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November 21, 2008

Silver in Crisis
by Adam Hamilton

The unprecedented financial turmoil plaguing all markets these days is dominating everyone's attention. In a troubled time when the flagship S&P 500 stock index can plunge 30.0% in a single month, it is hard to think about anything else. Thus many smaller markets, like silver, are languishing in relative obscurity.

Silver, an asset which many investors thought would thrive during a financial-market panic, has been scourged mercilessly. After briefly surging above $20 in March, it nonchalantly traded between $16 and $19 or so for the next 5 months. Silver was on top of the world, consolidating high, and all looked well.

But since early August, the global financial panic has radically reshaped the silver landscape almost beyond all recognition. So far in November 2008, silver has averaged just $9.73 on close. The stocks of the world's biggest and best silver miners, companies that held so much promise only 6 months ago, are now down 80%+. It really feels like Armageddon for silver investors, a once unthinkable living nightmare.

I've been a big silver fan since this gold bull started in early 2001. I bought a lot of physical silver back in the early 2000s and first formally recommended silver coins (US 90% bags) to our subscribers as a long-term investment 7 years ago this month when silver traded in the low $4s. Several of my core long-term investments are elite silver producers. So as a long-time silver investor, I am sure feeling the pain too.

Since silver has fallen off a cliff and even its best producers have cratered, silver investors and speculators are feeling tremendous anxiety. Me too, this crisis situation is just unreal. Like so many things in these crazy markets, today's horrific silver environment would've seemed impossible not too many months ago. So this week I decided to take a look at silver in crisis and see what insights we could glean.

To start, we need some perspective. Despite what it may feel like, silver has not been singled out. From early March to late October, silver fell 56.7%. Most of these losses snowballed since mid-July, a span over which this white metal lost an unbelievable 53.0%. This is terrible, no doubt. But realize over this same period crude oil, the king of commodities, plunged 63.3%! Heck, even the geometrically-averaged (hence very slow to move) Continuous Commodity Index is down 43.0% since early July.

Silver's losses are not happening in a vacuum. They have been driven by exogenous forces far beyond the usual small and insular silver market. The financial panic has driven a wholesale deleveraging of all assets, including commodities. It is crucial to keep this in mind. Considering silver technically in isolation, ignoring these unprecedented times, will certainly lead one to draw the wrong conclusions on its troubles.

And silver is unique among commodities even in the best of times. Its small market size, phenomenal historical price spikes, and fanatical following have forged it into one of the most volatile and speculative commodities on the planet. While its secular bull is indeed fundamentally-driven, inflows and outflows of speculative capital have driven violent swings all around this core uptrend. Silver has never been for the faint of heart, it takes no prisoners.

Because of this heavy speculative component driving silver's wild gyrations, speculator sentiment is disproportionately critical to silver's near-term fortunes. If silver speculators are greedy and excited, silver can rocket higher like it did in early 2008. But if silver speculators are fearful and scared, silver can plummet like it did in recent months. Speculators' mood swings drive silver's short-term price swings.

As I've traded silver and silver stocks over the years, it has become clear that one factor dominates silver-speculator sentiment much more than all other factors combined. It is gold's performance. Gold is the king of precious metals, its behavior governs sentiment for the entire PM complex. When gold is strong, silver traders get bold and buy aggressively. But boy, when gold is weak silver traders run for the hills.

In light of this truth, and considering how universal this financial panic's impact has been, we can't consider silver's behavior in isolation from gold's. Gold sets the PM tone, and silver amplifies it. If you are the least bit skeptical of this, I encourage you to study market history to investigate it on your own. I wrote an essay last year, Silver Lagging Gold, that illustrates this strong tendency with 7 charts spanning nearly 4 decades.

Today's silver crisis needs to be pondered in light of gold. It won't and can't make sense in isolation given all the unprecedented financial-market extremes we've witnessed in the last couple months. So in my technical charts this week, I rendered silver (blue) on top of the gold price (red). This first one takes a look at the past year or so in the precious-metals complex.

