Silver Is Again Outperforming Gold

Feb 23, 2009 – I am often asked whether I favor gold or silver as my preferred sound money.  It is a difficult question, and perhaps comparable to asking a parent which child is his or her favorite.  As we parents know, they are all wonderful, but perhaps in different ways because no two children are alike.  So too with gold and silver.

Both gold and silver can accomplish the same objective.  Physical gold and physical silver – in contrast to the numerous paper representations of these precious metals – are tangible and not financial assets, so their usefulness and therefore value is not dependent upon any one person’s, company’s or government’s promise. 

Though the value of gold or silver does not come from governments and central banks, these authoritarians would like you to believe that the fate of all money rests in their hands.  They can of course influence from time to time – and perhaps even for months or years at a time – the rate at which we exchange gold and silver for national currencies or goods and services.  But the true value of each precious metal is only dependent upon the assessment given to it by the market, which comprises the multitude of people throughout the globe who are continually evaluating the usefulness of these metals.

Government interventions can cause gold and silver to trade at prices lower than they would in a free-market, as has been so thoroughly and carefully documented in the mountain of research compiled by the Gold Anti-Trust Action Committee, now celebrating its tenth anniversary (www.gata.org).  But in the long-run, these market interventions cannot prevent gold and silver from rising when national currencies are being debased, as is evident by the fact that gold has risen against the dollar for eight years in a row.

Interventions into the free-market process inevitably become clear as greater numbers of people come to understand that governments and central banks do not determine the value of gold or silver anymore than they could set and then control at their desired level the value of a Picasso, a condo in Miami or a pound of sirloin steak.  We participants in the market process determine the value of all goods and services, and money is a good – but a special one because without it, the market could not operate.  And sound money is the best money of all.

So in the end, either gold or silver can get the job done when considering which sound money to hold, but there is a more important question.  Which of these two sound moneys does a better job?

It is a difficult question to answer because these two precious metals are different, and as a consequence, come with different risks and rewards.  The major risk with silver is that it is a lot more volatile, and that high level of volatility may not fall within everyone’s risk tolerance. But with risk comes reward, and in the long run, silver is likely to outperform gold, meaning the gold/silver ratio will fall. 

In other words, over time it will take less and less ounces of silver to exchange for an ounce of gold.  Importantly, that outcome describes exactly what is happening now, as we can see on the following chart of the gold/silver ratio.

Last year the ratio rose during the correction endured by the precious metals after the record high reached by gold in March. Then during the end of the correction in the precious metals that lasted from autumn through the end of the year, the gold/silver ratio repeatedly tested over-head resistance in the low 80s.  In fact, the ratio closed above 80 on twenty of the fifty-five trading days from October 10th through December 29th.  Resistance was well and truly probed.

The highest peak reached by the ratio was 84.3 on October 17th. This outer edge of resistance was probed again when the ratio touched 83.5 on November 21st and then again on December 26th when the ratio closed at 82.9, the last of three declining peaks.

The ratio closed on Friday at 69.1.  So from its highest peak the ratio has dropped 18.0%, which is by any measure a very healthy gain achieved in four months.  Nevertheless, the drop in the ratio that produced this outsized gain can hardly be seen on the above chart, which suggests to me that much more potential for gain lies ahead.

The parallel red lines on this chart mark a multi-decade trading range in which the ratio traded from around 40 up to the low 80s. Having just been tested repeatedly, the upper end of that trading range appears solid. It is unlikely that the ratio will break above resistance in the 80-84 area. 

Therefore, the logical conclusion is that the ratio will in time work its way lower and eventually fall back all the way to 40 as its first target. Given that it is now at 69.1, the potential gain in the ratio exceeds an eye-opening 42%, and that is to just the ratio’s first target. In time I expect the ratio to fall back toward to lows reached in 1980, when the last, great bull market move in the precious metals concluded.

My view is that in order to understand silver, one first has to understand gold. Namely, gold is money, and silver is money too.  But silver is also an industrial metal, and like other metals used in industrial applications, some silver is consumed and disappears.  It is these factors that make silver more volatile than gold, the amount of which is consumed is inconsequential compared to the total aboveground stock of gold.

Also, my view is that in order to view gold’s upside trading potential, one has to look at silver, and its ratio to gold in particular. I therefore often use the gold/silver ratio for my price forecasts and to help develop my short-term trading strategy.  And right now the ratio is clearly signaling that more declines in the ratio lie ahead. That is good news for the precious metals because experience shows that a declining ratio is bullish for both metals.

So to conclude, it looks to me as if the gold/silver ratio has probed the top of its trading range for sufficient time to suggest that over-head resistance in the low 80s is solid and unlikely to be broken.  Now that the ratio has started to move away from that level, we can conclude that the trend in the ratio has turned.  It is no longer rising.  It is falling, and a falling ratio is bullish for the precious metals, and for silver in particular. 

The major trend in the ratio has changed. Consequently, in the months immediately ahead I expect silver will rise more rapidly than gold.