Silver, Gold & Currencies Revalued Overnight
Here's a terrific 9 minute video posted this morning my Mike Maloney.
Silver, Gold & Currencies Revalued Overnight
Originally published by Adam Hamilton at Zeal LLC
Gold and silver have been pounded lower over the past month, contrary to their bullish seasonals. This selling pressure has come from the usual suspects, American futures speculators. They’ve been busy aggressively dumping gold and silver futures, particularly on the short side. But each time they pressed this bet in the past 15 months, gold soon surged higher. Shorts are bullish since they must soon be covered.
Gold suffered its worst quarter in 93 years in 2013’s second quarter, a nauseating 22.8% loss. This was triggered by the Fed’s stock-market levitation, which sucked vast amounts of capital out of alternative investments. Gold plunged early in that catastrophic quarter when major support failed, and again later on Ben Bernanke’s initial QE3-taper scare. This naturally left gold sentiment overwhelmingly bearish.
American futures speculators responded by betting heavily against gold and silver during that Q2’13 timeframe. And given gold’s once-in-a-century plunge, they obviously enjoyed great initial success. But even after gold decisively bottomed in late June 2013, this elite group of traders remained extremely bearish on the precious metals and kept selling their futures. This has continued for the 15 months since.
The ironic thing is that fantastic Q2’13 gold-downside bet hasn’t worked very well since then. Of the 303 trading days since gold plummeted to $1199 in late June 2013, it has only closed lower briefly on 3 trading days in late December. The universal gold bearishness of the past 15 months hasn’t paid off, it was a bad bet. Gold has weathered the heavy selling to grind sideways in a massive bottoming consolidation.
Yet American futures speculators still remain exceedingly bearish on precious metals, which is truly seriously irrational given their sideways price action. The reason is likely twofold. Until the Fed-driven stock-market levitation decisively rolls over, demand for alternative investments will remain weak. And given the extreme leverage inherent in gold futures, speculators must maintain an ultra-short-term focus.
At $1250 gold, a single 100-ounce gold-futures contract controls $125,000 worth. Yet the maintenance margin on US gold futures is now just $4600. Thus traders running at maximum margin have leverage to gold of 27.2x! That is astoundingly risky, as a mere 3.7% gold move against these guys would wipe out literally all of the capital they bet. For comparison, stock trading is legally limited to 2.0x leverage.
Big gold moves aren’t uncommon. Since 2009, fully 1/13th of all trading days have seen gold close 2%+ higher or lower. So highly-leveraged futures speculators can be wiped out in a matter of days if they make the wrong bet on gold! Thus their myopia is as extreme as their leverage, with their whole world existing between a week in the past and a week in the future. Any minor gold slide rekindles their bearishness.
If the stock markets edge up to new nominal records, American futures speculators are quick to dump gold. If the US dollar is stronger, they are quick to dump gold. If the Fed hints at interest-rate hikes, they are quick to dump gold. If some elite investment bank makes its umpteenth weathervane bearish call on gold, they are quick to dump gold. If some geopolitical hot spot appears to cool, they are quick to dump gold.
Already having a heavily-bearish bias and forced by leverage to be short-sighted, American speculators jump on every opportunity to sell gold futures. And that is exactly what happened to gold and therefore silver over the past month or so. Gold would droop for a couple days, futures traders would rationalize that as confirmation of their bearish theses, so they would sell more gold futures and amplify its decline.
This creates a vicious cycle. And in the absence of normal levels of gold investment demand thanks to the Fed’s artificial stock-market levitation, there isn’t enough offsetting physical buying. So futures selling dominates the gold price, and it slumps towards lows. The funny thing is these extreme bets against gold by such sophisticated traders always prove wrong, as gold rallies right at their peak bearishness!
This first chart looks at American speculators’ total long and short positions in gold futures, which are reported each week in the CFTC’s famous Commitments of Traders reports. On top of these collective bets the gold price is overlaid, as seen through the lens of the flagship SPDR Gold Shares ETF (GLD) that stock traders prefer. The worst time to be bearish on gold is when futures speculators force it near lows.
