Silver Takes the Lead over Gold

Long time readers of this site will already know that it is my opinion that silver requires an environment in which inflation expectations are alive and well in order to outperform gold. In an environment in which traders are more concerned over deflationary pressures, silver will fare far less well than the yellow metal.

In other words, one's investment or trading decisions need to take into account the sentiment among players when deciding to approach either or both of these markets. Even more so that than however is the signals that can be derived from tracking these markets. When rightfully understood, it can help one discern what is on the minds of some of the large speculators that dominate these markets and whose buying or selling decisions most greatly influence price direction.

Take a look at the following charts where I have created a comparison for you and you will see what I am getting at.

The top graph, the blue line, is another one of my pesky ratio charts ( Yes, I know, I am addicted to these things). I am essentially taking the price of silver and dividing it by the price of gold. By looking at the direction of the line, one can easily see which one of these metals is performing better than the other.

It is my contention, that if the market is expecting Deflationary pressures to win out, the line will move lower as the price of silver will lag gold to the upside on rallies but lead it on moves to the downside in both metals. If the market is expecting the opposite, namely inflationary pressures, silver will lead gold on the moves to the upside in the metals or will not drop as hard as gold during moves to the downside in the metals.

Below this ratio chart, is a graph of the Goldman Sachs Commodity Index, which I follow religiously to get a bird's eye view of what is taking place in the larger commodity complex as a whole. By closely monitoring these commodity indices, one can see any rise in prices at the wholesale level, long before most other folks have the faintest clue what is happening. The futures market are just that - "Futures" markets - they are not "past" markets nor are they "present" markets. They look ahead.

Now, there are other variables that need to be considered when monitoring commodity indices that I have spoken to here at this site many times - most notably the forward structure of the Board. I have noted this quite frequently in recent posts as I discuss my reasons for expecting lower food prices by Q4 of this year and certainly by Q1 2015.

That being said, I tend to look too far ahead at times as I like to have some idea where things might be headed. However, for the purposes of trading and understanding what the "crowd" is thinking, one can take the commodity indices at face value and draw the proper conclusions.

What do you see when you examine the ratio chart line and the line of the GSCI? Can you see a connection? Yes, you should. When the overall commodity sector is moving higher ( wholesale prices are rising) the ratio moves higher as a general rule ( again - it is not a 100% relationship but it is very close). When the overall commodity sector is moving lower ( wholesale prices are falling) the ratio line moves lower.

In other words, Silver will outperform gold if the market expects to see inflationary pressures in the commodity sector.

What is the GSCI doing right now at this moment and what is the ratio line doing? Both are moving higher. This tells me that the sentiment in regards to the commodity sector at the moment is that players are becoming concerned about rising commodity prices.

Keep in mind that the biggest component of this particular commodity index, the Goldman Sachs Commodity Index, is the energy complex so this index does tend to skew the perception of the complex as a whole in favor of what the price of energy is doing, but ever since my beloved Continuous Commodity Index or CCI, went the way of the dinosaur, I have used the GSCI. The CCI was the best balanced commodity index in my opinion and most accurately reflected what was going on in the entire commodity complex because it was weighted more evenly than any other index out there. We have to use what we have to use however and thus the GSCI, which by the way is a major benchmarking index used by INDEX FUNDS.

I mentioned these index funds in a separate response to a post here at the site yesterday. They are not hedge funds. In my profession, we often call them "long only" funds. The reason is because they mostly take only the long side of the commodity futures markets that they invest in. These funds essentially exist for the purpose of providing investors exposure to the commodity complex as an alternative investment class. They receive monies from clients and buy a basket of commodities exactly the same as the index that they are benchmarking against.

During the big boom in commodities back during the initial rounds of QE, index funds were very active in the commodity futures markets buying huge blocks of commodity contracts. I think it is important to understand that this group DOES NOT TRADE FUNDAMENTALS in individual markets. They must buy every single commodity that the index they benchmark against includes in its basket in the same percentages that comprise the index. These weightings change every year so the index funds who roll their positions from month to month are forced to realign their holdings in early January or February each year.

The thing to come away with however is that whenever one experiences rising interest in commodities as an asset class, these index funds become more influential in the markets because the size of their buying increases. As a trader, they cause me more grief than the hedge funds because of the reason I stated above; they will buy and take long positions no matter what the markets might be doing or what the current fundamentals of that particular market are. In other words, they buy BLINDLY.


However, and this is key - when index funds begin investing more money into the commodity sector, the asset class is coming back into favor and that only happens when investors are worried about potential inflationary issues.

I maintain that something is happening in the marketplace in regards to its confidence in the Yellen-led Fed. I am not sure exactly what Yellen said in her comments this week, but ever since those comments were made, things have heated up considerably in the commodity sector overall. One gets the distinct impression that the market currently has not exactly given her a ringing vote of confidence.

Yet, the VIX, or Volatility Index, has continued to sink lower indicating that COMPLACENCY remains incredibly widespread at least in regards to stocks. However, in watching this climb in the silver/gold ratio and the move higher in the GSCI, I see signs of cracks appearing.

I will leave you for now with this daily chart of silver. Note a couple of things - the market has recaptured the $20 level in very convincing fashion. So far today it has even run to $21 where some profit taking has emerged. Price is above the 50 day and the 200 day moving averages and the 50 day is turning higher. The ADX is rising but it remains below 30. That means the potential for a trending move higher is growing. Bulls are in control

If the price can power through psychological round number resistance at the $21 level, it should be able to make a run at $21.50 and the area just above that, which is the next level of chart resistance.