While
wreaking its unbelievable destruction, last quarter's financial-market panic
certainly showed no favoritism. Launching from ground zero in the financial
stocks, shockwaves of selling blasted out through the entire market landscape.
Everything speculators once loved was left in ruins, including silver.
Back in
July 2008 when the financial markets remained oblivious to the tsunami of
fear approaching, silver averaged $18.07 on close. But by November when
popular stock-market fear reached a fever pitch, silver only averaged $9.81. A
45.7% loss on the monthly averages, not merely the extremes, in just 4 months
was enough to test the faith of even the most dedicated long-term silver
bull.
But even
at the very bottom when things looked the bleakest, it was clear silver's
extreme lows were anomalous and not sustainable. The day after silver's $8.92
closing nadir on November 20th (not coincidently the very day the general
stock markets bottomed too), I published an essay called "Silver
in Crisis". The conclusion was silver's selling
was way overdone. So we were buying ridiculously-oversold silver stocks at
the time.
One new
long-term elite silver-stock investment we made in Zeal
Intelligence in November in the heart of the panic was
already up 81.9% as of this week. It pays big to be a contrarian and be brave
when everyone else is afraid. Indeed, since those depths silver has
strengthened considerably. Over the past week it has averaged $12.46, 34.1%
higher than its average $9.29 close in the week leading to its panic low.
This
impressive run in silver has led some traders to wonder whether it is getting
overbought and the short-term risk-reward equation is shifting out of
its favor. With a good fraction of my own capital deployed in physical silver
and various silver stocks, silver's near-term outlook intrigues me too. Of
course I am very bullish on silver in a secular sense, but after my research
this week I'm bullish on the coming months too.
Despite
all silver's own fundamental merits, its primary technical driver is nearly
always the price of gold. In a favorable gold-price environment, speculators'
interest in all the precious metals grows. So they deploy increasing amounts
of capital in silver. In this tiny market, it doesn't take much buying
(relative to larger markets) to drive big and fast price spikes. And when
gold is weak, silver speculators lose interest fast.
This
gold-driving-silver dynamic remains controversial among some silver
investors, but it certainly shouldn't be. In 2007 I did a study encompassing
decades' worth of big silver uplegs/bulls and the
resulting charts are crystal clear. Silver generally lags
gold initially, but as gold gathers steam speculators flock to silver and
ignite the sharp moves higher this restless metal is so famous for. Gold
leads the way.
In recent
years this centuries-old positive correlation of silver with gold continued. This
first chart compares the raw silver and gold prices over the last 4 years or
so. Note that these vertical axes are both zeroed, so there is no
scale-induced visual distortion of this critical relationship. Prior to the
financial panic in late 2008, silver indeed maintained a very tight
correlation with the gold price.
The
bullish ascents of the blue silver line and red gold line in recent years are
very similar. In fact you could probably pass one off for the other if there
were no price labels on the vertical axes. And this close relationship is not
just visual, but statistical. Between January 2005 and August 2008 (a secular
pre-panic span), the daily correlation r-square between the silver price and
gold price ran 94.7%. In other words, nearly 95% of the daily price action in
silver was mathematically explainable by gold's own.
But
during the stock panic, silver suddenly radically decoupled from gold. Gold
was fairly resilient through this fear bubble, but silver just plummeted. While
the yellow metal merely hit a 14-month low at worst, silver spiraled down to
a horrific 34-month low. It was trading way back at early-2006 levels before
the dust settled and its price started stabilizing. This fascinating
decoupling is actually the basis for silver's near-term bullish thesis today.
During
the stock-panic months (September to December), silver's correlation r-square
to gold plunged to 52.5%. Only about half of silver's daily price action was
statistically explainable by gold's. This is still based off a positive
correlation, but a much weaker one than we typically observe in silver. It
wasn't necessarily this weaker correlation that caused silver's problem, but
its newfound mid-panic asymmetry. The correlation grew lopsided to the
downside.
On most
days during the panic months when gold was up, silver would rise too. But
usually it would just pace gold's gains at best, and sometimes not even match
them. But on days when gold was down, silver would often plunge dramatically
and multiply gold's losses. Playing out over months, this outsized downside
pressure on silver whenever gold was weak led to the serious decoupling
evident in this chart.
