Is silver better than gold?

The financial crisis continues and, from where I’m sitting, it looks unlikely to be over anytime soon. I don’t know how it will rank in severity compared to Japan’s Lost Decade, the Great Depression or the South Sea Bubble, but I’m sure it will be up there with them.

Because of this, I believe we are heading into a highly inflationary environment. We are certainly experiencing a massive destruction of wealth as asset bubbles burst and deleveraging proceed. However, this is deflation that governments and central banks can address — and are addressing – with fiat currencies and the printing press.

The prevailing view among policy-forming economists is that economies require a degree of inflation for normal growth to occur. Politicians love this as it allows them to gently debase the currency, which erodes outstanding liabilities and ultimately allows them to spend more — expanding  the size and scope of government. They have the levers, the know-how and the motivation.

Unfortunately, once they’ve applied the heat and got inflation cooking again, they may not be able to control it. The upside is that this will be very good for gold, and even more so for silver.

For more than 2,500 years, until the late 1800s, the gold-silver price ratio was fairly constant at around 15:1. This corresponded to their relative abundance on the planet and the fact that they were both used as currency. By the early 20th century this ratio had widened out to 100:1 as supplies of silver increased relative to gold and while silver also was dropped as a currency. Silver was now
cheap and abundant, as huge above-ground stocks existed.

However, as the Industrial Revolution accelerated and the world started to benefit from electrification, silver was found to have many useful properties. Cheap and abundant, it was consumed extensively in industrial processes — as it is to this day. The gold-silver price ratio moved back down and again reached 15:1 in the 1980s (although in fairness, the Hunt brothers’ attempt to corner the market may have helped here).

But today, with gold above $900 and silver at $13, the ratio is 70:1.

Estimates put the total volume of gold production in all history at 5.3 billion ounces, and 43 billion ounces for silver. This gives us a ratio of 8:1, suggesting that if we anchor silver’s price to gold, as has been the case for most of history, then with gold at $900 we should expect silver at $112. Even if you feel that this overvalues gold, take it down to $300 and an 8:1 ratio gives $37 for silver.

But the argument for silver gets more bullish: the abundance of supply coupled with its low price and many uses means that of those 43 billion ounces,most have been used up — never to return. In fact, estimates suggest that above-ground stocks now stand at only around 1 billion ounces, whereas nearly all of the 5.3 billion ounces of gold still exists.

Annual gold production is approx 1.5 per cent of inventory, and the majority of that is added to existing stocks. Annual silver production is roughly 55 per cent of inventory or 550 million ounces, of which roughly 400 million are consumed and never to come back. The rest is available for jewellery and/or investment purposes such as coins, bars and other vehicles such as exchange-traded funds.

Silver has taken a hit as it has lost its historical position as an investment metal. For some time it has been considered solely as an industrial commodity and has suffered on two counts: a perception that it is abundant and the recent economic slowdown that has affected all base metals over the past year.

I believe that it will come back into favour as an investment vehicle. Furthermore, I believe that there is the potential for a supply shortage. Industrial consumption may continue to slow down, but so will supply if the price of silver doesn’t appreciate considerably in relation to its production cost.

There is a final, though contentious, observation to make concerning the price of silver: possible price suppression via the futures market. There is increasing disquiet over the size of the short position held by just two banks on COMEX. Ted Butler, a highly respected silver analyst of longstanding has been studying trade data going back many years and is convinced that price manipulation has been going on in both gold and silver. He is at the vanguard of a small but growing number of investors agitating for action to be taken and for the price suppression to end. The CFTC (the body responsible for regulating COMEX) is investigating, but while hoping they will conclude in his favour, Mr. Butler isn’t holding his breath. But as he writes: “The silver manipulation must end, suuddenly and violently, to the upside, no matter what the CFTC says or does.”

To my mind if you have an investment potfolio then you should have exposure to silver and gold. The percentage you hold would depend on the bleakness of your assessment of the world economy and your own outlook for inflation. The worse you think it will get, or the longer you think it will drag on, then the more you should own.

I prefer silver to gold. I don’t have anything against gold. In fact I own some. But if you are prepared to play in a much smaller and possibly highly manipulated market with the extra volatility that brings, then all the reasons for buying gold apply to silver — with a key extra one as well.