Buy Gold or Buy Silver?

Gold Close to a 28-year low versus Silver; An Opportunity?
It would be an inaccuracy to write that investors don’t like uncertainty. Provided that the return makes up for the risk involved, then some level of uncertainty is acceptable. It’s the nature of the game, after all, to maximize return on investment. But the financial crises which have been brewing over the past several months, first in the Eurozone and now in the United States, have created such a high degree of uncertainty, that investors’ collective “comfort zones” are quickly eroding.
To say investors are nervous would be an understatement; given the current global economic situation, the risk/return ratio is generally off-putting. The typical “safe” investments, i.e. Treasury and government bonds, aren’t so safe anymore, and the safe-haven currencies, the Swiss Franc and Japanese Yen, may be safe, but their return is not that attractive, plus there’s the added worry that there will be an intervention by either the Swiss National Bank or the Bank of Japan.
So what does that leave? Where are investors to turn as uncertainty and instability rise? Where else but to the ultimate safe haven asset: Gold. Historically, it’s always been that way. Just this past week, gold has been pushed to an unprecedented $1,800 an ounce and there’s justifiable expectancy that it could go significantly higher before the rally ends.
Gold during Periods of Financial Stress
Analysts point out that there is an indicator of financial stress and investors’ risk aversion known within financial circles as the “Ted” spread, which is the interest rate spread between 3-month T-bills and the 3-month Libor rate. The “Ted” spread is used as an indicator of investors’ fears, and historically shows massive spikes in gold prices during periods of financial turmoil. These spikes were clearly seen during the fiscally-challenged 1970’s, and in October 1987 following Black Monday and the ensuing stock market crash, then again during the 2007-2009 Lehman-generated global crisis.
Gold is often described as the “crisis hedge,” and there is a strong and definitive correlation between periods of financial stress and the demand for gold during such times. Analysts note that there are three “financial crisis” scenarios that have historically driven up investors’ interest in gold.
Scenario #1: During periods where there is increasing volatility in asset prices and sharp drops in the value of other assets, i.e. equities or currencies, investors seek out an asset with a store of value which is independent of other assets.
Scenario #2: Investors fear a systemic collapse, say of an entire banking system, or have valid concerns of the creditworthiness of sovereign debt instruments for distressed governments.
Scenario #: Desire and need for a liquid asset during periods when it may be difficult to obtain, or even determine, the full value of other types of assets.
Gold’s Relationship to Real Interest Rates
Another factor which influences the price of gold is its relation to inflation, and the levels of real interest rates. Because gold is considered a “sterile” asset and does not draw interest, there is an opportunity cost for holding gold which increases as real interest rates rise, and decreases as real interest rates fall. Gold is especially supported during periods where real interest rates are negative, as it was during lengthy periods in the 1970’s and as it is right now, across much of the developed world. The current economic situation for many of the developed economies, i.e., near zero percentage interest rates and a modest inflationary trend, implies negative real interest rates, thus are supportive of gold prices.
Gold and Political Instability
Finally, another factor which is supportive of gold prices is political instability. In the period following the late 1970’s, beginning with the seizure of the U.S. Embassy in Iran, and the Soviet Union’s invasion of Afghanistan, gold prices spiked. In 2001, gold prices spiked again after the terrorist attacks of 9/11. In more recent months and continuing still, there has been one insurrection after another in parts of the Middle East and Northern Africa. Even among the world’s developed and democratic economies, political instability of a sort exists; it is evidenced by no-confidence votes, the resignation of elected officials and the emergence and rise of new political parties.
Gold and the Current Environment
Gold prices have steadily climbed, striking a new record high almost on a daily basis. It’s easy to see why. The United States and the Eurozone are in a state of flux and uncertainty. In the U.S., even if the debt ceiling issue is addressed, there remains the little issue of an impending and highly likely rating downgrade. In the Eurozone, there’s still a question as to whether or not the newly designed bailout mechanism will be sufficient to prevent a worsening crisis. On both sides of the Atlantic, effective interest rates are negative as inflation continues to rise. And both the U.S. Dollar and the Euro are in danger of a meltdown; investors are just waiting to see which will go first.
Silver’s Role
But what about the price of silver, you might ask? After all, it is considered a “precious” metal, used for coinage and jewelry making, among other things. True, silver may be defined as a precious metal, but it clearly doesn’t have the same “safety” aspect, nor does it hold the same cachet, as gold does, and there is one very good reason for that and it is specific to its “among other things” usage.
Silver is a key component in the industrial sector, used in the creation of a wide range of goods, including vehicles, computers, electrical and electronic components, weaponry, photo voltaic panels, etc. During a bear market, when manufacturing and production output falls, so too does the price of silver.
Earlier this year, silver prices had been trading close to a record high $50; analysts point out that the Fed’s quantitative easing program was a key factor in silver’s rise. Precious metals analysts point out that silver prices could move into triple digits, but only under certain conditions. If the Federal Reserve does eventually initiate QE3, it’s possible that silver prices could trend higher again, but as always with the Federal Reserve, investors will have to wait, and see. For the foreseeable future, however, silver prices aren’t likely to see too much volatility, at least relative to gold prices.
The Gold/Silver Ratio
Because of the relationship between silver and industry, the price risks associated with silver becomes clear. It also becomes clear why investors prefer gold. How much they prefer gold over silver can best be visualized in the gold/silver ratio. The gold/silver ratio is the number of ounces of silver one would need to purchase a single ounce of gold.
At the close of business on Friday, gold slipped from its previous day’s high to around $1,740 an ounce, while silver was trading at around $40 per ounce. The gold/silver ratio then, was around 46, a level not seen in more than six months. Comparatively, following the 2008/2009 financial crisis, the gold/silver ratio averaged near 50 for a full year.
Precious metals analysts expect that it is highly likely that the gold/silver ratio is going to continue to rise, so long as investors’ worry over the global economy persists. How high can it go? In the past, the ratio has been as high as 100, but it’s also been as low as 17; in the earlier part of 2011 (during the pinnacle of the QE2 era), the ratio was around 32.