There have been several opportunities since the 1979-1980 gold and silver boom where the gold/silver ratio was so distorted that it was possible to trade out of one metal into the other to realize a possible gain when the ratio turned around.
Since the end of 1980, the gold/silver ratio has been anywhere from about 30:1 to 90:1. At last Friday’s closes, the ratio exceeded 74:1. In other words, the spot price of gold was more than 74 times that of silver.
The ratio has been in the 50s much of the time over the past few years. At the end of April 2011, when the silver spot price neared $50, the ratio dipped down to around 30.
I look for a long-term equilibrium to hit somewhere around 35:1 to 40:1 between the two metals. I know several analysts who expect the ratio to be much lower. I don’t think I know any who predict much higher than I do.
Here’s a simple example of how a swap of gold to silver could pay off. To make it the least complicated, assume that you can buy and sell both metals right at the spot price. So, as of last Friday, you could have traded one ounce of gold and received 74 ounces of silver.
Then, if the ratio falls to 37, you could swap 37 ounces of silver to get back your one ounce of gold and keep the rest of your silver as a profit. Or you could swap all 74 ounces of silver and receive two ounces of gold, with the second ounce being your profit.
In real life, there are a few complicating factors when contemplating a swap between bullion-priced gold and silver.
First, you cannot buy, sell, or swap precious physical precious metals right at the spot price. Any dealer helping you with such a swap won’t be willing to handle the transaction unless there is the opportunity to earn some income. If you do such a swap, figure the best you might come out is receiving merchandise that could be liquidated for about 5 percent less right then versus the metal you just traded away. Therefore, the gold/silver ratio would have to move 5 percent in your direction, at a minimum, just to break even.
Second, premiums on bullion-priced physical gold and silver coins and ingots can and do change. In the past 10 days, premiums have increased for silver products by a greater average percentage than for gold products. Yet, if the ratio were to swing in your favor, it is likely that the premiums would swing in the opposite direction. Because of premium changes, figure you have to get the ratio to move another 10-15 percent in your favor above and beyond the 5 percent transaction cost in the first point just to break even.
Third, you could have the ratio go in the wrong direction over your planned time frame. If this happens, your loss would be greater than if you had just kept your original holdings.
Fourth, you may have to pay federal, state and local income taxes on a swap between gold and silver. The Internal Revenue Service has changed its position over the decades as to which kinds of swaps could qualify as a like-kind exchange where there is no taxable event at the time of the swap. In a like-kind exchange, the tax basis of the former property is carried over to the new property until such time as it is ultimately sold. When gold and silver prices were rising, with people cashing out at a paper profit, the IRS wanted to force people to report these gains and pay taxes on them. However, when prices were falling, the IRS became more lenient in permitting tax-free like kind exchanges. Nonetheless, the rules for like-kind exchanges required that such transactions had to be with products of the identical metal. The IRS has always insisted that a swap of gold for silver, or vice versa, is a taxable transaction, with the gain or loss reported on each party’s tax returns. Those who have a low cost basis in their gold might have to pay some income taxes if they swapped that gold for silver. Of course, those with a cost basis higher than current spot prices might benefit from being able to deduct a tax loss when doing such a swap. Please check with your tax advisor for information.
With all of these warnings in mind, does it still make sense to consider a current swap of gold for silver? My answer is a definite maybe. If you assume that you might not break even until the ratio changes 20 percent overall, then what I am really saying is what do you think the prospects are for the gold/silver ratio to fall below 60:1?
Since even 60:1 is well above what I forecast for a long-term equilibrium ratio, I think it makes sense to consider. Having said that, I have four more caveats to mention to those thinking they might want to go ahead with a swap.
First, since none of us knows for sure which metal will perform better from now to any particular date in the future, I would recommend swapping no more than half of the gold you might hold.
Second, this really isn’t worth doing if the dollar volume involved is too small to get into better price brackets in a swap. I would not recommend any swap for a dollar value of less than $15,000.
Third, don’t do a swap unless you are prepared to sit tight for at least five years and possibly much longer.
Fourth, I would not recommend a swap unless you can do that with gold where your cost basis is higher than the value for which it would be traded today (i.e. you would be reporting a tax loss).
The question of whether to swap gold for silver on the basis of an extreme gold/silver ratio is different than asking if one should own any precious metals at all. A decision to own physical gold or silver is what I think of as buying insurance against the risk of calamities with paper assets such as stocks, bonds and currencies.
Contemplating a swap between metals is an attempt to maximize returns having nothing to do with the value of paper assets.
Patrick A. Heller was the American Numismatic Association 2012 Harry Forman Numismatic Dealer of the Year Award winner. He owns Liberty Coin Service in Lansing, Mich., and writes “Liberty’s Outlook,” a monthly newsletter on rare coins and precious metals subjects. Past newsletter issues can be viewed at http://www.libertycoinservice.com. Other commentaries are available at Coin Week (http://www.coinweek.com and http://www.coininfo.com). He also writes a bi-monthly column on collectibles for “The Greater Lansing Business Monthly” (http://www.lansingbusinessmonthly.com/articles/department-columns).His radio show “Things You ‘Know’ That Just Aren’t So, And Important News You Need To Know” can be heard at 8:45 a.m. Wednesday and Friday mornings on 1320-AM WILS in Lansing (which streams live and becomes part of the audio and text archives posted at http://www.1320wils.com).
More Coin Collecting Resources:
• Kick-start your coin collection with the Fundamentals of Coin Collecting set of essential resources and tools.
• Strike it rich with this U.S. coins value pack.
• Build an impressive collection with Coin Collecting 101.