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After being sucked into the general commodities correction, silver has
been relentlessly drifting lower since late February. But this weakness has
forced the white metal down to a very bullish place technically. Silver is
now quite undervalued compared to prevailing gold prices, its primary driver.
Thus it has great potential to rally mightily in the coming months to regain
much lost ground relative to gold.
Silver is a fascinating commodity that has won a fanatical following
among traders. It is extremely volatile, with big spikes or plunges always
possible. This makes it irresistibly alluring to speculators, who alternately
pile in to ignite huge rallies before running for the exits to spawn near-crashes. The perpetual
back-and-forth struggle between greed and fear is the essence of speculation,
and silver embodies it.
But what drives these winds of sentiment that buffet silver around? Gold. Silver traders constantly look to the yellow
metal’s fortunes to figure out whether they should buy or sell the
white metal. While there are rare and short-lived exceptions, the vast
majority of the time silver only rallies significantly when gold is strong
and only sells off materially when gold is weak. Gold is the key to
silver’s price action.
Greed flares up in silver traders’ hearts when gold is strong,
motivating them to aggressively buy silver and catapult it higher. And fear
rears its ugly head when gold is weak, scaring silver traders into dumping
silver hand over fist which crushes its price. Because gold overwhelmingly
influences silver-trader psychology, it is the primary driver of silver.
Technically this has proven irrefutably true for decades now.
And silver’s recent correction is no exception to this rule.
Silver’s last major interim high was on February 28th, the exact day
gold’s latest top was carved. The next day gold plunged when the Fed
Chairman failed to hint at a third round of quantitative easing in
testimony before the US Congress. Since then, silver has lost 26% while gold
only gave back 12%. This has left silver “undervalued” compared
to gold.
Now since silver doesn’t spin off any earnings like a stock, it
can’t be valued with traditional valuation metrics like
price-to-earnings ratios. But its historical relationship with gold is so strong
that it can be valued compared to gold, an alternative valuation measure.
When silver gets too high relative to gold, a correction is due to restore
this relationship. And when it gets too low, like today, a rally is probable.
This first chart simply looks at the silver price superimposed over the
gold price. Before 2008’s once-in-a-century stock
panic, silver tracked gold very closely. But the panic’s epic fear superstorm forced hyper-speculative
silver to decouple from gold to the downside. Silver eventually caught up
with gold again, and overshot to the upside in a mini-mania in early 2011.
And today it is once again way too low.
Before the stock panic, silver’s correlation with gold was very
tight both visually and statistically. Silver had a pre-panic r-square with
gold of 94.7%. This means nearly 95% of silver’s daily price action was
statistically explainable by gold’s own! Silver was truly a leveraged
secondary play on the gold price, rallying when gold was strong and selling
off when gold was weak. Gold overwhelmingly drove silver.
But the stock panic’s extreme fear radically disrupted this
historical relationship. While gold plunged 27% between July and November
2008, silver plummeted 53%! This dragged silver to a 34-month low, while gold
only hit a 14-month low. Silver was simply too low relative to gold, creating
an incredible buying opportunity as I discussed just after the panic.
Silver would have to soar to reestablish this relationship.
Interestingly during the panic, silver’s r-square with gold plunged
to 52.5%. Only half of its daily price action was statistically explainable
by gold’s own. This brings up a second important point for silver
traders to understand. While gold is silver’s primary driver, the stock
markets sometimes usurp it. Major stock-market down days generate so much fear that it spills into silver
and taints this hyper-speculative metal’s sentiment.
After the panic silver indeed rallied strongly with
gold, but the panic-driven gap between these metals persisted for a couple
years. Silver didn’t really start regaining
favor with traders in a big way until autumn 2010 when it started surging
much faster than gold. By late 2010 it had finally caught up with gold,
regaining its tight pre-panic relationship with the metal that drives its
traders’ psychology.
But provocatively silver’s strength had started to feed on itself.
The huge silver rally enticed more capital into silver, which forced its
price even higher, which drew in still
more capital. The result was a mini-mania in early 2011 where silver blasted
higher to hugely overshoot the gold price. While fun, silver was extremely
overbought and the rampant greed was mind-boggling. So a sharp plunge was
imminent.
