Silver prices fell nearly 70% after peaking in 2011, with over 27% of that decline coming in the last 52 weeks. What happened? An ounce of gold was worth 32 ounces of silver just four years ago, but now the same ounce of gold costs 74 ounces of silver. Why is silver so disproportionately undervalued?
Why Silver Prices Could Rise 420%
The answer lies in the silver-to-gold price ratio. The ratio tracks the correlation between gold and silver prices over time since the two metals tend to move in tandem. When gold prices rise, silver tends to follow, and vice versa. However, the movement is not always perfectly synchronized and the ratio will occasionally drift too far from the mean.
When the price differential between gold and silver diverges, investors should be paying attention. Historically, silver trades at roughly 43:1 with gold, far below the current ratio. An excessively high silver-to-gold ratio implies that silver is trading at a discount because investors became overly bearish on the grey metal.
Chart courtesy of StockCharts.com.
Investors made a killing the last three times gold was expensive relative to silver. In the run-up to1995, 2003, and 2011, we saw the ratio plunge after breaking 70, causing the price of silver to rise 70%, 200%, and 420% respectively. Right now the ratio is hovering between 73 and 75, indicating a coming boom for silver.
Another important thing to remember is that silver and gold aren’t just words on a page; they are physical properties that need to be extracted from the Earth. There are finite volumes for each metal, and far more than anything else, the size of those deposits should dictate prices.
When you compare the physical abundance of silver and gold reserves, an astonishing truth emerges: even by historical standards, silver is underpriced. The physical relationship between the two commodities is 17:1! Holding gold prices steady at $1,084, the natural conversion rate suggests silver’s intrinsic value is closer to $64.00 an ounce.
Is Silver Going to $50.00?
The last time the silver-to-gold ratio peaked, it was followed by a dramatic rise in silver prices to rebalance the discrepancy. Ultimately, reality is the counterweight to animal spirits in the market. There’s only so long that excessive pessimism or optimism can distort prices before market fundamentals will force investors to rethink their positions.
The conventional wisdom of 1999 demanded that investors swear fealty to the stock market. The Dot Com bubble had induced markets to behave with what Alan Greenspan called “irrational exuberance.” It didn’t matter that internet companies lacked a viable business model or any foreseeable revenues; all that mattered was the self-fulfilling optimism of a bull market.
As we know, that type of thinking ended in catastrophe. What I find interesting is the perfect inverse correlation between that stock market boom/bust and the rise/fall of the silver-to-gold ratio. The relationship is plain as day, and now the metric is disturbingly high again, investors who take heed stand to reap the rewards.
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The author, Gaurav S. Iyer is a research analyst and editor at Lombardi Financial. He currently writes for Profit Confidential where he focuses on macroeconomics and capital markets. On the equity side, Iyer is a fundamental analyst who focuses on company business models and how those companies are positioned within their industry compared to their competitors. His economic research and analysis has appeared in The Economist. Iyer co-founded the Rethinking Economic chapters in Toronto and Montreal, Canada.