February 11, 2010
Years ago, when I was a bright-eyed lieutenant anxious to defend the world against evil and tyranny, the government decided to ship me off to become an intelligence officer.
I remember a lot of the classroom training, learning about the enemy’s order of battle and maneuver capabilities. Ironically, we were still studying Soviet tactics at the time, even though the Berlin Wall had become a tourist attraction over a decade prior.
During my field training, we focused on collection efforts and intelligence gathering. My instructors would continually hammer into us the importance of ‘indicators,’ signs or symptoms that strongly imply a future action or trend.
According to our threat doctrine, for example, a small isolated scout platoon would be an indicator for a heavily armed vanguard only a few kilometers behind. Ground commanders would rely on these indicators to make tactical decisions, e.g. reinforcing defensive positions in expectation of the vanguard’s attack within the hour.
In his book Art of War, Sun Tzu wrote, “Intelligence is the most important work, because the entire force relies on it for every move… It is the essence of strategy.” Outside of war, the same holds true in finance. Savvy investors rely on market and economic indicators to provide intelligence on future trends.
Part of the trick is differentiating the valuable indicators from the worthless ones… and too many people pay attention to worthless indicators. Government-manufactured statistics like inflation and unemployment rates, for example, are merely comical charades masquerading as economic indicators.
To get an indication of where the economy is headed, you have to listen to the economy. To get an indication of where the market is headed, you have to listen to the market.
I’ll give you a few examples:
In a weak economy, voluntary employee turnover is very low– workers tend to stay put because they won’t be able to find a job elsewhere. In a strong economy, however, businesses generally experience higher employee turnover because workers are confident they can find better pay somewhere else.
This is exactly what is happening in Panama; I saw it with my own eyes a few weeks ago– workers who would voluntarily quit because they had total confidence in being able to find a better paying job elsewhere.
This is a far more insightful indicator than any official statistic in determining an economy’s prospects.
Moreover, when the intelligence becomes too extreme or out of line from the norm, it’s usually a great indication of a top or bottom. Case in point– I pay close attention to the gold/silver ratio, which is the number of ounces of silver required to buy one ounce of gold.
When gold was actually money during the time of Alexander the Great and the Roman Empire, the ratio was fixed around 12. Over time, the fixed ratio increased to 15, which stood firm until the beginning of the 20th century.
Once worthless paper money took over, metals started floating more freely against each other, hitting a high of 100 and a low of 17, with an average range of 50-60 over the past few decades.
In general, the higher the gold/silver ratio, the higher the ‘fear factor’ in the marketplace. This is because the market for gold is much more capitalized than the silver market. Thus, institutional investment capital can flow into gold much more easily than into silver, which pushes up the ratio.
Naturally, this only happens when institutions are looking for safe havens for large amounts of capital. Consequently, when expectations are poor and risk tolerance is very low, the gold/silver ratio increases. When risk tolerance is high and expectations are strong, the gold/silver ratio decreases.
Right now the ratio is about 71… higher than the norm of 50-60. I think this is an indication that markets are becoming risk averse. It certainly mirrors what has happened with world equity and currency markets lately.
Given the level of uncertainty in the world right now, I think it is too early to make a trade on the gold/silver ratio… but I am continuing to watch it; if it rises beyond 75, I will likely respond by shorting long-dated gold futures and buying long-dated silver futures.
When this trade is properly structured, it doesn’t matter if the metals prices rise or fall– the trade will make money when the gold/silver ratio declines back into the normal range.
This will happen once market and economic tensions ease… and I’m watching what is happening in Europe very closely to help make that determination. It is, after all, an indicator.