Gold/Silver Ratio

The rule of thumb about the gold/silver ratio is that when gold rises against silver, then liquidity is contracting, and when silver is rising against gold, then there's excess liquidity in the markets.

Since we know that derivatives and the delta hedging strategies being employed directly affect liquidity in the markets, then ratio is demostrating exactly what's happening. Since assets do not multiply, and that the only way to expand is through commercial bank lending and an increase of derivatives, then it follows that markets will be directly affected by derivatives expansion. That money goes out of stocks and into derivatives.

I think the GSR shows that, since the end of 2005 and the deregulation in the Canadian banking sector allowed full use of derivatives in the markets, that an essential change has come over how a gold stock is priced. GBN.V is a very good example of liquidity flows.

As the silver price falls behind the gold price, then liquidity is coming out of the market and going into hedges. That means that despite the rise in the gold price, that gold stocks are going through a rout, because they depend heavily on people leveraging up and buying stocks.

You can see that since the end of 2005 that the relationship of gold stocks with the GSR has completely reversed. This explains why a company like GBN.V is trading strongly inversely correlated with long-dated U.S. treasuries, rather than performing with the gold price.

Murray Pollitt wrote about the expanding liquidity bubble in the gold stocks, that they were being grossly overpriced. We see the result now, that this premature rush into gold stocks has resulted in a crash.

Its more than just blind sentiment at work. The likelihood of this kind of result out of random circumstance being repeated and going in for a second time, inversely tracking the GSR since the end of 2005, is probably zero.

The inverse correlation with the GSR of GBN.V stock has been better than -.75 since 2005 on the monthly chart. On the weekly chart, you saw a perfect inverse correlation very briefly this last year. So what that means is the stock is depending on liquidity expanding and contracting for stocks, rather than fundamentals such as the rise in the gold price.

The solution, of course in terms of delta hedging strategies, is to introduce arbitrage risk in the share price by providing dividends. That means people will look at the stock in terms of dividends and forward earnings, rather than trailing earnings, and perhaps GBN.V stock will track the gold price.

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-F6