Silver shorts play a dangerous game

銀價就來調整完成 ?

www.marketwatch.com

By Tom Essaye and Jim Woods 

LOS ANGELES (MarketWatch) — One of Wall Street’s many witty quips recommends you buy when there’s blood in the streets. Well, these days, the blood in the streets isn’t red — it’s silver. 

From late November through late May, the spot price of silver has bled nearly 35%. This sharp and protracted six-month plunge in the value of the metal has many causes, but the primary factor contributing to the silver selloff is the rotation away from precious metals and into stocks of all varieties. 

The heavy bout of selling in the space has created an extremely ugly technical picture for silver. In February, the spot price of silver, represented by the chart here of the iShares Silver Trust, plunged below both the short-term, 50-day moving average as well as the long-term, 200-day moving average. The drop below these two key technical resistance levels was followed by a near-capitulation selloff in April. Since that April meltdown, silver has fallen even further, and as of Friday, May 24, silver closed at $21.60.

For contrarian traders, or for those who like to sift through the detritus of beaten-down sectors in search of value, the severe drop in silver prices should trigger your blood-in-the-streets instincts. But why would anyone want to own silver here? Just because the price has come down so far, so fast, certainly doesn’t mean you should be a buyer. Here you have to ask yourself what would cause a rebound in silver prices.

The way we see it, silver prices rally for two basic reasons. First, silver rises in sympathy with gold as an inflation hedge. Second, silver prices rise in response to growing industrial demand, which is largely a function of enhanced global economic growth. 

Unfortunately for silver bulls, there hasn’t yet been any significant inflation (at least by official government metrics) that would drive the value of the U.S. dollar lower and the price of hard assets such as commodities higher. Although the camp critical of the Federal Reserve’s easy monetary policies (a camp we include ourselves in) has argued persuasively for the inevitable onset of inflation prompted by a debasement of the currency, this outcome has yet to be realized. 

As for global economic growth and higher industrial silver demand, that, too, is an outcome yet to be realized. Yes, there are signs of modest improvement the economy and the labor markets, but that’s yet to translate into increased demand for industrial metals in general and for silver in particular. If, however, you suspect that we could see either a significant increase in inflation, or a considerable spike in industrial demand, then buying silver here at these current levels means you are buying a fantastic value. 

Now, from a pure trader’s perspective, there’s an interesting phenomenon taking place in silver. We’ve noticed recently that the Commitment of Traders report, or COT, in silver continues to signal that there is no real risk of an impending washout in the price of the metal going forward. 

As of May 14, the “net long” position of speculators in silver was just 3,785 contracts. That’s extremely low by historical measures, although not nearly as low as the -2,497 net longs we saw prior to that April plunge. The current net longs are about 10 times below the net long high of nearly 36,500 set in November.

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On the short side, the COT reveals that the last time the number of “contracts sold short” was at current levels for more than just a week or two was in July 2012 (see chart above). Yes, there was a spike in short positions during that April decline, but now the shorts are back to their July levels.

The high number of short contracts, and the corresponding levels of net longs, we witnessed in July 2012 pretty much marked the low in silver for 2012. Interestingly, within eight weeks of the high mark in the shorts, silver prices rose some 30%.

Of course, we don’t know if this can happen again, but from a historical perspective, when the silver market gets this short, the chances of a continued decline are quite small. And while we did see a decline in silver prices in April despite the high level of shorts, that anomalous decline was more the result of a mass race to the exits in the precious metals space, along with a breakdown below previously held support levels. 

Finally, ask yourself this question: When it comes to silver, who is left to sell?

Basically, everyone who wants to sell silver has largely already done so. Moreover, the high level of short contracts out there means silver prices could explode higher on any exogenous event that prompts short covering. An example of such an event would be an unforeseen spike in bond yields of the sort we’ve witnessed of late in Japan. 

If investors get nervous over a spike in bond yields in the world’s third-largest economy, or if any number of other outliers or “black swan” events cause a flight to quality in precious metals, then the silver shorts will be caught with their pants down. The ensuing race to cover will undoubtedly cause massive short covering to take place, and that means a big spike in silver prices. It also means that traders wise enough to mop up the silver in the streets now could find themselves richly rewarded.