The Gold/Silver Ratio Recently Broke A 5,000-Year-Old Record

Summary

• The gold/silver ratio broke through its former all-time high last month.
• The gold/silver ratio is arguably the longest-running price series in financial history: some 5,000 years.
• What factors impact the gold/silver ratio, and what are the main implications for investors?

Written on Sunday, April 5, 2020. All prices mentioned in the article are as of the same date, unless stated otherwise.

Students of economic history will no doubt have been fascinated to see the gold/silver ratio increase to over 125 to 1 on March 18, 2020, meaningfully above its former all-time high. This is especially the case as the term 'all-time high' shouldn't be taken lightly, since the gold/silver ratio is arguably the longest-running price series in financial history: some 5,000 years.

This article aims to i) provide a bit of useful historical background, ii) briefly sum up the case for precious metals, iii) consider why the gold/silver ratio is making new highs, and iv) highlight the main implications for investors.

Historical background

Before we get into it, please bear with us as we remind ourselves of a number of key historical milestones for a bit of context and much-needed perspective.

• c. 13.5 billion years ago: Matter and energy appear. Beginning of physics and chemistry.
• c. 4.5 billion years ago: Formation of planet earth.
• c. 3.8 billion years ago: Emergence of organisms. Beginning of biology.
• c. 2.5 million years ago: Evolution of the genus Homo in Africa.
• c. 200,000 years ago: Evolution of Homo sapiens in East Africa.
• c. 70,000 years ago: The Cognitive Revolution and the emergence of language.
• c. 12,000 years ago: The Agricultural Revolution.
• c. 500 years ago: The Scientific Revolution.
• c. 250 years ago: The Industrial Revolution.
• c. 50 years ago: The Information Revolution.
• Now: The Biotechnological Revolution.

Source: Adapted from Harari: Sapiens - A Brief History of Humankind (2011)

Perhaps more relevant to our discussion, let us highlight a few key milestones relating to the history of money:

• Entire prehistory: Barter as a means of exchange.
• c. 5,000 years ago: Emergence of 'commodity money,' including gold and silver.
• c. 2,700 years ago: Emergence of minted gold and silver coinage.
• c. 700 BC to mid-1800s: Bimetallic standard.
• Mid-1800s to 1914: Gold standard.
• 1922-1971: Gold-exchange standard(s).
• 1971 to present: Irredeemable fiat currency standard.

It is also worth remembering the reasons why the broad-based and voluntary adherence to gold and silver as the most suitable form of money occurred. This is best summed up by this 1-min. video, which is an extract of Real Vision's 2018 documentary on gold.

In short, precious metals like gold and silver were - and arguably remain - the most suitable of elements to serve as commodity money because of their unique chemical properties relative to other elements.

The case for precious metals

We've written a number of SA articles in the past on the topic of precious metals, and gold specifically. Let us sum up the two main reasons why we consider precious metals as an integral part of our asset allocation.

1. Own a 'hard' currency as reserve

Call us sticklers, but for a portion of the savings that we hold in reserve for various reasons, we actually care about currencies fulfilling their central functions as money. These are to act as i) a store of value, ii) a unit of account, and iii) a medium of exchange.

By far the most important of these conditions is the first one: a store of value. This means that whatever we choose to use as money - be it gold, silver, or simply paper currency accepted as a legal tender of debts and backed by the faith and credit of a sovereign government - it must preserve its purchasing power over time. The phenomenon that hinders this from occurring is inflation, or the gradual depreciation of currency relative to the value of what it can purchase in the real economy. From the perspective of individual economic actors, this phenomenon is more easily observable as a persistent increase in the price of goods and services.

And let us remember that all irredeemable fiat currencies have a horrendous track record as a store of value. This should come as no surprise, given that most central banks are mandated to depreciate their currencies: i.e. price stability, typically referring to 2% inflation target p.a.!

Taking the USD as an example (although we could pick any other fiat currency), one can easily observe how inflation (as measured by the Consumer Price Index) has decreased the dollar's purchasing power over the last century: a decrease of over 96% between 1913 and 2019.

