How to make sense of the gold-to-silver ratio

(July 19, 2011 - by Myra P. Saefong, MarketWatch)

Silver’s recent climb has significantly outpaced gains made by gold. But a closely watched ratio based on the two prices suggests silver has even more catching up to do, analysts say.

The so-called gold-to-silver ratio, the price of gold divided by the price of silver, currently stands at 39.8 to 1. In other words, a single ounce of gold is worth 39.8 ounces of silver. That’s a decline from the end of 2010, when the ratio was around 46.

Silver (CNS:SI1U)  has surged 29% year to date to about $40 an ounce, compared with gold’s (CNS:GC1Q) 13% year-to-date advance, to just over $1,600 an ounce.

 “Some traders look at the gold-silver ratio as a way to determine if one commodity is over or undervalued relative to [the] other,” said Paul Simon, chief investment officer at Tactical Allocation Group.

“This can open up statistical-arbitrage opportunities, where a trader may try shorting the overvalued commodity and buying the undervalued commodity, with the hope of profiting from the reversion to the mean,” he said.

Comparing gold prices to those of silver “gives a good relative feel for the price fluctuations between the two metals,” said Matt Insley, editor of the Daily Resource Hunter. “Plus, it’s another tool for metals traders to gauge future metals trends.”

But analyzing the gold/silver ratio’s levels is a complicated task.

Indications

The 200-year average for the gold to silver ratio sits around 37 to 1, said Insley, and the ratio now stands very close to that historic average.

Still, “there’s much more to see if you look at the chart of the gold to silver ratio,” he said. Read more of Insley’s thoughts on gold.

Since the early 1990s, the price of gold relative to silver has dropped, so the overall trend clearly shows that silver is appreciating in terms of gold, he said.

And “when you think of the current ratio compared to the naturally-occurring ratio of gold to silver in the earth — 17:1 — there’s still room for silver to run,” he said.

Gijsbert Groenewegen, a managing partner at Silver Arrow Capital Management, said he believes the ratio can fall back to 30, implying that silver will continue to outpace gold’s gains.

“A high ratio number probably indicates a ‘calm’ period whilst a low ratio probably means a market in motion,” he said.

Silver is “cosmetically much cheaper” than gold, he said, and if the whole monetary systems breaks down, “gold is likely to be confiscated to back up a new monetary system and silver would become the safe haven of choice investors could still freely invest in.”

Silver’s run this year has included a steep drop and a sudden fall. After climbing close to $50 an ounce, silver prices fell much more than gold when precious metals corrected in early May, likely due to higher margin requirements for silver futures. On May 3, silver futures sank nearly 8%, while gold lost around 1%.

Demand for silver since last year has largely come from investors, says Chintan Karnani, chief analyst at Insignia Consultants in New Delhi.

“Higher silver investment demand and lower gold silver ratio indicates flight to safe havens by investors,” he said.

Not everyone agrees that silver will continue to outpace gold’s rise.

Jeffrey Wright, senior analyst of metals and mining equity research at Global Hunter Securities, pegged the normal range for the gold/silver ratio at about 40-50, and said the current ratio suggests that gold will actually make bigger gains than silver.

Silver has experienced a really nice run up, with good acceleration, over the last couple of quarters, he said. Gold has gone up, but clearly not as much on a percentage basis.

If gold sees a larger percentage gain over the next quarter or two than silver, the ratio would expand from 40 to a higher number, he said. Such a trend would be “indicative to where the macro global economic picture is,” with concerns over the U.S. budget and euro-zone debt issues.

Indeed, gold prices have outpaced silver amid the “current debt-deflation scare in the U.S. and euro zone, as well as during the financial panic immediately after Lehman’s collapse,” said Adrian Ash, head of research at BullionVault.com, an online service for gold-bullion trading and ownership.

And when gold’s gains outpace silver, it shows that store of value is more highly prized than industrial use, he said, noting that in 2010, industrial use accounted for 11% of total gold demand, but accounted for more than 60% of silver demand worldwide.

If anything, an analysis of the gold/silver ratio offers at least one definitive clue about the gold/silver relationship: traders can expect silver to make more exaggerated moves than gold.

Historically, the pace of silver’s rise has been greater than gold and the pace of silver’s price fall has also been greater than gold, said Karnani. “Silver is much more volatile than gold.”

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