And that’s exactly what’s going on today. Around $1250 gold isn’t far above its June 2013 low of $1199, its December 2013 low of $1190, and its June 2014 low of $1244. Seeing gold and therefore GLD shares heading towards the bottom of their 15-month consolidation trading range makes investors and speculators very nervous and bearish about gold’s prospects. It feels like gold is ready to fall off a cliff.
At times like this, nearly everyone is bearish except the hardcore contrarians. We humans have a natural tendency to extrapolate our present conditions out into infinity. We want to assume that trends in force today are going to persist indefinitely. This dangerous assumption is why the vast majority of traders lose money in the markets. They succumb to the herd groupthink and popular emotion near extremes.
That fails because the markets are forever cyclical. Once everyone is bearish, the selling has already happened and a reversal is imminent because only buyers remain. So it is foolish to sell low in the midst of extreme popular bearishness. Yet since nearly everyone wants to feel accepted by their peers, to believe markets move in the same direction forever, bearish calls abound right as prices are actually bottoming.
The elite and highly-respected Goldman Sachs is a prime example of this, reiterating its 15-month-old (and wrong) forecast that gold will fall to $1050 by the end of this year. Each time gold nears the lower support of its bottoming consolidation trading range, this high-profile bearish call gets much attention. But Goldman Sachs, along with all of Wall Street, is merely a weathervane extrapolating current trends.
Back in August 2011 when gold was skyrocketing and a few contrarians like me were warning that it was way overbought and due for a serious correction, Goldman Sachs was wildly bullish on gold. It came out with report after report upping its gold price targets over all time horizons. It declared that a year later, gold would be around $1860. But a year after that euphoria, gold had slid down near $1600!
Goldman Sachs is bullish on gold or stocks or anything when they are high and topping, the exact wrong time to be. And it is bearish on gold when it is low and bottoming, the smart time to be bullish. As a herd, American futures speculators are the same way. They are weathervanes that reflect prevailing sentiment, with no desire to fight the crowd to buy low and sell high. This is crystal-clear in this chart.
Note that the blue GLD-share price has a strong and nearly perfect inverse correlation with the total level of American futures speculators’ gold shorts. Just as this elite group of traders is the most bearish on gold as evidenced by their real-money bets, gold is bottoming and on the verge of a sharp rally. This happened in mid-2013, late 2013, mid-2014, and is almost certainly going to happen again soon here today.
After Q2’13’s epic once-in-a-century gold plunge, American futures speculators were so convinced that gold would spiral lower indefinitely that their bets against it surged to an at-least 14.5-year high. It may have even been an all-time record. But defying these guys, gold soon rallied sharply. Extreme gold-futures shorting is inherently self-limiting, as it sets the stage for massive and frantic short covering.
When everyone thinks gold is doomed to spiral lower forever, everyone who wants to sell gold futures has already done so. Traders with long-side bets who succumbed to the bearish groupthink are already out, and traders with the cojones or hubris to make hyper-leveraged short bets have already laid them in. And with essentially no futures sellers left, that leaves only buyers. So a minor gold rally can quickly explode.
At relatively-conservative-for-futures-traders 20x leverage, a 5% gold move against their bets will erase 100% of their capital risked. And it doesn’t take much at all to spark 1% to 2% up days in gold that will trigger nearly instant 20% to 40% losses for these speculators. A material stock-market down day, a worse-than-expected economic report, some geopolitical flare-up, many things can ignite a sharp gold rally.
And when leveraged futures speculators see 20%, 40%, 60% of their capital risked annihilated in a day or two, they have no choice but to cover. In the futures realm, shorts are covered by buying offsetting longs. So in terms of positive price impact, there is zero difference between adding a new long and buying one to offset and close a short. As speculators buy to cover, the gold-price gains naturally start accelerating.
The faster gold rises, the more other speculators are forced to cover too. This process forms a virtuous-circle self-reinforcing upleg for gold prices. The more traders buy it, the faster it rises. The faster it rises, the more traders want to buy it by adding new long-side positions and the more traders trapped on the short side have to rush to cover. Thus gold is due for an imminent sharp rally when futures shorts hit extremes.
