Using the Gold to Silver Ratio to Determine Precious Metals' Outlook

by: Irfan Chaudhry
The gold silver ratio shows the dramatic fashion in which silver has been outperforming gold since last August. The gold silver ratio is calculated by dividing the price of gold by the price of silver. The declining gold silver ratio indicates that silver has been outperforming gold. The gold silver ratio has declined from 65 last summer to a current level of 40. Since August 2010 gold has moved up 22% from the $1,175 level while silver has soared 92% from the $18 range.
Does the declining gold silver ratio indicate that silver prices are due for a correction (at the inflecting point of 40) or is this fundamental change in the price relationship? How low the ratio can go? At what point in the business cycle the ratio will inflect? What are investing implications? If we are able to project gold to silver ratio rightly and correlate it to other asset classes, it may give us some valuable clues about possible price action for other asset classes. Since ancient times, it has typically taken 16 ounces of silver to purchase one ounce of gold. Interestingly, the earth's reserves of silver exceed that of gold by roughly 16 times. If this ultra long term relationship were to reassert itself, silver would sell for approximately $90 per ounce based on the current price of gold.
Silver and gold prices had started gaining a bit of safe haven steam as protests in Middle East heated up. Initially, at the start of the 2011, the threat of China draining global liquidity pushed gold and silver prices down sharply. Shortly after though, speculation that the interest-rate hike might fuel concerns over rising global inflation saw precious metals reverse direction, posting some remarkable gains. The gold price crossed the previous intraday high US$1432. Silver has yet to reach its past high of $50 an ounce, leaving a lot more space for the metal to move. Silver prices rose hitting YTD highs above $35.50 per ounce
The gold/silver ratio at 40.2 is also lower than the 46 at the start of the February 2011 -- typically, the lower the ratio, the higher the silver price and vice versa. Silver is a more speculative play that is tied to more positive economic correlation. That is, Silver is much more correlated to positive economic activity (where we have sustainable growth in commodities as fuel for productive economic endeavors). This optimism typically occurs during times of leverage and liquidity.
Gold is much more of safe haven precious metal. Its moves are a lot less spiky than Silver's. Gold is a safe haven move in times of crisis. Investors often go to physical gold or to funds that have claims on physical gold. Silver, however, is a different animal. Silver is another monetary metal, yet it has a very wide range of industrial uses. As such it straddles the line between a currency and a commodity.
However Silver has some very interesting facts: For a long time it was not recycled (unlike gold which has been recycled for a long time in industrial applications). This is not true anymore- it is being recycled more now, but there are still many applications where it is not due to economic non-viability. As such, a large portion of silver is literally sitting in landfills. But because there is still so much industrial demand, the amount of silver sitting in vaults as a monetary metal is lower than the amount of gold. This makes Silver a bit of a conundrum at times.
Yet the current above-ground warehousing of Gold far exceeds Silver. Only around 100 million ounces of Silver is being warehoused, which is roughly 3 months worth of global mine production. The makes Silver susceptible to demand drive spikes. The GSR seems low and at near one of the extreme ends but still has room to run down to 35 and possibly 30 as we expect Silver to outshine gold through liquidity driven slow growth.
Silver will vastly outperform gold, and we expect the GSR to plummet to 35 or even to 30 or less. At the least I think Silver will lead the next phase of the cycle and outperform Gold. So, Silver will outperform for coming month or so and Gold will outperform after that. Silver will outperform again in 2012. If there are no manifest inflation and social unrest then Gold (at US$1435) will be flat (as risks may still linger) and we are bullish Silver (at US$35). However, if the inflation increases faster than expected and results in the social unrest in the parts of the emerging markets, Gold will vastly outperform Silver.
If the Middle East crisis is not resolved quickly or/and rising crude oil price triggers a new recession, Gold may be a safe haven in view of few policy choices and the GSR could challenge the 60 level again. In that case, gold will probably be putting on another +15% move at that time with a flat/decline in Silver (as demand for monetary metal heightens, expect Silver to behave like a commodity). However, even in that case, ratio may reverse by the end of end of 2011.
