 The
Gold/Silver Ratio Strategy
& the Case for Silver
By Franklin
Sanders
Editor, The Moneychanger
March 7, 2003
Ahh, reality
is stingy, and forces us to make choices. If you stop at McDonald's for lunch
you can't eat at Burger King at the same time...
Investors face the same choices. If you spend all your money
on gold, you won't have any left for silver. Which should you
choose? The one that will rise fastest and farthest. I
believe that will be silver, but how do we make that decision?
Is there some measure, some clue other than our bald opinion?
FUNDAMENTALS
Throughout history silver has served mankind as the primary
monetary metal. However, unlike fellow monetary metal gold,
most silver use is non-monetary. This industrial demand for silver
is quirky. In most applications only a very little silver is
needed, so silver contributes only a tiny fraction to end-product
cost. For example, the amount of silver on printed circuit boards
contributes only pennies to a computer's cost. Given this quirky
demand, unless silver's price skyrockets, higher prices don't
discourage use.
There's another quirk that keeps silver demand strong in the
face of rising prices: its unique properties. In most applications,
there is no good substitute for silver because nothing else acts
quite like silver. For instance, it is the most electrically
conductive metal, so the only near substitute in printed circuit
boards is - gold, which is even more expensive. In some
applications, like photography, there is no substitute at all,
because nothing else reacts to light like silver salts. To replace
silver in photography requires a completely new technology.
So silver demand doesn't drop much when prices rise (demand is
price inelastic). Moreover, the silver bull that peaked in 1980
scared silver users so badly that over the next two decades they
drastically reduced the amount of silver used . They figured
out how to get more work out of less silver, but most of those
one-time reductions can't be quickly or easily repeated. Usage
has been squeezed down about as low as it can go in the short
run.
Nor does silver production rise step for step with price. Obviously
developing a new mine or re-opening a mothballed one takes quite
some time, from months to years. Worse yet for silver supply,
75% of silver comes as a by-product of copper, lead, zinc, or
gold mining. All these base metals stand in oversupply at low
prices. Even if silver soars, no miner in his right mind will
turn out tons of unprofitable copper, lead, or zinc just to profit
from a little by-product silver. Open primary silver mines are
very rare, and real silver companies, miners who
draw a significant part of total revenue from silver, are even
rarer.
THE SHORTFALL
The high prices in 1980 brought lots of silver to market in the
following years, and left a big surplus to work off. Beginning
in 1990, however, the world began using more silver than mines
and recycling produced. By the end of 2001, that shortfall had
eaten up nearly 1.5 billion ounces. Since 1990 fabrication
demand has averaged 156% of yearly mine production. For every
ounce of silver the mines produced, industry consumed one and
a half ounces of silver.
Meanwhile demand for silver keeps on rising - even for photographic
silver. Demand rose from 513 million ounces ("Moz")
in 1985 to 880 million ounces last year.
But in spite
of production shortfalls year after year, silver's price remained
almost flat in the 1990s. Strange - where did all that silver,
1.5 billion ounces, come from? Some say a conspiracy exists to
suppress the silver price, and that may well be. I don't doubt
the shortfall has been papered over with derivatives,
leasing, and futures. All the same, eventually the price
must rise as demand grows and supplies shrink. If a conspiracy
has tried to suppress silver's price, so much the better.
When they lose control (as they inevitably will), the price will
surge even farther than natural forces alone would have sent
it.
KEY TO SILVER
PRICE
Keep one thing in mind: the key to the silver price is monetary
demand. Other categories of demand alter only slowly
over time due to technological or economic changes. Supply-demand
imbalances in commodities can persist for a surprisingly long
time without moving the price sharply. In the past decade, the
price of silver has been practically flat, with a few spikes,
because monetary demand has been absent. Strong, sustained
silver moves occur when many people decide suddenly
they want silver because it is money. Today, when stocks,
currencies, bonds, and other paper assets have begun to disappoint
investors, investor attitudes are shifting. What begins as a
trickle ends as a tidal wave when the panic peaks. When public
revulsion at the US dollar begins, the tidal wave will become
a tsunami. Silver, far more volatile than gold, will benefit
most.
RELATIVE MARKET SIZE
In the 1960 - 1980 precious metals bull market, gold rose from
$35 to $850, a 2,429% increase. At the same time silver rose
from 90 cents to $50, a 5,556% increase. Silver rose 2.3 times
as fast as gold.
What is the obvious reason for silver's greater volatility? Compared
to gold silver is a tiny market, so the same amount of
money drives silver much higher. That's why you expect to see
silver rising faster than gold in a bull market - the ratio ought
to be trending down as both metals rise.