Silver started this year strong, blasting 50.4% higher from December 2007 to March 2008 to dazzling new multi-decade highs. On a nominal basis, silver hadn't been above $20 since October 1980. And on a real inflation-adjusted basis, silver still hadn't exceeded $20 since March 1984. So seeing silver above $20 this year was very exciting and a big deal in a secular sense. Silver bulls were naturally ecstatic.

But note above that during this early-2008 silver surge gold was also strong. Over this same span of silver's rally, gold powered 24.6% higher. Gold was hitting a series of all-time nominal highs of its own in early March when silver was over $20. When gold is strong, silver speculators get excited and flood into the volatile metal. So it leverages gold's gains, by 2.0x in the case of this particular silver surge.

Unfortunately these maturing PM uplegs were cut short by a surprise from the Federal Reserve. Instead of slashing rates by 100 basis points on March 18th as the markets expected, the Fed only cut by 75bp. It was still a huge cut, it still should have hammered the US dollar. But provocatively the heavily oversold dollar started rallying on the Fed's "restraint". Gold plunged and dragged silver with it. By early May silver had fallen 22.3%, amplifying gold's own selloff by 1.6x.

Then in much of May and June, silver simply consolidated sideways. Note above that its daily rallies and selloffs mirrored gold's closely, as usual. In early July gold caught a bid and silver followed. But gold's rally wasn't all that large and silver speculators weren't too convinced it was worth chasing. Silver only rallied 18.6% over this span, merely amplifying gold's gains by 1.3x.

All today's silver woes started in mid-July and accelerated into August and September. Between $17 and $18 in late July, still in a typical mild summer-doldrums downtrend, silver looked solid. It wasn't until it broke below $16 in early August that silver technicians started to get scared. And indeed, if you considered silver in isolation it was plummeting down through its key support zones like a mobster wearing cement shoes.

Between mid-July and mid-September, silver plunged a breathtaking 45.5%! It was the worst selloff of this entire silver bull by far, as you'll see below. Speculators had to abandon silver at a frightful rate to drive such an incredible sell-side imbalance. Why did they flee? Because of gold's behavior. Gold was knifing down through support zones too, which quickly turned sentiment deeply negative in the entire PM realm.

Over this same span of silver's brutal selloff, gold was down 19.9%. So silver leveraged gold's decline by 2.3x. This is not far above the 2.0x leverage silver saw to gold in early 2008 during its upleg. So while silver's behavior was terrible in an absolute sense, relative to gold it wasn't beyond the pale. Interestingly this comparison is even a bit skewed thanks to gold bottoming 3 days before silver in September.

If you optimize this mid-July-to-mid-September decline to the exact days of gold's swing instead of silver's, the silver-to-gold leverage ratio looks even more normal. Silver fell 44.5% to gold's 23.8%, a solidly normal 1.9x. While I am certainly not trying to downplay the magnitude of this silver crisis, realize that relative to gold's decline silver's selloff wasn't atypical at all. Silver amplifies gold's behavior, to both the upside and downside.

This begs the question, if gold killed silver speculators' sentiment then what happened to gold? The unprecedented global financial panic, first in bonds and later in stocks, drove one of the fastest and largest US dollar rallies in history. Foreign investors rushed to buy US Treasuries to protect their capital, and they had to buy dollars first. Gold futures traders saw this huge dollar surge and sold gold aggressively. I wrote an entire essay on this particular unique gold/dollar event last month if you want more background.

Out of mid-September's lows, silver surged following gold. On September 17th, gold rocketed 11.1% higher in its biggest single-day rally since January 1980. Silver speculators naturally loved this, bidding silver 15.2% higher that day. By the time this rallying spell ran its course in late September, silver was up 29.3% which leveraged gold's own gains by 1.8x. But although the bond panic into dollars had abated, the stock panic into dollars was just starting. The dollar surged, gold fell, and silver plunged again.