And such extremes certainly aren’t hard to define. Between 2009 and 2012 in the last normal years before 2013’s crazy Fed-driven gold anomaly, American speculators held the short side of 65.4k gold-futures contracts on average in any given week. That’s the opposite of extreme, the baseline. And early July 2013’s at-least-14.5-year record high of speculators holding 178.9k gold short contracts is peak extremeness.
While this latest week’s read of speculators holding 108.5k short gold-futures contracts was nowhere close to that, it is still extreme by a couple key measures. First, over the past 15 months as gold failed to plunge into oblivion despite the extreme bearishness, futures traders are gradually learning not to listen to the sentiment weathervanes. With each subsequent gold low, their zeal for shorting this metal wanes.
So a strong downward-sloping resistance line on extreme gold-futures shorting tops has formed. And the levels of speculator shorts we are seeing today are almost there. Odds are it will hold again, that a sharp short-covering gold rally is imminent. If gold couldn’t be hammered to decisive new lows over the past 15 months despite the most extreme bearish headwinds seen in well over a decade, it probably can’t be now either.
The second clue we’ve reached extremes is the speed of the surge in speculators’ gold-futures shorts over the past three weeks. These super-leveraged downside bets on gold have rocketed 50.1% higher in that short span! An explosion of shorting is the bearish equivalent of a speculative mania to the upside, an unsustainable surge to a climax of pessimism. Once that peak hits, all the sellers have already sold.
American speculators’ gold-futures shorting surged similarly near gold’s major bottoms in late 2013 and mid-2014. These short bets can’t soar at such spectacular rates for long. So it really looks like gold is carving a major bottom in today’s extreme bearishness, on the verge of a serious rally initially sparked by frantic short covering that will catapult it higher. One final clue buttresses this bullish outlook on gold.
Despite their recent propensity for emotional and theatric shorting, futures traders are a big and diverse group. More of them are betting on gold’s upside through long contracts than the other way. The green line above shows their total long-side bets. They’ve been gradually rising all year in a nice uptrend despite the extreme bearishness plaguing gold. These traders understand the great wisdom in buying low.
With speculator longs rising all year even when gold happened to be wilting, it is very unlikely the short-side traders will get much help from long-side liquidations. And without heavy long-side selling like we saw in that catastrophic second quarter of 2013, there is just no way gold prices are going to plummet to the deep new lows that Wall Street is calling for. This increases the odds gold is carving a bottom today.
Interestingly most of this analysis holds true in silver futures too. Silver has always been slaved to gold, amplifying its gains and losses. When gold is strong traders rush into highly-volatile silver to catapult it higher, and when gold is weak traders abandon it. Silver has also seen a huge spike in speculator shorting, raising the odds it too is on the verge of its own parallel short-covering rally when gold’s starts.
Here silver is represented by the prices of the flagship iShares Silver Trust (SLV) shares. It too has a strong inverse correlation with futures speculators’ short positions. Silver tends to be bottoming right when they are peaking, futures traders as a herd are the most bearish at exactly the wrong times. Silver-futures shorts actually hit their staggering at-least-15.4-year-if-not-all-time high just recently in June 2014.
That 65.2k contracts is truly extreme, and in this latest Commitments of Traders week speculators’ shorts surged back up to 54.4k contracts! Such excessive selling is self-limiting, as soon everyone who is willing to sell silver low has already done so and only buyers remain. All it will take is a decent gold up day to ignite some gold-futures short-covering, and silver-futures traders will scramble to cover as well.
Silver acts as a sentiment gauge for gold, maybe its premier one. So the terribly-weak silver prices over the past 15 months reflect the exceedingly-bearish gold sentiment. Yet despite this, silver hasn’t fallen below its original mid-2013 lows! This is partially due to a strong uptrend of speculator buying of long-side silver-futures contracts. Like in gold, these bullish bets indicate fewer traders willing to short silver.
As usual, the entire precious-metals complex hinges on gold. With gold-futures shorts so extreme and gold sentiment so overwhelmingly bearish, an oversold rally is inevitable very soon here. And that will ignite short covering that will feed on itself and accelerate gold’s mean reversion higher. I still believe the most-likely catalyst will be the Fed-spawned levitating US stock markets decisively rolling over.
