Guest Post: The Gold-Silver Ratio – Another Look

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Submitted by Andrey Dashkov of Casey Research

The Gold-Silver Ratio – Another Look

The gold-silver ratio (GSR) measures how many ounces of silver one can purchase for an ounce of gold, on a certain date.

Reference
to the ratio has a long history. One of the first mentions was that
upon the death of Alexander the Great, the ratio was 12.5 to 1. During
the Roman Empire, the ratio was set at 12. By the late 19th century, the
ratio had risen to 15.

Interestingly, these historical ratios
roughly reflect geologists’ estimates that silver is 17 times more
abundant than gold in the earth’s crust. This gives many investors a
reason to believe that 17 is the natural balance between these elements,
and that eventually the GSR will return to it.

Monitoring the GSR
is quite popular among gold and silver investors. It seems that
whenever it makes a big move, many start drawing conclusions about the
direction of the prices of its underlying metals.

Here at Casey
Research, we stick to the dictum that the GSR “suggests a lot but proves
nothing.” Indeed, the GSR is determined by the price action of gold and
silver; the price action of gold and silver is not determined by the
GSR. Rather, each metal’s price is influenced by various fundamental
factors. What complicates any analysis of interactions between gold and
silver prices is that the two metals have different markets, each with
peculiar supply and demand structures.

Briefly reviewed, the gold
market is characterized by a large above-ground supply as the vast
majority of gold ever mined still exists in refined form, and annual
mine supply represents only a small fraction of that volume. Demand is
mostly for jewelry and investment. Gold is not widely used for
industrial purposes.

Silver demand, by contrast, is mainly for
industrial fabrication of things like electronics and batteries. The
metal is consumed during the process and removed from above-ground
stocks. The other major areas of demand are jewelry, investment,
photography, coins and household silver, in that order. Supply comes
mainly from mining and scrap recycling.

From this picture comes
one conclusion: over time, supply and demand for the two metals has been
fluctuating in response to industrial and technological advancements,
shifts in monetary systems and market turbulence. Today, as investment
and jewelry are the primary sources of gold demand and most of the
silver goes into industrial and related applications, it is no surprise
that the gold-silver ratio is different than the historical average of
17. The following chart shows how the ratio has fluctuated since 1968.

The GSR was extremely volatile over the past five decades and averaged
53.5 from 1968 to April 2011; during the last ten years (since April 2,
2001), the ratio averaged 61.8.

The ratio has been falling for
several months, however, as shown on the chart above.
Counterintuitively, however, rumors that a low GSR signals undervalued
silver started spreading. We say counterintuitively here since it is
unclear why a falling GSR should signal undervaluation after silver
gained over 80% within a year. Appeals to the mega-long-term GSR of 17
alone do not seem to provide enough basis to think that silver will
continue to soar indefinitely.

As of April 1, the GSR stands at
37.7. We, however, do not think that it is going to fall to 20 or 15
from this point: history shows that high volatility is the ratio’s
essence. After a plunge, there usually follows a rapid surge. That
happened in 1980 when gold reached its inflation-adjusted peak, and in
1987 and 1997. We don’t know how steep the current plunge in the ratio
will be, of course, but using history as a guide, we do not expect the
ratio to continue its decline for much longer.

Uncertainty about
the economic recovery in the Western world and the growth of developing
countries can result in slowing industrial output and hence falling
demand for silver that would hinder the price. These conditions also
create a favorable environment for gold driven by safe-haven demand. In
such circumstances, the ratio may climb.

History shows that the
GSR tends to rise significantly during a recession and create an interim
peak on the way. See the chart below.

We
believe that the measures taken by the current administration to battle
the recession are largely counterproductive, temporary, and will be
unable to prevent the onset of another major economic decline. It is
difficult to judge when the turmoil might start, but the odds of it
happening soon get higher as the levels of government debt increase and
the dollar is debased. When push comes to shove, the GSR can react
quickly and create a fluctuation of an unpredictable magnitude.

In
times of recession, as we discussed above, gold and silver behave in a
quite different manner. Have a look at the following charts.

Note
that it is not quite statistically sound to plot a ratio against one of
its components, but for the purpose of illustration we find it quite
useful.

As you can see, in 1980 gold and silver both peaked on a
historically low GSR. This may imply that a low ratio can take place not
only when silver appreciates faster than gold (as it did in 2010 and so
far in 2011), but also when fundamental and speculative conditions
influence both metals. Of course, the 1980 silver peak happened while
the infamous Hunt brothers were massively accumulating the metal.

Conventional
opinion attributes silver’s rise to the Hunts, but we are skeptical. It
cannot be determined to what degree the metal would have otherwise
risen absent the Hunts in the market. In any case, attempts to influence
markets are nothing new – today, major investment banks are accused of
manipulating the silver market by holding huge short positions that
cause artificial price suppression.

Returning to the charts and
how gold and silver behaved in the last recession, we can see that
silver moved counter to the GSR while gold moved in a mixed, sideways
pattern. Because of this, many see a lot of upside potential for silver,
but we should not forget that silver is the denominator in the ratio.
So absent strong fluctuations in gold – and gold was on an ascent since
the beginning of 2009 – the GSR would to some extent simply mirror
silver price movements.

The silver price was also influenced by
hopes that the global economy is reviving and that industrial demand is
going to last. In 2010, silver gained more than 80% while gold added
less than 30%. The difference resulted in the GSR falling throughout
2010. Will that performance be repeated? We cannot say. Speculators
should remember that the GSR is merely a ratio of two prices often
driven by different forces. It has limited, if any, predictive power.

With
that in mind, we will finish by juxtaposing the ratio against the
Toronto Venture Exchange (TSX-V) index, and it reveals an interesting
picture: it seems that the TSX-V has been negatively correlated with the
ratio for the last ten years. Again, statistically it’s arguable if a
ratio should be compared to an index, but looking at various
combinations of time series, and the stunning correlation, we couldn’t
help ourselves.

It
would be easy to conclude that there is a strong – and negative –
correlation between the index and the ratio. However, this correlation
does not provide any sort of guidance on whether the metals themselves
look expensive or not, or where mining stocks are headed. An interesting
image, that’s all it is.

Conclusion

The
gold-silver ratio attracts a lot of attention nowadays, but it is not a
reliable tool in an investor’s toolbox, and we don’t think it can
predict future price movements. But the reality is that nothing does.
Those who look at GSR charts, including ours above, should not forget to
analyze all the fundamentals behind the price movements of both gold
and silver. We advise you to be extremely cautious and not get caught in
the trap of believing that a single number or ratio, or a set of them,
can provide you with a crystal ball.

Identifying an opportunity
for future profit based on facts and a reasonable amount of risk is
another thing. This is what we do day in and day out – just not based on
the GSR.