Will history repeat itself? Yes, I think that silver will
again outperform silver.
THE RATIO RECENTLY
Today's rising ratio does not prove that I have been wrong
the past few years to recommend buying a large silver component.
Just the opposite: silver is becoming a better and better
buy against gold.
When you walk into the grocery store and they are offering the
usually more expensive Community Club coffee on sale, do you
buy it or Folgers? No choice there, right? Well, silver is on
sale against gold. We have been given more time to buy silver
at lower prices. In the last precious metals bull market, silver
lagged gold about three years, and then passed gold without ever
looking back. If silver rises faster than gold, we'll get a lot
more bang for our buck - and end up with more ounces of gold
as well.
I'll be first in line to admit that the gold/silver ratio chart
has been very, very hard for me to interpret lately - maliciously
tricky.
Last July the ratio appeared ready to break down from a five
year correction uptrend, when suddenly it shot skyward. At that
point I projected at top around 77:1, later 79+. It continued
up to 74.07 (10 Oct. 02), then seemed to be forming a head and
shoulders top.
Had it changed directions again? Right when it seemed ready to
break down in December, suddenly it shot skyward again. On February
7, 2003 the ratio hit 79.6, traded sideways a few days, then
dropped all the way to 74.9. The 74.5 level, which was formerly
resistance, is now support. That is the first level to watch
for a ratio breakdown and change to primary downtrend. Then the
ratio must confirm by dropping through 70.0, 62.5, and, finally,
59.5. A head and shoulders top seems to be building with a neckline
at 69.5, the top of the shoulder(s) at 74.50, and the top of
the head above 79.
RETURNING
TO THE MEAN
Over the years markets tend to return to their mean or average
values. However, as they correct they also tend to overshoot
the mean, swinging like a pendulum first too far to one side,
then too far to the other.
Based on year end average prices, the 1792-2002 mean ratio is
31.32. If the ratio merely returned to that mean over the bull
market's course, silver would rise about 2.4 times faster than
gold. However, based on the extreme ratio swings of the last
125 years, and the ratio's drop in the last precious metals bull
market, I believe it is safe to speculate that the ratio will
drop much, much lower than the 200 year mean. In fact, my target
is 16:1, the bottom of the last bull market.
What makes the ratio work? Why would it return to the old monetary
ratio at 16:1? I presuppose that both gold and silver are money,
although both have been politically demonetised. That demonetisation,
and the devaluation it causes, has encouraged lower order uses
of both metals, in jewellery, for instance. However, periodically
the metals' monetary character reasserts itself, and the old
monetary ratio reappears.
THE PHYSICAL
GOLD/SILVER RATIO
I have seen wildly differing estimates of the physical occurrence
of gold and silver in the earth's crust. What difference does
it make? It's a fair guess that one factor determining the gold/silver
value ratio is the physical ratio in the earth's
crust. Over the years I have found that ratio of given as low
as 10:1 and as high as 40:1, but usually at 12:1. I asked a mining
engineer, and he turned up definitive data.
According to AGI Data Sheet 57.1, "Abundance of Elements,"
on average silver occurs at 0.07 parts per million, and gold
at 0.004 parts per million in the earth's crust. Thus the naturally
occurring ratio is 17.5:1. Interesting - that's not far
from the last monetary ratio - 16:1 -- set when
both gold and silver were still universal money in the last century.
Nor can I forget that when the great Bunker Hunt was investing
in silver back in the 1970s he was often heard to say he expected
the ratio to fall to 5:1. Never forget, either, that year by
year industry consumes silver, while most of the gold
ever mined still sits in a vault (or hangs around a neck) someplace.
For 100 years and more that industrial consumption has put steady
downward pressure on the ratio.
ANCIENT RATIOS
Now consider the ratio's behaviour before it first broke through
its ancient boundary at 16:1. If you had a chart 45 feet long
where every foot represented one century of history, the ratio
of gold to silver would never rise above 16 to one until the
last fifteen inches. It ranged from a low of 2.5 to 1 to
a high of 16:1, and never rose above 12:1 until after 1500. (The
ratio's jump above 13:1 after 1500 stemmed from massive silver
supplies from the Spanish mines in the Western Hemisphere. The
backbone of North and South America, the Cordilleran mountain
range, holds the world's richest silver deposits.) For most of
human history, a band from 8:1 to 12:1 has contained the ratio.
