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Having dwelt a lot on the topic of the gold:silver ratio from a technical and quantitative standpoint in our earlier essays, it is about time we examined the ratio fundamentally. In the strictest sense of mean reversion, the ratio between gold and silver should follow a straight line over time. However, as observed in the previous article, the ratio not only has a wide range but also fluctuates between extremes. This means that the prices of gold and silver are perceived differently in different market conditions and a concept of mean reversion is not enough to interpret the gold:silver ratio.

In fact, the ratio reflects economic and political factors governing the markets fairly well. A study of the ratio, therefore, has to be a combination of the quantitative approach and a fundamental approach. In this essay we will travel through history and see how sensitive the ratio has been to external factors outside of pure supply and demand picture. We will also examine current fundamentals in the light of factors found to be instrumental in determining prices (and hence the ratio) in the past.

Historical Fluctuations in the Gold:Silver Ratio

Breaking down the ratio in the last ten years into distinct regimes, we can observe how fundamentals play a part in shaping regimes. The first regime is that of a steady outperformance of gold over silver from the start of 2000 to the middle of 2003. This despite gold reaching a 21 year low of about USD 250 per ounce in 2001!

From 1998 to about 2003, starting with the Asian and the Hedge Fund crises, the economic downturn of 2000, through the Y2K jolt and the Iraq war, investments poured into gold more than silver. As observed in any period of crisis, gold was deemed an important crisis commodity. As fear gripped the commodity markets, gold increased in value relative to silver - the gold-silver ratio increased from 40 in 1998 to close to 80 in 2003.

The rallies in gold in this era were a result of a combination of factors. China deregulated gold markets in the early 2000s that increased demand significantly. Additionally, the dotcom crash and the 9/11 terror attacks encouraged investments in this safe haven. Introduction of the euro also devalued the U.S. dollar in the international market helping gold more than silver perhaps.

The period from the middle of 2003 to the first quarter of 2004 witnessed a widespread correction in the ratio, with a pullback in gold prices and strengthening of silver. The equity market started to rally reflecting the end of a crisis period, as 9/11 drifted further back in the minds of investors - silver prices once again increased relative to gold. This is one of the many instances in history where a period of crisis is followed by more investments flowing into silver, leading to corrections in the gold:silver ratio.

From first quarter of 2004 to the end of 2005, the ratio bounced back and stabilized at a higher level. The year 2006 perhaps witnessed the most volatile fluctuations, with the ratio first going down, then recovering before going down again. The first half of the year saw widespread dumping of dollars. Italy dumped billions of dollars from its reserves and replaced it with the pound sterling. Russia and a number of smaller European nations also slashed dollar reserves considerably, creating uncertainties in the dollar market and making gold volatile.

After the volatile year for gold in 2006, gold witnessed a steady upsurge (in comparison with silver) in 2007. Oil producers in the Middle East announced major gold bullion purchases; China announced plans to increase gold bullion purchases with its excess cash reserves; Vietnam also opened its first gold exchange. A combination of these factors saw gold demand outpacing supply for the most part of the year, propelling prices north.

In 2008, the ratio corrected marginally from the 2007 highs. Not because gold demand was waning - in fact gold demand continued to surge on the inkling of a financial crisis in the upcoming months. However, the ratio corrected because silver started to outperform gold for once at the onset of what would be a deep global recession. The primary reason for silver's strong performance was a surge in investment demand of silver, both in the United States and Europe (where the impact of the recession was the biggest).

During the height of the recent economic crisis in late 2008, the gold:silver ratio peaked to its highest level in four years at 84.4. Just three months prior to this peak, the ratio was hovering around the 50 mark, the average for the early half of the decade. At this stage, the ratio reflected significantly overbought gold, as its safe haven properties pressed the yellow metal to outshine its industrious counterpart. A natural equilibrium began to re-emerge during 2009. The strong correlation between gold and silver helped silver to gain in tune with gains in gold. Despite corrections in the ratio in the first half of 2009, the ratio still appears to be at relatively high levels compared to historical averages.

