Monday, January 18, 2016

Latest Silver Analyst Newsletter Published

Issue 40 of our newsletter is now out. The main feature is on Peak Gold. Talk of a peak in gold production is back in the news as it was eight years ago when I last looked at the subject. We look at the geology of the situation and whether any drop in production can be construed as a blip or something with greater consequences for the gold and silver in your portfolio and the fiat money in your back pocket.

Also included are the usual features in which silver mining stocks are ranked and our recession watch section.

Is Gold Undervalued?

 In my daily trip around the latest opinions and analyses of the precious metals markets, there was one phrase that seems to recur again and again. That phrase is “gold is undervalued”. One article I read pronounced on this matter by stating that the gold market was under government control and that the fundamentals of gold supply and demand did not matter at all. Anyone who invests in gold believing this can only be doing it in hope rather than analysis.

Another article made the novel suggestion that gold is undervalued because gold mining companies diluted shares and took on more debt in order to mine more gold (the implication being that without this debt, less gold would have been mined, therefore the price would be higher).

Apart from some questionable analysis (using number of shares instead of the self-adjusting share price and expressing ratios by ounce of gold rather than the price of gold), the conclusion was again that gold was undervalued.

But is that true? Is there some indefinable price which gold “should” be at but somehow is being held back? Can the advocates of this theory tell us what this mysterious price of gold is? Is it $5000 or $10000 or perhaps higher? And why is it always “undervalued”? Was there ever a time in the last 15 years when it was “overvalued”?

Or is the market sufficiently free and efficient to accurately discover the price of gold better than any other mechanism that science and society can offer? I think it is as it seeks equilibrium between buyers and sellers across all markets at all times across the world. That, of course, will include any so called surreptitious sellers and buyers beloved of conspiracy theorists. As you can guess, I do not subscribe to the theory that paper gold can hold down the price of physical gold for any sustained period (but that’s another article for another day).

But, going along with this view, how would you devise a metric as to whether gold is overvalued or undervalued? Perhaps, like the famous price earnings ratio of the equities market, we can see whether gold is above or below an average historic metric? One approach would be to calculate the inflation adjusted price of gold over the last 140 years and then work out the average price over that same period. The result is the chart below.

The average price of gold turns out to be about $562 per ounce. As you can see, gold is well above that value just now. By way of comparison, the P/E ratio of the US equity markets is somewhere around 24 and the historic average is nearer 16. This is used as an indication that stocks are overvalued and should be sold. Does this mean the chart above is issuing a sell signal for gold?

That is rather debatable, just as the stock market can gravitate for years above its P/E average, so could gold. The point I am demonstrating is that I have found a metric that suggests gold is overvalued, but will certain analysts agree with this? I don’t think so and I would have my own reservations (as regards silver, this is for subscribers only).

My take on this pricing perception is that it doesn’t matter, the price of gold is neither undervalued nor overvalued, and it is as close to the correct price as it can be. What is actually up for debate is whether events will change in the future that make the current price of gold undervalued or overvalued by comparison.

In other words, events change and the gold prices adjusts accordingly as the market absorbs the information. For example, if information arrives which suggests the supply of gold may become constrained in the imminent future, then the price should rise.

However, that does not mean that gold was previously underpriced. It merely means new information means a new price adjustment. In regards to the information published by gold conspiracy theorists, the market has absorbed and assessed that information long ago, made its collective decision and reflected that in the price.

Of course, if verifiable information came to the market that Fort Knox was empty; the price would readjust to the upside. But it cannot be said that gold prior to that point was undervalued as the market had as best as possible reflected all knowledge available.

In this light, going back to the argument that gold mining companies have rendered gold undervalued due to share dilution and debt loading, this is again a non-argument. The truth is the gold price has adjusted to a changed paradigm in the way it is extracted from the ground. What is actually being said is that gold is undervalued compared to a paradigm where mining companies do not dilute shares or increase debt.

But that is merely a theoretical construct in the same way as one could state that gold is undervalued (or perhaps overvalued?) because governments impose royalty taxes on indigenous gold mine production. Markets deal in reality not theory. It is the cumulative effect of myriads of buyers and sellers striking a deal for their particular piece of gold.

Does this mean I am not bullish on gold? Certainly not. The point is analysts should try and avoid language which may give investors a false impression of the current situation (with the emphasis on “current”). In my opinion, the price of gold will rise as inflation returns and when Peak Gold arrives. When these events become verifiable facts, then the market will adjust and that will be somewhere well north of where we are just now.

Timing Market Tops and Bottoms in Gold and Silver

 I would like to tell you about a proprietary indicator that I use in the precious metals market. Take a look at the chart below which shows the indicator against the price of silver (in green) since 1967.


The graph shows the leverage that silver achieved over gold over a rolling four-year basis. I have addressed the subject of the gold-silver leverage ratio in previous articles, but this indicator uses a different approach to calculating the relationship between gold and silver prices. Note that this chart peaks on various major occasions in the last 48 years.

The first of those peaks is near the top of the 1968 "Johnson" spike when silver doubled in price after the USA government went off silver coinage. The second is near the well-known 1980 "Hunt" spike. The third is near the 1998 "Buffett" spike when Warren Buffett purchased nearly 130 million ounces of silver. Finally, two more peaks occur near the February 2007 peak and the April 2011 peak at $50.

Three false peaks occurred in January 1970, July 1976 and December 2012, and I say “false” because one would have exited silver for other reasons before then. Or one could take the view they were final warnings to get out!

Each time that the four-year leverage breached our sell threshold, that particular bull market was over for a number of years. No matter how high the price was or how long it took to get there, the leverage number peaked just above the 1.50 level. Our thesis is therefore simple; sell silver and gold when this rare threshold is entered. What is the reasoning behind this indicator? There are four pillars to this theory:

1. In a precious metals bull market, silver will tend to outperform gold.
2. However, there is a limit to which this silver out performance can go.
3. This limit is hit at the top of major silver bull markets.
4. The reaching of this silver limit tends to also be the end of the corresponding gold bull market.

For example, back testing this indicator, you would have got out 3% below the top price of the 1968 peak, 12% below the 1980 peak, 6% below the 1998 peak and 3% below the 2011 peak. Using price per ounce numbers, this indicator flagged a sell five days after the 1980 silver bull peaked for a closing exit price of $37 as opposed to the closing $42 on the 21st January 1980. Sad to say, the majority failed to get out at such a high point.

Based on 48 years of historical data, We believe this indicator is useful in determining silver and gold tops. However, the next major top in silver seems a long way off, but at the other business end of the chart, we see that the indicator is at a low which has only been seen twice before in 1972 and 1984. One of these triggered before the greatest silver bull market ever and the other triggered at the other side of it as silver was obliterated during the disinflation of the 1980s.

What multiyear move in silver does this major low presage? My money is on a major move up in silver into next decade.