I warned our subscribers in advance, just as silver was topping. And the
resulting plunge was actually a near-crash, an extreme
selling event nearing crash magnitude. Unfortunately silver’s
mini-mania had pulled most near-term buying forward, leaving overwhelming
selling pressure in its wake. So silver started grinding lower on balance,
ultimately correcting 46% between April 2011 and June 2012.
The latest part of this correction since February is particularly
interesting for us today. Note that silver had nearly regained its historical
relationship with gold before Bernanke’s latest QE3 scare hammered the
precious metals. But the subsequent outsized selloff in silver, which
leveraged gold’s downside in recent months by 2.2x, has left silver too low relative to gold
today. A panic-like gap is back, a very bullish omen.
Silver, which is trading near $27 this week, would have to rally to
$35ish to regain its historical “valuation” relative to gold.
This is a 30% move higher, and assumes gold doesn’t advance which would
push the silver target even higher. This silver catch-up rally is likely to
begin soon, no later than September. Once we get through this year’s
usual precious-metals
summer doldrums, silver has a lot of ground to make up.
But silver’s near-term potential is even greater than this as
evidenced by the Silver/Gold Ratio. The SGR mathematically quantifies
silver’s close relationship with gold. It is calculated by dividing the
daily silver close by the daily gold close and charting the resulting
multiple over time. Since the true SGR results in tiny decimals (like 0.017
today), I prefer to use an inverted Gold/Silver Ratio scale as
an SGR proxy.
For me at least, it is a lot easier to think in terms of ounces of silver
per ounce of gold (58) than the other way around. So the SGR proxy on this
chart is rendered in blue off the right axis, superimposed over the raw
silver price in red. This particular perspective on silver’s
relationship with gold is far more precise than the visual comparison in the
first chart. And it shows silver is quite undervalued relative to gold.
Prior to the epic discontinuity of the stock panic, silver traded in a
range between 60 ounces per ounce of gold on the low side to 45 on the high
side. This is highlighted in darker blue in this chart. When silver was in
favor among speculators it was high in this range, and when it was out of
favor it was low. The pre-panic average was 54.9. But silver plummeted so
fast during the panic this average briefly fell to 75.8.
Silver was quick to recover after the stock panic, temporarily regaining
the lower support of its trading range as early as autumn 2009. But then it
drifted lower again until autumn 2010, when gold rallying to new all-time
nominal highs finally rekindled greedy excitement among silver traders. So
silver took off like a rocket, blasting higher in a mini-mania that
ultimately peaked at an SGR near 32 in April 2011.
This incredible spike opens up another technical perspective beyond
silver’s horizontal trading range relative to gold. As you can see on
this chart, the SGR was actually in a secular uptrend before the panic and
regained that trend channel for over a half year in 2011. So there is a
chance as silver’s allure spreads to more mainstream speculators this
metal could once again be pushed back up into that secular uptrend.
Today the SGR is trading near 57.9,
it takes almost 58 ounces of silver to equal the value of a single ounce of
gold. But this is very low in the SGR’s trading range, and way below
its secular uptrend. These metrics yield a variety of near-term upside
targets for silver, all possible between this autumn and next spring. No
matter how you want to look at silver today, it remains quite undervalued
relative to gold.
After the SGR has fallen relentlessly for 14 months, silver is certainly
due for some outperformance relative to gold. Silver enthusiasm is like a
sine wave oscillating around the gold price, periods of underperformance are
followed by periods of outperformance and vice versa. So conservatively it is
not hard to imagine silver shooting back up near the top of its horizontal
SGR trading range by next spring.
This means silver would have to rally until just 45 ounces of it equaled
the value of an ounce of gold. At this week’s gold price of $1580, a 45
SGR implies a silver price of $35. Interestingly this is the same target the
first chart yielded, so once again it is a 30% rally from today’s
levels. That’s not too shabby at all, and would certainly lead to
soaring prices for today’s all-but-abandoned silver miners’
stocks.
