CTMPR

If there is anything that investors should have learned in the past decade it’s that commodities (which include metals) have a place in a well diversified portfolio. When it comes to investing in the metals, investors have traditionally favored Gold, Silver and Platinum. However, in recent years the more industrial metals Palladium and Copper have increasingly found their ways into investor portfolios.

Those who believe the monetary system is on the verge of collapse will tell you the only reasonable thing to do is purchase the physical metal and bury it somewhere safe. At this point I’m not convinced the end is at hand so I choose to use ETFs for my investing. Today after the metals have had such a big run there is much more downside risk which is another reason I use ETFs. It’s much easier to get out of an ETF when the time comes to sell. Most current investors didn’t buy gold or silver in 1980 so they don’t know what it feels like to go through a 20 year bear market. Many who bought physical metal back then (especially silver) are just now getting back to break even.

Gold Versus Silver

If you look back over the past 6 or 7 years you can see that Gold and Silver price performance was almost identical leading up to the credit crunch / recession. Coming out of the crisis Gold performed much better because it is more influenced by investment demand and less by industrial demand. In general, this out-performance creates a gap known as divergence. When two markets that normally trade together are not, this divergence creates opportunity.

This chart is a compares the Gold ETF – GLD and the Silver ETF – SLV from April 2006 – January 2011. You can clearly see that as late as July 2010 that gold was up over 100% in that time frame but silver was only up 40%. When gold began to break out to the upside in early August that was an indication to buy silver as we discussed in a previous article.

Platinum VS. Palladium

A similar situation occurs with Platinum and Palladium but they tend to take several years to play out. Since both metals are heavily used as industrial metals they tend to move more with the business cycle. Since both have similar properties there is a strong substitution effect that takes place between the two metals. By looking at the chart below you can see that the pendulum swung in favor of Palladium (rising nearly 10 fold) from 1996 until mid-2000 when the economy began to tank.

Coming out of the 2001-2002 recession Platinum was the metal of choice because many industrial applications had switched back to platinum due to the sharp rise in palladium prices. As you can see Platinum rose from $400 per ounce to $2200 between 2001 and 2008. When everything collapsed during the credit crunch both platinum and palladium suffered but palladium went back to the lows of 2002 whereas platinum prices bottomed out at twice the 2002 level.

This created an opportunity to invest in palladium and even though both metals have bounced from their low it’s very apparent that palladium has been closing the gap with platinum. In fact, in 2010 you can see that palladium dramatically outperformed platinum.

Looking at this chart you can see how dramatic the out-performance has been the past year, the Platinum ETF – PPLT is the worst performing of all metals in 2010. Based on the long term chart this trend could continue until Palladium once again becomes over valued compared to the price of Platinum. However, since the Palladium ETF – PALL was up over 80% in the past year I would definitely be afraid to jump in right here.

The point of this article is just to show you that the best metal to buy is the one that has been out of favor. When normal relationships get stretch to an extreme one way or another it provides low risk, high reward opportunities. Then you can profit as the otherwise normal relationships move back toward their long term equilibrium.

The stock market in general is considered to be forward looking, in other words the prices are based on future expectations not on present reality. That’s why the best time to buy stocks is usually when things look the worst, like March 2009 for example. Stock market turns generally lead turns in the economy by about 6 months.

Precious metals stocks are no different. Quite often you will find that the gold and silver stocks will begin making a move ahead of the actual movement in the metal. This is called divergence and it may be just a couple days or it may last for several weeks or longer.

Since the beginning of the gold rally in August the Gold Stocks had been outperforming the actual price of gold as you can see by the chart below.

Even when gold made a slight new high in early December, the Gold Stock ETF – GDX made a significant new high meaning that investor conviction remained strong. However you can see that sentiment began to change over the coming month. As the gold etf – GLD retested the highs for the 3rd time you can see that GDX (the gold stocks) made a much lower high. This was the indicator that investors were taking profits in anticipation of weakness in gold.

As we came into the new year the underperformance of the GDX accelerated and this lead to declines in both silver and gold.

By no means is this always the case, but when you do notice that the Gold Stocks begin to outperform or underperform the actual metal it is simply a cue to start watching for a change of trend in the actual metals.

When investing or especially trading you want to find correlations within the markets that you can use to determine when a trend will change or whether it will continue in the direction it’s going.  This is one thing that has made trading tough the past few years because during the financial crisis most of the correlations broke down.  Also, during the recovery there has been so much government and fed intervention in the markets that things haven’t really returned to normal.  However, the correlations I’m about to share with you regarding gold and silver are still alive and well.

There are 3 components to the metals markets that you should watch:

#1  The actual price of the metals themselves.

#2  The price relationship between Gold & Silver

#3  How Gold Stocks are performing compared to Gold

For this example we are going to use the Gold ETF – GLD to represent the price of Gold and the Silver ETF – SIVR to represent the price of Silver.  I use SIVR instead of the more liquid SLV because the price of SIVR tends to track the front month silver futures more closely than SLV.

First of all, I look at the Gold and Silver Charts to see what is going on in those markets.  You can see by looking at the two charts below that going into August, Gold was beginning to show signs of strength.  You can see right at the beginning of August GLD broke above the 20 day simple moving average, then it went down and successfully tested that level and then gapped higher.  This is a powerful indicator of a trend change.

At this point Silver (which had underperformed gold since January) was still under performing as a result of the sluggish economy. You can see that as late as mid-August silver was still unchanged (brown line) on the year but gold was up almost 10%.

When gold has been outperforming it’s often a good time to look for a spot to buy silver, because in the end if gold stays strong silver will also rally. If it’s going to be a big rally, the relationship will flip flop and silver will start to outperform gold.

Looking at the charts I noticed that silver had been testing the 200 day Simple Moving Average during it’s consolidation. On Tuesday August 24th the stock market was weak and silver opened down at $17.80 which was once again testing the 200 day sma. At this point gold was up almost 10% on the year but silver was basically flat. When silver rallied off the 200 day simple moving average it was a low risk place to buy silver.

Once silver gapped higher and broke out of the consolidation pattern there was no looking back. The fundamentals of a large short position trying to cover along with the QE2 effects made an explosive combination. However, even if you didn’t know the fundamentals you could’ve seen the situation brewing just by watching the charts. It was clear that this was going to be a huge rally once silver began to dramatically outperform gold. This setup continued to work right into the end of the year.

This is an extreme case, normally the precious metals don’t have this kind of dramatic moves. However, even in more mild times you will see these relationships taking place.

In the next post I will show you how you can use the comparison of Gold Stocks versus Gold to spot turns in the markets.