Monday, May 23, 2011

Issue XXVII - Silver Decline

Dear Readers,

On Sunday, May 1 I was still in Omaha following the Berkshire Hathaway annual meeting. Shortly before President Obama announced the death of Osama Bin Laden that evening, I made a routine check of Bloomberg to see how the Asian markets had opened. Silver futures trading in Hong Kong had fallen at the open from about $49 to lower than $42, settling overnight around $45 before resuming its decline the next morning in New York. By the end of last week, the price of Silver had fallen another 23% to $34. Predictably, the reaction from bloggers and commentators has been divided over whether this represents the end of the bull market in Gold and Silver, or whether it is just a correction in the midst of a secular bull for precious metals. The confluence of several factors led to its swift decline, and while no one can say for sure where the medium-term price bottom will be, right now the volatility is so high that it would be ill-advised to recommend long or short positions.

The decline happened for several reasons. First, CME Group, parent company of the COMEX exchange, increased the margin requirement to hold physical Silver several times over the past two weeks. Indeed, such an announcement after the close on Friday, April 29 contributed to the swift decline that began on Monday, May 2. Effective on May 9, the margin requirement for a single contract (5000 oz.) is $21,600, up from $11,745 just two weeks ago, a full 84% increase. Therefore, the margin requirement has jumped from 5% of the price of a contract to about 12% after May 9, if last Wednesday’s closing price is used. Not surprisingly, this has caused fund managers who hold physical Silver, such as George Soros, and Eric Sprott, who runs the physical silver ETF PSLV, to reduce their holdings. In turn, the rapid decline triggered repeated sell orders on the way down, further amplifying the decline in both physical Silver and the SLV ETF. The sheer size of this decline in the face of margin hikes helps to illustrate just how over-speculated the Silver market had become. Going forward, it is going to be much more expensive to own the physical contracts, as the CME has made it clear this will not be the last of the margin increases.

One of two things is happening; this is either a long-term (10+ years) bubble popping and Silver will not reach those highs for another few decades, or it is a major, long-in-the-making correction within a secular bull market for precious metals. There are reasons to expect that the corrections within this bull market will continue to be sharp and swift. First of all, the price-tracking ETF’s (SLV and PSLV are two of the largest) that many traders use to trade the price of Silver are required to adjust their reserves of physical Silver bullion depending on the daily closing price of the ETF. In effect, this means that if the price of physical Silver experiences a sharp run-up like it has since last August, the ETF’s act like a sponge. They have to buy up boatloads of physical silver on the way up, constraining supplies on exchanges like the COMEX and depleting inventories, which contributes to further price increases. The vicious cycle works on the inverse on the way down, as well. Just as the ETF’s absorb physical supply like a sponge on the way up, they have dumped physical Silver on the market as investors have dumped their shares over the past week, exacerbating the rapid price decline. In fact, because the ETF’s selling their supply tends to lag the price declines of the ETF, the physical supply does not hit the market until after the price has declined, potentially opening up the door to further price decreases.

As a result of the rapid decline, the double-short Silver ETF that was mentioned in the March 19 newsletter, ZSL, has gone from a low of around $13 on Friday, April 29 to a high of $24.38 on Thursday, May 5, more than an 85% increase in only four trading days. I mentioned that Silver and its related mining stocks appeared risky right before the New Year and that early 2011 could bear witness to a correction. Obviously, the prediction turned out to be a bit premature. After declining a bit the first few weeks of the year, from late January until Friday, May 3 the price of Silver nearly doubled, capping off a remarkable 200% increase since last July. To illustrate the degree to which SLV and the related ETF’s were traded/speculated, from April 20-May 3 the daily volume on the SLV ETF regularly exceeded that of the most popular S&P 500 ETF, SPY. Think about that for a minute. The trading volume of an ETF that tracks the price of a precious metal that only a tiny percentage of investors own was exceeding the volume on the most popular ETF to track the broadest US stock market index. If that isn’t indicative of a frothy market for a commodity, I don’t know what is.

