Are We at A Precious Metals Top?

The last week has seen a wild ride in the precious metals. Along with this wild ride, has come an increase in margin requirements on the futures exchanges which on some level should align the margin deposit with the actual riskiness of the underlying investment/speculation. For instance, the margin requirement for silver was raised to $14,500 on Friday, but on a 5,000 ounce contract, that only covers a $2.90 change in price. Any more movement would put the exchange at risk because participants would not have deposited enough money to cover a potential loss. And so it was last night, that silver opened weak, and traded off $6 in a matter of minutes, which suggests to me that the exchange could easily double the margin from $14,500 to $30,000. Some brokerage houses have been imposing double margin requirements of their customers. Incidentally, gold barely moved during silver’s dramatic sell-off last night.

The seeds for Sunday nights move started on Friday, when it seemed as if silver could not get off the mat, while gold climbed 2%, or about $30 an ounce. This is a divergence of massive proportions. In fact, a close look at the tick chart of the gold silver ratio (see attached) shows that the ratio started to diverge on Friday, and continued into last night’s opening with a spike higher.

Over the past few weeks, I have received many links and articles forwarded by readers about the precious metals. Since this has been my over-riding macro-strategy, most readers tend to think of me first when taking in the incredible rise of precious metals. On the one hand, the incredible rise in prices looks quite parabolic, which ultimately means that the near vertical rise will be followed by an equally impressive decent. I agree with that assessment, from a technical market analyst’s perspective. In fact, I embraced that stance for a brief time period over Easter weekend. However, despite the technical picture which looks precarious, there are still fundamental reasons why precious metals will continue to outperform all other asset categories.

* As a Marc Faber, in a past newsletter, once quoted:  

“When that which you have expected for a long time comes about, it usually takes a different form than what you would have expected.” 

This is not an exact quote, but it gets to the point that precious metals are moving significantly higher than any other asset class over the last 10 years, on almost all time frames. Currently, the collapse of the dollar and an imminent demise in our financial system are not upon us, conditions which I consider required for gold to spike above $5,000 an ounce, and silver well above $100 an ounce. Nonetheless, the precious metals have risen well above what most people would have expected within this time period, me included.

This leaves me trying to separate out my fundamental view that precious metals will go a lot higher over the course of the next few years, with the over-bought technical nature of the run-up to the current highs. My gut tells me that one can make some money by taking some positions off the table (taking profits) and waiting for a correction to re-load. However, I have tried that in the past on a limited basis, and usually, I was wrong and had to buy back into my position at higher levels. So whatever I do on this sort of basis will only be for a small amount of my position, and preferably in options

Here is a summary of what others are saying about precious metals:

Howard Ruff: Has been a big proponent of silver for the last few years, and he is one of the guiding lights which clued me into precious metals a few years ago. In his newsletter a week ago, he re-asserted his contention that the metals will go a lot higher. He also said he could not advise anyone on how to counter-trade the current rally, but that silver and gold will go much higher over the long term. And despite silver’s out-performance vis-a-vis gold over the last 8 months, he still thinks it will continue to out-perform gold by a large margin.

Eric Sprott, on his quarterly conference call last week, reaffirmed his belief in his long precious metals strategy, with the addition of the idea that silver should out-perform gold going forward, despite silver’s dramatic run so far. Eric also views the mining stocks, which have lagged over the past few weeks, as a buying opportunity. Eric runs his hedge fund which is long precious metals (bullion and mining stocks) and shorts US equities, which in my opinion, is a great way to go. For the record, Sprott’s track record is +24.9% annualized since it was started 9 years ago.

Most other market prognosticators warn caution towards the precious metals, and notably silver. In fact, I would say that the general consensus is to be cautious towards initiating new positions in silver and gold to a lesser extent. It is due to this general consensus of caution, which leads me to want to fade this cautious approach. Before I convince you that you should invest your life savings in silver, let me share with you the bearish indicators which cause me concern:

1> The shares of the SLV ETF have dramatically dropped over the last 5 trading days, by an 12.4 million, represents about 12 million ounces of silver. This refers to some form of liquidation going on.

2> The open interest in the silver futures contract has dropped by a whopping 20,000 contracts, or about 1/7th of the total open interest, representing 100 million ounces. Liquidating markets as new highs are being made usually indicate that an interim top is near. Such an occurrence reminds us that the markets are now liquidating at these levels, and accordingly, will lose some of its strength. This is not always an indicator that we are at a top, but it was at the interim high in 2006. As the next graph on the attachment shows, open interest dropped dramatically, 149,000 contracts down to 110,000, or a 26% drop. What followed was one last high without much change in open interest, and then a 30% drop in the price of silver, from $15 to $10, in the span of one month. If such an event were to occur today, my gut feel tells me that we will get a new high in the $53-$54 range, with a correction to about $40. I will be monitoring the technical divergences in the RSI if we make a new high, according to the parameters I sent out two weeks ago.

3> Along the lines of declining activity in gold, the CFTC’s commitment of traders report show a corresponding large drop in the number of commercial players short positions. On some level, this also removes latent buying power from the market.

4> Last week, there were 97% bullish consensus amongst silver futures traders for many days in a row. That sets an all time record for excessive bullishness, and usually this is a precursor to a market top.

Now let me share something which is decisively bullish:

There is backwardation in the pricing of silver futures, meaning there is not enough silver around to cover the needs for future delivery, with an implied squeeze over the near term. As I have mentioned before, usually there is a stable relationship between the price of spot silver and the futures. In fact, during 2010, the futures contracts out in time should be about 0.77% higher as one goes out in time for each year forward. As of Friday’s close, the difference between Dec 2011 and Dec 2013 futures contracts was -0.35 pts, or -0.72%, instead of being +1.54% as the historical relationship indicates. In other words, there is not enough silver around for arbitragers to deliver against Dec 2011, and buy Dec 2013 futures. The profit potential is 2.26%, which does not sound like much, except for the fact that if all you needed to put up was the current margin rate of 10%; (Commercial players get a lower margin rate than speculators). That still adds up to a double digit return over 2 years. And the reason why this arbitrage is not possible is because silver is in tight supplies, and the arbitragers cannot borrow, or rent out the silver for these purposes.

Then there is the whole range of fundamental reasons why silver (and gold) should do better over time which I have espoused in past blogs, so I will not bore you today, assuming you have actually made it this far. One last look at the gold chart will show that gold is nearing the upper end of its very neat channel. The 10 year chart, using weekly data, has the top of the trend channel crossing around $1650. The largest correction we have seen in this ten year span was the correction into November, 2008, of 33%. The 2.5 year chart since the recent low in 2008 has the channel crossing around $1610 today, and $1630 by month end. A high in that zone later this month, with technical divergences would be a good sign that we are at an interim top, and perhaps one worth trading. For the meantime, I will stick with my long term holdings, mixed with a smattering of put options.