If diamonds are a girl’s best friend, and everything that glitters is gold, where did silver go wrong?

This is precisely the question making the rounds among precious metals enthusiasts these days. How is it that silver took such a beating recently, while gold escaped relatively unscathed? Was it, as some suggest, manipulation by a dark, totalitarian cohort that seeks to rule the world and all its wealth with impunity? Was it the collusion of banks looking to profit from a manipulative short sale scheme?

Those claims we’ll address when time and space permit.

But first, the damage assessment.

Silver stocks were without question the most reviled quarter of the resource sector this last half year. While gold bullion prices dropped 23% from their highs back in March, silver bullion plummeted over 40%. The average silver stock took the boots to the tune of 51%. And all told, silver miners as a group gave up $21 billion in market cap in just a couple of months.

A look at the last few years of trading reveals just how deep the damage was. This is a chart of the continuous silver futures contract from the beginning of 2006.

1. Note that from a high above $21, silver was crushed, trading down to the $12 range for a couple of weeks in mid-July.

2. See, too, how well the metal held above support – both the 200 day moving average and its two year trendline, both of which look solid at or above the $12 level.

3. Finally, RSI and MACD indicators tell a tale of a vastly overbought market in the first quarter of ’08 that was due for a correction.

And a mean correction it was. But in the meantime, the opportunities for investors are explosive. It appears the general public is preparing to join the upcoming silver buying melee.

Bankers are buying gold?

When was the last time you heard three major banker/brokerages advising clients to BUY precious metals?

We couldn’t believe our eyes either. But last week, UBS, Citigroup and J.P. Morgan all advised clients to start purchasing precious metals. Yes, the contrarian within us shouted “SHORT SILVER!” on hearing the news, but after a brief period of reflection we realized that something else might be at hand.

Perhaps, we thought, the first leg of the precious metals bull market – the quiet accumulation phase – had come to an end. And perhaps we were about to embark on the next great upleg, the longest of the three, upon which ride the institutions and a smattering of the broad public. Yes, we thought, on taking another look. Phase two…

And this is what the banker/brokers had to say –

UBS: “Buy Gold”… with an initial target of $850, and further gains expected towards $900 and beyond.

Citigroup: ‘Pockets of opportunity’ exist in quality copper and gold mine developers.

J.P. Morgan: We love gold…. the gold price will surpass its previous peak.

And now to the crux of the matter. While brokerages are touting gold, we see something enormously profitable in gold’s poorer cousin, silver. Here it is in chart form. Take a look first. We’ll explain in a moment.

What you see is a chart of the gold/silver ratio for the last year. The chart essentially tells investors how many ounces of silver a single ounce of gold will buy. As you can see, the ratio spiked (downward) in silver’s favor this past March when silver prices exceeded $21 an ounce. They subsequently sold off to more equilibrium levels at roughly 52:1. And then in the meltdown of July the ratio ballooned to an unsustainable 61:1 relationship.

And here’s where the money will be made.

In the last precious metals bull market (that ended in 1980), gold climbed from a mere $35 to $850, for an overall increase of 2,429%. But silver did better. An ounce of silver in that same time frame rose from 90 cents to $50, for a 5,556% gain. Silver rose over twice as fast as gold.

But will it happen again?

The answer to this question lies in the centuries old relationship that has existed between these two currency metals. Historically speaking, the gold/silver ratio for the last 200 years has averaged 31 ounces of silver to one ounce of gold. That does not mean the ratio was always constant, nor that it will be going forward. Silver will certainly overshoot to extremes at times. And that is where we are currently.

The best academic research indicates that the gold/silver ratio is shrinking toward the historical mean at 31 as the price of the precious metals rise.

The gap, therefore, may never be as wide as it is now.

Silver believers: your day has arrived. Rejoice!

Cheers,

Matt McAbby
Quantitative Analyst, Oxbury Research

About the Author: After graduating from Harvard University in 1989, Matt worked as a Financial Advisor at Wood Gundy Private Client Investments (now CIBC World Markets). After several successful years, he moved over to the analysis side of the business and has written extensively for some of corporate Canada’s largest financial institutions.

Matt’s successful approach to investing combines brute strength, unconventional instruments and creative strategy in all market environments. His knack for exposing weakness and exploiting market opportunity is proven in both bull and bear markets and his martial approach to investing is unique in the world of professional market advisories.

Matt’s proprietary measure of investor sentiment, the SENTIMETER, marks intermediate trend turning points in the major market averages and proves effective in identifying tremendously lucrative option-selling opportunities. Matt is an expert chartist and the former editor of IntermediateTrend..