At the same time, this correction is what many long-term precious metals bulls have been waiting for, but most will tell you that buying Silver right now is risky. For example, the price appeared to have stabilized over the first two trading days of this week, and many investors got caught in what appears to be a classic “bear trap,” that typically occurs after the initial stage of a large asset price reversal. After some investors re-initiated long positions, the price resumed its decline by falling 8% on Wednesday, May 11. Looking at the Silver corrections over the past decade, the current decline is more likely to take a few months. Additionally, the decline could be as sharp as the run-up of the past two months, overshooting to the downside. Perhaps the best thing to remember at this point is that the big/fast money has taken over. It’s best to go with the trend and not fight it, especially during times of great volatility like the past two weeks. Hedge funds and other big money players by and large were the ones who pushed the price up 100% in less than five months and they are now the ones who are selling, with a few inevitably making lots of money off of its collapse.

Furthermore, as a result of the price run-up, all of a sudden many more economic commentators are paying attention to Silver. One advantage of this is that there will be no shortage of opinions to read and compare that will be issued over the next six to twelve months as to when the bottom has been formed. I will be one of them, and will issue it at that time. For now, my opinion is that there is still money to be made in the ZSL ETF or by shorting SLV or double-leveraged Silver ETF’s like AGQ. Whenever Silver has experienced mid-term corrections since the bull market began in 2001, the decline has, on average, lasted for two to three months and usually the bottom has formed around the 200-day moving average, currently around $28.50 today. As mentioned, because of the robust nature (albeit fueled by speculators who have access to cheap financing) of the most recent price run-up, the correction could be equally as harsh and overshoot to the downside as we head into the summer season, historically a weak time for precious metals. If the 200-Day Moving Average is breached to the downside, it could very well signal that Silver could correct to the low $20’s, or even lower.

Another thing to keep in mind is that the fundamentals supporting precious metals haven’t changed, and until governments around the world fix their nations’ financial problems the bull market in precious metals will probably remain in place. Many who hold Silver are concerned that if the Fed starts raising rates, the bull market will end. Looking back at the last precious metals bull market, in 1979 President Jimmy Carter gave Federal Reserve Chairman Paul Volcker a mandate to crush inflation, no matter what the cost. Volcker immediately started raising rates, but precious metals did not peak until January 1980 (the collapse was initiated when the COMEX raised margins and the Hunt Brothers, who had used a massive leveraged position to try and corner the market, were forced to sell amidst the large resulting losses). Interest rates and inflation did not peak until mid-1981, when the US entered a recession that would last until late 1982. Therefore, the oft-repeated argument that the precious metals bull will be done at the moment Bernanke begins raising rates is insufficient, especially because in the event that inflation picks up it will take much higher rates than the current ones to lower it. In addition, the US currently has a national debt that is many multiples the size it was in the 1970s. Back then, the US was still the world’s largest creditor. To illustrate this, Volcker’s raising rates back then contributed to financial crises and subsequent government defaults in several Latin American countries that were in debt to the US and the IMF, including Mexico in 1982 and Peru later in the decade. This time around, it is not as easy to raise rates quickly because the US Government would need to greatly reduce its expenditures first to accommodate the extra costs for paying the debt that would be issued at the higher rates.

In closing, at the present moment this appears to be a much-needed correction within a secular bull market for precious metals, and I expect precious metals to stabilize sometime before the end of the year. If inflation begins to gather steam and interest rates are not raised high enough to lower it, the precious metals bull could potentially be in the 5th or 6th inning of 9, so to speak. However, if inflation does reverse course like the Federal Reserve has been predicting, this correction in the metals could quickly become a multi-year bear market. Therefore, it is impossible to say for sure whether the bull market in precious metals is over. Many commentators try to call bubbles whenever a particular asset runs up in price, but in reality bubbles are all but invisible until they burst, and thus are only definitively identified in hindsight. Rational reasons are always given for the soaring prices, and then these same reasons are suddenly proved irrelevant as the price falls. That said, there are still plenty of relevant reasons for precious metals to keep rising in price over the next five to ten years. For now, the speculators have been curbed, and going forward investors will need to demonstrate their commitment to Gold and Silver by paying higher margin costs to own the metal. If the fundamentals do not change and prices resume their upward climb, you can count on hedge funds and other sophisticated investors jumping right back in as they recognize the sheer robustness of the bull market and get more serious about staying invested in it for longer than a few days or weeks. If this proves to be the case, get ready to take advantage of lower prices for Gold, Silver, and the equities of their miners. If the S&P 500 declines as well, there could be a few situations where we see the best opportunities to invest in Gold and Silver mining equities since late 2008. Such an opportunity would be nothing less than fantastic.

