A silver lesson in hedge against soaring inflation

Just when you thought it might be safe to go back into the credit markets the warning signs are flashing red again. And precious metals are expected to be the best place to hide in such a crisis with silver the best option to maximise returns, just like the Hunt brothers and their Arab partners did in the 1970s.

In what looks like a re-run of the Bear Stearns tragedy in March, the cost of insuring bonds from Lehman Brothers, Merrill Lynch and other brokerages against default has jumped in the past couple of weeks. There has been a steep rise in swap spreads over the past week. It could be that stage two of the credit crunch will shortly be upon us, triggering another sell-off of United States equities and serious trouble for more major financial institutions.

Analysts are also worried that the US Federal Reserve could be facing a crunch itself as its huge $800 billion (Dh2.93 trillion) assets have been dented recently with $300bn of T-bonds swapped for dubious mortgage debt and $130bn put up for term auction credit.

Arabian investors have largely shunned international investment this year, preferring to stay on the sidelines. Instead, they have participated in a modest rally in their own stock markets, admittedly mainly driven by global funds, and directed money into the booming local property sector. It is perhaps wise not to be too bold when the global banks are in trouble.

Many analysts are drawing parallels with the 1970s, a decade characterised by high oil prices and a huge boom in the Middle East. Then as now inflation surged, property prices crashed in Western markets and the banks and capital markets took a big hit. The '70s were a tough time for investors, and only energy and precious metals scored highly.

The classic tale of the '70s is that of the Hunt brothers, then the richest family in America, and their success in monopolising the silver market with a group of Arab investors. The Hunts saw the inflation problem coming and decided to beat inflation by buying silver, starting at $1.95 an ounce in 1973. This worked brilliantly and by 1979 the Hunt brothers and their Arab partners had amassed half the world's silver in a pool and the price peaked at $54. But they used too much leverage and the authorities changed the rules on margin trading to pop the silver bubble. Could this happen again today?

As inflation rears its ugly head there are bound to be very wealthy people like the Hunts who look for a way to protect their assets. Indeed, Warren Buffett, George Soros and Bill Gates are among individuals known to have invested in silver.

But so far nobody has gone as long on silver, or invested as publicly as the Hunt brothers. That perhaps was one of the mistakes that the Hunts made, although it must be difficult not to attract publicity if you are effectively cornering a market, something the Hunts still deny.

Why did the Hunts pick on the silver market? Then as now hard assets provided a hedge against surging inflation: the supply of silver is basically finite while the paper money supply is infinite. So in a time of inflation precious metals make sense for investors looking to preserve real value and are monetised. The Hunt family clearly did not originally make its billions without a shrewd investment gene in its pool. And choosing silver was a leveraged play on the much larger gold market that is also an inflation hedge. Basically the silver market is around one hundredth the size of the gold market so it is possible for a very large player to dominate the silver market to its advantage.

Even the richest private individuals or oil sheikhs would fail to control the gold market that is simply too large. Silver is another matter, and actually 28 years post-Hunt nothing much has changed. Silver is still a tight market where surges in investment demand produce violent price changes, and it has recently outperformed gold.

But it says something about the silver market collapse that the Hunt's precipitated – when central banks pulled the rug out from under their margin trading – that silver is trading today at about $17-18 an ounce, still down on its $54 peak almost three decades ago. Confidence has still to rebound and investor demand for silver is a tiny fraction of the demand for gold, although it is growing strongly.

Perhaps we will not see another blatant cornering of the silver market. But the inflation protection story that originally caused the Hunts to invest in silver in 1973 is another matter entirely.

The silver-to-gold ratio has a long-term average of 15 and not 52 as it stands today, and that price gap should now close, along with the gold-to-oil ratio. Bring silver back to its long-term average ratio to the gold price, and restore gold to its long-term ratio to the oil price, and silver will be five times higher in value than it is today – with no further increase in oil or gold price.

Just how cheap is silver? Consider how its absolute price is still a substantial discount off the $54 all-time peak 28 years ago. Then I was an economics undergraduate at Oxford University and British Rail tea cost 19p a cup – today it costs more than five times that amount. Indeed, I cannot think of anything apart from silver that is cheaper in absolute price than in 1980. Even gold is up on the $850 spike of 1980.

The big difference between gold and silver is that silver is consumed by industrial processes while gold just accumulates. That is why there is only a tiny fraction of the amount of physical silver in existence compared with physical gold. If you are thinking about scarcity it is silver that should be more highly priced than gold, not vice versa.

In March this year this was only too evident. It was not the bullion dealers who ran out of gold in the price spike, it was silver coin shops that saw their stocks quickly exhausted. Even the Perth Mint is taking a few weeks to convert unallocated silver to allocated metal because the demand exceeds immediately available supply.

The demand for coins from retail investors is similar to what happened in the late 1970s. As a young student I found that pre-1947 UK coinage was valued above its face value for the silver content and fortunately my father had coin-operated launderettes as a business – so I used to sort the coins and make a profit selling the ones with a high silver content. Later the silver price crashed and my little sideline was not worth the trouble. But looking back the sudden interest in silver coinage was an indicator of the boom, spike and crash that was to come in the silver price.

Yet if the Hunt saga offers a single lesson it is to avoid margin trading in precious metals. For one thing price movements can be far too volatile to make this worthwhile, for another it leaves you vulnerable to your lenders. And just remember that the Hunts would have remained brilliantly hedged against inflation if they had not got greedy and borrowed too much. That was their real error, ignoring the central banks that spiked the silver bubble by cutting off their credit lines.