Due to scant warehouse supply of Silver, expect demand to skyrocket by the third quarter of 2011. Silver demand will increase dramatically in the coming years. In summary, the two favored scenarios in the current precious metals market according to our unique reconsideration analysis of gold/silver prices and ratios are that silver will outperform gold by in coming few months and then will underperform till end of 2011. One may wish to consider the investment implications and portfolio allocation factors resulting from such a conclusion derived from the foregoing analysis — but not before also evaluating the possibility that the strong recent advance in silver prices will simply resume in short order and thereby provide impetus to a substantial further decline in the gold/silver ratio.
The gold-silver ratio represents the number of silver ounces bought by a single ounce of gold. Currently the ratio floats, as gold and silver are valued daily by market forces, but this wasn't always the case. The ratio has been permanently set at different times in history - and in different places - by governments seeking monetary stability. The ratio was fixed at 12.5 in 323 B.C at the time of death of Alexander the Great and stayed at around 12 during Roman times. By the end of 19th Century, when the age of bi-metallism came to an end, the ratio stood fixed almost universally at 15: 1.
In the 1930's and 1940's the ratio reached 90:1. In 1980 – at the time of the last great surge in gold and silver, the ratio stood at 17. It peaked at around 100 in 1991 when silver price hit its lows. During the 4 years leading up to great recession of 2008, silver averaged a ratio of 57, touching a low of 32 in 2005 (Ratio averaged 51 in 2007, 65 in 2008 and 70 in 2009). The ratio fell down to 41.2 on Friday’s trading which may be the case for a reversal of the ratio. Current momentum in silver is forcing the Gold/Silver Ratio below major support at 46.00. Gold to silver ratio is falling as the silver price rises faster than gold, the ratio of gold prices to silver and next support at the 2006 low of 44.00 followed by 1998 low of 39.00. This implies a gold price declining to the level of US$1320 / Oz by the end of year, whereas silver price at US$42 /oz (+30% from current level).
Extremes and Mean Reverting Levels: Mean reversion analysis of the ratio show a strong mean reversion of the time series with an R2 of 82%, F value of 363 with a level of 62 against the current of 70 and possibly to pre crisis level of 55. Incidentally, the miners will often report equivalent numbers. A primary silver miner will take its byproduct gold production and convert it into silver ounces using the cash equivalent. A primary gold miner will do the opposite, converting its byproduct silver into the cash equivalent of gold ounces.
In countless SEC reports I’ve waded through of gold and silver miners, this 55 ratio is usually the number they all use for equivalent calculations. It is well-established. Despite the fact that this 55 average held nicely, the ratio went down to level below 40 in 5 of last six expansions in business cycles. We believe that despite breaking the near most level of 46, the ratio has some way to go to test next level at 39.
Over recent years, the variance in the SGR has actually decreased considerably as you can see above in the tightening wedge. It seems that an SGR near 55 is far more normal for late expansion part of the bull market than at the current level. The ratio may slide down to 32 and possibly 30 at the current boundary of early and late expansion. In a rising interest rate and high inventories environment in a late cycle, gold will be slide down but silver will be driven by shortages which will keep downward pressure on the ratio. In a recession or crisis, speculators may flee everything including silver, and its price may plunge far more than gold’s. This will drive the SGR back to the upper part of its oscillation.
Long Term Production Based Optimum Ratio: The “optimum gold/silver ratio” is an interesting question, because in prior centuries the ratio was based on both being monetary metals. The two metals previously had little practical day to day use for common people (accept monetary), and they functioned mostly as status symbols of wealth and power for the privileged. All that changed with the industrial revolution, when silver slowly started playing an essential role in technology. Today’s gold/silver ratio is based on gold being primarily a monetary metal, and silver being primarily an industrial metal, thus making the gold/silver ratio very unstable. The earth currently yields about 80 million ounces of gold per year, and about 650 million ounces of silver per year.
These figures are in the same ballpark with total planetary production of the two metals from the dawn of recorded history, which are about 4.5 billion ounces of gold and 44 billion ounces of silver. So, global silver/gold production ratios have drifted somewhere between 8:1 and 11:1. About 2500 years ago, the silver/gold price ratio started off near 10:1 (which makes sense), and slowly edged up to about 16:1 by the 1860’s, where it was currently fixed by the US Government. However, the gold/silver ratio destabilized in the mid 1860’s, triggered by fiat currency creation used to finance the American Civil War, and the ratio has since been all over the map in the last 140 years, ranging as high as 100:1.
