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Silver Technicals Suggest Basing Patern Before Next Leg Up

Commodities / Gold & Silver May 23, 2008 - 02:02 PM GMT

By: Zeal_LLC

Commodities

Best Financial Markets Analysis ArticleI've never seen any other commodity generate such a fanatical following as silver. There are many investors and speculators interested in nothing but silver and its miners. There are financial newsletters focused solely on silver. This metal's ecosystem, birthed by a legendary superspike over 28 years ago, is totally unique.

With so much riding on silver for so many traders, emotions are amplified tremendously. If 10% of your portfolio is exposed to silver, and it doesn't live up to your expectations, you can shrug it off. But if 90% of your capital is deployed in the silver realm, and silver lets you down, it is devastating. This is made all the worse by the capricious and hyper-volatile nature of silver. It takes no prisoners.


The silver faithful had such high hopes running into March when this white metal spent a couple weeks over $20. But these were soon dashed when silver plummeted. Since then, psychology has deteriorated even more into something of a sentiment wasteland. Widespread discouragement has led to serious selling in silver and especially the silver stocks. Many traders are feeling like all hope is lost.

In reality, silver's price action doesn't look all that bad in recent months if you divorce yourself from your emotions. I've been studying silver for a long time and think it looks very impressive today. Perspective on silver's technicals is everything, and it is impossible to get perspective on anything if you are too emotionally involved. Silver is great, but it must be viewed with cold neutrality like all assets.

I started recommending physical silver as an investment for our newsletter subscribers in late 2001 when it traded near $4.20. While I own many elite commodities stocks as long-term investments, a silver stock I recommended back in early 2002 still has the biggest unrealized gain at 961%! I have other long-term silver-stock investments and actively trade silver stocks on a short-term basis. So I am fond of this metal.

But I am not a fanatic simply because it clouds my objectivity to like anything that much. More power to you if you are, I have no quarrel with you. But if your love for silver burdens you with such stellar expectations for this metal that it keeps letting you down, your odds of trading it successfully will plummet. So please shelve your silver greed and fear for this essay and consider its technicals in coldly rational terms.

Technicals, of course, simply refer to price action. Every day, all of the silver buying and selling on the planet distills down into a closing price. Motives, and identities, of buyers and sellers are totally irrelevant. The only thing that matters, which charts capture, is the net daily market-clearing result of all silver demand and supply. Even with a short-term chart, it is readily apparent that silver remains quite high today.

All the psychological angst started back in mid-March. A couple weeks before that, silver had soared 80.5% since mid-August to a new bull high above $20. Silver's fortunes were looking very bullish. But then on Tuesday March 18th, the Fed spooked commodities speculators by cutting interest rates by 75 basis points instead of the widely-anticipated 100bp. Fast commodities selling ensued.

If you're a subscriber, I explained all this in depth in last month's April Zeal Intelligence. In a nutshell, Wall Street believed that commodities were in a bubble that would pop if capital exited them and returned to the stock markets. So when the Fed cut less than expected, Wall Street thought it was very bullish for stocks because the worst must have been over. The S&P 500 surged 4.2% that day, one of its biggest daily runs of the past decade.

Futures guys who bought into this flawed thesis started dumping commodities simultaneously. It took several days for the dust to settle. Silver plummeted 16.9% in the 3 trading days following the Fed's mid-March decision. This was indeed frightening as it looks like a crash on this chart. This crash-type event is very important to ponder since it illustrates two key attributes of silver that all traders must live with.

First, the price to pay for silver's high upside potential is fast downside potential. Silver's steep risk/reward profile is a double-edged sword. Almost without fail, whenever silver starts shooting parabolic in a vertical advance it crashes soon after. As soon as speculative buying burns itself out, silver falls fast . This tendency is readily apparent in today's 2000s bull as well as many decades into the past. Crashes are par for the course, not uncommon at all in silver. It is a speculators' playground.