They have done nothing but power higher since early 2013 because the Fed’s QE3 bond-monetization campaign was seen by traders as a backstop. But QE3 is scheduled to end in a matter of weeks, in late October. This has ominous implications for the lofty stock markets, which plunged sharply in major corrections after both QE1 and QE2 ended. When QE3 is over, the Fed can no longer short-circuit stock selloffs.
Once investors and speculators are jolted out of the Fed’s fantasyland back into the real world where stock markets go up and down, alternative investments led by gold will regain their attractiveness as a prudent portfolio hedge. Gold and silver will surge as capital returns, but that will be dwarfed by the gains in the radically-undervalued stocks of their miners. Contrarians buying them low will earn fortunes.
Contrarian trading is so simple in theory, yet so hard in practice. In order to buy low and sell high, you have to buy when everyone hates a particular sector and sell when everyone loves it. That means you have to fight the crowd and your own dangerous emotions. You have to force yourself to be bullish when everyone else is bearish, like in gold today. And bearish when everyone else is bullish, like in general stocks.
And contrarians are what we are at Zeal, not Wall Street weathervanes foolishly selling low and buying high. We’ve spent decades intensely studying and trading the markets, and know from long experience the contrarian approach works. By buying low when few others had the courage, all 686 stock trades recommended in our newsletters have averaged stellar annualized realized gains of +22.6% since 2001!
Our renowned contrarian expertise will help you overcome the Wall Street tendency to succumb to herd groupthink. We’ve long published acclaimed weekly and monthly newsletters for speculators and investors. They draw on our decades of hard-won experience, knowledge, wisdom, and ongoing research to explain what’s going on in the markets, why, and how to trade them with specific stocks. Subscribe today and start thriving as a contrarian!
The bottom line is gold and silver were hammered by heavy shorting by American futures speculators over the past month. These elite traders have been extremely bearish on gold since its major lows in mid-2013, quick to ramp up their downside bets. But they are actually a strong contrarian indicator. Every time their shorts soar up near extremes, gold is bottoming and ready to surge on short covering.
Futures trading is an exceedingly-risky hyper-leveraged game, so these speculators can’t afford to be wrong on gold for long. Once it inevitably starts rallying, the losses on the short side explode so those traders are forced to rapidly cover. This initial buying entices in more long-side buyers, which can ignite major new uplegs. With speculator shorts back at extremes today, gold and silver once again look very bullish.
I ran across this article the other day where the author mentions of series of "all-time records" set in 2014. The list is worth reading so I'll reproduce it here:
1. Highest ever Wilshire 5000 market cap to GDP valuation for equities
I'm constantly reading about extreme conditions in the economy, so I did a bit of research to really get my arms around just how stretched things have become. What I found was really interesting (and by "interesting" I mean terrifying).
Below are a number of graphs that represent a current snapshot of the macro economy. Taken individually, these graphs might cause you to raise an eyebrow or pause and reflect for a moment, but probably not much more than that. Taken as a whole, however, they should stop you in your tracks. As a believer in mean reversion, I just don't see how this is going to end well.
To kick things off, let's first take a look at the S&P 500, making new all-time highs all the time.
From there I'll get into some macro data. Here's the adjusted monetary base. Yes, that's a 400% rise since 2008. Thank you bailouts and Quantitative Easing. All time high
Next up is a graph of total federal debt. And yes, we have almost $18 million millions in public debt (aka $18 trillion). All time high
Here's a graph of the Velocity of Money. If velocity measures "the rate at which money in circulation is used for purchasing goods and services," then we're in pretty bad shape. 50 year low
Here's a fun one. Total public debt as a % of GDP. We're now over 100% which means we've borrowed more than the value of what produce on an annual basis. And this doesn't even include $13.4 Trillion in unfunded liabilities for Social Security and Disability Insurance Trust Funds. Go America! 50 year high
Now we'll move on to some market-related charts. Here's one that shows real NYSE margin debt at all-time highs - higher than both the 2001 and 2007 market peaks.
The next graph from the Acting-Man Blog shows Rydex money market fund assets at 15 year lows. If funds are fully invested (ie. low cash & money market holdings), then who is left to buy equities?
And here is a graph of the CBOE Put/Call Ratio. The lower this chart goes, the more bullish investors are (investors are buying more calls than puts). After spiking down to 10 year lows, it has reversed all the way back up near 10 year highs. Does this look like a healthy market?
