Are gold and silver warning us of a new stage in the financial crisis?

By Dominic Frisby:

The earth's crust contains something like 0.08ppm (parts per million) silver. There is, on the other hand, just 0.004ppm gold. In other words silver is about 20 times more abundant in the earth's crust than gold.

The historical monetary ratios between the two metals pretty much reflected this. It varies according to time and place, but on average it seems roughly 16-18 silver coins were exchangeable for a gold coin of the same weight wherever - or whenever - you were.

In 2009, about 80 million ounces of gold were produced and, according to the Silver Institute, 709 million ounces of silver - about nine times more.

But gold is not nine times more expensive than silver. Nor is it 16, 18 or 20 times more expensive than silver. It is 40 times more expensive.

That seems rather a lot, especially when you consider that most of the gold that has ever been mined remains in the world, yet much of the silver has been consumed by industry.

Is that ratio normal? Or is it some kind of anomaly? Let's have a look...

Silver looks expensive - but only by recent standards

If we look back at the last 35 years, that 40 level for the gold:silver ratio is not only not normal, it's in fact extreme: silver is unusually expensive relative to gold, at least by the standards of recent history.

But this hasn't always been the case. Let's look first at historical chart of the ratio over the last 300 years. My thanks, as always, go to Nick Laird of Sharelynx. When the ratio is low, silver is expensive relative to gold; when it is high, silver is cheap.

As you can see, since the early 18th century, not long after the formation of the Bank of England, that ratio was fairly constant just around the 17:1 area. Then, in the mid-1870s, it began to climb. The old 17:1 ratio would not be seen for a generation.

The ratio became extremely volatile and, in the early 20th century, hit highs at around the 42 to 43:1 area. But, thanks to World War I, by 1920 it had come all the way back to 17:1.

This didn't last. By the 1930s, the ratio had climbed to 85, before capitulating briefly to the 45 area. Then, when WWII was in mid-flight, the ratio went above 100.

But 25 or so years later, come the late '60s, and the ratio fell back at 17, its historical 'norm'. It spiked back to that 40-45 level in the 1970s, before falling below 20 in the notorious spike of 1980 when silver went to $50.

Silver is more expensive relative to gold than in nearly 30 years

Since 1984 that ratio has never fallen below 45.

Until last week, that is. When it dropped to 39.

Why is that important?

Because you can see that, from the above charts, the 40-45 area has been a pivotal technical level. There are periods or cycles in history when the gold:silver ratio trades above it: 1932 to 1960 and 1984 till now. And there are periods when it has traded below, such as around 1963 to 1984, and pre-1930.

So I was terribly excited to see that $40 level breached. I thought we might be re-entering a cycle at the end of which silver's 'true value' would once again be recognised. If we were entering such a period, it might be that within a few years we would see that ratio below 20, once again, finally reflecting the amount of silver there actually is in the world relative to gold. Were that ratio to do that and head back to 17, and the gold price to remain unchanged at around $1,400, we'd be looking at $80 silver. Nice work if you can get it.

Is this the beginning of the next phase of the financial crisis?

But, as I have said many times, silver has a nasty habit of disappointing. On breaching that 40 level on the ratio, silver has hit a wall. Yesterday it was down about 2%. And, it wasn't just silver. Gold was down, the FTSE too, the Dow, commodities - you name it. The junior resource sector has been absolutely annihilated this past week.

It could be that this turn down is the beginning of the next phase of the financial crisis. It wouldn't surprise me. It's long-overdue and there are bearish signals all over the place. Senior gold stocks have been in a downtrend since late last year, even although gold has been rising. Emerging stock markets have been falling, although their Western counterparts have been rising. And a spike down in the gold:silver ratio often marks a major market turn.

Or it could be that this is just a temporary stumbling block on the inevitable road back to that magical 17:1 ratio.

For my own part, I think the ratio is heading a lot lower - eventually. The key is that last word, 'eventually'. Look at the run silver has had since August. Look at that last spike down in the gold:silver ratio. I would venture that much of that needs to be retraced, just as it was in early 1998 and 2004, when the gold:silver ratio had similar runs to now. (They're worth studying in the chart above).

Dominic is MoneyWeek's commentator on commodities, and is an active private investor in junior mining and energy companies. He is the presenter and producer of Frisby's Bulls & Bears - an internet radio show where Dominic discusses the commodities and financial markets with leading lights of the sector. Dominic was educated at St Paul's School, Manchester University and the Webber-Douglas Academy Of Dramatic Art. Aside from his involvement in the commodities sector, Dominic is also one of the UK's leading voiceover artists, a TV presenter and stand-up comedian.

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