The gold-to-silver price ratio measures the relative price differential between the two metals. Some investors theorize that there is an appropriate ratio and that deviations from the ratio can be used to identify mispricing. Usually investors use a historical average ratio and estimate mispricing based on a return to the mean. Unfortunately, most investors don't realize the complexities that go into using this ratio as a yardstick for valuation.
For starters, throughout history, the long-term gold-to-silver price ratio has ranged anywhere from 10-100, and the further back you go the lower the ratio seems to be. Investors often hear gold-to-silver price ratios quoted in the media, with little regard for the time period from which those ratios were taken.
This article attempts to split historical price data into three distinct periods to help investors determine if gold is underpriced relative to silver (or vice versa). Currently the gold-to-silver price ratio stands at 43.64.
1. The Days of Old (i.e. Days of Bi-Metalism)
Periods of bi-metalism are distinct because they are times when the state supports convertibility of paper money into both gold and silver at a pre-determined ratio. In America, this ratio was around 15. Some have argued that the 10-15 range for the gold-to-silver price ratio is the natural range for bi-metalism monetary regimes since the ratio is bound by the physical fundamentals of the metals, with gold supposedly being 10-15 times as scarce as silver. (Perhaps a geologist out there can confirm this.)
Result: Using Friday's gold close of $1852/oz, a return to the average midpoint ratio of 12.5 suggests silver should be trading at $148/oz, which is 249% higher than silver's Friday close. On the other hand, it could mean that gold is overvalued and should really be trading at $530/oz.
Conclusion: Silver may be underpriced relative to gold.
2. All Encompassing (Data from 1840 - August 19, 2011)
This data includes periods of bi-metalism standards, gold standards and fiat currency systems. The first chart below shows the range of ratios dating back to 1840, and it is apparent that the variation is quite wide. By using all-encompassing data, the variation in the gold-to-silver price ratio created by different monetary regimes can arguably be averaged out.
Result: A return to the long-run average gold-to-silver price ratio from 1840-present (50.56) suggests silver should be trading at $36.63. Looking at the ratio from the opposite direction, the ratio could indicate that gold should be trading at $2138/oz.
Conclusion: Silver might be overpriced relative to gold.
3. Modern Day (Post-1971 Gold Standard Abandonment)
In 1971 Richard Nixon abandoned the gold standard. From this point on both gold and silver prices were totally determined by free-market forces. The second chart below illustrates the ratio during this period, and it is clear that the ratio is currently below its average.
Result: The average gold-to-silver price ratio since 1971 is 57.89. A return to this average ratio indicates that silver should be trading at $31.99/oz or gold should be trading at $2456/oz.
Conclusion: Silver might be overpriced relative to gold.
click to enlarge images
So here's my question for investors: What is the right ratio?
Are the higher ratios of fiat-money regimes appropriate? Or are the lower ratios of bi-metalism periods the right measure?
Disclosure: I am long gold and silver.
