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Understanding the Gold/Silver Ratio as an Investment Tool

Understanding the Gold/Silver Ratio as an Investment Tool

The Gold/Silver ratio can be a useful metric for seasoned investors seeking insights to inform their investment strategy. Simply put – it measures how much silver can be bought with the identical unit of gold.

Over the long term, the Gold/Silver ratio has been remarkably stable. Prior to the 20th century, governing bodies often set the ratio to achieve price stability between these two commodities, as they were widely used as a currency to settle trade.

  • The Roman Empire set it at 12:1 (so one gram of gold would buy 12 grams of silver).
  • In Europe in the Middle Ages, it hovered around 14:1.
  • In 1792 the U.S. government fixed it at 15:1.
  • In 1939, at the start of World War 1 it climbed to 98:1.
  • Through the 20th century, the average was 45:1.

However, the last 60 years have brought unprecedented fluctuations in the ratio as seen in the chart below. Silver prices have not grown alongside gold.

 

With the ratio peaking at 110:1 in 2020, and now sitting at  82:1, what are the potential implications for investors?

There is a statistical concept known as Mean Reversion theory, which notes that prices usually tend to return to the mean or historical average over time. This theory also notes that the larger the divergence from the mean, the more likely the next move will be back towards the historic average.

An example of mean reversion is the dot-com bubble of the late 1990s. Over this time, technology stocks saw inflated prices far from their long-term averages. Once the boom ended, these eventually returned close to their historical mean.

Another example is when an unexpected increase in oil production temporarily lowers crude oil prices. These prices may return to the average, once the market adjusts to the new supply.

Ironically, one of the ways in which Mean Reversion sometimes works is as a self-fulfilling prophesy! As many hedge-fund, institutional and seasoned investors are aware of this ratio, they may eventually trade against it, which can have the effect of helping bring prices back to average levels.

With the Gold/Silver ratio, this theory becomes a lens through which investors can anticipate possible market movements over time. The current ratio (82:1) is high compared with recent historical averages (54:1), meaning silver is potentially priced cheaply against gold. Investors that track the Gold/Silver ratio can leverage historical averages, aiming to enter the silver market when the ratio is above the norm and selling when it dips below.

Based on this theory, many investors believe now may be a good to time increase their silver holdings.

Demand for silver is growing

There is robust and growing demand for silver in medical, technology, solar, and automotive industries. Silver demand has outstripped supply for the last three years, with demand growing in renewable and green energy technology.

Silver tends to have larger volatility than gold, with more pronounced price swings – however, silver usually appeals to most gold investors because of their shared traits as fungible, malleable, time-tested precious metal stores of value. They both appeal to investors seeking a hedge against inflation and asset diversification.

In conclusion

The Gold/Silver ratio is a vital tool for investors in the precious metals market. Recent fluctuations, like the 2020 peak and the current 82:1 ratio, signal potential strategic opportunities.

Mean Reversion theory highlights the potential for the ratio to return to historical averages, influencing market dynamics. The strong demand for silver, surpassing supply in key industries, adds a fundamental dimension to its attractiveness alongside gold.

Essentially, the Gold/Silver ratio provides a lens for anticipating market shifts. With the current ratio favouring silver, many investors are considering augmenting their silver holdings. In a dynamic market, this ratio remains a key indicator guiding many savvy investment decisions.

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