-- Posted 27 May, 2009 | | Discuss This Article - Comments:

The dollar is out. The U.S. dollar index has fallen 5% last week.

Treasury bonds are quickly falling out of favor. The yield on 10-year Treasury bonds has climbed from 2.5% to almost 3.5% since March signaling inflation fears and an unwillingness to fund ballooning government borrowing.

Gold is hot. Gold prices are back on the rise and gold stocks have done even better.

Is this a sign of things to come?

Well, if you take a look at the mainstream headlines, you’d think so.

An editorial headline on Bloomberg proclaims, “Dollar is dirt, Treasuries are toast, and AAA is gone.”

Even CBS News is warning, “Inflation could be coming to a U.S. dollar near you.”

To me, it seems just like a typical overreaction in the short-term.

Yes, the long-run trend for the dollar is down as the Fed keeps printing more and more of them and monetizing government debt. And yes, the prospects for gold get brighter and brighter with each passing week.

But there’s no reason to lose your head here. It’s going to take a few years for all this to play out. And the window of opportunity is still wide open to buy precious metals, real assets, and assets not denominated in the dollar (like ADR’s).

That’s why, despite the strong interest in gold at the moment, I encourage you to continue to look for value in the sector. Right now, there seems to be some exceptional value in an asset which is so undervalued, it could outpace gold by 400% or more.

I’m talking about Silver.

When Gold Climbs, Silver Soars

In the past few weeks gold has been getting a lot of attention. With all the big money finally taking a liking to gold, the attention is justified. Remember, a turn in the big money’s attitude towards gold must happen before gold can break through the $1,000 mark and stay there.

The excitement surrounding gold’s surge has only pushed silver further onto the back burner. (You don’t hear about any major hedge funds loading up on silver do you?) And that’s the point. Gold is hot and silver is – in a relative sense - not.

So if you want to find an investment which isn’t so hot but still has a lot of potential in an inflationary environment, you’d want to look at silver. When you do, it won’t take long to realize silver – at current levels – could easily trounce gold in the months and years ahead.

That’s right. Silver has a much brighter future than gold. All you have to do is look at the silver/gold ratio to see how potentially lucrative the situation has become.

Ratios Don’t Lie

We’ve looked at a few ratios in the past. The reason is because ratio analysis can help identify value even in volatile markets. For instance, we looked at how the gold/oil ratio was signaling oil was a buy back in January. Oil prices are up almost 50% since then.

We looked at gold/gold stocks ratio back in December. We saw that gold stocks were significantly undervalued relative to gold. Since early December, gold is up a respectable 22% while gold stocks – as a group - have rebounded 70%.

That’s the value of ratio analysis. They can quickly show you how undervalued some assets are relative to other others. And if you’re able to find them at extreme points, you can get into a trade or investment with less risk and greater upside.

Right now, the gold/silver ratio (the measure of how many ounces of silver can be bought for an ounce of gold) is at an extreme and working its way back to historical norms.

The chart below shows the gold/silver ratio is slowly working its way back to a much more normal level:

As you can see, the gold/silver ratio hung around 50 for most of 2008. Then the credit crunch threw everything out of whack and now it’s slowly working its way back to normal. But this chart doesn’t show the real upside in silver. That comes from the long-run average.

Over the long term, the gold/silver ratio has averaged about 30. That means one ounce of gold would buy about 30 ounces of silver. Today, with silver at $14.60 an ounce and gold at $953, the gold/silver ratio is 65. In other words, an ounce of gold would buy 65 ounces of silver. That’s more than twice the long-run average.

Silver prices would have to double just to be in line with the long run average.

Silver Slingshot

But here’s the kicker, when gold races, the gold to silver ratio gets flipped around. During the last precious metals bull market in the late 70’s and early 80’s the gold/silver ratio hit lows of 15.

That means if gold goes nowhere (granted, chances are pretty slim of that), silver could easily shoot up to $50 an ounce. That’s a 400% move for silver without gold moving up a single dollar.

Here’s the thing though, gold isn’t staying where it is. Over the next few years, gold is going much higher. And silver is going to go even higher. Silver will slingshot past gold.

Think about it. With a gold/silver ratio of 15…

At that ratio, silver would be at $66 when gold hits $1,000.

$1,500 gold = $100 silver.

$2,000 gold = $132 silver.

So if you expect gold to do well, you’ve got to expect silver to do even better.

According to the historical relationship between gold and silver, if gold does well, silver will do exponentially better. In past gold bull markets, silver prices zoomed past gold in relative terms. There’s no reason to expect this time to be any different.

In Search of Value

In the end, precious metals have been one of the few sectors which have maintained an uptrend through all this. As the long run prospects for the U.S. dollar continue to worsen, I expect the uptrend to continue. However, I expect this to take a long time to play out than most.

Just take a look at what happened earlier this week. The Financial Times reported China is continuing to buy U.S. Treasuries. Granted, they’re switching to short-term durations, but they haven’t even come close to invoking their “nuclear” option yet and probably won’t for a long while.

We’re in the midst of a slow and steady decline of the dollar. The Fed is printing dollars to fund the growing government deficits and there haven’t been any significant inflationary consequences…yet.

That will change and it’s not too late to get prepared. Now is the time to buy precious metals and precious metals miners for your portfolio. Right now, with the gold/silver ratio indicating silver as undervalued and gold a hot topic, silver is a bit more enticing.

Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing