FSU Editorial "Could Silver Cost More Than Gold?" by the Optimist (Jim Otis) 12/21/2006

COULD SILVER COST MORE THAN GOLD?
by the Optimist
December 21, 2006
Silver Season's Greetings to all!

Have you heard these lines before?

Silver is the poor man's gold. Rich people prefer to buy gold.
Gold will rise and drag silver up with it.
Gold is a store of wealth, but silver is just an industrial commodity.
Silver is cheaper than gold because more silver is mined than gold.
Silver is a better investment in good times when the economy is humming, but gold is best when global financial concerns predominate.
Swap silver for gold and vice versa when the gold/silver ratio is at extremes.

Many people accept the above statements as truisms, but the Optimist offers a different perspective. Let's take a look at how silver has performed relative to gold in the past, and then take a flight of fantasy to see how silver might do in the future.

Gold/Silver ratio

For a long term view of the relationship between gold and silver from 1970 through 2003, consider the chart above. During the metals bull market of the 1970s, gold rose rapidly, but silver consistently outperformed gold, so that the gold/silver ratio was low and falling. For the 1980s and 1990s, gold was a losing investment throughout the metals bear market. With the exception when Warren Buffett bought silver in 1997, however, silver performed even worse than gold over those two decades, and the gold/silver ratio was high and rising. The Optimist's clear conclusion is that it has been better to own silver during metals bull markets, and better to own neither silver nor gold during metals bear markets. A quick look at real interest rates shows that we are still solidly in a metals bull market, and the Optimist is convinced that this time will not be different.

Silver/Gold ratio

From 1980 to 2003, silver was solidly locked in the claws of the bear. To get a better perspective of the relationship between silver and gold since 2003, I prefer to look at the ratio of silver divided by gold because it helps me to better focus on silver than the traditional reverse ratio of gold divided by silver. A chart of the silver/gold ratio from 2001 through 12/15/06 is presented below. A link to the weekly updated chart will be added to the Optimist charts page.

Ratio of Silver Divided by Gold

This chart of the silver/gold ratio tells me that since 2003 when the silver bull awakened from a 23 year slumber and chased the bear away, silver has been gaining steadily against gold. Obviously, the Optimist cannot promise that past trends will continue, but that is part of the basis for my continued preference for being long silver instead of gold. Just as the battle is not always to the strong or the race is not always to the swift, the Optimist prefers to bet his money on strong and swift silver.

My mind's made up already. Don't confuse me with facts!

All of the above historical data can be summarized with the statement that silver rose faster than gold in a precious metals bull market, and did worse than gold in a precious metals bear market. Unfortunately, that simplified view of the past does not give clear guidance for the future. Assuming (which I do) that we are still in a precious metals bull market, how much faster than gold can silver rise? Should we swap out of silver and into gold before the bull gives ground to the bear? How will we know when the time arrives? Those are all great questions. Since the past data doesn't tell all the answers, maybe we can find some interesting guidance in a fantasy future.

What if the prices of silver and gold were forced to be equal?

Yes, I know that it is crazy to talk about silver and gold prices being equal, and that it has never been that way, so obviously there is no need to waste time with that ridiculous idea. Humor me for a few seconds. Suppose that 20 or 30 years in the future there could be a nation that can be isolated from the rest of the world economy, and that can be ruled absolutely by an iron fisted dictator. Let's call it Nutzy Kookoo and abbreviate that name as NK. The previous supreme ruler of NK had an abundance of irrational exuberance about nuclear weapons and old American films, but his replacement is reasonably rational and sane. Other than sharing his predecessor's compulsion about isolation from the world, the new leader had only one small mental deficiency. That new leader of NK insisted for a generation that all precious metals must be considered equal. The supreme edict of NK was that silver, gold, platinum, and palladium must all be priced exactly the same throughout NK. Since the people of NK were all isolated from the real world so they did not have access to real world prices, those people would have no alternative but to believe the official proclamation from their supreme leader. During the first generation that the new ruler imposed his equal pricing command, the people wouldn't care about it anyway because they had not enough money to buy food, and they couldn't consider buying metals. After more than a generation of life in an isolated NK where all precious metals were legally required to cost exactly the same, the people would not question or even consider that it could be any other way. It was just an accepted fact of life that the prices of silver, gold, platinum, and palladium were all exactly the same throughout the kingdom of NK.

Mandated equal prices for all precious metals worked great for the first generation when no one had enough money to buy any of the metals, and there was no mining industry to produce more, and there was no industrial use of them. The government just kept a modest stockpile of the same amount of each, and the size of each stockpile did not increase or decrease. Alas, all things change, and the nation of NK is no exception. After more than 20 years with no mining to produce metals, and no investing to put them away, and no industry to consume them, NK began to make a transition to an industrial economy. The transition was slow at first, but the wise advisors of NK recognized that things would move faster later. As metals developed different values in the changing society, it would be essential to allow them to have different prices. The kingdom of NK was still perfectly isolated from the rest of the world, so prices elsewhere had no effect on the prices in NK. The only factors that impacted on prices inside NK were the relative utility of each and the relative ease with which a new supply of metals could be mined to satisfy the increasing demand. At the insistence of the advisors, the king of NK decreed that NK would keep gold at exactly the same fixed price, but that platinum, palladium, and silver would be allowed to gradually float higher or lower than gold, depending on relative supply and demand, in a price envelope which expanded by 1% per month. By letting the prices of each metal vary, NK planned to retain the same amount of each in its vaults.

Platinum higher and palladium lower than gold

As all would expect, NK mining, industry, investment, and consumption increased slowly at first. By an interesting coincidence, the availability of metals to be mined from the land in NK was in exactly the same percentage as the comparable availability throughout the world. Amazingly, that coincidence also extended to the total use of the metals through industry, investment, and consumption combined being in the same proportion as the average comparable use throughout the world. NK was exactly a microcosm of the entire world for precious metals supply and demand.

The new buyers and sellers in NK quickly realized that platinum had greater utility and less production than gold, so the price of platinum was continually elevated relative to gold. Similarly, palladium was found to have less utility, and its price was continually lowered relative to gold. Isn't it great how even in a fictional fantasy, prices properly respond to real world economics?

So, what happened to silver?

As the fledging NK mining industry began to develop, it quickly became obvious that there is more silver that can be extracted from the land than there is gold, and that silver costs less per ounce to mine than gold. The palace pool wagering on future prices bet early that the price of silver would quickly fall relative to gold because of the increasing amount of silver that could be mined. Those bearish betters were surprised, however, to find that the amount of silver consumed by the faster growing markets of industry and investment and jewelry was actually more than could be mined. In contrast, only a small percentage of the gold that was mined was consumed by industry or investment or jewelry. The amount of gold available to the market increased every month from the additional supply produced by mining. In order to keep the price of gold from dropping in the open market, NK found that it had to always print more paper currency so that the new supply of gold which was continuously added would always be matched with a comparable supply of additional paper currency. Since more silver was consumed by industry and investment and jewelry than could be mined, the amount of silver in the stockpile was continually reduced, and the result was that the price of silver began to rise relative to gold to reflect its greater utility.

The combination of mining, industry, investment, and jewelry resulted in decreasing availability of silver, and therefore in higher prices, compared to the increasing amounts of gold that became available over time. The additional amount of currency in circulation, which was required to hold the price of gold constant, also added to the increasing price pressures on silver.

Why is silver less expensive than gold?

Some people will object to my fantasy situation in NK by saying that the relative descriptions of silver and gold supply and demand only describe the same conditions that prevail now throughout the world, and the price of silver is only 2% as high as gold. Since the market is always right, gold must be much more valuable than silver. Right? Well, I'm not so sure about that. The market is composed of people, and sometimes people make mistakes. For thousands of years, gold was indeed more rare and more valuable than silver. Through countless generations, babies would grow to be grandparents in an environment where gold was rare and expensive, but silver was plentiful and cheap. That was just the way it has always been, so everyone simply accepted that relationship as an unchanging constant.

The future isn't what it used to be! (Yogi Berra)

Just like always, silver is universally considered to be less valuable than gold. There is no need for people to ask about how much of either is available for investment or use, because silver has always had plentiful supply while gold was scarce. Everyone knows that means silver must be much less expensive than gold, so sure enough, silver is much less expensive. But Ted Butler and other people ask questions about the relative availability, supply and demand factors. Those people noted that the U.S. Government storage shelves, which just a few decades ago were once stacked wall to wall and floor to ceiling with billions of ounces in silver bullion bars, are now conspicuously empty. At the same time, more gold was mined than could be used for jewelry, dental crowns, and a relatively small number of industrial applications. Every day, more gold is mined and refined into additional bullion bars and added to an ample supply already in storage. Compared to the consistently increasing quantity of gold bullion bars, the persistent draw down of silver bullion bars can only result in silver prices increasing faster than gold.

One of the reasons that the rich preferred gold instead of silver is that they had lots of wealth to protect. Since gold is expensive, a very substantial amount of wealth can be stored in a small safe the size of a shoe box, or easily carried in a briefcase or backpack. The biggest problem with silver for storage of wealth is that it takes too much of it. A 70 pound bar of silver is currently priced at only $15,000. If Bill Gates or Warren Buffet wanted to sock away $15 Billion for their retirement, they would need to buy 1,000,000 of those 70 pound bricks! Imagine trying to coordinate the logistics to rent a thousand armored trucks just to transport a stash like that! Because silver is relatively cheap, physical silver has very limited utility in protecting a large amount of wealth. As the price of silver continues to increase faster than gold, however, silver becomes increasingly useful as a store of wealth and that added demand further escalates the relative price of silver. At the same time, the new silver ETF has created an easy way for high rollers to push a large amount of wealth into silver, with less worry about the previously insurmountable obstacles of movement and storage. All of those factors argue that the demand for silver will increase as prices rise, and silver will continue to outperform gold.

Another factor which strongly argues for silver instead of gold is an approaching shortage of physical silver, so that there will not be enough relatively cheap bullion bars available to supply the needs of industry. At the same time that industry is in a panic to purchase the silver it will need, publicity about the rapidly rising price of silver will propel investor demand into overdrive. The resulting price spike will become legendary. Gold will also rise during that frenetic time, but it will be silver that pulls gold to higher prices, and the ratio of silver divided by gold will rocket to heights that most cannot dream of today.

The Optimist hopes that all readers will have happy holidays filled with golden dreams and silver wishes. Cheers!

This commentary presents only the viewpoints of the Optimist and it is intended only for perspective and entertainment. Please do not interpret any portion of this work as investment advice. If any of the concepts discussed here appeal to you, then you must do the work to decide if and when and how you should invest. The Optimist does not ask for any profits you make, and he cannot be liable for any losses incurred as a result of your investment decisions. The Optimist wishes you the best of luck in whatever you decide to do or not to do. Cheers!

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The opinions of FSU contributors do not necessarily reflect those of Financial Sense.