Second, like it or not, silver follows gold . If gold is strong for a long-enough period of time, speculators will flood into silver. This is why almost all sharp silver surges happen late in underlying gold uplegs. I know this idea of silver being gold's protégé is controversial, but I wrote a whole essay on it last autumn if you want to see silver's technical history relative to gold with your own eyes. It is gold selling near a gold high that almost inevitably drives a silver crash.

When the Fed cut by 75bp in mid-March 2008, the US Dollar Index rallied because the cut wasn't as bearish for the dollar as the 100bp expected. Many futures traders still live in the old Stage One paradigm where the dollar's fortunes were the primary driver of gold. So the modest dollar rally ( real rates were still massively negative) after the Fed cut drove aggressive and outsized selling in gold.

Gold plunged 9.3% over the same several days post-cut when silver plummeted 16.9%. Silver speculators inevitably look to gold for trading cues and the sharp gold selloff understandably spooked them. And the falling silver price really frightened silver-stock traders. Most of the silver stocks fell far more steeply than such a modest crash by silver's wild standards really warranted. It was an ugly 3 days for everything precious-metals related.

But although it was painful in real-time, perspective is everything. By March 20th, 3 days after the Fed's 75bp cut, silver closed at $16.71. Was this a bad price? Heck no! Silver had only first hit this level in this bull 30 trading days earlier in February. $16+ silver is still a dazzling multi-decade high! Since silver averaged $13.36 in 2007, its crash low of $16.71 was still 25.1% higher. Is it rational to fret about such a big gain?

Back in December when silver struggled between $14 and $15, silver traders would have considered $16-to-$17 levels rapturous. Yet their perspective was skewed by the $20-to-$21 levels of early March. Sure silver looked weak on a 1-month short-term basis, but it still looked very strong on a 3-month short-term basis. Within the broader context of this bull, silver traders should have been jumping for joy at these high levels after a sharp fall.

A myopic perspective leads to poor trading, as focusing on the immediate with such intensity that broader context loses focus leads to extreme emotional swings. And once you are trading on your own greed or fear instead of gaming others', the battle is already lost. All good traders carefully try to maintain perspective and actively train their minds not to weight the most immediate trading action too highly

Another factor driving this poor psychology was a lack of knowledge of silver's modus operandi. For decades, maybe centuries, silver has been known for its extreme volatility. Traders with silver exposure should study some of its history to gain an idea of what to expect. Neither the sharp surge in late February nor the sharp plunge in mid-March was impressive by silver's standards. And students of silver know well that after a fast vertical ascent the probabilities for a sharp correction balloon.

Traders who expect nothing less from silver than for it to behave like its usual frenetic self certainly weren't frightened by the volatility surrounding its latest interim high in early March. After silver crashed, as usual it bounced and started defining a new high-consolidation trend channel. Nothing abnormal here.

As you can see above, so far this new consolidation is drifting sideways to a little lower. This initial downward bias is not a problem and is not uncommon so early in a high consolidation before the trend fully stabilizes. Eventually silver will stabilize at a new level and drift sideways until excitement starts building again.

The absolute price levels of this consolidation are the key to understanding silver technicals today. Since its latest crash, so far silver has bounced between roughly $16 and $18. These are excellent levels within the context of its bull to date, and they are likely sustainable based on bull precedent. And if they are, this young high consolidation has big bullish implications for the traders of both silver and silver stocks.

This final chart, which zooms out for context, helps build this case. It shows the last several years of silver's secular bull. Silver's recent parabolic ascent, and crash, mirror the events of early 2006 rather well. Although studying history can't foretell the future, it can certainly help us understand how silver tends to behave. And trading in line with silver's tendencies vastly increases our odds for success.

In early 2006, silver launched into a far-more-extreme parabola than we saw this year. Silver rocketed 124% higher from August 2005 to May 2006! It was a wonderful and highly-profitable episode for silver enthusiasts. Comparing this parabola and its aftermath with 2008's parabola and aftermath really builds an impressive bullish case for silver. Note above that these two events even look very similar on the chart.

