The US Dollar / Gold versus Silver

Here is an extract from commentary that was posted at www.speculative-investor.com on 6th October 2002. 

The Dollar

A popular argument these days is that the US$ will not drop any further because the stock markets of Europe are even weaker than the US stock market and because the economies of Europe and Japan are even weaker than the US economy. Does this make any sense?

To answer the above question, let's consider the case of a European investor with a large investment portfolio. Our hypothetical investor has a portfolio comprising European stocks, US stocks, cash and bonds, and is considering how he should position himself for the next 12 months. According to those who argue that the dollar will 'hold up' because Europe is even weaker than the US, our investor will think along the following lines: "The European stock markets are dropping at the rate of 50% per year whereas the US stock market is only dropping at the rate of 30% per year, so I'll sell my Euro stocks and buy US stocks. This way I'll only lose 30% rather than 50%."

Of course, our hypothetical European investor will not think that way. His goal will either be to get a return on his capital or a return of his capital, not to make a loss. In order for him to increase his exposure to the US stock market he will need to believe that US stocks will out-perform European stocks and that the US stock market will rise. If he perceives that the US stock market offers only relative strength, rather than absolute strength, he would probably decide to sell all of his equity investments and keep the proceeds in cash. Since the euro has been trending higher against the US$ for 2 years and since short-term euro interest rates are higher than short-term dollar interest rates, a rational investor who 'goes to cash' is likely to give euros a heavier weighting in his portfolio than dollars. Alternatively, if our investor is value-oriented he might conclude that European stocks now represent better value than US stocks, partly because they have fallen much further than US stocks, and might therefore decide to increase his weighting in European stocks at the expense of US stocks.

Regardless of what our hypothetical European investor might or might not do, the main point being missed by those who argue that the US$ will remain strong because the US is 'less weak' than Europe, is that Europe does not need net investment in-flows in order for the euro to rise against the US$. The US, however, needs to attract almost $1.5B in net foreign investment every day just to prevent the US$ from falling. If the US' quarterly current account deficit remains near its present level and the US manages to attract only, say, $1B of net foreign investment every day, then the US$ will fall.

Our view has been, and continues to be, that the Dollar Index will rally to around 111-112 before its next major decline gets underway. Furthermore, since the US$ almost never falls during the final quarter of the year we do not expect the next major decline to begin until January of 2003. By that time the chorus of "the dollar is not going to fall because things are not as bad in the US as they are elsewhere" will no doubt have reached a crescendo. The Dollar will then be ready to embark on a rapid decline of around 20% against the European currencies.

Gold versus Silver

Throughout the 1990s the silver price trended higher relative to the gold price. This is one of many important trends that changed during the 1999-2001 period. The below chart of the gold/silver ratio shows the 1990s' trend (silver out-performing gold) and the trend that began in mid-1999 (gold out-performing silver). 
 

Our long-held view has been that gold would out-perform silver for the first 2-3 years of the current precious metals bull market, after which silver would begin to out-perform gold. This is still our view, but recent price action in gold and silver suggests that silver's days of under-performance are not yet over.

When the silver price dropped below $4.70 a few months ago it was an indication that the preceding breakout above major resistance at $4.80 was false. When this happened we said that a drop to $4.20 had become likely. A new multi-year low (below $4.00) is possible over the next 2 months, although this is not something we expect given that the stocks of silver companies have held up quite well to date.

Gold stocks should continue to be given a much heavier weighting than silver stocks in any precious metals portfolio. Investors should be prepared to buy junior gold stocks on weakness, but we would avoid any new buying of silver stocks (with one exception) until the silver price shows some sign of strength or, at least, some sign that it is bottoming.

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