In the first three quarters of 2010, gold started to rise again over silver, emphasizing its evergreen investment characteristic. This time gold demand surged as a hedge against inflation - anticipated because of the monetary stimulus packages that had been implemented during the recession. The recessionary concerns had started to ease during this period, but uncertainty still loomed large about the nature of recovery. Silver could not gain from rebounding industrial activity because of this uncertainty. Large buying activities from China and India also held gold in good stead during this period.

In the rear half of 2010, we started observing sharp corrections in the ratio. Apparently, silver has started getting its due. The rebound in industrial activities has rubbed off on silver prices, while the gold markets have started to exhibit signs of short-term sluggishness. So where does the ratio move from here? Will 2011 be a sluggish year for gold while silver rides on the recovery wave to outperform gold? Or has the silver rally lost steam already?

While there is no questioning the long-term fundamentals of precious metals, especially gold, 2011 could be sluggish as gold may not be able to sustain its current pace of growth, say some in the industry. Read our articles The Economy is Still on Shaky Foundation and Gold's Gleam Will Not Fade Away Because of the Current Decline to comprehend the strength in gold fundamentals in the long term.

Silver's fundamentals are improving. With a majority of silver demand coming from industrial applications, and rising stock market (at least that is the case at the moment of writing this essay) so will demand, thus pushing silver prices higher. The big question is whether this recovery is already factored in the price and the recent rally in silver is over and done with for the medium-term.

Gold-Silver Ratio to Stabilize in the Medium-Term

Historically, it has been observed (we have dwelt on this in the first section of this essay) that gold exceptionally outperforms silver in any downturn. In case the downturn impacts industry, silver lags due to damp industrial demand, amplifying gold's performance. Other occasions such as the dot com crash (where silver's industrial demand remains unaffected) will also possibly witness gold outperforming silver, but less significantly as silver also meets requirements of a safe haven. Let's face it - at least now Investors believe that silver cannot beat gold in the safety that the latter provides. The dependence on industry adds further volatility to silver, unlike gold's almost unidirectional move.

Generally, after a crisis, silver tends to catch up with gold, bringing the ratio down again. The pent up momentum in silver caused by gold's wide upward fluctuation during the era of crisis takes effect now and silver tends to outperform gold. The economic crisis of 2008 was perhaps an exception to the rule.

Although signs of a recovery were apparent in early 2010, silver did not rebound immediately. Monetary stimulus, followed by possibility of inflation again drove gold to the fore. Silver has begun to claw back and catch up with gold only in the past few months on the back of industry and momentum. And the momentum in silver prices has been quite dramatic!

As the global economy recovers and markets begin to even out, risk appetite will return. As the need for a safe-haven recedes, investments will begin to move away from gold into higher volatility (higher return) securities. This means that a lot of investments will move away from gold into silver in the precious metals space as well (silver is always a higher beta metal).

If we learn our lessons from history, the fluctuations in silver prices should have legs for some more time because it has only started to emulate what gold did during the recession. However, the ratio has plunged quite sharply in the rear end of 2010 and is almost at ten year low levels. When held in the perspective of a typical rebound in silver post economic recovery, the current retracement of the ratio appears close to historical retracements. So, from a historical standpoint, silver's move might be complete and going forward, the ratio will stabilize for a bit before gold starts edging up again. This could be caused by a consolidation on the general stock market.

Fundamentally too, indications are of a range-bound ratio in 2011. The bull run in gold is already showing signs of fatigue. In 2011, gold is expected to gain at a slower pace supported by investment demand. Investors should remain cautious and wait for appropriate signals before another leg of the bull run resumes. Silver too will remain subdued, but at these elevated levels with good support from industrial and investment demand. As both legs of the ratio gain steadily, the ratio will remain largely range-bound, which could make pair-trading particularly profitable. Long-term predictions of the ratio are anybody's guess, however one might expect the ratio to move below the 20 level, as it was the case at the end of the previous bull market at the beginning of 80's. As seen historically, the ratio is sensitive to market conditions and will generally fluctuate between peaks and troughs. Individual legs, gold and silver, will continue to gain though in the long-term (despite minor fluctuations in the medium-term).

Thank you for reading.

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