From the Investment Series written by Richard Schwary – www.golddealer.com ……..
The Gold to Silver Ratio has been carefully studied by precious metal partisans since I got into the coin business in the early 1970’s. And since that time it prompts disparate opinions and commentary from dealers, investors and even complete outsiders.
Proponents claim that the ratio can be predictive and the thinking behind the theory is that at certain times gold is overpriced relative to silver and at other times gold is underpriced relative to silver. In other words some believe the ratio can be used to determine the value of gold and silver relative to each other.
If true an interesting corollary is presented. You should be able to sell one metal when it’s overpriced and invest the proceeds in the underpriced metal – and this trade would be to your advantage as gold and silver once again adjust prices to an accepted middle ground. And, as the theory goes if the investor traded both gold and silver bullion at the most advantageous time their net ounce position would increase without adding additional funds.
The Gold to Silver Ratio is actually simple – it’s the amount of silver ounces it takes to purchase one ounce of gold. But that is about all that is simple with this ratio.
Advocates believe that when the ratio is at the higher end of its range it is silver friendly. So selling gold and buying silver may be popular because silver is cheap relative to gold.
When the ratio is at the lower end of its range it is gold friendly. So selling silver and buying gold may be popular because gold is cheap relative to silver.
This is where the subject gets blurry. Like so many things relating to the Gold and Silver Ratio the science is difficult to document. Given the ratio’s lengthy history why hasn’t a math student proven a positive correlation? Still the same non sequitur can be directed at the most popular techniques commonly used in technical analysis today.
Bimetallism and the 16 to 1 Ratio
Bimetallism is a two dollar word which describes how our founding fathers came to view the definition of real money – sometimes called “specie” or hard money. In early America you could find a wide variety of hard currency available most of the time. Gold, silver and copper coins from all over the world circulated freely in what would become the United States. The Spanish silver dollar for example remained legal tender in the United States until the Civil War.
When the US Constitution placed the monetary system under the control of Congress early America began to consider its own circulating currency. Alexander Hamilton recommended a bimetallic US standard (like England) which defined our dollar both in terms of gold and silver and bimetallism became a part of American thinking.
The genesis of the Gold and Silver Ratio strategy may have begun with the early notion that there is a “natural” relationship between the value of gold and silver because of its defined legal tender value. And there is at least anecdotal evidence that the Gold to Silver Ratio advocates co-opted early bimetallism as part of their explanation as to the importance of the ratio.
I will leave it to the reader to determine whether this link exists or the often quoted 16 to 1 ratio is a convenient historical artifact which happens to fit the “facts”.
Some commentators use the US Geological Survey claiming that silver is 17.6 times more abundant in the earth’s crust than gold to support the historical 16 to 1 claim. Again it sounds interesting but I’m not sure this is relevant or perhaps it was relevant at one time but modern mining methods may have forever altered the original ratio.
A few writers claim that the 16 to 1 ratio was dramatically altered when the massive Comstock Silver Lode (1859) increased the amount of physical silver and changed the ratio to 23 to 1. If this sounds reasonable you may ponder the effect of modern conspiracy questions. Like the GATA.org claim that silver traders “cook” the books with “naked” silver short positions which promise more physical silver than is available.
To some the Gold to Silver Ratio has become an interesting historical footnote but in the physical gold and silver community it still holds sway and is worth examination.
Within the dealer and fringe investor community there are some who believe that we will return to a real gold and silver based economy because currency debasement will force the issue. This old story has been around for some time and needs to be quietly retired.
I believe the definition of money has been redefined and is now a mathematical construct. The old idea that fiat currency will be replaced with real gold and silver coins and thus the 16 to 1 ratio will be embraced is highly unlikely. This does not mean you will not again see this early fixed ratio – there are many price combinations which will yield the familiar 16 to 1. But I think looking forward to real gold and silver coins in circulation may be obsolete. And in fact waiting for such an occurrence may detract from the usefulness of the ratio.
This from Wikipedia – In 1787 the United States Constitution established gold and silver as the legal tender of the United States at a floating exchange rate. Then in 1792, Secretary of the Treasury Alexander Hamilton proposed fixing the silver to gold exchange rate at 15:1, as well as establishing the mint for the public services of free coinage and currency regulation “in order not to abridge the quantity of circulating medium.” With its acceptance, Sec.11 of the Coinage Act of 1792 established: “That the proportional value of gold to silver in all coins which shall by law be current as money within the United States, shall be as fifteen to one, according to quantity in weight, of pure gold or pure silver;” the proportion had slipped by 1834 to sixteen to one.