Between late September and late October, the white metal fell another 33.3%. It was amazing, earlier this year I never thought we'd see silver in the $8s again. Nevertheless, despite silver's atrocious absolute levels it only leveraged gold's own decline over this span by 1.8x. No matter how ugly silver looks in isolation, compared to gold (its primary driver) silver's recent selloff was not out of proportion.

Now that you've considered all silver's big swings over the past year, look at this chart again as a whole. All silver has done in going from $14 to $21 to $9 is follow and amplify the underlying moves in gold. Silver's daily and multi-day rallies/selloffs in this chart mirror gold's exceedingly well, as usual fitting like lock and key. Technically, silver is merely gold's little lapdog as it always has been. Without gold strength to ignite silver speculators' greed, silver can never rally for long on its own.

Silver's only problem since August was gold. And a big part of gold's problem was a giant contraction in speculative capital deployed. Due to forced redemptions, margin calls, and sheer fear, traders all over the world pulled capital off the table. Their selling forced virtually all prices lower. Unfortunately gold was not an exception this time around, as it should have been during a full-blown panic. And with gold weak, silver didn't stand a chance.

In recent weeks, angry and shell-shocked silver enthusiasts have been looking for a villain to blame. While conspiracy theorists from various factions will shrilly disagree with me, I don't think there is a silver-specific culprit to tar and feather for the extraordinary chaos of the past few months. Gold got crushed and silver followed and amplified gold as it always ultimately does. End of story.

But one thesis today suggests mainstream stock investors added to this silver plunge by dumping their holdings in the SLV silver ETF. Last week I investigated this claim for gold made by opponents of gold's ETF, and they were groundless. I was curious about SLV so I checked out its holdings. The results will be very surprising to many and suggest stock investors buying SLV are much stronger hands than expected.

While speculators abandoned silver since mid-July, stock traders owning SLV didn't really succumb to this irrational panic. SLV's total holdings, amazingly enough, actually grew and hit new all-time record highs during the silver crisis of recent months! A steep uptrend in SLV's bullion holdings that began during the sharp early-2008 upleg somehow held intact through the brutal late-2008 correction. The silver ETF actually helped retard silver's selloff!

SLV holds silver in trust for its investors. Its mission is to track the silver price. This only happens naturally if SLV supply and demand trends are very similar to underlying silver supply and demand trends. If relatively more SLV is demanded than silver, this ETF must issue shares and use the proceeds to buy physical silver to equalize this demand differential. The opposite is also true, SLV must sell silver bullion and buy back shares if SLV selling pressure exceeds that in silver futures. If these mechanics aren't clear to you, I explained all this last week for GLD. SLV works the same way.

If SLV and silver always had the same supply-demand pressures on a minute-by-minute basis, SLV's holdings would never need to change (outside of the modest annual management fee). SLV's holdings only grow when SLV demand exceeds silver's and only shrink when SLV supply exceeds silver's. Since SLV still grew its holdings even while silver cratered, SLV buying pressure in recent months was greater than the selling pressure driven by silver's collapse. This is incredibly impressive.

SLV has grown fast during silver uplegs, grown slowly during silver consolidations, and has even grown or remained stable during silver selloffs. Stock traders want to be able to get silver-price exposure via their usual stock-trading accounts, so SLV demand has continued to grow despite silver's wild volatility. No matter how you feel about metals ETFs personally, you can't argue that SLV contributed to silver's recent weakness. This ETF actually had to buy physical silver during this futures-based selloff!

Whenever you analyze silver it always comes down to gold in the end. If gold is strong enough for long enough, silver will explode higher as speculators flood in to drive one of its characteristic parabolic spikes. If gold is drifting in a consolidation, silver will dutifully follow in a sideways grind of its own. And if gold sells off, silver speculators will abandon silver in a heartbeat without thinking twice. Gold is the key.

I fully know silver is a religion for some investors who will own nothing else but this metal, its producers, and its explorers. More power to them, silver is definitely very exciting and exceedingly lucrative when it rockets higher. This being said, silver is still at the mercy of gold. This final bull-to-date chart of gold and silver, from my multi-decade study of this relationship, offers some important lessons.

