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A Gold & Silver Top?
by David Stanowski
29 April 2006


The perfect way to buy and sell investments is to buy low and sell high! Unfortunately, the age-old investment dilemma is how to tell when a price is "high" or "low". What exactly does this mean?

A high price is one that is substantially above a level of prices that represents the "known value" of the investment. 
A low price is one that is substantially below a level of prices that represents the "known value" of the investment. Therefore, the real secret to investing is in discovering how to determine a level of known value.

Investments that produce earnings can develop an accurate measure of known value by computing their Price/Earnings ratio. Stocks, businesses, and developed real estate can all be measured using P/E ratios. After P/E ratios are computed for many years, it is easy to determine the average P/E ratio for any investment, and then recognize when its P/E ratio is very low or very high.

The astute investor sells high P/E ratios, because prices are above known levels of value, and buys low P/E ratios, since they are below levels of known value. This is because market history shows that when markets are overvalued, they cannot be sustained at these levels, so they revert back towards known levels of value, and usually overshoot even further until they are undervalued. The reverse is true of undervalued markets.
 

Of course, things are usually not that simple because, even after prices are accurately gaged to be "high" or "low" they will often continue to go even higher or lower; or they will simply hold their current "high" or "low" level for a long period of time before they reverse.

Investments that pay no earnings, like gold, silver, sugar, cattle, and land, cannot use P/E ratios to determine their value. 
The best way to determine the value of an investment with no earnings history is to compute a long term moving average of its prices. As the name implies, this "moving average" indicates what the average price has been over a long-term period of time.


For the purposes of this article, weekly closing prices of gold and silver were used to compute their 156-week moving averages. These averages represent what investors were willing to pay, on average, for gold and silver, over the last three years, which is assumed to be a reasonable approximation of value, at any given point in time. 
This is true since investors have been willing to pay these prices for a long period of time, which has established a baseline.


Figure 1 shows a plot of the difference, in percentage terms, between the price of gold, and its 156-week moving average from the week of 01 January 1979 up to the week of 17 April 2006; so it includes the great bull market of the 1970s.

Gold versus its 156 week MA
Figure 1

Gold's highest close occurred on the week of 14 January 1980 at $823.00, where it was 260.77% above its 156-week MA; a point where it was obviously grossly overvalued. (NOTE:
The actual inter-week high occurred during the week of 21 January 1980 at $873.00.) This extreme over valuation lead to a plunge in price to $304.20 on the week of 14 June 1982; where it was 36.42% below its 156-week MA; a point where it was undervalued.

Figure 2 plots the same data, except that it begins on the week of 14 January 1982, so as to eliminate the point where the 1980 top took place, to better illustrate more recent action. 

Gold versus its 156 week MA
Figure 2

After the low, the week of 14 June 1982, gold rallies to $476.20 on the week of 11 May 1987, where it is 34.39% above its 156-week MA measure of valuation, and then makes a slightly higher high on the week of 7 December 1987, 32.29% above the MA.

This amount of over-valuation lead to sideways to lower price action for about 14 years to lows of $253.90 on the week of 23 August 1999, and $257.90 on the week of 26 March 2001. From there a 5-year rally has pushed prises to $632.20; 47.04% above its 156-week MA, last week!

One could easily argue that over-valuations of 35%, or less, have contained all rallys for the last 25 years, and lead to prices moving back to, and below the 156-week MA, which currently stands at $429.96, so the next major move should be down towards this level, and probably substantially below that! The only thing that makes this far less than 100% certain is the fact that over-valuations can always extend further than this in both price, and time, as witnessed in 1980! However, the odds greatly favor a large price drop more than a large rally!

Figure 3 shows a plot of the difference, in percentage terms, between the price of silver, and its 156-week moving average from the week of 01 January 1979 up to the week of 17 April 2006; so it includes the great bull market of the 1970s.

Silver versus its 156 week MA
Figure 3

Silver's highest close occurred on the week of 14 January 1980 at $40.50, where it was 423.73% above its 156-week MA; a point where it was obviously grossly overvalued. (NOTE: The actual inter-week high occurred during the week of 21 January 1980 at $41.50.) This extreme over-valuation lead to a plunge in price to $5.10 on the week of 14 June 1982; where it was 64.04% below its 156-week MA; a point where it was undervalued.

Figure 4 plots the same data, except that it begins on the week of 14 January 1982, so as to eliminate the point where the 1980 top took place, to better illustrate more recent action. 


Silver versus its 156 week MA
Figure 4

After the low, the week of 14 June 1982, silver rallies to $9.41 on the week of 11 May 1987, where it is 50.02% above its 156-week MA measure of known valuation.

This amount of over-valuation lead to sideways to down price action for about 14 years to lows of $3.51 on the week of 18 February 1991, $3.57 on the week of 15 February 1993, and $4.04 on the week of 19 November 2001. From there a 4.5-year rally has pushed prises to $12.97; 87.46% above its 156-week MA, last week!

One could easily argue that over valuations of 50%, or less, have contained all rallys for the last 25 years, and lead to prices moving back to, and below the 156-week MA, which currently stands at $6.92, so the next major move should be towards this level, and probably substantially below that! The only thing that makes this far less than 100% certain is the fact that over-valuations can always extend further than this in both price, and time, as witnessed in 1980! However, the odds greatly favor a large price drop more than a large rally!


Since the gold and silver markets are flashing basically the same message, anyone who believes in the concept of over-valuation should consider liquidating their gold and silver holdings. Aggressive traders might even take short positions or buy an inverse mutual fund like SPPIX that moves opposite to the action in gold and silver stocks. 

In addition, residential real estate appears to be in an unprecedented bubble, based on measures of known valuation, and due for a very large move to the downside. Such a move should cause a major credit collapse, which would unleash a deflationary wave that would exert tremendous downward pressure on gold and silver prices.

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