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February 22, 2005

What Does the Past Tell Us About Silver, Gold, and China?
by Yi-Chang Wang

Regular readers of this investment website may have been exposed to China as an emerging power. They may also have been exposed to generally bearish-prone analysis of the US stock markets, thereby, advising them to focus on precious metals investment. But which is better? How will the future performances of silver and gold compare to emerging-market investments in China? While I don't claim to be clairvoyant, I think there exists a good way (if only a back-of-the-envelope calculation) to at least guess about the relative future returns of these two important asset classes.

Before I go on, I like to thank the readers who e-mailed me about my last article, "Does Technical Analysis Work in the Silver Market?" One critiquing e-mail particularly standout. I enjoy well-reasoned criticisms, which make a writer think harder, improve contents, and build up analytical arsenals. I hope to return to the topic of technical analysis when I have time.

Back to the Future

If you are a regular reader, you may have already been exposed to the concept that compares the current global economic environment, particularly the US economy, to that of the 'Seventies. While I think that there are some differences, I do feel that this is a good way to think about the relative performance of precious metals and China. Similar to the first decade of the new millenium, the 'Seventies witnessed an emergence of a new economic power in East Asia. That is: Japan.

Therefore, I felt that a good proxy about the future is to tabulate the past performance of the Japanese stock markets during the 'Seventies. And then compare that return to that of silver and gold of the same decade. The result is summarized in the following table:

Before you rush to draw your own conclusions, we have several issues to consider...

Data Sources

The return for the Japanese stock market is calculated from the data compiled by professors Dimson, Marsh, and Staunton in their work, Triumph of the Optimists. On page 271 of their work, Dimson et al tabulated, for Japan's 'Seventies, the real return on equities, real exchange rate return of Yen relative to US$, and inflation rate as 3.4%, 6.1%, and 9.0%. All three figures are annualized returns for the decades. I merely added the three up (3.4 + 6.1 + 9.0 = 18.5%) to obtain the Japanese annualized return in US$.

Please note that the real equities return of 3.4%, tabulated by the three professors, is total return. This is important because dividends under high inflation era of the 'Seventies can actually become quite high. This is due to inflation's valuation multiple contraction effect on the stock market. Therefore, presumably a significant portion of the Japanese equities' return may be due to dividend return. When comparing to silver and gold, the dividend takes an even more important role since the precious metals don't pay dividends.

Two additional interesting notes: the real return from exchange rate for a US-based investors is as high as 6.1%, better than the stock market! The other interesting fact from the professors' work is that Japanese actually experienced higher inflation rate, despite of strengthening Yen, than the Americans. According to their data, the US annualized rate of inflation for the decade is 7.4%. That's a good 160 basis points below that of Japan's. This maybe due to Japan's policy decision to pursue a high growth strategy. Interestingly, Peter Drucker in Managing in the Next Society has observed that during the 'Sixties and the 'Seventies, the Japanese pursued a high growth strategy due to large number of poor rural-area inhabitants. Sound familiar?

For the precious metals, I have trouble obtaining the exact price series. Therefore, I used estimates from the graphs.

Silver's return is obtained from TFC Charts' historical section of the chart menu. Price at the beginning of 'Seventies is estimated to be $1.82 per ounce. I used the opening price of 1970 chart for the estimate. The closing price chart of 1979 is used to estimate the ending price of the entire decade. I estimate it to be $29 per ounce. Taking the 10^th root of the ratio, $29 divided by $1.82, and subtracting one from the result; I get a rounded up return of 0.3190. That's an annualized return of 31.9%.

Gold's ending price in 1979 is estimated from the BigCharts.com's graphs. It's estimated at $525. The BigCharts gold graph (ticker symbol: 38099902) only went back to the beginning of 1971. Therefore, I have decided to use the $35 fixed gold price as the beginning for calculation. Note that this may overestimate gold's return a little bit. I think it's OK because I am a silver bug! Moreover, if one plug in other possible numbers such $36 or $37 per ounce, gold's return is still significantly higher than the Japanese equities. So, taking the 10^th root of the ratio, $525 divided by $35, and subtracting one from the result; we get a rounded up return of 0.3110. That's annualized return of 31.1%.