Respectfully Yours,

Matthew R. Green

May 12, 2011

Issue XXVI - US Dollar Rally

Dear Readers,

If Mark Twain were alive today, he could easily reference his own famous quote when speaking about the US Dollar; in short, rumors of the greenback’s death have been greatly exaggerated. After falling well over 15 percent since last June, the US Dollar appears to be setting up for a rebound, if not a multi-year recovery. Amongst all the negative commentary that has surrounded the greenback recently, the fact of that matter is that all fiat currencies will remain under pressure as the US and Europe continue to stagger through difficult financial times. With the looming problems concerning Medicare and Social Security, along with the recent budget impasses, many commentators believe that the Dollar will continue to fall. Over the longer term, this is likely true. Despite this, the impending end of QE2, the potential tightening of monetary policy, and technical signals point toward a bottom. In short, the US Dollar could be ripe for an upward reversal, potentially for the
short-to-medium term.

Even before the onset of the Great Recession and subsequent financial crisis in 2008, the US Dollar was in secular state of decline for most of the 2000s. The expenditures from the Iraq War, low interest rates in the US, massive budget deficits and the Euro coming into its own were among the reasons for the decline. The current massive amount of negativity surrounding the Dollar is being pushed by escalating fears of a potential US Government debt default, rising inflation and interest rates, speculation of a third round of money printing by the Fed, and the potential reduction of importance of the Dollar as the global reserve currency. These fears, while not unwarranted, are overblown and have resulted in the Dollar currently being oversold.

Due to its role as the reserve currency of the world, the performance of the Dollar has a greater effect than many, even seasoned professionals, realize. The value of the Dollar affects the equities markets, commodities, bonds, inflation, consumer confidence, and most of all, macroeconomic policy for not just the US but the rest of the world’s governments and central banks. In other words, economists, politicians, and just about everyone else who monitors financial markets study the Dollar’s movement because of its effects on their subsequent economies, policies, standards of living, and many other factors.

Recently in op-eds or on CNBC and Bloomberg, economists and commentators have covered the bullish and bearish cases thoroughly. First, the bearish argument. Public debt in the United States is already high, and continuing to rise at a staggering pace. On April 18, Standard and Poor’s downgraded the outlook for US government debt to “negative.” This followed a nearly 5% drop in the preceding month as Congress repeatedly failed to agree on the federal budget until the eleventh hour. If a formal downgrade of the US credit rating from the AAA level were to take place, it would immediately trigger selling of US Dollars by central banks around the world. This would likely be a harbinger of the US permanently losing its economic hegemony, although the arguments for and against this are too lengthy to discuss here. At any rate, this stems in part from the devaluation of the US Dollar due to the Federal Reserve’s quantitative easing programs since March 2009. While these programs have not been extended yet, last week Federal Reserve Chairman Ben Bernanke affirmed a commitment to exceptionally low interest rates for an extended period of time. This comes despite the Fed seeming to ignore rising inflation over the past year, as seen already in the prices of food and other everyday commodities. While a part of the rising prices of can be attributed to poor harvests in many food commodities and higher oil prices, the fact is that many economists and citizens alike are concerned that that Fed is counting on price rises to taper off, and are worried it may not happen. Rising prices would only hurt the Dollar more. The end of the Dollar as the world’s preeminent reserve currency could take place if one or a combination of the aforementioned events materialize. Additionally, a main concern of some economists is that if a watershed event such as a US debt downgrade occurred, the process could not be controlled. The Dollar’s decline would be exacerbated by central banks quickly moving to diversify their currency reserves, quickly selling Dollars and moving them into either gold or other currencies. To illustrate this, several prominent commentators have expressed concern at the fact that China holds approximately 70 percent of its reserves in US Dollars, and its future actions could lead the way in diversifying out of the Dollar. The concern stems in part on the fact that such a rapid decline of the Dollar could lead to a currency crisis and potentially hyperinflation.

