October 16, 2007

Why Is Silver So Volatile?

Gold and silver have many similarities, but they are also different in many ways. One big difference is their volatility.  If owning gold is like flying in a 747, then owning silver is like flying in an F-15. With silver one needs to be prepared for heart-stopping reversals and zigs and zags that are all but unheard of in gold.  Why the big difference between these two precious metals?

The normal pattern in precious metal bull markets is that silver leads and gold follows.  There is also a corollary to this point, which is that silver typically outperforms gold. The reason for this pattern is simple.

When monetary problems with the dollar and other national currencies increase the demand for gold, it is in fact an increase in the demand for precious-metal-money. Silver of course meets this requirement, as it is a precious metal, and as I explained in my previous article,  it too is money. Functionally, silver is a good substitute for gold. Both are tangible assets, and both are money that does not have counterparty risk.

Thus, any increase in the demand for precious-metal-money has an impact on both gold and silver. However, on the margin, this increase in demand has a bigger impact on silver because the demand for silver as money is more ‘elastic’ – to put it into economic terms – than the demand for gold as money.

When demand is ‘elastic’, it means that people’s preferences are changeable. An ‘inelastic demand’ means that the item will be acquired pretty much regardless of the cost.  As an example, we are seeing that the rising price of gasoline has hardly reduced the demand for it. Gasoline consumption has not dropped as its price has risen. People are generally not too price-sensitive to it, at least at present prices, though the demand for it may become more elastic at higher prices.

Silver though has an elastic demand.  When people move out of national currencies and into precious-metal-money, money moves into both silver and gold. Eventually, this flow reverses when people’s confidence in national currencies returns.  It does so when the monetary problems that caused them to flee the currency in the first place (for example, rising inflation, bank crises, or other problems) are solved. When that flow reverses, the impact on silver is greater than the impact on gold because the demand for silver is more elastic than the demand for gold.

Demand is impossible to measure, but we can see the changes in respective demand for the precious metals in the following weekly chart of the gold/silver ratio. This ratio shows how many ounces of silver it takes to purchase one ounce of gold.

The movements up and down in the gold/silver ratio very clearly show the ebb and flow of demand between gold and silver. This ratio also shows us something else.

There exists a phenomenon that I call the ‘silver paradox’.  Namely, if we analyze the minerals in the earth’s crust, there is about ten times more silver than gold. Therefore, given this amount of the relative supply of these two metals, why isn’t the gold/silver ratio 10:1 instead of the present level of 55:1? 

The simple answer is that supply is only one-half of the supply/demand equation that determines price. The demand for gold and the demand for silver also need to be factored in, which leads to the second part of the silver paradox. Given that there is relatively little demand for gold as an industrial metal or for its use in items such as jewelry, gold’s demand clearly arises almost entirely from its monetary use, but silver is different.

Silver has a very strong industrial demand.  What’s more, in contrast to gold which is hoarded and not consumed – i.e., gold does not disappear – silver is consumed in photographic and other applications, never again to re-appear. To explain this observation another way, essentially all of the gold mined throughout history exists in its aboveground stock. While the size of the aboveground stock of silver is controversial and probably unknowable, it seems likely that less than one-half of all the silver mined throughout history still exists in its aboveground stock, which brings us back to the silver paradox. Given the relative amounts of gold and silver that appear in the earth’s crust and given silver’s relatively small aboveground stock compared to gold, should not their ratio be 10:1 or perhaps even less?

The answer again comes back to demand. The demand for silver is elastic, while that for gold is relatively inelastic. Therefore, at the bottom of the precious metal bear market in the early 1990’s, it took over 100 ounces of silver to buy an ounce of gold. It still takes 55 ounces of silver to buy one ounce of gold, but the trend is clear. Silver is gaining on gold, and will continue to do so as this precious metal bull market continues to develop because on the margin any new money coming into the metals has a bigger impact on silver. 

Thus, while I am very bullish on the long-term prospects for gold, I am even more bullish on silver.  Historically, the ratio of these two precious metals is about 16-to-1. Therefore, as both gold and silver climb higher in this current bull market, I expect silver to climb even faster than gold, outperforming so that eventually the gold/silver ratio approaches 16-to-1.



by James Turk
Copyright © 2007 by James Turk.  All rights reserved.

James Turk is the Founder & Chairman of GoldMoney.com http://goldmoney.com/. He is the co-author of The Coming Collapse of the Dollar www.dollarcollapse.com.


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