Why would investors buy silver over gold?

I wrote a piece last week analysing the thesis behind investing in gold. But how does silver stack up against its slightly-shinier cousin?

Is gold a recession hedge?

First, let us look at gold. Typically, gold is viewed as a safe-haven asset. This is due to its uncorrelated nature with risk assets and the fact that it rises in times of uncertainty, as the below chart shows.

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Then there is the inflation narrative. Long reputed as one of the soundest assets to protect one’s purchasing power, gold plotted against inflation since 1970 more or less backs this theory up.

The notable deviation is this past year, when inflation has spiralled aggressively while gold has lagged, closing 2022 out at pretty much the same price it opened the year at. This may seem counterintuitive, as inflation is meant to send gold upward, but the kicker is in the Federal reserve’s actions this past year.

The Fed has been adamant that it will fight inflation and has proceeded to raise rates swiftly. We have gone from 0% rates to above 4% in a matter of months. This attacks the heart of inflation, which is the impetus behind a rise in gold. The muted return of gold this year is hence the market pricing in the Fed’s actions.

How does silver compare?

OK, so gold is traditionally an inflation hedge and rises in times of uncertainty. Fine. But how does silver compare? From the same shiny metal family, are its return drivers similar?

The first thing to point out when investing in silver is that it is cheaper than gold and more thinly traded. This helps kick its volatility up a notch when compared to gold.

Let us now plot silver against periods of recession, just like we did for gold earlier:

It is clear that the volatility is a notch above, but the price action follows a similar path – it rises during times of uncertainty. Note that the above charts use the official definition of recession, i.e. two consecutive quarters of falling GDP, and hence it can be somewhat of a lagging indicator with regard to market uncertainty. This is why both gold and silver have often risen in the late stage of the cycle just before a recession officially kicks in.

A clearer way to show gold’s relationship to silver is just to whack them on the same chart:

It is evident that gold and silver trade in lockstep and with an extremely high correlation, albeit with a higher volatility by silver.

Why invest in silver over gold?

The question then becomes why an investor would choose silver over gold. This question is even more poignant when comparing their returns. The ratio of the price of gold to the price of silver was 29 in 1973. Today, it is 75, while it reached as high as 114 during the pandemic.

Put another way, since 1973, gold has returned investors 23X in their investment, whereas silver has only returned 8X (both of which pale in comparison to the stock market, which has yielded 33X).

It is a little befuddling what drives the ratio between gold and silver. I played around with a few options and could not find a statistically significant relationship.

It is also worth mentioning that the above charts plot data back to the 70s, but silver and gold have traded for thousands of years, and the ratio in 2020 was the highest according to what records we have. So it does suggest that for whatever reason, gold has extended its dominance over silver in recent times.

Perhaps this is one theory for why silver may be the better investment than gold right now. If the ratio is so out of whack, surely there will be mean reversion? But the flip side is that there could have been a structural break, i.e. a change in the pattern of supply and demand that for whatever reason, has kicked gold permanently up a notch against silver.

The one factor that could throw a spanner in the works here is industrial use. Around half of silver’s demand is derived from its industrial uses – manufacturing, electronics, automobiles, solar panels and so on. This means that demand is somewhat affected by the state of the overall economy.

Gold, on the other hand, has far less industrial uses and therefore, at least theoretically, has much less reason to be affected by the state of the economy, hence allowing it to act as a hedge more freely. Perhaps this is one reason that investors have flocked to the asset over the last few decades ahead of silver.

Final thoughts

It is hard to pinpoint exactly why these assets have performed differently. But what is clear is that the duo do act as solid hedges in times of uncertainty, and have a unique but valuable place in the modern financial environment.

Silver is significantly more volatile than gold and traded more thinly, but both metals are highly correlated and are pushed by the same factors. Gold has comfortably outperformed the “poor man’s gold” in recent decades, but whether this continues or not is hard to say.

With inflation expectations softening over the last couple of months, there is now thought that the Federal Reserve could pivot off its interest rate policy earlier than otherwise anticipated. High rates are attacking inflation head-on, and hence curtailing gold and silver’s greatest return driver.

If that ends, the path of the duo will be very interesting to follow.