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As gold enjoys the strongest bull market it has seen in a generation, many commentators have pointed to its secular climb upward via measures such as the Dow priced in gold and the accompanying ratio. The Dow/Gold ratio since 2000 clearly illustrates the strength and resiliency of precious metals this past decade and carries implications for the next few years for precious metal’s as a store of value through these uncertain times.

For those with a higher risk tolerance, there is another ratio that could provide useful insights. The gold/silver ratio points to silver as being undervalued when one considers its historic performance, but particularly during commodities/precious metal bull markets. Regardless of other factors, (including the alleged manipulation of silver) silver’s industrial uses and its current price relative to gold indicate silver could potentially offer more robust returns for the duration of the bull market in commodities. Knowing the history of this monetary ratio within the history of the U.S. is helpful in understanding its relevance today.

Silver is about 17.5 times more abundant than gold in the earth’s crust (.07 parts per million to .004 ppm, respectively, according to the U.S. Geological Survey). This ratio was recognized by civilizations as currency systems were developed over time. Thus, in 1792 the newly formed U.S. Congress passed the First Coinage Act. The Act officially established the Dollar as our currency, defining one Dollar as a weight of pure silver, 371.35 grains to be exact. A Quarter Eagle ($2.50), was defined as 61.875 grains of gold. The Act legally set the gold/silver ratio at 15.

In 1834, Congress passed the Second Coinage Act, slightly tweaking the gold/silver Ratio from 15 to 16. This better reflected market values at the time and drew it closer to the natural ratio. Things began to get interesting in 1858, when silver was discovered at Comstock Lode, Nevada. The resulting influx of ex-49er’s and subsequent discoveries (Eureka, Pioche, etc.) led to the proliferation of silver mining as an industry in the 1860’s.

Needless to say, this threatened to collapse the price of the metal. In response, the 1873 Fourth Coinage Act discontinued the minting of silver Dollars, and decreed that silver coins above $5 were no longer legal tender. Thus, the gold/silver ratio was allowed to rise. Silver advocates and miners for the next generation would refer to this statute as the “Crime of ’73.” The closest the U.S. came to reintroducing silver as a monetary metal was when William Jennings Bryan advocated bimetallism during his ultimately unsuccessful 1896 presidential campaign. Bryan argued that it would induce inflation and help indebted farmers along with the rest of working-class America, who had lived through a deflationary economy from 1873-96. The debate over this at the time was aptly summed up by the metaphor of the Yellow Brick Road in L. Frank Baum’s The Wonderful Wizard of Oz, originally published in 1900. It should be noted that in the original story, Dorothy’s slippers were silver, not ruby as was made indelible in the classic 1939 film version. Indeed, the name “Oz,” as in ounce, implied that bimetallism was the “golden road” to renewed prosperity (refer to Chart 1).

Chart 1: The Gold/Silver Ratio from 1900 – 2008

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In the early years of the 20th century, the ratio rose to the low 40’s but fell back into the teens during the Roaring Twenties. After Roosevelt confiscated gold from the American people in 1933 and devalued the U.S. Dollar by revaluing an ounce of gold from $20.67 to $35, the ratio nearly cracked 100 in 1939. After Bretton Woods, the ratio fell to around 20 amidst the economic prosperity of the postwar era until Nixon abandoned the Gold Standard in 1971. As the price of the yellow metal floated, gold outperformed silver until the fallout from the 1973 oil crisis, and then for the remainder of the decade silver outperformed gold as the ratio fell. Restrictions on the private ownership of gold were lifted in late 1974.

Meanwhile, in part due to the restrictions on gold ownership prior to 1974, the Hunt brothers began to buy large quantities of silver beginning in the early 1970s. Their buying spree culminated with a mega-spike in the price of silver in late 1979 and early 1980, when it became known that they were gradually cornering the market. The gold/silver ratio hit a bottom of 16 at this time. In response to this, the Comex introduced “Silver Rule 7” in early 1980. Steep restrictions were placed on leverage and the use of margin when buying commodities. Immediately, the price of silver began to fall, culminating in a 50% drop at the end of March. The heavily leveraged Hunts were wiped out, and silver continued to fall even faster than gold, which itself crashed from $850 to $600 in just three months (refer to Charts 2 and 3, note the activity in 1980). By May 1980 the ratio was back at 40.

Charts 2 and 3: The Gold/Silver Ratios 1970 – 2009

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For the duration of the decade and into the early 1990s, the ratio continued to rise because gold outperformed silver, but only because it did not lose as much of its value. While the ratio reverted back to its 20th century average by 2000, gold and silver did not bottom until 2001 and 2003, respectively. At that time, silver once again turned up and the ratio began to fall. This trend continued until the onset of the 2008 Financial Crisis. The 2007-2008 spike in the ratio provided a very attractive entry point for those who were in a position to take advantage of it.

This brings us to today (refer to Chart 4). The ratio spiked to over 80 in 2008, and was over 70 as recently as February, currently standing at 66.73 as of Friday’s close. The trajectory is downward, but is currently on an interim upswing. This creates a potential advantage for investors in 2010, as silver becomes more undervalued. As in 2008, it is a good opportunity to get in.

Of course, it’s not going to fall to its pre-1873 ratio of 15 or 16 anytime soon. Despite the historical and geological ratios, the ratio’s average was roughly in the range of 47-50 after the Industrial Revolution and throughout the 20th Century. The gold/silver ratio always falls during precious metal/commodities bull markets, so at the very least it makes sense that it would fall to its historical average.

However, a much lower ratio is not out of the question if the current bull market in commodities sustains for long enough. In the 1970s, ratio averaged between 20 and 40, falling below 20 during the final spike in early 1980. With the current trends, if precious metals stage another breakout in the second half of 2010, expect the ratio to fall below 60, and possibly break downward into the 50-55 range.

Chart 4: The Gold/Silver ratio May 2007 – Present

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Disclosure: No positions

Source: The Historical Gold / Silver Ratio and Why It's Time to Buy Silver