In my last article, I explored whether there was a correlation between gold and silver and the characteristics that silver possesses as both an industrial and precious metal. This led me to conclude that in the current economic and political environment silver is a superior investment to gold.
But I do not like relying solely on fundamentals to draw conclusions as to what makes a good investment, especially in volatile and unpredictable markets where heuristics and sentiment dominate.
As a result, here I will take a closer look at what the gold-to-silver ratio is telling us and what it means for silver (NYSEARCA:SLV). I realize that the ratio is considered to be a somewhat arcane and esoteric metric by some but it does help to establish a relative valuation and whether silver is overvalued or undervalued.
Understanding the gold-to-silver ratio
The relationship between gold (NYSEARCA:GLD)(NYSEARCA:IAU) and silver is reflected in the gold-to-silver ratio which measures how many ounces of silver are required to buy one ounce of gold. By doing this it gives investors an idea as to when to buy silver in preference to gold. When the ratio is high, it indicates that silver is undervalued relative to gold and the opposite when it is low.
The ratio has gyrated wildly in recent times.
When silver hits its lows in 1991 the ratio stood at 100 ounces of silver for one ounce of gold. At the height of the precious metals bull market, 44 ounces of silver was needed to buy one ounce of gold but by February 2016 it had widened to stand at 81 ounces of silver for one ounce of gold. This came as gold and silver plumbed new lows with silver plunging to under $14 per ounce.
By the time of the post-Brexit precious metals rally, the ratio had closed to 66 ounces of silver for one ounce of gold. Since then the ratio has widened again with gold and silver both giving back the gains made during that rally. At the time of writing with gold trading at $1,227.54 per ounce and silver at $17 per ounce the ratio stands at 72, as shown by the chart below.
Source: World Gold Council and The Silver Institute.
The wider ratio indicates that silver is undervalued relative to gold, making it a better precious metals investment at this time.
Silver is heavily undervalued
While the current ratio is not the highest that it has hit this year, it is sharply disconnected from historical averages. This becomes clear when considering that for the period charted, February 1990 to November 2016, the mean and median ratios are 66. If the average and median ratios are then calculated over the last 50 years they fall to 55 and 57 respectively, both of which are significantly lower than the current ratio.
Furthermore, over the last 100 years the ratio has averaged between 50 to 60, highlighting just how far the ratio has deviated from its historical average at this time.
This can mean one of two things, either gold will continue to fall giving back more of its post-Brexit gains or silver will appreciate in value.
My bet is on silver appreciating in value.
You see, gold would need to plunge by 24% to around $938 per ounce for the ratio to move back to its historical average, meaning it would fall below the psychologically important $1,000 per ounce barrier. Even with signs that precious metals have fallen into disfavor in a market that expects a Trump presidency to stimulate economic growth this appears improbable.
All Trump and his policy machine have done is create unrealistic expectations and added considerable volatility and uncertainty to financial markets and the global economy.
The U.S. economy while performing well on paper is not as healthy as it appears. Consumer confidence and consumption remains low while under-employment is rising with employment growth predominantly coming from part-time and minimum wage jobs. Meanwhile, real wage growth for the average American remains negative and until this issue is remedied it will keep a lid on consumption.
All of this is occurring in a world still filled with a wide range of economic and political fissures. These include the economic and political crises playing out in the E.U. and growing uncertainty over whether China can sustain its credit fueled economic stimulus.
All this uncertainty will support the price of gold, preventing it from falling sharply over coming months, although it will soften further until the current round of optimism wears-off. This means that for the gold-to-silver ratio to move closer to its historical averages the price of silver must rise. At current prices this means silver would need to appreciate by just over 30% to reach the historical average of 55. While I don't expect silver to surge by 30% for the foreseeable future it is probable that it will test the $20 per ounce mark in coming months.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I/we have extensive investments in physical gold and silver bullion as well as collectible antique gold and silver coins.