Yes, silver has awesome potential. Yes, its secular bull has already carried it from around $4 to nearly $21 at best. Yes, investors and speculators in silver including me and our subscribers have made fortunes trading it and its producers. All this is true, there are many reasons to love silver going forward. Yet ultimately, silver is slave to gold. It is a hyper-volatile speculation that amplifies gold-driven PM sentiment.

In silver's bull to date, literally all of its gains have come from just 3 fast uplegs. Silver's bull really didn't begin in earnest until early 2003, about 5.5 years ago and about 2 years after gold's own bull began. Out of 22 calendar quarters of silver bull, silver only gained big on balance in about 7 quarters. Note above that all 7 of these big silver quarters, distributed across 3 mighty uplegs, happened when gold prices were strong.

Silver is strong only after gold is rallying high enough for long enough to ignite excitement in precious metals. When gold consolidates and excitement bleeds away, silver is weak. And when gold corrects, silver amplifies gold's downside moves quickly and efficiently. So when gold succumbs to rare extraordinary weakness, any prudent silver investor or speculator will expect silver to suffer even more.

And although the global loss of confidence in all speculations drove silver's biggest correction of this bull by far, I also wanted to point out that extreme silver declines are par for the course from time to time. In early 2004, silver plummeted 32.8% in 24 trading days. In mid-2006, silver plummeted 35.1% in 23 trading days. So its 2008 selloffs of 22.3% in 40 days and 45.5% in 45 days aren't too out of character. Indeed, 40+ day declines for silver are actually a slow pace for a sharp selloff!

Silver always has been very volatile and always will be. Since it is such a small market with so much exciting history and such a fanatical following, speculators will continue to exert an outsized influence on silver. And if the last 4 decades of history continue to hold true, as I suspect they will, the biggest single factor influencing silver sentiment by far will be gold's own price performance. Gold is the key to silver.

So if you believe in gold's long-term fundamentals, that its secular bull will continue to power higher on balance for years to come due to increasing investment demand, shrinking mined supply, and incredible fiat-paper inflation worldwide, then there is nothing to fear in silver. Silver will follow, and amplify, gold in the end. Yes silver is in crisis today, it has been eviscerated technically. But this is an anomaly.

Flight capital desperately buying US dollars to buy US Treasuries to escape a once-in-a-generation global financial panic drove a massive and fast dollar rally. Futures traders saw this and sold gold and other commodities aggressively. Naturally silver fell as gold sentiment imploded. And relative to gold's extreme decline, silver's selloff was not outsized. It was just about right given the magnitude of this anomaly.

At Zeal we've certainly been beaten up by this silver selloff too. Our long-term physical-silver and silver-stock investments were driven to brutally-low levels I never thought we'd see again. Despite this intense pain, this financial panic too will pass like all before it. As soon as confidence returns to the financial markets, probably driven by a major stock-market rally, capital will return to the commodities realm. Gold will benefit greatly and silver will follow it higher as always.

We actually took advantage of this carnage to add a new long-term investment position in an elite silver miner we've long wanted to own. Details are in the current issue of our acclaimed monthly newsletter. If you watched silver soar from $11 in summer 2007 to $21 in March, and wished you could've gotten into silver stocks on the ground floor, today's anomaly is a very rare second chance. Subscribe today and don't miss this incredible opportunity.

The bottom line is silver has indeed been slaughtered. It hurts. But despite unbelievable technical carnage, silver's plunge was not unreasonable given the size of gold's own selloff. As a highly-speculative asset even in the best of times, silver's poor performance during a peculiar panic episode when all speculations were shunned should not be too surprising. Speculators simply abandoned it.

While extreme times can drive extreme price levels, realize that financial panics never persist for long. While silver probably won't hit new bull highs soon after rationality returns, its fundamentally-driven equilibrium price is probably up in the mid-teens at worst. That's much higher than today's levels! As financial-market confidence returns, and gold's bull resumes, silver's crisis of confidence will end too.

Adam Hamilton, CPA
Zeal LLC.com

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If you have questions I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/financial.htm for more information.

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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