The 2006 parabola was bigger and badder than 2008's by any measure. It soared 124.0% over 9 months compared to 80.5% over 7 months ending March 2008. In its terminal stage in spring 2006, traders drove silver up so fast that it stretched 1.704x and 1.651x above its 200-day moving average at its twin tops. Such stellar rSilver (silver divided by its 200dma) multiples reveal the euphoria surrounding the May 2006 top.

Back then, traders were actually excited about silver and silver stocks. If you were trading the silver complex around that May 2006 top, you are well aware of the vast difference in popular sentiment between then and mid-March 2008. While traders were euphoric in May 2006, they were only starting to get excited in March 2008. At best, rSilver only stretched to 1.465x above silver's 200dma.

This is aggressive, but nowhere close to euphoric levels. I suspect that silver should have reached euphoria this spring, but sadly the Fed-driven gold plunge short-circuited silver's latest upleg before it could blossom into maturity. This is certainly disappointing, but such is life in speculation. Exogenous events, if their timing is exquisite, can sometimes temporarily derail in-progress trends.

But for our purposes here, looking forward instead of bemoaning the past, the fact that silver's 2008 parabola was much weaker than 2006's buttresses this metal's bullish case. If silver could perform as well as it did after 2006's extreme parabola, then it should be that much easier for it to perform similarly well today after 2008's modest parabola. A parabola's aftermath lays very bullish foundations for silver and silver stocks.

Note that after the 2006 parabola, silver crashed. It plunged 35.1% in about a month! Crashes are not only par for the course in silver, but they don't signal the end of its bull. After this sharp correction to bleed off excess greed, silver soon bounced and started grinding sideways. While it struggled a bit lower in the initial few months after the crash, silver soon stabilized in a high consolidation between about $12 and $14.

Now $12 to $14 certainly wasn't the $15 parabola top, but it was still very impressive. Prior to the 2006 parabola, silver had been languishing around $7. So the high consolidation was very important for silver psychology. It gradually proved to traders that $12 to $14 was the new prevailing market-clearing price point for this metal. The longer silver traded in this basing range, the more comfortable the markets became with it.

This high consolidation in the upper range of the preceding parabola was also very beneficial for silver stocks. Prior to the 2006 parabola, silver miners were existing in a $7-silver world. All their mines, development projects, and exploration efforts were geared towards bringing silver to market at costs well under $7. And since it takes many years to bring new silver into production, the 2006 parabola did not change these existing production economics.

So during the high consolidation in 2006 and 2007 following the 2006 parabola, silver mining was wildly profitable. Silver miners were able to sell silver produced for under $7 at prevailing prices of $12 to $14. This led to surging profits, and cash coffers, for the silver producers. As they grew stronger financially and their valuations dropped, their stock prices were gradually bid higher despite silver's long consolidation.

Fast-forward to today. Silver just entered a modest parabola that collapsed and now it is grinding sideways. But where $12 to $14 used to be the norm ahead of the 2008 parabola, going forward there is an excellent chance $17 to $19 will be. As you can see in this chart, $17 to $19 is about the same range relative to the preceding 2008 parabola as $12 to $14 was relative to the 2006 parabola. Silver looks like it is starting to consolidate high again!

These new high levels will form a strong base for silver traders to bid silver into its next major upleg down the road. Where silver traders were wary of $17 to $19 in February and March since such levels seemed so high and new, now they are starting to get comfortable with them. After a few more months in this new high consolidation, everyone will view silver around $18 as normal.

And the unhedged silver miners, that were just starting to get used to a $12-to-$14 world, can suddenly sell their metal for around $18. Just like in the last high consolidation after the 2006 parabola, this is going to lead to much higher profits and lower valuations for silver stocks. As stock traders start to understand these new highly-favorable economics for silver mining, they will bid up silver stocks even as silver grinds sideways.