Gold and silver, on the other hand, have adequately acted as a store of value for centuries (with anecdotal evidence suggesting that it has done so for millennia). For those that understandably require more than just anecdotal evidence, the chart below displays monthly real gold and silver prices in USD between 1915 and April 1, 2020. In the case of silver, one can observe that more than 100 years into the chart, silver is basically flat from where it started. In other words, it has maintained its purchasing power (provided we believe the CPI to be an accurate measurement of inflation). Gold, on the other hand, has more than maintained its purchasing power. We come back to the possible reasons for that divergence later in this article.

Source: Oyat. Data obtained from MacroTrends.

2. Create a hedge against the frailties of the monetary and financial system

The second main reason for owning precious metals as part of an asset allocation is to create a hedge against a variety of what statisticians call 'extreme left-tail risks,' including those related to the frailties of the current monetary and financial system.

In that regard, gold (and silver to a lesser extent) represent an effective hedge as a result of two main trading characteristics: i) their price is negatively correlated to sharp declines in the price of risk assets such as equities, and ii) their price is largely uncorrelated to asset prices over market cycles, which enhances diversification.

First Eagle Investment Management sums this up nicely when it points out that:

Most economic crises are characterized by either inflation or deflation, [and] gold has the rare ability to maintain its real value in both these conditions.

Few of our readers will need reminding that such risks are very elevated as of today. Both deficit spending by governments and monetary inflation by central banks is running amok, and to make matters worse, we are now facing one of the most rapid and severe economic contractions ever witnessed.

Why is the gold/silver ratio making new highs?

Let's now get to the crux of the matter. Why does the ratio of gold to silver fluctuate over time, and why is it now making new all-time highs?

In essence, the gold/silver ratio indicates how much silver it takes to buy gold. When the ratio is high, it means silver is inexpensive relative to gold, and vice versa.

Here are a few milestones that remind us of the long-term history of the gold/silver ratio according to various monetary scholars:

• A ratio of 2.5 to 1 in Egypt under Menes (c. 3100 BC).
• A ratio of 6 to 1 in Mesopotamia under Hammurabi (c. 1750 BC).
• A ratio of 12.5 to 1 in Greece under Alexander the Great (c. 330 BC).
• A ratio of 12.5 to 1 in Rome under Augustus (c. 27 BC).
• A ratio of 15 to 1 in most of Europe throughout the Middle Ages.
• In 1792, Congress under President George Washington fixed the U.S. gold/silver ratio at 15 to 1.
• The geophysical availability of these two elements in the earth's crust puts the natural gold/silver ratio at 17.5 to 1 (silver at 0.07 ppm, gold at 0.004 ppm).

In short, one can observe that the gold/silver ratio has been on a structural upward trend since the very beginnings of money, but it remained below 20 to 1 until the late 19th century. It then shot up towards 40 to 1 at the beginning of the 20th century, and has since fluctuated quite significantly, as shown below. It reached over 125 to 1 on March 18th, before coming back to 111 to 1 by the end of the month.

Source: Oyat. Data obtained from MacroTrends.

So what are the main reasons why the gold/silver ratio fluctuates widely, and why is it so high as of today? In trying to understand the many factors that influence the price of gold and that of silver, it is useful to remember a number of key differences between these two metals:

1. Demand: Because of its electrical and thermal conductivity, ductility, malleability, and high sensitivity to light, silver is used extensively in a variety of products and applications, including solar panels, LED lighting, flexible displays, touch screens, cellular technology, and water purification. As a result, industrial usage of silver accounts for about 60% of its annual demand, versus only about 10% for gold (not accounting for jewelry demand). So while gold is almost entirely a precious metal, the price of silver is impacted by both demand for precious metals as well as industrial demand.
2. Supply: It is also important to note that according to the World Silver Survey 2019, only 26% of silver comes from mining activities where silver is the primary source of revenue. The remaining 74% comes from projects where silver is a by-product of mining other metals, such as lead and zinc, copper, and gold. This has implications about the price elasticity of silver's supply.
3. Durability and recyclability: Firstly, while gold is chemically inert (i.e., all of the gold that's ever been mined remains in existence), silver slowly corrodes over time. Furthermore, the economics of recovery and recycling are vastly different, resulting in a very limited amount of silver returning to the market through recycling, compared to gold.
4. Market size: It is also of crucial importance to understand that gold and silver are vastly different markets in size. While the total supply of new silver each year is over 1 billion ounces, annual gold supply is currently around 120 million ounces. But because of the vast difference in price, the market value of silver is only about USD 15 billion, versus nearly USD 200 billion for gold. In other words, the gold market is about 13x bigger than the silver market at today's prices. The main consequence of this is that the price of silver is a lot more volatile than the price of gold. It doesn't take large flows of capital to move the price of silver significantly. This is also the reason why many believe that the price of silver (and gold too) is easily manipulated by central and commercial banks. This is mainly done via derivatives markets, which are very large. For instance, the 'paper' market for silver is approx. 250 times larger than its physical counterpart. For gold, the ratio of the 'paper' to physical might be as high as 300x. according to some estimates. And for those that believe that manipulations of the price of gold and silver are just conspiracy theories, you should read this Forbes article (not exactly a 'radical' publication!).
5. Storage: At current prices, the same USD investment will get you 111x more ounces of silver than gold. Factor in the fact that gold is nearly 2x more dense than silver, and you end up needing over 200x more space to store the same USD amount of silver compared to gold.
6. Central banks: Last, central banks have massively reduced their silver holdings between the mid-1980s and the mid-2000s, and they have remained stable ever since. Conversely, many central banks have been rapidly accumulating gold over the past two decades, including China and Russia.

With so many different factors impacting the price of both gold and silver, it probably shouldn't surprise us that the gold/silver ratio can fluctuate widely over time. Some might even reasonably argue that it is a pretty useless indicator.

Yet, there is one factor that seems to correlate to the gold/silver ratio better than most, and that's inflation expectations. And by inflation we are referring to both monetary inflation and its impact on the general price level. This is the thesis expressed by Wheaton Precious Metals (WPM), which views the ratio as 'an indicator of the global monetary condition.' According to their analysis,"during periods of inflationary monetary proliferation, the ratio falls. During eras of deflationary monetary destruction, the ratio rises." This is also the observation of Marshall Gittler from BDSwiss Group when he writes that "the ratio tends to rise when inflation expectations fall," providing the following graph to illustrate his observation.

Source: BDSwiss Group

Implications for investors

Here is a summary of what we see as the main implications for a family office such as Oyat, concerning not only the current gold/silver ratio, but also today's broader investment landscape. Hopefully, this proves helpful to other investors as well.

In short, today's very elevated gold/silver ratio may indicate:

1. A pervasive shortage of 'real' capital (i.e., the categories listed at the very bottom of Exter's Pyramid)
2. That disinflation (i.e., a declining rate of positive inflation) or deflation (i.e., a negative rate of inflation) is still what lies ahead, despite the gigantic monetary and fiscal stimulus programs that have been announced worldwide.

Having said that, as inflation expectations increase following the massive stimulus that is currently being undertaken, which is a distinct possibility in our view, the gold/silver ratio could plunge substantially.

Therefore, we believe that:

• Despite a very rapid correction in the price of equities (and subsequent rebound), we believe that a balanced - yet decidedly defensive - positioning remains appropriate as of today.
• For us that means that precious metals should definitely play a substantial role in our asset allocation. As of today, our current precious metals allocation is close to its max. range, representing nearly 25% of liquid assets.
• We've always favored the physical metal, and have never owned any precious metal in 'paper' form. We urge investors to think long and hard about the merits (or lack thereof) of holding such financial instruments, and strongly suggest they keep a close eye on the growing signs of a breakdown between the 'paper' and physical precious metals markets.
• We complement our physical holdings with an allocation of precious metals mining and royalty/streaming companies, such as Franco-Nevada Corp.(FNV). Physical metal currently accounts for about 90% of our total exposure to precious metals.
• Thus far, we've focused exclusively on physical gold, and do not own any physical silver. In view of the current environment, including a high gold/silver ratio, we are assessing the merits of complementing our gold holdings with a small amount of physical silver.

Disclosure: I am/we are long PHYSICAL GOLD, FNV, NUMEROUS OTHER PRECIOUS METALS MINING COMPANIES. WE MAY INITIATE A POSITION IN PHYSICAL SILVER OVER 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.