Tuesday, July 10, 2012

The Gold Silver Ratio As An Early Warning Indicator

acting-man.com / Pater Tenebrarum / July 6, 2012

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.

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