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The Gold & Silver Ratio

With Gold Prices moving so high, so fast, will silver catch up anytime soon...?

WHEN AMAZON.COM recently reported its top-selling Christmas gifts, there was a real surprise.

   Consumers were still spending money despite the stock market and economy's gloomy news. But the top selling item from the world’s largest on-line retailer wasn't a book or even a DVD.

   It was silver jewelry.

Gold & Silver: The Investment Case

   Maybe we shouldn’t be so surprised. Silver is cheaper than gold by weight. You can buy a nice pendant or a brooch for less than $50. And silver, like gold, still means something to people.

   Silver is a precious metal. You feel like you own something of real value when you own silver...even if its value is barely 2% of the current Gold Price.

   Despite the secure feeling owning precious metals may give you, is there an investment argument to be made for them? According to the cost of raw materials there is.

   Commodities prices are soaring. Oil is near $100 per barrel. Soybeans have reached 34-year highs on a spike in demand. And Gold Bullion is within shouting distance of $1,000 per ounce.

   And according to the much-ignored gold/silver ratio, there's a case to be made for thinking the best-performing metal and commodity of 2008 may well be silver.

Gold & Silver: Historical Ratio

   Before the modern era of floating currency exchange rates – where the relationship between currencies varies based on their respective strengths and weaknesses – the world was on a Gold Standard. Money was backed by physical metal, and precious metal with an intrinsic value gave money genuine value, too.

   Silver also played a role in the United States and China up until the end of the 19th century. So both precious metals were money, and the ratio between the Gold Price and silver historically stood around 15-to-1.

   Gold was always more valuable than silver, because gold is harder to find and mine. Silver is relatively more abundant and can also be consumed in industrial processes. Whereas gold is more durable. Its primary use is monetary.

   But in the last thirty years, the gold:silver ratio has exhibited quite a bit of volatility. A higher ratio shows both gold strength and silver weakness. When the ratio declines – as it appears to be doing right now – it means silver is getting stronger.

   (It should be noted, however, that a declining ratio doesn’t mean the Gold Price is falling. It could mean that both metals are rising, but that silver is rising faster than gold. In fact, I believe that’s what the falling gold/silver ratio is telling us.)

Gold & Silver Ratio Shows Silver Rising

   Back in 2001, the gold:silver ratio spiked up to 80. That means it took you 80 ounces of silver to buy one ounce of gold. But since then, the ratio has declined.

   You might be surprised to know that despite gold’s headline-grabbing move to $935 per ounce, silver has actually outperformed gold since late 2001. In November 2001, silver hovered at just $4.05 / oz. In recent trading in New York, it touched $16.19 for a gain of around 300% in the last seven years.

   In that same time frame, gold has increased too, enjoying a gain of about 219%. But where to from here?

   A chart of the gold/silver ratio contains two further pieces of information worth noting. First, the ratio began increasing in mid-2007 as the price of Investing in Gold moved up in US dollar terms. This was in reaction to both geopolitical events and the housing market crash in the US, which has led the US Federal Reserve to slash its interest rates, weakening the Dollar again and further strengthening gold.

   Silver has not followed gold’s 2007 move up. But during the last great inflationary boom in precious metals – back in the 1970s – a speculative blow-off top drove the gold:silver ratio back down below its historic level of 15.

   Might that happen again?

   In 1980, when the infamous Hunt brothers nearly cornered the silver market in New York, silver prices went as high as $48 per ounce. But that doesn’t tell the real story. Adjusted for inflation, the 1980 price was more like $129 in today’s rapidly depreciating US currency.

   The historical silver price, adjusted for inflation, has now begun to move up, but it hasn’t come close to imitating its performance during the last precious metals bull market. If it does, then a new high in inflation- adjusted terms is not just likely, it’s probable. The gold:silver ratio is currently around 55. Let’s say the ratio begins to narrow again and goes to 30. At a current gold price above $900, you’d have silver at $30 an ounce or more. If the ratio narrows even further, the possibility for a much higher silver price also exists.

Gold & Silver: Investment Demand Driving Prices

   Are there reasons for caution? Absolutely. One reason silver tends to lag gold is that silver is more an industrial commodity than a precious metal. In fact, according to industry statistics, 45% of the demand for silver comes from the electronics industry. Thirty percent of demand is from the jewelry industry, 20% from silver’s use in photography, and just 5% from investment demand.

   But provided the industrial demand holds up, increased investment demand could well drive the silver price higher in 2008. There is a precedent for this with gold.

   The first exchange traded fund for gold in the US came out in late 2004, when the gold price was just above $400. The creation of an easy way to be “long gold” for institutional investors  – albeit without any direct ownership – stimulated demand for real Gold Bullion itself. And with investment demand unleashed through the ETF trust structure, the Gold Price began a serious move higher.

   A silver ETF began trading in New York in mid-2006, and it tracks the silver price, again without ownership. It’s been in a choppy trading range. However its latest move higher signals good things for silver bulls, I believe.

   There are never any sure things in the investment world. Silver may continue to underperform gold for years, as gold behaves like money and silver behaves like an industrial metal. But even a modest up-tick in investment demand for silver could push it to new highs. And if silver is embraced again as money in the same way that gold has become a clear store of wealth for investors around the world since 2001, watch out. The rising price of silver will only attract ever more investor attention.

   Perhaps that is the biggest yet most irrational reason I can see for silver’s bright future. In the speculative phase of a bull market, people buy because prices are rising. That is not the best reason to buy, of course. You’d much rather buy earlier, when there are still fundamental reasons to buy and BEFORE the big moves have been made. The good news is that for silver and gold, the really big moves may be just ahead.

Best-selling author of The Bull Hunter (Wiley & Sons) and formerly analyzing equities and publishing investment ideas from Baltimore, Paris, London and then Melbourne, Dan Denning is now co-author of The Bill Bonner Letter from Bonner & Partners.

See our full archive of Dan Denning articles
 

Please Note: All articles published here are to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it. Please review our Terms & Conditions for accessing Gold News.

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