Silver’s Vexing Slumber

Silver has had a rough year, slumping to major new secular lows.  After sliding on balance for years now, even the diehard silver bulls are losing faith in their metal.  But despite its vexing slumber, silver’s price-appreciation potential from today’s levels remains enormous.  Between radical underinvestment and very-high speculator silver-futures shorting, silver is poised to see massive buying as gold recovers.

Silver has proven very disappointing in 2015.  Late last year, it was battered down near $15.50 as gold plunged into the $1140s on extreme futures shorting.  That looked to be a decisive low, as silver spent the next 8 months forming a strong technical base around $16.  But unfortunately in early July, silver fell to new lows near $15 as gold was crushed by an epic futures-shorting attack.  Silver was collateral damage.

Despite silver’s unique and compelling investment merits, it has always been slaved to gold.  Investment demand on the margin is the dominant driver of silver’s price, despite only being around 1/5th of total global demand.  The 4/7ths of silver’s demand from industrial fabrication, and 1/5th from jewelry, is relatively stable year in and year out.  The only demand category that shifts dramatically comes from investors.

And their silver buying and selling is overwhelmingly driven by the fortunes of gold.  Capital floods into silver when gold is strong, catapulting the white metal higher.  And investors flee when gold is weak, pummeling silver lower.  Thanks to this ironclad sentiment link, silver is simply a leveraged play on gold technically.  The correlation between silver prices and gold prices has proven incredibly high historically.

So with gold weak so far in 2015, silver had the deck stacked against it.  By late August when silver hit a major 6.0-year secular low just above $14, it was down 9.9% year-to-date.  Over that same span, gold had fallen 5.0%.  That 2x ratio of silver’s price movement relative to gold’s is actually the dominant rule of thumb historically.  Silver tends to double the gains and losses in gold, and gold hasn’t fared well this year.

But interestingly, silver’s vexing slumber is par for the course for this volatile metal.  Historically, silver’s price action has been characterized by long spans of sideways consolidations followed by explosive and massive moves higher.  Investors and speculators with the mental toughness to ride out silver’s long periods of inactivity are richly rewarded with huge wealth-multiplying rallies.  And the next one is overdue.

The last time silver was this down in the dumps and universally despised was during 2008’s epic stock panic, when silver was pummeled under $9.  You couldn’t give silver away back then, just like today traders were totally convinced silver was doomed to spiral lower indefinitely.  Yet out of that very despair, a monster bull was stealthily being born.  Over the next 2.4 years, silver would skyrocket 442.9% higher!

Over that span, the benchmark S&P 500 stock index merely gained 80.8%.  Silver was one of the best investments on the planet after the inexorable market cycles finally turned favorable again.  And since the financial markets are forever cyclical, I strongly suspect silver is on the verge of another one of its mighty uplegs.  After plunging 70.8% in 4.3 years between April 2011 and August 2015, a trend change is coming.

It will be fueled by the overdue mean reversion higher in gold, which is starting to recover from the most extreme speculator gold-futures-shorting episode ever witnessed.  Gold’s coming upleg will get both investors and speculators interested in silver again.  And once they start buying back in, they have a long ways to go to return to normal levels of capital deployed.  That’s super-bullish for silver’s outlook.

While much silver investment demand is small physical purchases, investors and speculators each have one dominant venue for tracking their silver positions.  For investors it is BlackRock’s iShares Silver Trust, which trades under the symbol SLV.  SLV acts as a conduit for the vast pools of stock-market capital to flow into and out of physical silver bullion, and is the leading proxy of silver investment demand.

This first chart looks at SLV’s silver-bullion holdings held in trust for its shareholders and the silver price over the past several years or so.  Since SLV is very transparent and publishes its silver holdings daily, it offers an excellent window into investors’ silver exposure.  And it is super-low now, which means there is much room for capital to return as silver inevitably returns to favor again.  Investors’ buying potential is immense.

The biggest mistake traders are making on silver today is assuming these exceptionally-weak conditions are normal and righteous.  But nothing could be farther from the truth!  Back in early 2013, the US Fed spun up its third quantitative-easing campaign to full steam.  Unlike QE1 and QE2, QE3 was completely open-ended with no predetermined size or end date.  This Fed used this ambiguity to manipulate traders’ psychology.

Whenever the stock markets started to sell off, Fed officials were quick to step up and declare that they could increase the size of QE3 if necessary.  So all dips were quickly bought, short circuiting normal market behavior.  This created gross distortions in all kinds of markets, including stocks and the leading alternative investment that moves contrary to them of gold.  With stocks magically levitating, gold was abandoned.

And naturally silver followed gold lower.  Silver’s average price in 2012 before the Fed’s manipulative QE3 debt-monetization campaign greatly skewed everything was over $31!  Given the extreme market conditions of the QE3 era, those pre-QE3 silver prices are much more representative of righteous fundamental silver-price levels than today’s.  As QE3’s vast distorting influence fades, silver will return to normalcy.