But what if gold rallies too? Throughout its decade-long secular bull, gold has averaged a seasonal rally around
19% between late July and late May during its strong season following its
summer doldrums. If gold is 19% higher by next spring, we are talking
$1875ish. Plug a 45 SGR into that, and silver’s upside target for its
coming strong season rises to $42. This is an impressive 54% rally from this
week’s levels!
But since silver has been out of favor relative to gold for so long, I
suspect merely seeing silver head back up near the resistance of its
pre-panic trading range is fairly conservative. So how about an aggressive
upside target? If silver regains favor among speculators again over its
coming strong season, which is certainly possible, it could punch back into
its secular uptrend in SGR terms. Its midpoint is 34 now.
At today’s gold prices, a 34 SGR implies a silver price of $46.
This is 70% higher than today’s silver prices! But if you assume a
normal seasonal gold rally between now and spring, a 34 SGR implies $55
silver by May. This is a staggering 104% above today’s levels! While
this higher target is a lot less likely since speculators will have to fall
in love with silver again for it to happen, it is still definitely possible.
Regardless of which SGR target you think is most likely in silver’s
upcoming strong season, there is no doubt that silver is undervalued relative
to gold today. After being out of favor compared to gold for over a year,
silver has been driven to such compelling price levels that it
shouldn’t take much of a gold rally to get speculators salivating over silver
again. And gold’s usual summer-doldrums drift is nearing its end.
Don’t underestimate the power of this mean-reversion tendency in
the precious metals. Back in February
2009 when I first ran these charts just after the panic, the SGR was
trading way down near 72. There was so much silver despair after its
panic-driven plunge that people thought I was nuts for thinking silver would ever
recover. But recover it did, not only regaining its historical average
relative to gold but far exceeding it.
This is a fantastic lesson for precious-metals-stock investors and
speculators to take to heart. Recently despair hammered the gold stocks and
silver stocks down to panic levels relative to the gold price! I wrote about this
extensively, explaining what extreme bargains PM stocks have become. Yet
traders are still so scared they won’t touch PM stocks with a ten-foot
pole. They believe a mean reversion is impossible.
But as silver’s meteoric mean reversion and overshoot
relative to gold proved in late 2010 and early 2011, sectors don’t stay
out of favor forever. Sooner or later new investors and speculators
recognize the incredible undervaluations in
left-for-dead sectors and start buying. And this feeds on itself, as nothing
begets higher prices like higher prices. Silver, silver stocks, and gold stocks are all overdue to benefit
from this cyclical mean-reversion phenomenon.
And now is the time to start buying, in the heart of the
summer doldrums. Nearly every year like clockwork, gold drifts sideways in
the summer while silver and the PM stocks grind lower. This is driven by the
lack of seasonal gold-demand spikes, as I explained in an essay last week. This
leads to widespread capitulation among precious-metals traders this time of
year, just before the big autumn rally.
So seasonally the best entry points for gold, silver, and the PM stocks
are spread across the next couple weeks. Precious-metals psychology is down
near an ebb of despair this
time of year, leading to excessively-low prices in the entire PM complex.
Even though the summer doldrums happen every year, for some inexplicable
reason PM traders seem to be frightened anew each time summer rolls around.
At Zeal we just added a new high-potential silver-stock trade this week
in our weekly newsletter. Because silver is so low relative to gold, its
near-term upside potential in the coming strong season is outstanding. And
the silver stocks are even far cheaper than silver, as they’ve been
dragged down into the irrational pessimism plaguing gold stocks. Thus the
bargains to be found in this sector are amazing.
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The bottom line is silver is now quite undervalued relative to gold. It
has been losing ground compared to its primary driver for over a year now
following a massive mini-mania spike. But the selling in recent months has
been excessive, driving silver too low relative to prevailing gold prices. So
silver is likely to outperform gold in this year’s upcoming strong
season for the precious metals, which is due to start soon.
Brave contrarians willing to fight the crowd have a great opportunity
today to buy silver and silver stocks cheap ahead of this rally. As usual the
summer doldrums have frightened the weak hands into selling low. And with
silver cheap relative to gold,
and silver stocks trading near panic levels thanks to the gold-stock
capitulation, the bargains today are amazing. Seize the day and load up
before the autumn rally.
Adam Hamilton, CPA
July 20, 2012
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