How to make savvy investments in gold

There are better ways to invest in gold than simply buying the stuff, says Jim Stanton. Here, he explains how to use the relationship between the price of gold and the price of silver to make savvy buys.

Since the Obama administration took office in January, we've seen hundreds of billions pumped into the economy and the US budget deficit now forecast to top the $1trn mark in the coming years.

Many believe it's only a matter of time before we also see much higher inflation - perhaps even hyper-inflation.

That prospect has kept the gold bugs banging the drum to buy the metal, with the television and radio cluttered with ads that tout the benefit of doing so.

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Last week, Lou Basenese noted the numerous reasons why the price of gold should be moving higher - but countered with the reasons why the price has continued to languish around $935.

Today, I'm going to look at another important factor that drives gold prices

The dollar-gold-inflation relationship

While the recent rash of government spending hasn't propelled gold prices to new highs, it has contributed to a decline in US dollar.

Having reached a high of 89.70 less than two months after President Obama took office, the dollar index has since pulled back to around the 80.00 level. It could easily be lower, but because it's measured against a basket of other currencies, the price is relative.

For example, the euro makes up about 60% of the dollar index weighting, since there are 16 nations using Europe's single currency. And because Europe is also battling fiscal problems, in addition to Japan and Britain (whose currencies are also weighed against the dollar), the greenback has held its ground.

Most of the time, a weaker dollar will cause gold prices to rise, while a stronger dollar usually sees gold decline.

Add in the prospect of inflation (or hyper-inflation) at some point and the scene is set for gold to potentially make new, all-time highs.

Except we're not even close to that point yet. Inflation is nowhere to be found - as evidenced by the Consumer Price Index falling by 1.3% in the 12 months through May. That was the largest drop in 50 years.

So how do we play gold in the short-term?

Don't blindly follow the crowd into gold

The main reason why the gold market concerns me at the moment is that despite almost everyone being bullish, the metal hasn't been able to set new highs.

The long side is crowded with bulls, just like the technology sector was back in 1999. And we all know how that turned out.

That said, the gold market is much different than the tech sector. I believe every investor should have some gold or another precious metal in his or her portfolio but there's a better way to do it than by simply buying it outright at the moment.

The easiest way to do so is by following this ratio

Use the gold/silver ratio to make your gold and silver purchases

In the sell-off that began in March 2008, gold prices fell about 34% from high to low. By contrast, silver prices fell 60%.

This relationship is important because, by the time the market set lows in October 2008, the gold/silver ratio (how many ounces of silver it takes to buy an ounce of gold) was trading at 81:1 - an extremely high level.

A ratio of 80:1 is considered high, while and 40:1 is considered low.

From the October lows to the recent highs, the gold/silver ratio has corrected itself, with silver more than doubling (and making new recovery highs in June), while gold has risen just 49%. However, the ratio remains around 69:1.

Here's how to use the gold/silver ratio to make savvy metals purchases

How the gold/silver ratio works

Investors who always keep a percentage of their assets in precious metals should keep a close eye on the gold/silver ratio.

Having a 'ratio' position is a strategy that you want to adhere to all the time because it's such a dependable trade and carries less risk than just being long, or short on the metals.

It works by basically timing your gold and silver purchases according to the ratio. For example, when the ratio is relatively high (as it is now, at 69:1), we swap gold for silver. When the ratio is relatively low, we buy back into gold.

So right now, the 69:1 ratio is too high to buy gold. I'm looking to make my next swap from silver back into gold when the ratio drops to around 40:1.

Personally, each time I cycle through a complete swap - gold to silver and back to gold again - I increase the value of the trade and hold more ounces of gold or silver than I started with.

Go the ETF route with the gold/silver ratio

If you don't always have a percentage of your portfolio in precious metals, you can simply play the "ratio" using the SPDR Gold Shares (NYSE: GLD) and the iShares Silver Trust (NYSE: SLV).

When the ratio is high, you can short GLD while buying SLV, using the same dollar amount for both positions. When the ratio approaches 40:1, just reverse the positions.

This article was written by Jim Stanton, editor of The 1-2-3 Trader , and was first published in the Smart Profits Report on 6 July