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

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