What drove silver above 16 to 1? It was politically demonetised
beginning in 1873 and ending in the late 1930s when Roosevelt's
silver manipulations forced China off the silver standard. Removing
all that monetary demand for silver naturally made it lose value
against gold, and rising industrial demand could not yet soak
up the excess supply. From 1873 until 1941 the ratio rose until
it hit 100:1 for the first time in history. With numerous zigs
and zags, the ratio hit a low in 1980 below 16:1.
I know. I saw it. (On a yearly average basis, the post-1941 lows
were 16.97 in 1967 and 14.07 in 1979).
From that January
1980 low the ratio climbed back to 100 to 1 in February, 1991.
It continued on a steady downward path until January, 1998 when
it touched under 40:1. From there it has risen to 76.4 to one,
and right now the ratio appears to be peaking, ready to roll
over and turn down. It seems that the long term trend from 1991
is down, and the upmove from 1998 has been only a correction
of that primary downward trend, which should resume when the
present correction ends.
REFINEMENTS OF THE RATIO
Understanding the gold/silver ratio makes possible very profitable
arbitrage refinements to our investment strategy.
First, we time our purchases by the ratio. When the ratio
is relatively high, we favour silver in new purchases. When the
ratio is relatively low, we favour gold.
Second, we buy that form of silver that offers a possibility
of extra profit. When the silver market gets hot, new investors
will be buying US 90% silver coin. That drives up the premium
to 30 or 40% above the silver value. At that point we can swap
90% coin for one ounce rounds or 100 ounce bars, and convert
that premium to extra ounces of silver.
Third, we play the ratio. When the ratio is high, we swap
gold for silver. Then when the ratio drops, we swap silver back
into gold. From the present 76:1, I am looking to make our next
swap from silver to gold below 40:1. Every time we cycle through
a complete swap - gold to silver and back to gold - we increase
our ounces.
These ratio refinements certainly beat the alternative strategy:
sitting still with a sterile investment, waiting for the price
to rise.
RATIO TRADING BENEFITS & DRAWBACKS
Our strategy is to buy silver with gold when silver is cheap,
and then reverse the trade, buying gold with silver, when gold
becomes cheap in terms of silver. We swap, for example ten ounces
of gold for silver when one gold ounce buys 80 silver ounces
(the ratio is 80:1). Then when the ratio drops to 40 to one (40
ounces of silver buys one ounce of gold), we swap back our 80
silver ounces for 20 ounces of gold, doubling our holdings.
DRAWBACKS
1. Tax consequences.
If you have a profit in any gold that you sell and you file income
tax returns, you will have to claim the gain on the gold because
gold for silver does not qualify as a "like kind" exchange."
2. Storage. It takes 80 times as much room to store your
silver.
3. Market risk. I could be wrong. The ratio could go higher
still, even back to 100, and you would just have to wait that
much longer.
4. Transaction costs. Transaction costs (shipping, spreads,
and commission) can be as high as 10%, although they should be
somewhat lower. You have to hold the trade long enough to justify
the transaction costs, and the transaction costs of trading physical
gold and silver is higher than trading some sort of paper like
futures or options. (To keep your costs low, I only charge commission
on one side of the trade. If your dealer won't do that,
find one who will.)
BENEFITS
1. Growth. It takes an investment that pays no dividends
and no interest (gold) and makes it grow by increasing the number
of ounces you hold.
2. Potential outperformance. In the last great precious
metals bull market, 1960 - 1980, silver outperformed gold about
2.3 times (230%). Gold rose from $35 to $850 or 2,429%. Silver
rose from 90 cents to $50, or 5,555%, 2.29 times as fast. Silver
is a smaller and therefore much more volatile market, and repeated
this outperformance several times between 1941 and 1980. The
200 year mean for the ratio is 31.3:1, so if the ratio just reverts
to its historic mean without overshooting it (as in 1980), it
will outperform gold over two times.
3. Precious metals. You never step out of your position
in precious metals. You are invested in gold or silver at all
times.
Never skew your portfolio more than 70% to silver. That is, at
current market value you should never have more than 70% of your
total investment in silver. Keep the other 30% in gold. Always
take delivery of your physical metal. Never leave silver
in storage with any dealer.
THE RIGHT SIDE OF THE RATIO
Fair warning:
I am
not a prophet. If I am wrong about gold/silver ratio, it will
cost you money. You'll buy silver instead of gold and the gold
will outpace the silver.
For all the reasons listed above, however, I don't
think that will happen. I think the best way to profit in
the next years will be to slant your precious metals portfolio
toward silver, using a ratio trading strategy to increase your
gains.
I could be wrong - but I've got 4,500 years of history on
my side.
Copyright ©2003
The Moneychanger
March 2003
--
F. Sanders
email: moneychanger@compuserve.com
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website: www.the-moneychanger.com.
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