For now, bet long on silver, but keep an eye on gold’s crash

WHEN Archimedes was given the task of determining whether King Hiero’s commissioned crowd was made of real or fool’s gold, he merely had to sink back into the bath to work out the answer.

Unfortunately, traders are experiencing a rather choppier period in their quest to work out if their gold assets are overvalued. With price fluctuations wiping out a week’s gains in one day of trading last week, and silver on a sustained rally since the end of August, traders have begun to ask whether the gold price is over-inflated compared to its lesser cousin.

At $19.97 an ounce, silver is close to its two-year high and, having briefly broken through $20 per ounce, there are suggestions that investors in search of a safe haven might start stockpiling long silver bets alongside their gold bars. Although the price of silver does not respond directly to economic data in the way that gold does, ongoing uncertainty about the pace and reliability of global growth could push up interest in the metal.

But although traders could see some upwards movement over the next month, also in part due to industrial demand, the fundamentals are not supportive of long-term gains. And, unlike gold, silver is governed by real supply and demand.

Capital Spreads’ Simon Denham says: “There’s a real problem for long-term bulls of silver, which is that there are any number of waiting silver mines mothballed years ago when the price of silver went down below $10, across Latin America.” If the price of silver is driven up past $22 per ounce, Denham thinks the miners will simply dust off their diggers and jack up production. So although traders could catch a rally before this happens, they will need to get out quickly before it collapses.

As for precious metal alternatives, it is worth keeping an eye on platinum. Although it is unlikely to go anywhere in the short-term, production issues could manifest down the line. Castlestone Management’s Connor Noonan says: “The cost of production for platinum seems to be going up and up, partially because of deals that have been made in South Africa: a mining company with close ties to President Zuma has obtained mining rights that used to go to others, who therefore have to buy from a middle man, a shell company, that has increased the prices, which will translate into higher market prices.”

Of course, betting on political chicanery is not the same as betting on safe haven demand, which brings traders back to gold. Unlike platinum and silver, gold does not trade on fundamentals. It makes little difference that, because gold is rarely used up through industrial or other uses, most of the new gold mined is adding to – rather than replacing – the world’s supply.

Even those who think gold is overvalued think it could keep rising for as long as it takes to resolve advanced economies’ debt problems and jumpstart economic growth. Central banks are still buying, after all – last week’s gold sell-off was interrupted by the news that Bangladesh had stumped up for 10 tonnes of gold from the International Monetary Fund.

Still, the fall shook some traders’ confidence and profit-taking should cap rises for the next couple of weeks. Denham says: “It’s probably worth selling rallies until it gets through $1,265 per ounce, then see how far it goes. I’d put a stop at $1,265.”

In the long-term, however, traders should keep a careful eye out for a correction. Gold cannot keep rising above its fundamental value interminably, and it is better to miss part of a rally than get caught in a crash when the goldbugs have a eureka moment of their own.