The Potential Offered by Silver

Jan 20, 2006 – Silver is frequently said to play “second fiddle” to gold, but this characterization is not only incorrect, it can seriously mislead anyone trying to consider the potential for silver in the years ahead.

In the last alert, I included a table which presented gold’s performance over the past five years. I reproduce that table below, but also include silver.

Though their performance has differed over any given year, it is clear that silver is holding its own. Even though gold gets nearly all the media attention, do not overlook the potential offered by silver.

I’m not going to get into all the supply/demand considerations in this alert. I will no doubt comment about them in future alerts, and perhaps also invite some silver experts to offer their view, as I have done from time to time with gold. Instead, in this alert I will provide two things, one fundamental and one technical, both of which are very important to help describe silver’s potential. But first I need to provide some background information.

In contrast to gold, the demand for silver arises from two different sources. The demand for gold arises principally because it is money. Whether it is Westerners buying gold coins or bars, or Asians buy high-karat jewelry, they are buying gold for the same reason – it is money. The net result is that the demand for gold for its use in electronics, dentistry and fashion jewelry (in contrast to monetary jewelry) is inconsequential compared to the demand for gold because it is money. But silver is different.

Silver historically had a major monetary role, but subsequent to the discovery of the great Comstock Lode in 1859, silver’s monetary role began a long decline. The supply of silver gushing out of Nevada simply overwhelmed its monetary usefulness, with the result that silver became viewed as an unreliable standard for paper currency. Additionally, as the industrial economies of the world grew and photography was invented, a growing demand for silver began emerging for uses in these new areas. This industrial demand conflicted with silver’s monetary demand, which also caused volatility in silver’s purchasing power. This result too made silver seem unreliable for a monetary standard.

As a consequence, one-by-one countries left the silver standard, following the path already established by Great Britain, which went on a gold standard circa 1705. The United States was one of the last major countries to abandon the silver standard, and when it did so in 1900, silver was relegated to a secondary role – it was used in coins as small change, gold being so high in value that low-value gold coins were impractical to mint. From this very brief background information*, I would like to highlight one fact. Silver has a large industrial demand, while gold does not. This observation is important to understanding silver’s potential.

When people become fearful about the safety of their national currency and look for alternatives – as they are now doing – they buy precious metals. But on the margin, this new monetary demand has a greater impact on silver than it does on gold.

To explain this point, let’s assume that the monetary demand for silver last year was 20% of the amount of silver purchased, and that its industrial demand accounted for the remaining 80%. Gold’s demand last year was probably 90% monetary (coins, bars and high-karat monetary jewelry) and 10% industrial (electronics, dentistry and low-karat fashion jewelry). Thus, if new buying comes into the precious metals, where will it have the biggest impact? Clearly, the biggest impact will be on silver, because on the margin new buyers are adding to the 20% that was purchased for monetary reasons.

Now you may be saying that this observation is great in theory, but because there is no way to measure demand, it therefore has no relevance. Well, it’s true that one cannot measure demand, but we don’t need to. To prove this theory all one has to do is to watch the trend in the gold/silver ratio.The gold/silver ratio identifies how many ounces of silver it takes to buy one ounce of gold. In other words, it is the price of gold in terms of silver. With the price of gold and silver presently at $539.70 and $9.11 respectively, their ratio is 59.2. In other words, it takes 59.2 ounces of silver to buy one ounce of gold.

To test my theory about the impact of monetary demand on the precious metals, the gold/silver ratio should rise during precious metal bear markets and fall during bull markets. The reason is that the monetary demand for silver should fall when people are not fearful about their national currency, so it will take an increasing number of silver ounces to buy one ounce of gold because the declining monetary demand will on the margin have a bigger negative impact on silver it than it does on gold. Conversely, in precious metal bull markets – which are caused by people looking for a safe haven from national currency – the ratio should fall. The reason is that it should take a declining number of ounces of silver to buy one ounce of gold because the rising monetary demand on the margin will have a greater positive impact on silver than on gold.

In January 1980 when the precious metals reached their historic peak, the ratio touched 17. Subsequently, as order was restored to the dollar and people throughout the 1980’s became less fearful about inflation, the ratio climbed, as would be expected by my theory. The ratio eventually rose to over 100 in the early 1990’s, and has been in a downtrend ever since. Particularly in recent years, people are becoming more fearful about the dollar and growing inflationary pressures and threats. Thus, the monetary demand for the precious metals is growing, and the ratio over the past fifteen years has been falling as explained by my theory. I expect the ratio to continue to fall further in the years ahead, probably again reaching the 17 level last seen in January 1980. What will silver’s price be when it happens?Tell me whether Mr. Bernanke will inflate or deflate the dollar and by how much, and I’ll give you the answer. The important point is that if you expect gold’s purchasing power to continue rising – and I do because my Fear Index remains in a powerful uptrend – then money will continue to flow out of national currencies into the precious metals, and that demand for sound money will on the margin have a greater impact on silver. In other words, the gold/silver ratio will continue to move toward 17.

The gold/silver ratio will not of course decline in a straight path, as is clear from the table immediately above. Silver is notoriously volatile, and understandably so. The competition for silver between its industrial demand and monetary demand can at times be intense, and volatility is often the result. But the point is, if I am right and the ratio falls, then perforce silver will outperform gold in the years ahead. That outperformance provides some reward to offset the risk from volatility one can expect from silver.

So far I have completely sidestepped the question of silver’s potential price in terms of dollars. To forecast a price, I would like to present the following long-term chart of silver.

The above chart is very bullish. Over the past twenty years or so, silver has formed a huge base where it was accumulated. Recently, silver has broken out from a bullish pennant formation, suggesting that its base is complete. In other words, silver is beginning a multi-year uptrend.

Let’s assume that gold reaches $850 sometime this year, as I expect it to do. Let’s further assume that as gold rises, the gold/silver ratio declines from its present 59.2 to 40, the level it briefly touched during the mad-dash to buy silver in early 1998 after Warren Buffett announced his 130 million ounce silver purchase. To achieve that ratio at that gold price, silver would need to be $21.25 ($850/40). At first blush, that price may sound outrageous, but it is a price entirely consistent with the very bullish technical picture presented in the above chart. It therefore has to be considered as a realistic target, but let’s temper this forecast. Let’s say that gold will rise this year to $600, and the gold/silver ratio drops to 52. That projects a silver price of $11.54 ($600/52), which by any measure would still represent a great return – if it happens. And as usual, that’s a big “if” because no one knows the future. The best we can do is ride the obvious trend because historical experience shows that macro-trends continue for a very long time.

It was five years ago when the trend to acquire precious metals began, as is clear from the above table. Though it was not so obvious in the early years, no one can today deny that wealth is fleeing national currencies into the safe haven offered by gold, and more to the point of this alert, into silver as well.

Consequently, as problems with the dollar and other national currencies continue to worsen, some of the wealth fleeing national currencies will continue to flow into silver, causing the ratio of the precious metals to decline as it has since the 100+ level was reached in the early 1990’s. That means I expect silver to continue outperforming gold.