Why was
silver so much weaker than gold during the financial panic? Silver's price is
much more dependent on sentiment at any given time than gold's. And sentiment
during the panic was exceedingly rotten. Speculators sold everything
universally, sparing nothing. The riskier any particular asset, the more
aggressively it was liquidated to raise precious cash and to protect from the
threat of further losses.
Silver is
a speculators' playground in the best of times, a very exciting and
hyper-volatile precious metal. But in the worst of times, the stock panic,
silver's very attributes that usually work for it suddenly conspired against
it. As a tiny market easily blown about by relatively small shifts in capital
flows, unlike gold it wasn't big enough to decently weather the intense
fear-driven selling. And of course the farther it plunged, the more selling
it sparked. As its price crumbled, anxiety soared even among its biggest
fans.
By the
time the panic-driven sentiment storm started to abate, silver was far lower
than the gold price suggested it should be. It was extreme fear that drove
this silver anomaly, and this extreme fear was driven by a global stock
panic. Not only is that panic over today, but general fear and anxiety in the
markets have been abating continually since late November. And with no more
extreme fear to hold it down, shouldn't silver recover to historical norms
relative to the gold price?
I not
only think it will, but I am betting on it. A relationship that has been
demonstrably very strong for
decades, and has actually existed for centuries, probably can't
be totally wiped away by a fleeting fear bubble lasting a few short months. Silver
is highly likely to mean revert to its long-time relationship with gold. We
can nicely quantify all this with the Silver/Gold Ratio, which the next chart
explores.
Technically
the SGR is the silver price divided by the gold price. Unfortunately this
leads to tiny numbers that I have a hard time wrapping my little brain
around. At $12 silver and $900 gold, the true SGR is 0.0133. I charted this
and unfortunately it really isn't very intuitive. This is the same reason
currencies with low values (like the yen) are quoted differently in forex
markets than currencies with high values.
So I
decided to use an easier-to-digest proxy for the SGR, the inverse of the
silver/gold ratio. At $900 gold and $12 silver, this is 75. An ounce of
silver is worth 1/75th an ounce of gold. To make this SGR proxy properly
reflect silver strength and weakness, I had to invert its axis. A falling SGR
means silver is getting weaker relative to gold and vice versa. This resulting chart
is very interesting.
During
the 44 months leading up to the Great Stock Panic of 2008, silver averaged
1/55th the price of gold (I'll just use this number rather than the fraction
from here on out). This pre-panic 54.9 average was fairly tight too. It
wasn't defined by a few rare extremes, but many years of gentle meandering
near the middle of a range between 65 and 45. Despite the countless
market-moving gold and silver developments since 2005, this 55 average held
nicely.
Incidentally,
if you do any deep silver-stock or gold-stock research, the miners will often
report equivalent numbers. A primary silver miner will take its byproduct
gold production and convert it into silver ounces using the cash equivalent. A
primary gold miner will do the opposite, converting its byproduct silver into
the cash equivalent of gold ounces. In countless SEC reports I've waded
through of gold and silver miners, this 55 ratio is usually the number they all
use for equivalent calculations. It is well-established.
And over
recent years, the variance in the SGR has actually decreased considerably as
you can see above in the tightening wedge. All this leads me to believe that
an SGR near 55 is far more normal for this bull market than the levels seen
during the stock panic. As speculators fled everything including silver, its
price plunged far more than gold's. This drove the SGR to its lowest levels
of these entire precious-metals bulls.
It was
the plunging
stock markets that drove this extreme universal
fear. So silver fell to its lowest level relative to gold on November 20th,
the very day the S&P 500 swooned to its lowest close of the panic by far.
That day, silver at $8.92 was only worth 1/84th of the price of gold at $745!
I had never imagined such a low SGR was even possible prior to that panic,
and I am certainly not the only silver investor who was surprised by it. The
panic blew apart all kinds of previously unassailable historical
relationships.
And
incredibly such an extreme wasn't just a single-day anomaly. During the
entire panic (September to December), the SGR averaged 75.8. This is just
ridiculously low relative to silver's history with gold. Gold was actually
being bid up mid-panic as investors recognized that its performance was
really quite good compared to nearly every other asset during the panic. But
speculators, quaking in fear, refused to return to silver as readily as the gold
investors returned to gold.
