Many investors in commodities use ratios to determine if one resource is incorrectly valued as compared to another. These relationships, based on historical prices, can often give us vital information on oil vs. natural gas, corn vs. soybeans, and especially gold vs. silver. While certainly not the most important factor in determining the possible returns in a commodity, these ratios can help guide our analysis.
Having been used as money for thousands of years, there is much data to reflect upon the ratio of gold vs. silver. The ancient Greeks set a ratio that fluctuated in a narrow range of 10:1 to 13:1. From that point on, much evidence exists that the gold/silver ratio climbed steadily for thousands of years, crossing the 20:1 barrier before civil war in the United States broke out in the middle of the 19th century. Since that time, the ratio rose sharply, and has revisited the previous levels only briefly during the last commodity boom of the 1970s. Much of the data in between 1934-1968 is relatively worthless, as the government of the United States dictated the price of gold, while the value of silver was allowed to fluctuate. Nevertheless, it is clear that over the centuries, the value between these 2 commodities has been on a steady increase.
As of today, the ratio between gold and silver stands at relatively high value of around 50. Since this is above the trendline at this point on the time spectrum, it is likely that silver will outperform gold over the next several years. While this conclusion could be drawn from a historical persepective, does it coincide with fundamental factors as well? The answer to that, is a resounding yes.
Over the past 20 year bear market in commodities, the exploration for new metals was almost non-existant, with the exception gold. The gold market is poised to soak up new supply from greenfield mines and the expansion of existing mines like no other commodity. In fact, there are very few silver mines in existance at all. Most of the silver is mined as a by-product of nickel, copper, or zinc. If the price of silver were to rise, it would be virtually impossible to increase the supply, while in a bear market, it would make little sense to decrease the supply. The inelasticity of silver’s supply makes its value extremely volatile compared to other metals, especially gold. The upside of this was seen in the 70’s as the value of silver jumped from $1 to $50 in the course of decade. Clearly in that decade, the gold/silver ratio fell tremendously as silver far outperformed gold.
Another factor adding to the extreme volatilty is the small market of silver. Being much more of an industrial metal than gold, silver’s demand has been more consistent. If investors start piling into this small market, the price of the metal could take off. On the same respect, it would take a far larger amount of investor money to move gold in the same way.
Using the gold/silver ratio as a guide, and backing it up with fundamental analysis, it becomes clear that silver is bound to outperform gold in a commodity bull market. The opposite is true though, in a bear market. Commodity Investors are urged to consider carefully their time spectrum. With metals having experienced several years of outstanding gains, some consolidation may be needed before jumping back into the Silver game.
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