environment, the more fragile the system becomes, and therefore the more you have to pay up for insurance in the form of precious metals.

While there’s no denying that inflation expectations play a large role in driving gold and silver prices higher, another reason is the demand for a store of wealth in the event of a systemic breakdown with the magnitude and impact of the market meltdown of 2008.


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