Primer 1: Au & Ag Allocation System

Observations and back-testing of price action of the Gold and Silver ETF's has indicated to me that a nifty little trading system may yield better results than a simple buy-'n-hold strategy. While also decreasing volatility and risk of course. For many investors, "trading" or "trading systems" might have a poor reputation and I'm sensitive to that. I actually think describing this as an Allocation System is truly more accurate but, in the end, most will likely think of it as trading. Please don't let that dissuade you from maybe following-along as I try to test and document this system here. At this point the data don't indicate to me that a hyper-active number of market trades would be triggered. So most investors would hopefully come to recognize it as a moderately passive system but one that investors with differing risk tolerances and speculative desires could adapt to their styles and comfort levels. Read-on and then watch the results over the longer term and see what you think. Questions and feedback/suggestions are very welcome. This is a work-in-progress.

In the short-term, given the relatively advanced state of the bull market in the precious metals at this date, I do not necessarily expect this system to show significant outperformance relative to some broad market indices like the S&P500 or other major markets. Unless, that is, there is a broad and steep stock market sell-off (a not unlikely possibility I think, read on). But the point in the cycle where I've begun documenting this here almost surely sentences the system to a struggle against the broader markets for at least the immediate time-horizon if not for some time to come. I would expect--if most of my other hypotheses are accurate though--this system to make slow and steady progress in catching-up with the traditional investment markets and possibly staying ahead for some years to come however. First, some premises and assumptions I'm using:

• Equities as a broad asset class are in a Secular Bear Market that began in early 2000. Precious metals, at least as measured in terms of US Dollars, are in a long Secular Bull Market that began in 1999 or 2000 depending upon the nuances of how you want to mark the beginning. To date, Gold and Silver have actually been rallying strongly in terms of most major global currencies as a matter of fact.
• Yes, US equities markets have rallied strongly since making a Cyclical Bear market low in late 2002. But when one compares the performance of the spot price of Gold and Silver (essentially "bullion" or a proxy for the ETF's that came-along later) compared to the S&P or DJIA from either the bull top in early 2000 or the bear bottom in 2002 until today, the metals have outperformed the stock market solidly. If my thesis that US stock markets are in a Secular Bear and the rally since 2002 has been a Cyclical Bull within that longer Bear market, then we should expect the US Stock markets to broadly underperform and relatively soon. For those wishing to understand this context more, studying-up on the market cycle from 1966 to 1982 would serve as an excellent introduction. Many of us "hard asset bulls" these days refer to the markets of the late 1960's and through the 1970's as a kind of benchmark for what we might generally expect to see for as much as another 10 years forward from here.
• Some other historical data trends that form a basis for the theory of this Allocation System include the DJIA/Gold Ratio and the Gold/Silver Ratio. I'll try to post on these in more details later but some of you may already be familiar with these concepts. The DJIA could be replaced with the S&P500 in the Stock-to-Gold ratio if one wanted but this long term pattern has historically used the DJIA since this work often goes back as much as 100 years. And some analysts also compute a Stocks/Silver ratio in addition to, or instead of, the Stocks/Gold ratio. The Gold/Silver Ratio has an even longer history of use amongst buffs of the metals. Trading the ebb and flow of the Gold/Silver Ratio forms the core of this system I am testing here. It is theorized by many followers of these long term patterns that we are in a long-cycle in which the Gold/Silver ratio will eventually "bottom" at roughly 15 or 16. That is, 16 times the current per-ounce price for Silver would equal the per-ounce price for one ounce of Gold (16 ounces of Silver buys 1 ounce of Gold). I won't go into great detail now but maybe can provide links to other sources on this later. The Gold/Silver Ratio stands today at approximately 50. It currently takes roughly 50 ounces of Silver to trade for one ounce of Gold at today's prices. GLD closed today at $64.94, implying a per-ounce price for Gold of $649.40; SLV closed today at $128.80, infering a per-ounce Silver price of $12.88. $649.40 / $12.88 = 50.42, the Gold/Silver Ratio.
• It is observed by many, and also is implied in the historical patterns of the Gold/Silver Ratio, that Silver usually outperforms Gold. Silver is a smaller ("thinner") market and therefore tends to be more volatile in its price moves. In the Gold/Silver Ratio equation above, if SLV instead were trading near $20 per ounce of Silver, the Ratio would be lower: 649.40 / 20.00 = 32.47. So one can see that if Silver does indeed outperform Gold over time, the Ratio should decline. The historical basis for a final Ratio of ~16 and historical trends in the Ratio will have to wait for a later post but the history indicates that in a bull market for Precious Metals the Primary Trend in the Gold/Silver Ratio is down. Another premise here then: "the trend is your friend". For even relatively passive investors, getting positioned to ride with the Primary Trend is job one. If one then wants to attempt to mitigate periodic risks and/or opportunistically leverage to trends within the major trend, well, that is what this system will also hopefully provide guidance on as well.
• The Gold/Silver Ratio can obviously be calculated daily. Or even on an intraday basis but I'm not suggesting that. During past market cycles in the precious metals, trading patterns can sometimes be seen that might indicate when it is most advantageous to be invested most fully in Silver and when it might be best to be more concentrated in Gold. If these historical patterns can be successfully used to adjust allocations over time going forward, then one might be more exposed to the greater performance of Silver during strong uptrends and more exposed to the relatively more stable price action of Gold after having exploited the best of the action in Silver. I am not the first to identify or attempt to exploit these relationships. Indeed, I have many "older hands" in the metals markets to thank for their insights and I will maybe offer links to some of them in the future. I am just attempting to apply the lessons of the past to the more recently created ETF's and in the context of a bull market and, if the bull lasts, a market in which an even greater proportion of the investing public may find it relatively easy to invest or speculate in the Precious Metals given the proliferation of instruments coming to market (i.e., the ETF's).

In posts to follow, I will begin to discuss how I am applying any knowledge gained here through testing and in the context of my own portfolios and personal tolerances for risk and investing time-horizons.

Of course, I must remind all readers that I am not an investment advisor or even a market professional. You should studiously perform your own research or consult other experts if you feel unable to make your own investing choices. There are numerous caveats and warnings one should be familiar with before investing in narrow market sectors like the Precious Metals and in very new investment vehicles like Physical Bullion "Backed" ETF's. I am simply using this forum as a place to objectively document my own work on my personal investing theories and strategies for my own portfolios. Everyone is responsible for themselves in the end.