For a
variety of reasons, I fully expect silver's historic relationship with gold
to normalize. It has existed for so long that a fear bubble in the stock
markets lasting a few months shouldn't be able to sever it forever. Nothing
fundamentally changed on the silver or gold mining fronts during the stock
panic, so the secular-bull pictures for both metals look similar today as
they did back in July. And silver speculators will always be interested in
the much larger gold market and watch it for clues on how to bet on silver.
At $900
gold and a normal historical 55 SGR, silver should be trading near $16.36
today. This is 30.8% higher than it was trading in the middle of this week! So
even if gold does nothing, a simple mean reversion in the SGR to pre-panic
levels implies a silver price much higher than today's still-depressed
levels. Until silver returns closer to its normal range relative to gold, the
short-term case for this white metal remains very bullish.
And
interestingly there are a few factors that make silver's near-term potential
look far more bullish than this simple mean reversion to reflect today's
prevailing gold prices implies. The first is gold's own bullish fundamental
outlook. The second is the strong tendency in financial markets for extremes
in one direction to rebound with such momentum that they overshoot into the opposite
extreme before normal relationships are reestablished. And the third is the
way most silver is mined today, as a byproduct.
For many
reasons I outlined in an essay in late December, gold's
fundamentals are awesomely bullish. Its price is likely
to rise substantially to dramatically in 2009. I can't imagine not seeing at
least a 20% gain in this calendar year. So a mean reversion of the SGR to today's
gold prices is conservative. If we indeed see gold power higher this year,
then the usual 55 ratio implies an even higher silver price to reflect it. As
an added bonus, a rising gold price will entice speculators back into silver
much more rapidly than a flat one.
And while
I am more cautious on this secondary factor, I think it is fair to mention
it. Extremes in the financial markets are driven by sentiment, a great
pendulum of popular consensus swinging from greed to fear and back again. This
pendulum almost never gets pulled to extremes in one direction, starts
swinging back to recover, and then simply stops dead mid-swing at normal
levels. Its momentum usually carries it well through normal to the opposite
direction. Applied to the SGR, this means we could very easily see a
temporary spike well under 55.
At $900
gold and a 40 SGR, silver would easily exceed its March 2008 bull high to
trade above $22 in a greed spike. And if you run the math for a higher gold
price or better SGR, it gets even more bullish. But realize this reversion
thesis certainly doesn't need either a higher gold price nor an outsized
oscillation of the SGR to the other extreme. It is plenty bullish for silver
even if gold stays flat and the ratio merely returns to normal.
A true
fundamental factor spawned by the panic could play a role too, and it is very
bullish for silver. Something like 3/4ths of all the silver mined worldwide
is merely a byproduct, primarily of base-metals mining. And the base
metals' prices were obliterated in the fear that
surrounded the stock panic, plunging by more in a few months than they fell
in the entire Great Depression in some cases. If base-metals miners
respond to this crisis by mothballing mines or reducing production, the mined
silver supply could fall as well. Less silver for speculators to chase means
higher prices sooner.
In light
of all this, a really compelling bullish case can be made for silver over the
near term. We've been trading accordingly in our subscription newsletters,
recommending various silver trades that should thrive as the silver price
returns closer to its historical relationship with the gold price. Unless
gold plunges, which is very unlikely in today's inflationary
world, the silver price needs to go higher regardless of any
other factors.
In the
new February issue of our acclaimed Zeal
Intelligence monthly newsletter, I recommended a silver
stock that big capital will flood into as the silver price normalizes with
gold's. And as always, it is full of deep, insightful, and actionable
contrarian financial-market analysis that you can't find anywhere else. Fortunes
will be made emerging from these panic anomalies, so subscribe today so you
don't miss out on the coming gains.
The
bottom line is silver's primary driver is the price of gold. But general fear
grew so intense in the sentiment firestorm of the stock panic that silver
radically decoupled from gold. It was driven to incredible lows that are
unlikely to persist as fear abates and the financial markets return to
normal. As speculators slowly emerge out of their fear-induced stupor, they
will return to silver and other speculative assets.
So almost
regardless of what happens anywhere else, the silver price should gravitate
towards more normal levels relative to gold. Even if gold stays flat and
silver merely returns to its average ratio with gold, this white metal still
has excellent near-term appreciation potential. And of course the best silver
producers' stocks should nicely leverage any silver gains driven by its mean
reversion to normalcy with gold.
Adam Hamilton, CPA
Zealllc.com
January 23, 2009
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