One key driver of silver’s powerful mean reversion higher will be the return of stock investors to the white metal via SLV.  In 2012 when silver averaged near $31, SLV’s holdings averaged 313.2m ounces.  So that equates to stock-market investors having an average daily silver exposure of $9.8b.  While SLV silver holdings have grown on balance since in these Fed-distorted years, capital investment has still fallen.

With silver’s bear market slashing its prevailing price levels, SLV’s holdings are worth a lot less in 2015 than they were in 2012.  So far this year, SLV’s holdings have averaged 324.6m ounces or 3.6% over 2012’s levels.  But with an average price just above $16, silver is 48.4% lower.  That puts 2015’s average daily silver investment by American stock traders at $5.2b, just over half the levels seen in 2012 before QE3.

So silver investment today is undeniably very low, which is not surprising given silver’s discouraging price action in recent years.  That means there is great potential for big investment buying as gold mean reverts higher and silver follows over the coming years.  While the value of SLV’s holdings has fallen with silver, they have actually enjoyed a strong uptrend in recent years despite lower prevailing silver prices.

Several times in both 2013 and 2014, the heart of the extreme Fed-QE3 market distortions, investors bought enough SLV shares to catapult its silver bullion holdings way up to the overhead resistance line seen in this chart.  And there’s no reason not to expect another surge back up to resistance, which is up near 351m ounces today.  With SLV’s holdings now near 322m, this would require another 29m ounces of buying.

And that’s a lot of extra silver investment demand!  According to the venerable Silver Institute, global bar-and-coin demand ran 196m ounces in 2015.  That averages out to just over 16m per month.  American stock investors have the potential to essentially double that demand alone as they return to SLV in the months ahead!  It usually only takes a couple months for SLV’s holdings to surge from support to resistance.

Since SLV is a tracking ETF, differential buying and selling pressure on it has to be directly shunted into underlying physical silver bullion.  When stock traders buy SLV shares faster than silver is being bought, this ETF’s price threatens to decouple to the upside and fail its tracking mission.  Thus SLV’s custodians have to issue new ETF shares to meet and offset this excess demand, and use the proceeds to buy silver.

So whenever SLV’s bullion holdings are growing, it translates directly into growth in global investment demand for silver.  And naturally as silver’s primary driver, that really boosts its price.  And provocatively even when SLV’s holdings revisit their 351m-ounce resistance, at 2015’s average silver price just over $16 its holdings would still only be worth $5.6b.  That remains far below the pre-QE3 average in 2012 of $9.8b.

In order to regain those kinds of SLV-investment levels at 351m ounces of holdings, the silver price would have to surge an incredible 73% higher from this year’s average!  That would take it back up to $28, which is certainly not extreme in pre-QE3 terms.  Back in April 2011 the last time silver was popular, it skyrocketed above $48!  This metal can really soar when investors and speculators return in a major way.

While SLV is the dominant venue for tracking investment positions in silver, American silver futures are the best place to track speculators’ silver bets.  And just like SLV, they reveal lots of room for buying in the near future.  This is especially true on the short side.  Speculators’ silver-futures short positions remain very high historically, and they are guaranteed near-future buying as silver mean reverts higher.

The Fed’s manipulative QE3 era greatly distorted speculators’ silver-futures positions too, particularly on the short side.  Between 2009 to 2012, the last normal years before QE3, speculators’ downside bets on silver averaged 21.5k contracts.  Each contract controls 5000 ounces.  Yet since QE3 started enticing capital away from alternative investments, speculators’ silver-futures shorting has skyrocketed to record extremes.

The peaks in speculator shorting have grown since QE3’s launch, most recently hitting an astounding 81.6k contracts in early July!  This was the highest level seen since at least 1999, the extent of our silver-futures data, and almost certainly ever.  Speculators effectively borrowed all that silver that they didn’t own, and sold it.  So they were legally and contractually obligated to buy that silver back to repay their debts.

And indeed major short covering out of those recent extremes has already happened.  In the 8 weeks since early July’s all-time record peak of speculator silver-futures shorting, they have bought to cover 25.3k of these contracts.  So much short covering should have fueled a strong silver rally, but that didn’t happen in recent months.  The reason is speculators’ long positions paradoxically mirrored their short ones.

Normally in futures markets, speculators’ long and short positions move in opposition.  When they grow bullish as a herd, they both add longs and reduce shorts to bet on further upside.  When they become bearish, they cull longs and grow shorts.  So it is very odd to see speculators’ longs and shorts move in unison.  Yet that’s exactly what’s happened in silver futures for the better part of a year now, since last autumn.

At the same time American speculators bought to cover 25.3k short-side contracts in recent months, they liquidated 17.1k long-side contracts.  Thus over 2/3rds of the upside silver-price influence by the short covering was completely offset by long liquidations!  This unnatural correlation will end as soon as silver mounts a rally decisive enough to convince speculators that normalcy is finally returning to this battered market.