Bimetallism was effectively abandoned by the Coinage Act of 1873, but not formally outlawed as legal currency until the early 20th century. The merits of the system were the subject of debate in the late 19th century. If the market forces of supply and demand for either metal caused its bullion value to exceed its nominal currency value, it tends to disappear from circulation by hoarding or melting down.
If the subject of gold and silver as money really interests you consider A History of Currency in the United States (Hepburn) and The History of Bimetallism in the United States (Laughlin).
Again from Wikipedia – Silver often tracks the gold price due to store of value demands, although the ratio can vary. The crustal ratio of silver to gold is 17.5:1. The gold/silver price ratio is often analyzed by traders, investors and buyers. In Roman times, the price ratio was set at 12 or 12.5 to 1. In 1792, the gold/silver price ratio was fixed by law in the United States at 15:1, which meant that one troy ounce of gold was worth 15 troy ounces of silver; a ratio of 15.5:1 was enacted in France in 1803. The average gold/silver price ratio during the 20th century, however, was 47:1.
Ratio trading got a lot of attention during the big Hunt Brothers short squeeze in 1980. The price of gold topped $800.00 and the price of silver topped $50.00. So doing the math divide $800.00 by $50.00 and the ratio becomes 16 to 1. This was seen as a big opportunity which favored gold accumulation – in other words believers in this abstract idea sold silver and purchased gold.
I traded gold and silver bullion in the 1970’s when every dealer in the country claimed that the 16 to 1 ratio was a financial incantation. This was a wonderful era for the ratio because it all made perfect sense – and the idea morphed into folklore. It was rarely challenged – generally accepted by hard-core believers and embraced by dealers because it encouraged business.
But anything relating to my early coin career should be challenged. If history has proven anything it is that the status quo changes quickly in precious metals. That’s why over my desk I have one of my favorite Sam Clemens quotes: “When I was younger I could remember anything, whether it happened or not.”
Trading the Gold-Silver Ratio
What follows is an example of trading the ratio. The numbers are a bit whacky but this is the best published example I could find which uses simple illustration. Once you get the idea an investor can move the ratio around – experiment and decide if this tactic makes sense.
This from Investopedia – “First off, trading the gold-silver ratio is an activity primarily undertaken by hard-asset enthusiasts like “gold bugs”. Why – because the trade is predicated on accumulating greater quantities of the metal and not on increasing dollar-value profits. Sound confusing? Let’s look at an example.
When a trader possesses one ounce of gold, and the ratio rises to an unprecedented 100, the trader would then sell his or her single gold ounce for 100 ounces of silver.
When the ratio then contracted to an opposite historical “extreme” of, say, 50, the trader would then sell his or her 100 ounces for two ounces of gold.
In this manner, the trader would continue to accumulate greater and greater quantities of metal, seeking “extreme” ratio numbers from which to trade and maximize his or her holdings.
Note that no dollar value is considered when making the trade. The relative value of the metal is considered unimportant.”
I highlighted the last sentence to avoid unwarranted conclusions when considering the ratio. Some people cite a high ratio as a reason to buy silver bullion. Or use a low ratio to suggest it’s time to purchase gold bullion. The ratio theory only suggests trading at the extreme edges will increase your ounce position – it makes no claim as to where you are in the price cycle.
You could for example make a number of gold to silver or silver to gold trades – increase your net ounce position and still lose money if the markets in general move lower. I have never seen this disclaimer mentioned in any coin dealer commentary.
Ratio Opportunities in a New Era
Over the past 10 years gold moved to record highs as investors first sought financial protection from the banking crisis only to watch the market sell off when the immediate danger had passed. During that same time silver was equally volatile on stories of shortages and investor demand.
I believe these dramatic price swings in both gold and silver created today’s either “all-in” or “all-out” investor especially in the United States. But let’s not forget that both gold and silver are simply surrogates. Their relative prices only reflect the degree in which the public trusts fiat paper money. And because paper money trust is fleeting expect more volatility.
So is it time to dust off the old Gold to Silver Ratio and perhaps reinvent the way it is viewed by the public? Just because we have questioned the immutable nature of the 16 to 1 ratio does not mean that fundamental ratio thinking is flawed.
You might conclude that coin dealers in the sixties and seventies crowed around this idea because it was good for business. But you might also intuitively sense a fundamental relationship between gold and silver as part of the natural order. If this were true – perhaps an investor could trade the extreme highs and extreme lows to financial advantage.
These investment questions are similar to a discussion of technical versus fundamental analysis concerning precious metals. It is common to find repeating chart patterns used in technical analysis useful in talking about what the market might do in the future. The fundamentalist approach however discounts the technical analysis and believes charting techniques are simply another Rorschach test.
