While the soaring gold price has been front page news as the price of gold continues to set record highs on a daily basis, its sister precious metal, silver, has actually outperformed in 2009. The silver price has rocketed up 62.8% this year against a 32.6% rise in the gold price. However, as the gold price rises to all-time highs, the silver price is merely recovering lost ground from its 2008 plunge, stemming from the specter of a global recession and a wave of deleveraging liquidation not seen since the 1930s. Even at a 16-month high, the silver price is more than 12% below its record high. There is a growing contingent of investors and market commentators who are touting higher prices for silver in 2010 - noting both rebounding industrial demand for silver and growing investment demand.

Like gold, silver has both commercial and monetary utility. Physically, they share common attributes such as immutability, non-corruptibility, and excellent electrical conductivity, making them indispensible to a growing number of industrial and commercial processes and products. If the nascent recovery in several industrial sectors picks up steam, then the prospect of higher silver demand looks bright.

Many market commentators advocate silver as an investment substitute for gold claiming that, in a much cheaper manner, silver offers a hedge against currency debasement. Is silver really an investment substitute for gold? Silver has long been used as money, dating at least to 2000 BCE in Mesopotamia, and was the primary monetary element until the silver boom of the 1860s. The flood of silver coinage resulting from the boom drove many European countries to abandon the bimetallic standard in favor of the gold standard. Despite its demotion in monetary status, silver continued to serve as money well into the 20th century. By this time, industrial uses for silver were increasing.

In the United States, silver was officially eliminated from coinage in 1965 by an act of Congress given that the gap between silver supply and demand for the metal had caused the market price to exceed the official prices of exchange then in place. Silver has been used as money in more civilizations and for longer periods than gold. Milton Friedman once stated, “The major monetary metal in history is silver, not gold.“

One key difference between gold and silver is the fact that industrial demand has a negligible impact on the movement of the gold price. Last month GoldAlert discussed the market mechanics of the gold price in a piece which cautioned investors not to apply traditional supply-demand analysis when assessing the value of gold. We were prompted to do so after a number of stories appeared in the financial press that warned of a gold “bubble“ and emphasized the decline in gold demand in the form of lower jewelry sales and industrial uses. As we pointed out, even the largest increase in the annual growth of gold production is approximately 2% of the above-ground stock of all gold ever mined - meaning that even sizable fluctuations in annual supply have a negligible effect on the gold price. Instead, the price of gold fluctuates based upon its investment demand, which is affected by macroeconomic factors such as the level of real interest rates, money supply growth rates, fiscal deficits, and the overall confidence in the integrity of fiat currency.

The gold/silver ratio has seen significant volatility over not only the past year, but over the last few decades. The ratio has ranged from 100 (in late 1990-early1991) to a low of 15 (in 1980). In the last ten years, the ratio has ranged from a high of 84.4 to a low of to 43.6. Currently, the ratio is almost exactly in the middle of this ten-year range at 63. The ratio trends upward during difficult economic times, as the price for silver declines due to waning industrial demand. As markets recover or rise, industrial demand for silver picks up and the silver price begins to rise as risk appetites re-emerge. The gold/silver ratio has contracted from its 10-year high of 84.4 in October 2008 to its current level of 63.

Despite the increase in the gold price over the past year, silver’s ascent has been much greater on a percentage basis. However, if equity markets reverse direction and head lower, if credit markets seize up again, or if another deflation scare manifests, then the price of silver can be expected to underperform the price of gold.

The question of gold versus silver is a question of what one’s view is on the state of the global economy and whether a double-dip global recession will emerge in 2010. For those speculating that reflation efforts by central bankers have succeeded in stimulating private demand and the global economy will build on the recent growth experienced this past quarter, the silver price should out-perform the gold price. For the more bearish investor, one who believes a new round of asset price liquidation will occur in 2010 on the back of weak growth and a failure to revive employment, the gold price will be the relatively stronger asset.