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 isimpossible.

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.

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.

By Adam Hamilton, CPA

Questions for Adam?   I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/adam.htm for more information.

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