Why The Gold/Silver Ratio Is A Useful Indicator

There’s a debate in gold bug circles over whether the price difference between gold and silver – the gold/silver ratio – tells us anything useful. Some skeptics, for instance, view the original gold/silver ratio of 15 — from America’s 18th century bi-metallic system – as just a political number pulled more-or-less out of thin air by Alexander Hamilton and therefore useless today. Others note that gold is a purely monetary metal and silver is part industrial, part monetary, and conclude that it’s apples to oranges — and therefore not an indicator of future prices.

Both points are factually defensible, sort of. But they’re also irrelevant. The real reason the gold/silver ratio has tended to fluctuate within a broad but well-defined range is that humans have a vivid visual imagination. Here’s how it works:

Early in a precious metals bull market, people are skeptical of the need for safe-haven assets, so the money that flows into the sector goes mostly to the big-name, super-safe choice, which is gold. Gold goes up relative to silver, and the gold/silver ratio expands.

Gold keeps rising and new money – much of it attracted by the metal’s newfound price momentum rather than an understanding of the nature of money – flows in, pushing gold even higher.

The early gold investors register big gains and begin to feel smart and therefore more willing to take on a bit of extra risk in return for potentially even bigger gains. They look around for “the next gold” and find silver, the other monetary metal, languishing at a relatively low price.

Then they start thinking in images. First, they picture a single one-ounce gold coin and consider what it would cost. At gold’s new, higher price, this seems like a lot of money for such a small, though admittedly pretty, thing.

gold coin gold/silver ratio

Next, they consider the price of silver and envision how many – also very pretty – one-ounce coins they can buy for the price of a single ounce of gold. And their imagination conjures up something like this:

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