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Trendlines Suggest Silver's Fair Value To Be in the Pre-Teens


What are commodities really worth once the Fed-induced speculation is gone? Here, a comparison of silver to its own trendline is offered in attempt to answer the question.

What are commodities really worth once the Fed-induced speculation is gone? I have written a few articles that made attempts to answer this question. These articles typically had a common theme of using ratios of commodities such as gold and silver to other assets such as stocks or real estate. Today, we will take a different approach. Instead of comparing silver to another asset class, we are going to compare silver to its own trendline.

The first step is to take a daily chart of silver and then create a trendline for it.

The next step is to find the formula for the trendline. The final step is to make a chart of silver relative to the trendline. Here it is:

There are a lot of positive aspects to this chart. We can see that overbought signals worked not only in 1980 but in 1920 as well. Silver went down by over 81% from 1920 to its 1932 low. And silver went down over 91% in the popping of the last bubble. Silver's 2011 high valuation was not far off from the 1920 peak with respect to distance from the trendline.

Just when you thought the removal of the gold standard was going to cause the indicator to not work anymore, the bottom for the 2000s came extremely close to the all-time low. The November 1942 low was 51.5% below the trendline while the November 2001 low was 51.3% below the trendline. When you see this indicator trading 46%-51% below its trendline, you may want to consider investing in large quantities of silver.

The bottoms are very similar to each other with respect to distance from the trendline. This is an excellent sign of a good indicator. Here are the readings at the low of each decade:

As for now, it will come as no surprise to discover that silver is overvalued. The trendline suggests fair value to be $12.45. As of September 25, 2011, this indicator was still at the 94.3% percentile despite silver's recent crash. At its April 28, 2011 top, this indicator was at the 97.5% percentile behind only behind the days surrounding the 1920 and 1980 tops.

Over the period of the 1920-2011, silver annualized at 3.78%. This is very close to the 4.22% annualized return of the trendline. So that fits rather nicely.

From Jan. 1, 1920 (where the daily data from starts) to August 31, 2011, the inflation rate was 2.74%. So silver has outperformed inflation by 1.01% over the last 91.66 years. Silver bugs seem to have a remarkable tendency to pick January 21, 1980 for their "inflation-adjusted" price of silver. It is indeed a useful tool to see how insane bubbles can get. The problem is this tool seems to have somehow metamorphosed from a "how high can silver go" number into what silver should trade at. How often do you read about silver's inflation adjusted price of $5.31? That would be calculated by using silver's price from November 30, 2001 as the base. Yet the 2001 inflation-adjusted low does not receive anywhere near the airtime of the 1980 inflation adjusted low. It should. Reward and Risk. Yin and Yang.

One possible criticism with the 1920 trendline indicator is inflation was lower prior to 1971. For the crowd who only looks at post 1970 data, here is the same analysis performed starting on August 16, 1971 when the U.S. took itself off the gold standard.

The same exact indicator with a later starting date suggests silver's fair value to be $10.05.

It is interesting to note that the $10.05 and $12.45 figures fit in rather well with the estimated fair value of silver by stocks and real estate regressions written about earlier (see Indicator Warns of 93% Collapse in Silver's Purchasing Power). Those regressions suggested fair value to be in a range of $10.48 to $11.70. If silver trades at these estimates of fair value, many miners would enjoy a reasonable profit margin while not attracting excessive competition.

While these numbers are likely to be scoffed at by the precious metals mob, keep in mind silver was trading below $9 less than three years ago. Is it possible that Mr. Bernanke's easy-money policies have created a disproportionate amount of money being "invested" into silver which made it overvalued? The Fed's easy-money policies created the NASDAQ bubble, the housing bubble and the oil bubble amongst others. Is silver's big run just another in a long list of artificially propped-up assets which eventually collapsed back to reality? Or is this a new era for silver?

The precious metals crowd warns that hyperinflation is going to come any day now. The bond crowd does not appear to be as concerned. The 20 year TIPS implies 1.97% inflation over the next two decades. While a 0% is optimal, 1.97% is less than half the post 1971 average of 4.38%. Somebody is going to be very wrong. Note the reigning word of the year is austerity. The next interest rate move is up. Increased deficits will not come as easily as they have over the last few years. The bar for QE3 has been raised higher than many gold and silver bugs had predicted.

The tremendous amount of pre-austerity fiscal and monetary stimulus warns of a potential danger of distorted assets somewhere. One tip-off is that a disproportionate amount of money seems to be flowing into commodities relative to other assets. Stocks haven't gone anywhere in 11.5 years. Real estate has been going south since 2006. Stocks and real estate were trading way over their "fair value" in 1999 and 2006 respectively. Back then you heard "this time is different" quite a bit. It wasn't.

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