-- Posted 28 March, 2008 | | Discuss This Article - Comments:

A couple of weeks back I looked at the issue of how silver stocks were performing against their main product, silver. It was not a pretty picture as it was revealed that a basket of silver stocks we track in my newsletter had underperformed silver by 27%!

I said I would have something more to say but recent events in silver have led to a critical juncture for the metal obliging me to focus on daily updates to subscribers. We are not out of the woods yet and silver could easily from here break down big time or break up big time. The jury is still out as the daily and intraday charts are monitored.

But back to silver stocks. We previously displayed the chart below to show the relative disconnect between silver and those stocks which are not only not delivering leverage but not even keeping up with silver (silver in green).

The conclusion we arrived at was the fact that silver stocks have one foot in the stock market and one foot in silver. If they both go up, silver stocks do great. If one is going down then they suffer. All in all, it seems that bullion is the place to be.

But there was one situation which could negate this assumption and the chart below has bugged me ever since I laid eyes upon it. It is the chart of the gold price versus the Barron’s Gold Mining Index (BGMI) during the last great gold bull of the 1970s.

The price of gold is in green and the price of this venerable gold stock index is in black. Note the familiar gold spike to over $850 in January 1980. Also note how like today the mining index began to lag gold in the late stages of the great gold bull in 1979. In fact, when the gold bull began and ran up to its lower peak of $195 an ounce in December 1974, the BGMI increased 6.9 fold and gold increased 5.6 fold in price. Dividing these two numbers tells us that the BGMI outperformed gold by 23%.

However, once the bull got going between the lows of August 1976 and up to the top of January 1980 it was a totally different story. Gold increased 8.3 fold in that time but the BGMI only increased by a factor of 3.8. In other words, gold outperformed its derivative stocks by 118%! Does that not look a bit familiar to today’s situation not only with silver stocks but gold stocks in general too? Perhaps the blame being put on ETFs is a bit misplaced.

But astonishingly look at what happened next. Gold crashed to $540 and then only managed to rally to about $720 before the 21 year gold bear market began in earnest. However, gold stocks defied expectations by finally getting it right by beating their old high of 736 to put in a new high of 1285 and outperforming gold by a healthy 82%! Why the sudden turnaround in performance?

Plotting the S&P500 against the BGMI over the same period gives us a clue. While that gold rally was going on, the S&P 500 was putting in an increase of 40% over the same period and had just taken out its previous multiyear high set in January 1973. The great 20 year bull market in stocks had just commenced and stocks everywhere got a boost. The BGMI had the best of both worlds and was off to the races. However, once it dawned on investors that this was only a gold bear market rally and not a new gold bull, the BGMI plummeted.

That doesn’t explain it all but the performance of the general stock market had a bearing on the BGMI v gold question. So what lessons does that hold for us today?

Firstly, I believe gold and silver will experience a fairly big correction this year. It may have already started but that is not a given yet. The big question for investors reloading at the next bottom is how to weigh their bullion v stocks allocation. Just like our current run up today, we see stocks underperforming metal. But will they outperform gold and silver on the next big rally after the initial drop? Clearly the answer depends on how the general stock market is doing. All I can say is that if the credit squeeze fears are finally put aside around the same time gold and silver form their next major bottom then mining stocks may well be the place to be. In other words, if the S&P500 can rally to new highs in the next 12 months while the precious metals gun for their old highs then the HUI and other mining stocks will have the best of both worlds.

At the very least, one should act the contrarian’s contrarian and seriously consider a good weighting of mining stocks over ETFs and physical holdings when the next big post-correction move in precious metals begins.

Further analysis of silver can be had by going to our silver blog at http://silveranalyst.blogspot.com where readers can obtain a free issue of The Silver Analyst and learn about subscription details. Comments and questions are also invited via email to silveranalysis@yahoo.co.uk.