The gold/silver ratio never regained stability, possibly due to the massive silver discoveries in the American west, and the advent of technological uses for silver including photography, which started silver’s shift away from a monetary metal and towards an industrial metal. This instability caused silver to be widely demonetized starting about 100 years ago, because silver could no longer work together with gold to form a stable monetary base. For example, prior to 1900 the US dollar was defined as 3/4 ounce of silver, and after 1900 the US dollar was defined as 1/20 ounce of gold. (And of course, in 1933 the US dollar was totally redefined by the Parker Brothers, with the Monopoly board game actually being patented in 1935. Annual silver demand has exceeded annual planetary production for many of the past 50 years. Until the last 2-3 years, monetary silver investment has been less than zero, due to silver coin melting and other recycling making up the industrial deficit. Yet, the shortfall is unsustainable at current silver prices, because silver in electronics often cannot be recycled economically, so it is simply thrown away. Also, every time the US military explodes a smart bomb, 100’s of ounces of silver are vaporized. Vast stockpiles of silver accumulated over many centuries have now been “consumed” in the last few decades, and it is unclear how much is left. For example, after World War II ended the US Government had stockpiled billions of ounces of silver. As of 2002, this stockpile is completely gone, as are all other official world government stockpiles. In many expert opinions, at least 80% of all silver mined in history is now gone, unrecoverable by any means, while at least 80% of all gold probably remains. So, the current ratio of existing silver to existing gold is probably more like 5:1, and not 10:1. On top of this, most of the remaining silver exists in things like jewelry, silverware, or coins. Therefore, in regards to world bullion stockpiles the 5:1 ratio is flipped, with gold bullion actually being around 5 times more plentiful than silver bullion. So, we now have a price ratio of 39:1, but an availability ratio at current prices of 1:5. In this light, remember that silver (not gold) is the metal that is indispensable for modern society.
Good Value Or Not?: From the chart we can see that the gold:silver ratio has provided a reliable buy signal for gold every time it has touched the 40:1 ratio since 1997. The 1997 signal was premature but you weren’t buying gold too far off its historic lows and all four signals since then have marked excellent buy points. Since we’re currently seeing gold: silver ratio at the 40:1 level, history suggests that 40:1 level to pinpoint a good buying point for gold. Interestingly, 200 days moving averages gold to silver ratio is 42.
Using silver as a ‘base’: If silver were to fall to the $23.7 level (its 200-week moving average) then 60 X 23.71 = $1625/oz gold.
Using gold as a ‘base’: If gold were to fall to the $1370 level (its 50-week moving average) then we’re looking at $27 for silver from mean reverting level of 55. If gold falls to US$1320 level, and GSR ratio stays around 32, which is its near term target, the silver price may be at US$41.25 per ounce – which seems more realistic if crude oil price does not break the ceiling and inflation does not rear its head with accompanying social unrest.
However, if inflation starts rising above expectations and there are near term interest rate hikes whereas social unrest is contained, gold may plummet to $1050 (its 200 week moving average). Then 1050/32 gives us $32.20 for silver. In the case where there is widespread social unrest and rising commodity prices bring on another recession, the gold price may rise to US$1700 per ounce. In that case, the GSR may be higher towards the level of 50, which implies a silver price of US$34. I personally don’t think we’ll see a gold price that low in 2011. Again, this implies that silver won’t correct much at all even as the gold price takes a whack.
However, the “magic” gold to silver level of 55 does give us some kind of objective number to consider when buying either metal. I suggest keeping this ratio as well as the metals’ 50/200 week moving averages in mind for future buy/sell decisions.

How to Trade the Gold-Silver Ratio

The essence of trading the gold-silver ratio is to switch holdings when the ratio swings to historically determined "extremes."

  • When the ratio contracted to an opposite historical "extreme" of, say, 50, the trader would switch the trade.
  • In the case of devaluation, deflation, currency replacement - the strategy makes sense. Precious metals have a proven record of maintaining their value in the face of any contingency that might threaten the worth of fiat currency which may be the case today.
Drivers of the Ratio:
  1. Economic recovery - Negatively
  2. Fiat currency fears - Positively
  3. Inflation fears - Positively
  4. Industrial production – Negatively
  5. Political Fears - positively

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.