But more exciting and bullish is the silver-futures short covering of recent months remains far from running its course.  During these Fed-QE3-stock-market-levitation years starting in early 2013, the speculators’ silver-futures short positions have had support near 27k contracts.  As this chart reveals, even within these QE3-distorted years speculators’ total shorts have already returned to this level 5 separate times!

So there’s little doubt that the next silver rally will drive speculators to cover their shorts down to that 27k-contract support level again soon.  And that will require another 29.3k contracts of buying from the latest levels, more than the 25.3k contracts already covered since that extreme record peak.  And that is a heck of a lot of silver buying, the equivalent of 146.5m ounces over the couple months or so short covering takes!

Again global investment demand for silver averaged 16m ounces per month last year.  If the rest of the silver-futures short covering takes speculators two months, we are looking at marginal new demand over 73m ounces per month!  That would more than quadruple normal silver investment demand while that short covering is underway, catapulting silver prices higher and ending the offsetting long liquidation.

Just as investors are radically underinvested in silver, speculators are still radically short it today.  Since 1999, speculators have only had higher silver-futures short positions 3% of the time.  So odds are they are going to have to cover aggressively out of these extremes.  Even a minor silver rally will spark this self-feeding process, which is guaranteed by the extreme leverage inherent in silver-futures trading.

Today futures speculators are required to have margin of just $6k for each silver-futures contract that controls 5000 ounces of silver.  Even at the dismal $15 price levels today, that is worth $75k.  So silver-futures speculators can run leverage up to 12.5x on silver, dwarfing the decades-old legal limit in the stock markets of 2x.  At 12.5x, a mere 8% silver rally will totally wipe out 100% of the capital risked shorting!

And once silver finally awakens from its long periods of consolidation slumber and starts moving, it tends to rally fast.  Speculators have to rush to cover shorts or be annihilated, and the more buying they do the faster silver rallies.  This frantic speculator short covering usually provides the initial spark that ignites new uplegs.  Then as silver rallies, long-side speculators and investors return to accelerate its gains.

These investors and speculators alike flock back to this metal with a vengeance once gold paves the way, and odds are that day is rapidly nearing.  There are a variety of powerful factors that are aligning today to ignite a strong gold upleg, this metal’s long-overdue mean reversion higher out of recent years’ artificial price levels from Fed manipulation.  Once that gets decisively underway, silver will amplify its gains.

With the first Fed-rate-hike cycle in nearly a decade on the verge of launching, these overvalued and overextended Fed-levitated stock markets are due to roll over hard.  That will really stoke demand for prudent portfolio diversification through alternative investments led by gold, which will lead to serious silver buying.  And contrary to the popular myth today, Fed-rate-hike cycles are not bearish for gold at all.

Last week I published an essay exploring a comprehensive study I did on gold during all Fed-rate-hike cycles since 1971.  In 6 of these 11 cycles, gold rallied dramatically by an average of 61%!  The bigger the rate-hike cycle, the better gold performed.  And in the other 5 where gold lost ground, the rate hikes always started when gold was near a secular high.  That certainly isn’t the case today at these dismal lows.

Fed-rate-hike cycles are bullish for gold and silver because they inflict such great damage on stocks and bonds, leading investors to seek alternative investments.  Adding to the gold and silver bullishness, the precious metals are both overdue for strong seasonal rallies running into February on Asian demand.  Not surprisingly since the gold price drives silver, silver’s seasonals closely mirror gold’s own seasonals.

Silver’s coming dramatic mean reversion higher can be played in physical bars and coins as well as the SLV silver ETF.  But investors and speculators alike can get far more bang for their buck in the battered stocks of silver miners.  Today these stocks are priced as if silver is going to grind lower forever, ignoring the profitability of many silver miners even at today’s low silver prices.  These stocks will skyrocket as silver recovers!

As hardcore contrarians at Zeal, we’ve long specialized in precious metals.  While this has been a tough sector thanks to the extreme Fed policies of recent years, that is all due to reverse as the Fed starts the long road to normalization. As the gross market distortions of QE3 and ZIRP are gradually unwound, there is no doubt gold and silver will mean revert to normal levels.  The gains to be won in this sector are vast.

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The bottom line is silver looks poised to awaken from its vexing slumber.  The brutal bear market it has suffered due to the Fed’s extreme market distortions is ending as policy normalization begins.  Silver is set up for lots of buying as gold’s recovery encourages traders to return.  Not only are investors radically underinvested today, but speculators remain heavily short which provides guaranteed near-future buying.

Like all markets, silver is forever cyclical.  It perpetually meanders from in favor to out of favor and back again.  And after falling on balance for years as QE3 sucked capital and interest away from portfolio diversification with alternative investments, silver is way overdue to reverse into its next major bull.  The brave contrarians willing to buy silver and its miners low before this becomes widely apparent stand to earn fortunes.

Adam Hamilton, CPA

September 11, 2015

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