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?
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
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.1
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
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.2 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 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.
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.
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.
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
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.
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
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.
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.3
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.
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.
OF THE RATIO
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.
refinements certainly beat the alternative strategy: sitting still with a
sterile investment, waiting for the price to rise.
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.
- 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."
- Storage. It takes
80 times as much room to store your silver.
- 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.
- 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.)
- 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.
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.
- 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.
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.
with permission from The Moneychanger. Franklin Sanders lives on a farm in Middle
Tennessee by choice, deals in physical gold & silver, and has been
writing and publishing The Moneychanger for nearly 26 years. In 1993 he wrote
Silver Bonanza for Jim Blanchard. Last year he published "Why
Silver Will Outperform Gold 400% and & The Professional Trading Secrets
That Will Make the Most of Your Silver & Gold Investments," still
available at www.the-moneychanger.com/order/publications.phtml.
You can sign up for Mr. Sanders' free daily e-mail
commentary on gold & silver at www.the-moneychanger.com, and download your free portfolio calculator to
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