Mining Stock Could Line Your Pockets With 40% Profits

Gold and silver prices are well below the highs reached in 2011, but analysts at major Wall Street firms are bullish. Both Goldman Sachs (NYSE: GS) and Merrill Lynch recently recommended gold in a note to clients. Merrill set a price target of $2,000 an ounce for gold within the next year, which would be a gain of more than 25% from recent prices. That price target also means silver could deliver gains of more than 55%.

That's not too shabby, but there is an even better way to trade precious metals, which I will get to in a moment. First, let's go over how I came by that calculation for silver.

Silver usually moves with gold prices because both are viewed as inflation hedges. The relationship between the two metals can be captured with the gold/silver price ratio, which measures the ounces of silver one ounce of gold will buy. During the 1900s, the average ratio was 47, meaning that one ounce of gold would buy 47 ounces of silver.

If gold reaches $2,000 an ounce, silver should move to about $42.55 an ounce ($2,000/47 ounces = $42.55 per ounce). That would be a 57% gain in silver from the $27.17 close on July 12. The chart pattern of silver supports this price target and also shows that silver is looking for a bottom.

As you can see below, silver has been forming a triangle pattern with support near $27 an ounce becoming clear in the past four weeks. Relative strength (RS) has been forming a bullish divergence during the past three months, moving up as the price declined. And volatility has been contracting since the beginning of the year. Taken together, these indicators show that a sharp rally in silver should start any day. The triangle supports a price target of $42.50 when measuring from the March high to the support level.

Miners could see even bigger gains. Mining companies offer a leveraged return on price moves. If a company's mining cost is $10 an ounce, it would earn $17.17 an ounce at current prices. Assuming production costs remain constant, the profit increases to $32.55 an ounce at the target price, a 90% gain on the 57% jump in silver prices. While this is an oversimplification as miners have other costs that factor into their net profits, this math shows why miners are a good trade when metal prices are moving higher.

Focusing on miners, Hecla Mining (NYSE: HL) jumps to the top of my buy list. It has the highest RS among the components of the Global X Silver Miners ETF (NYSE: SIL), and recently has been outperforming almost every available stock and ETF.

HL has pulled back after gaining more than 34% in eight weeks. Traders who buy this pullback could enjoy a potential gain of 15% in the short term. There is some resistance at $5.01, but a break above that level completes a cup-and-handle pattern, which has a target of $6.28 for a potential gain of 44%.

HL is a trade that could become a core long-term holding since the company also has solid fundamentals. Hecla is the largest silver miner in the United States, and is pulling about 10 million ounces of silver a year out of its mines at a cash cost of only $2.24 an ounce. This makes HL the lowest cost miner in the country and positions the stock to enjoy the biggest gains in a silver bull market. Value stock pickers should also appreciate the price-to-earnings (P/E) ratio of 11 and the dividend yield of 2%.