Is there a correlation between the technical analysis and price patterns? Or are positive results created because all of this is self-fulfilling – meaning there are so many people which believe and act on a certain pattern that the desired result is achieved.
In what might be considered a modern model of gold to silver trading (1970 to the present) the ratio has moved from less than 20 to more than 100 – a reasonable middle ground during that time being between 50 and 60. And there are a number of sources which place the 20th Century average ratio at 47 to 1.
The following long term graph comes from www.macrotrends.net and is illustrative because it captures the ratio going back to the early 20th Century.
But as a trading tool let’s consider the recent past and assume the most useful Gold to Silver Ratio can be seen over the last 10 years. The Macrotrends graph over this time frame shows the ratio varies – moving between 30 and 80 – a reasonable middle ground being between 50 and 65.
In the last 5 years the Gold to Silver Ratio moved from 40 to 1 through our middle ground construct into a range exceeding 70 to 1.
Is Today’s Ratio High or Low Enough?
The question now becomes is the ratio number high enough to favor silver? If the answer is yes the trader would sell gold and buy silver bullion. Or is the ratio number low enough to favor gold? If the answer is yes the trader would sell silver and buy gold bullion.
The theory only defines a “high” or “low” ratio in general terms meaning there is a great deal of what Daniel Boone called Kentucky Windage in deciding when to act on the information.
Most believers stake out a central ground of between 50 and 60 or if you want to be more conservative 40 and 70. Using these arbitrary guides the investor would watch the Gold to Silver Ratio over time and if it moves below 40 consider selling silver bullion and buying gold bullion. If the Gold to Silver Ratio moved above 70 the investor would do the opposite – sell gold and buy silver bullion.
The obvious challenge with using the ratio is determining exactly when an imbalance between gold and silver exists – or in other words when the ratio is too high (favoring silver) or too low (favoring gold).
Because of this some investors might only decide to trade the extreme highs or lows of the ratio and because the time between these periods is often a matter of years such trades would not be frequent. And because we are dealing with a pure ratio the relative value of either gold or silver is not important. If the theory is sound traders will increase their total number of ounces without adding additional funds.
For decades I have seen customers bring in silver bullion and trade for gold bullion or bring in gold bullion to trade for silver bullion. My guess is that about 10% of these people claimed the Gold and Silver Ratio influenced their decision. So the number of people using this idea remains small. Unfortunately I have never had a customer who claimed they increased their total ounce position using this ratio.
That does not mean it did not happen – I just have not seen a documented case. So it would be interesting if a reader could supply a real life example (RSchwary@aol.com) – a series of trades which resulted in an increase in ounces to their precious metals position. Not points of trade on a graph which is essentially hind sight but actual physical trades by an investor. We could then publish the results and update this article.
How Commissions Change the Ratio
The ratio theory is straightforward but proponents do not often mention the cost of making the trade – meaning there are commissions. You are selling at the “bid” price and buying at the “ask” price so there is the “spread” to consider. Advocates claim this trading commission is small relative to the overall potential gain but evidence is anecdotal.
Still there are many experienced physical owners of gold and silver who follow this ratio carefully so it’s worth considering. And perhaps understanding this dynamic will improve your investment results should you decide to trade gold and silver bullion.
If we are favoring silver meaning the ratio is on the high end like it is today with gold at ($1200.00) and silver at ($16.00) the ratio is around 75 to 1. Now use typical spreads for gold bullion ($50.00) and silver bullion ($3.00) – meaning you’re paying the commission costs for the trade. These costs do affect the ratio – in this case it drops about 10 points meaning the 75 to 1 is now effectively 65 to 1.
Also consider the costs of trading a low ratio number which favors gold. With gold at $1400.00 and silver at $40.00 the ratio would be 35 to 1. Now figure typical spreads for gold ($50.00) and silver ($3.00) and the 35 to 1 ratio increases by about 1 point – 36 to 1. It’s interesting to note that in this example the ratio is altered to a much greater degree when you are selling gold and buying silver.
Let’s Not Get Carried Away
The Gold to Silver Ratio like other technical trading data used to make investment decisions is problematical and so our discussion is presented for informational purposes only. I have searched the net concerning this ratio and cannot find much in the way of documented science. GoldDealer.com includes this information because the ratio is widely quoted and so is of interest to readers. Do not act on this information without consulting your own financial planner as many trading ideas sound logical but may not be reliable.
Your comments are most welcome. This initial walk through the Gold and Silver Ratio is another look at how relative value might change our investment decisions. But it is still not clear whether the Gold and Silver Ratio presents a valid strategy or is wishful thinking. If you would like to add your thoughts please email RSchwary@aol.com and I will include them in the upcoming Gold and Silver Ratio Report Part II. Good luck and thanks for reading.