There is nothing bearish about a world where $17-to-$19 silver gradually becomes the norm until the next major silver upleg! I find this prospect very exciting. It not only establishes a high base from which silver's next major upleg will launch, but it virtually ensures that silver stocks will be bid a lot higher as more traders come to realize just how profitable they are in such an environment.

And there is one more technical point that buttresses this new-high-consolidation thesis. After the 2006 parabola, silver crashed 35.1% or 0.283x the percentage gains of its preceding major upleg. After the 2008 parabola, silver crashed 22.3%. Provocatively this works out to 0.278x the percentage gains of its preceding upleg.

0.278x is very close to the 0.283x magnitude in 2006 which suggests silver's post-parabola lows are likely already established. And post-parabola lows tend to be carved soon after the crash anyway, not later. The technical symmetry between now and mid-2006 is very nice. If silver's low is indeed in, then we've already seen the worst of this high consolidation.

If you're a pure silver trader, you should take comfort that silver is basing high for its next major upleg. Now since silver follows gold, and gold's seasonals are very unfavorable in summer, we may have to wait until autumn for the next major gold and silver uplegs. Both of the past two uplegs started in Augusts of their respective years. But if there was ever a summer for gold to buck seasonal trends, 2008 is it. The coming inflation scare is going to be the worst seen since the 1970s, great for gold investment demand.

Silver-stock traders shouldn't have to wait all summer though. Sentiment in silver stocks is so rotten now that bargains abound. Most of the elite silver stocks would have to be bid up dramatically to reflect their profitability at today's new prevailing silver levels. They still have yet to price in the March 2008 upleg.

Talk about fortuitous timing! Over the past couple of months at Zeal, we've comprehensively researched nearly 80 silver stocks. My business partner Scott Wright and I gradually whittled this field down to our 12 favorites. Scott wrote up the results of hundreds of hours of research work in an awesome new Zeal Report describing the outstanding fundamental prospects underlying each of our favorite silver stocks. This fascinating new report will be available for purchase later today.

Not only are the elite silver stocks not yet valued for a $17-to-$19 silver environment, but many are rapidly growing production as well. Higher prevailing silver prices, rising production, and a sentiment wasteland are combining to make the coming months look like a very compelling time to add bargain positions in elite silver stocks. Subscribe to our acclaimed monthly newsletter to see which specific silver stocks we end up trading ourselves, and when.

The bottom line is silver technicals really don't look anywhere near as bad today as the rotten sentiment implies. True, silver's upleg ended in mid-March before it reached full euphoria-driven maturity. This is unfortunate, but such is life in the markets. Looking forward silver's bull precedent suggests it will consolidate high, probably forming a new basing zone between roughly $17 and $19.

If such levels hold, silver will build a strong base ahead of the big seasonal strength in gold due this autumn. After a truncated upleg, silver is certainly overdue to experience some popular euphoria in its next upleg. Meanwhile, silver stocks will have to be bid higher to price in the new prevailing $17-to-$19 silver prices. Traders will gradually bid up silver stocks until they reflect today's favorable silver economics.

By Adam Hamilton, CPA

So how can you profit from this information? We publish an acclaimed monthly newsletter, Zeal Intelligence , that details exactly what we are doing in terms of actual stock and options trading based on all the lessons we have learned in our market research. Please consider joining us each month for tactical trading details and more in our premium Zeal Intelligence service at … www.zealllc.com/subscribe.htm

Questions for Adam? I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/adam.htm for more information.

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com . Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

Copyright 2000 - 2008 Zeal Research ( www.ZealLLC.com )

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Comments

mike king
25 May 08, 02:37
Gold & Silver -Think beyond the norm

For many years investors have viewed silver and gold as investments...... this is no longer the correct view....... these metals.... at this point in time and for several years to come.... are rising in price due to one thing and one thing only.....THE DEMISE OF THE AMERICAN DOLLAR. The charts are worthless..... the normal investment strategy is worthless..... viewing silver and gold as "investment" is incorrect at present..... you are "investing" in the failure of the United States Monetary System....that..... has no means of recovering without severe debasement.


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