The Results

As one can see, silver triumphs! Gold shines! The famed Japanese equities investment is actually a loser. And it's quite a significant performance gap according to the numbers in the third row. If an investor put $10,000 into each of the three assets in the beginning of the 'Seventies, at the end of the decade, the proceed from either silver or gold investment would have grown to almost triple of Japanese stocks!

This is all the more amazing considering the fact that during the 'Seventies, Japanese stocks not only outperformed the US stocks (3.4% versus negative 0.7% annualized real equities return according to the professors), Japanese Yen also produced quite handsome return for US-based investors. In fact, the Yen almost doubled against the Dollar at the end of the decade.

Japan versus China

This issue may already be in the minds of astute readers as they go through this numbers. Although my calculation and assumptions are fairly generalized, I think the 'Seventies Japan is a relatively good analogy to that of China in the new millenium from the perspective of stock market investors only.

In terms of their similarities, both East Asian countries draw from the same root, and are likely to have similar business practices and, more importantly, similar development policy mind set. On the later point, one can observe both countries have political leaders that are eager to pursue a high growth strategy during their developmental phrase. It's almost a growth at all cost mentality!

On the other hand, size maybe a very significant difference between the two countries, at least intuitively. The shear size of Chinese population, not to mention the Indians, would seem to indicate either a tremendously lengthy period of growth, an intense and high rate of growth, or perhaps both.

Although the size factor maybe a positive for Chinese stock market return, I think one must consider an often over-looked difference between these two-decades apart growth stories. When the Japanese experienced rapid economic development during the 'Sixties and 'Seventies, it was a "stealth" economic growth. Only the very vanguard very internationally minded investors, such as John Templeton and Jim Rogers, took advantage of it. Therefore, it's fair to characterize the Japanese bull market for both decades as "stealth bull markets." Only in the 'Eighties did the Japanese growth story became well known globally. China, on the other hand, is a fairly well disseminated theme. Even a few years ago, the financial media had already begun to discuss this issue quite frequently. Because of this difference, the Chinese stock market has the possibility of producing less stellar return at the end of this decade when comparing to Japan's 'Seventies. Even though I'm very bullish on the Chinese economy, I'm not terribly bullish on the Chinese stock markets when comparing to silver and gold.

Conclusion

I cannot predict future. But I think I have made a case for possible future relative returns in this article. When we reach 2010, both silver and gold are likely to outperform the Chinese stock market. Therefore, long-term portfolio allocation strategy would be well advised to be aware of such possibility.

As for choosing between silver and gold, I think many writers have illuminated the relatively more favorable supply and demand characteristics of silver when compare to gold. Interestingly, even back in the 'Seventies, when silver's supply deficit wasn't as tight as now and there were a lot more verifiable above ground silver stockpile, silver had already outperform gold. This report focuses strictly on the period from 1970 to 1979. If one look at the absolute high prices for both metals (i.e. January of 1980) both silver and gold reached $50 and $850 per ounce prices. That's 27.47-fold (=$50/$1.82) and 24.29-fold (=$850/$35) capital gains for silver and gold respectively. I favor and recommend silver.

As for the idea of investing in China, I recognize that there are some diversification benefits in the concept. Even though I favor a core holding in silver for a long-term portfolio in this first decade of new millenium, there may exist some interesting investment opportunities of China-related investment themes. In the future, when timing seems right, I hope to comment on these relatively low risk, "going through the backdoor" approach to China investments. So stay tuned.

Yi-Chang Wang

DISCLAIMER: The author is not a registered stockbroker nor a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliability of his own credible sources. Of course, the author recommends that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.

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