As you know, many investors and central banks the world over have been turning to precious metals in the past year to protect against inflation. While gold is enjoying the best bull run it has seen in a generation, its little brother silver is currently underpriced when one considers the historic gold/silver ratio. Additionally, given its additional uses as an industrial metal, along with a potential shortage lurking in the wings, silver potentially offers more robust returns for the duration of the bull market in commodities. Knowing the history of this monetary ratio in the United States is necessary to understand its relevance today.
Silver is about 17.5 times more abundant than gold in the earth’s crust (.07 parts per million to .004 ppm, respectively, according to the US Geological Survey). This ratio was recognized by civilizations as they developed currency systems over time. Thus, in 1792 the newly formed US Congress passed the First Coinage Act. The Act officially established the Dollar as our currency, defining one Dollar as a weight of pure silver, 371.35 grains to be exact. A Quarter Eagle ($2.50), was defined as 61.875 grains of gold. The Act legally set the gold/silver ratio at 15.
In 1834, Congress passed the Second Coinage Act, slightly tweaking the gold/silver Ratio from 15 to 16. This better reflected market values at the time and drew it closer to the natural ratio. In 1858, silver was discovered at Comstock Lode, Nevada, and the resulting influx of ex-49er’s and subsequent discoveries (Eureka, Pioche, etc.) led to the proliferation of silver mining as an industry in the 1860’s. Needless to say, this threatened to collapse the price of the metal. In response, the 1873 Fourth Coinage Act discontinued the minting of silver Dollars, and decreed that silver coins above $5 were no longer legal tender. Thus, the gold/silver ratio was allowed to rise. Silver advocates and miners for the next generation would refer to this statute as the “Crime of ’73.” The closest the US came to reintroducing silver as a monetary metal was when William Jennings Bryan advocated bimetallism during his ultimately unsuccessful 1896 presidential campaign, arguing that it would induce inflation and help indebted farmers and the rest of working-class America, who had lived in a deflationary economy from 1873-96. The debate over this at the time was made indelible by the metaphor of the Yellow Brick Road in L. Frank Baum’s The Wonderful Wizard of Oz, originally published in 1900. Indeed, the name “Oz,” as in ounce, implied that bimetallism was the “golden road” to prosperity. (Refer to Chart 1.)
Chart 1: The Gold/Silver Ratio from 1900 – 2008
In the early years of the 20th century, the ratio rose to the low 40’s but fell back into the teens during the Roaring Twenties. After Roosevelt confiscated gold from the American people in 1933 and devalued the US Dollar by revaluing an ounce of gold from $20.67 to $35, the ratio nearly cracked 100 in 1939. (I referred to this devaluation in my January 1st commentary on Chairman Bernanke.) After Bretton Woods and against the backdrop of economic prosperity of the Post-War era, the ratio fell to around 20 until Nixon abandoned the Gold Standard in 1971. As the price of the yellow metal floated, gold outperformed silver until the fallout from the 1973 oil crisis, and then for the remainder of the decade silver outperformed gold as the ratio fell.
This culminated with a mega-spike in the price of silver in late 1979 and early 1980 when the Hunt Brothers tried to corner the market. The gold/silver ratio hit a bottom of about 16 at this time. As traders exited their positions en masse and the Hunts were wiped out, silver fell even faster than gold, which itself crashed from $850 to $600 in just three months (refer to Charts 2 and 3 and my subsequent comments). By May 1980 the ratio was back at 40.
Charts 2 and 3: The Gold/Silver Ratios 1970 – 2009
Chart 2 is Gold, Chart 3 Silver. Overlaid on both is the Gold/Silver Ratio. Note the extreme activity in 1979-80 on both. In percentage terms Silver rose, and eventually fell more, hence the crashing and then rocketing ratio.
For the duration of the decade and into the early 1990’s, the ratio continued to rise because gold outperformed silver, but only because it did not lose as much of its value. While the ratio reverted back to its 20th century average by 2000, gold and silver did not bottom until 2001 and 2003, respectively. At that time, silver once again turned up and the ratio began to fall. This trend continued until the onset of the 2008 Financial Crisis. The 2007-2008 spike in the ratio provided a very attractive entry point for those with the means to take advantage of it.
This brings us to today (refer to Chart 4). The ratio spiked to over 80 in 2008, and was at 70 as recently as last July, currently standing at 62.17 as of yesterday’s close. The trajectory is downward, which creates a potential advantage for investors in 2010. In short, silver is still undervalued. Of course, it’s not going to fall to its pre-1873 ratio of 15 or 16 anytime soon. Despite the historical ratio and the natural ratio, the fact is that after the Industrial Revolution and through the 20th Century, the ratio’s average was roughly in the range of 47-50. However, a lower ratio is not out of the question if the current bull market in commodities sustains for long enough. During inflationary times such as the 1970’s, the ratio averaged between 20 and 40, falling below 20 during the final spike in early 1980. Given the current trend, in 2010 I expect it to fall below 60, and possibly even break 50.
Chart 4: The gold/silver ratio January 2007 - Present
If inflation begins to pick up in the next few years, there is no reason that the ratio will not fall back into the 20-40 range or even below. Even then, if the gold/silver ratio fell to just 50, and prices held at their current levels, gold would be worth about $1,110 but silver would rise to $22.20, representing a 24% increase from the January 20 closing price of $17.90. Thus, if gold merely surpasses its early December 2009 high of $1,225 and the ratio continues to revert to its 20th century average, $24-25 silver would not be out of the question by the end of 2010. For that reason, silver potentially offers more lucrative returns than gold.
As I write this, a pullback is occurring in precious metals. Current events, including continued worries about Greece’s financial woes, China’s curbing of bank lending, and Scott Brown’s Senatorial victory in Massachusetts, led to silver selling off by 3% today, with gold down slightly less. In my opinion, this is because for silver, China’s continued expansion is particularly important because of the metal’s plethora of industrial uses. I have no doubt that will continue, and today’s movement merely reflects the short-term focus that permeates today’s markets. Additionally, the Dollar Index, after falling for the past week, shot back up over 78 solely due to the weakening of the Euro. The USD has actually continued to fall so far in 2010 against the pound and other currencies in the six-currency-basket Dollar Index (refer to Charts 5 and 6). In fact, gold and silver priced in Euros were only down slightly today. For 2010, I am confident that the long-term trends that favor precious metals will reassert themselves, including that of the gold/silver ratio.
Respectfully Yours,
Matthew R. Green
Chart 5: US Dollar vs. British Pound July 2009 - Present
Chart 6: US Dollar vs. Euro July 2009 – Present
Note the jump that began with the Dubai debt scare in late November/early December, and the spike this week due to the Greek finance debacle.
No comments:
Post a Comment