The positive outlook arguments for the Dollar are largely contrarian in nature, and address the fact that at least a portion of the Dollar’s recent decline can be attributed to overblown fears. First and foremost, it needs to be considered that the extreme level of pessimism may already be priced into the current Dollar Index, which fell to as low as 72.70 last week before rising to close at 74.91 on Friday, a sharp increase that perhaps signals the beginning of a medium-term rally. The droves of investors that have been running to physical gold, silver, or precious metal ETF’s like GLD and SLV have been doing so in part to protect their portfolios from a collapse in the Dollar. While this was a major factor in the price run-up, the events of this past week in the precious metals sphere have revealed that it was at least in part being driven by speculation. Therefore, the rapid run-up and
equally swift decline of precious metals could be indicative that the big drop in the Dollar has already taken place, and it may be near or already has seen a medium-term bottom.

Second, a timely end to the second round of quantitative easing (QE2) could create further headwinds for the stock and precious metals markets. This was the case in 2009-10 with the start and end of the first round of quantitative easing (Refer to Chart 1). Note that the Dollar began to fall in 2009 after the March 2009 announcement of Quantitative Easing, and began to rise once again after the Dubai debt crisis in November 2009, continuing with the European Debt crisis and the end of QE1. The latest round of Quantitative Easing, along with the subsiding (but far from over) debt crisis in Europe, contributed to the Dollar’s slide since last summer that, in my opinion, has led to the Dollar being oversold. Indeed, tighter monetary policy has been argued for by members of Congress and the Federal Reserve Board alike. While the situation in Libya and the rest of the Middle East has contributed to higher oil prices, commodities in general have been rising. Tighter monetary policy in response to this will help ease inflationary concerns and help strengthen the Dollar. Although the Federal Reserve left rates unchanged at the latest meeting, it has thus far not expressed any intention to commence another round of quantitative easing, although maturing bond purchases will occur on a more limited basis.

Finally, a weak Dollar isn’t necessarily welcomed by the rest of the world, contrary to popular belief. For US trade partners with a large export sector, such as Germany and Japan, a low US Dollar is detrimental because that means lower levels of trade with the US and effectively puts a cap on future growth. A number of currencies, including all of the other currencies that make up the US Dollar Index, have appreciated against the Dollar. Therefore, it is possible the foreign central banks could increase their Dollar purchases in the name of slowing their own currency’s appreciation. This would help stabilize the Dollar, and perhaps even contribute to a medium-term rally.

Looking at the technical analysis, indicators are signaling, as they were in March, that the Dollar could be at or near a medium-term bottom. Looking at long-term charts, despite the Dollar’s pronounced downtrend over the past decade, it could potentially be setting up for a break to the upside. While the Dollar has dropped, the Moving Average Convergence-Divergence (MACD) has been rising. A positive divergence while the Dollar is in a downtrend could signal a pending reversal to the upside. This is also true of the short-term charts, as you can see from Chart 1. Looking at a chart of the Dollar over the past year, the charts are also showing divergence in the Relative Strength Index (RSI), which, despite the continuing drop in the Dollar, has failed to make significant new lows, instead floating around its previous lows (Refer to Chart 2). Such a divergence/chart pattern often precedes a reversal, in this case to the upside.

Therefore, with the robust upturn in the Dollar over the past week, the medium-term bottom may very well have been made. While all fiat currencies, at least amongst Western economies, will continue to be under pressure as currencies are devalued, for now the Dollar appears to be commencing a medium-term rally.

Respectfully Yours,

Matthew R. Green

May 8, 2011