This is another graph from the Acting-Man blog that measures investor confidence. As noted in the chart, we're currently at an extreme state of investor optimism.
The SKEW Index tracks S&P 500 tail risk. In layman's terms, it measures how aggressively investors are buying up protection against a big potential downside move, or "black swan" event. We're just a few % off of all-time high SKEW readings. Not good.
And lastly, just to show that the Fed has everything under control, here is definitive proof that we have nothing to worry about - there is currently a zero percent chance of a recession. Whew!
Not long ago I posted a couple "big picture" analyses suggesting that we're setting up for a major market top (linked here and here). I supported my arguments through technical analysis, the interpretation of price and volume movements, along with associated indicators, plotted on a graph. Tonight I want to share a different type of analysis that leads one to the same "end-of-the-bull-run" conclusion, namely, historical cycles.
In particular, I'm going to share excerpts from a book written 17 years ago that focuses on 100-year cycles of the social fabric of society. The authors' observations and prophesies for the future, both in substance and timing, are uncanny.
(While these "big picture" posts are not directly related to gold and silver, they provide important context for making precious metals investment decisions. For thousands of years gold and silver have been secure stores of wealth during times of economic uncertainty, weakness, and chaos.)
In 1997, William Strauss and Neil Howe, historical economists, published their national bestselling book An American Prophecy: The Fourth Turning. In it, the authors argue that the modern age is characterized by the saeculum, a seasonal cycle of history, roughly the length of a human life (80-100 years), that explains periodic recurrences of Crises and Rebirth. The Anglo-American saeculum dates back to the end of the Middle Ages, from which time there have been seven saecula, the most recent of which began in 1946 with the end of World War II.
Each saeculum can then be broken down into four seasons, or Turnings. A Turning is a social mood that changes each time the "generational archetypes enter a new constellation" (approximately every 20-25 years).
The First Turning is a High (Spring) - an upbeat era of strengthening institutions and weakening individualism, when a new civic order implants and the old values regime decays (think Eisenhower America and baby-boomers post WWII)
The Second Turning is an Awakening (Summer) - a passionate era of spiritual upheaval, when the status quo comes under attack from a new values regime (think 1960s social revolution).
The Third Turning is an Unraveling (Autumn) - a downcast era of strengthening individualism and weakening institutions, when the old civic order decays.
The Fourth Turning is a Crisis (Winter) - a decisive era of secular upheaval, when the values regime propels the replacement of the old civic order with a new one. It is a period characterized by conflict and chaos (think Revolutionary War, Civil War, WWI, WWII).
Strauss and Howe wrote this book in 1997, before 9/11, before the housing bubble, before the ebola outbreak, and before the Ukrainian civil war. America was in the middle of the Third Turning with the Fourth Turning predicted to begin in the mid-2000s. Keep this in mind as I quote the following extraordinary passage from the book:
Sometime around the year 2005, perhaps a few years before or after, America will enter the Fourth Turning.
Strauss and Howe sound like they are reporting on what actually happened, not what might happen. These scenarios were derived from the study of previous saecula and how Crisis periods unfolded in times past. They were simply using history as their guide, and, in my opinion, their warnings of an impending upheaval need to be heeded. Sitting here in 2014, we're about halfway into the 20-25 year Fourth Turning. We see the potential catalysts all around us - ISIS in Iraq, the outbreak of Ebola, the Ukrainian civil war, tit-for-tat jousting with Russia, an anemic economy marked by unprecedented leverage - you name it, it's out there. It seems as though we're just waiting for that initial spark to push us over the edge and into serious Crisis. Strauss and Howe describe what happens once that spark ignites:
Before long, America's old civic order will seem ruined beyond repair. People will feel like a magnet has passed over society's disk drive, blanking out the social contract, wiping out old deals, clearing the books of vast unpayable promises to which people had once felt entitled. The economy could reach a trough that may look to be the start of a depression. With American weaknesses newly exposed, foreign dangers could erupt.
Perhaps we won't know for many years, but are we now on the doorstep of this terrible Crisis?
A couple weeks ago I wrote a piece about how the supply and demand dynamics of the silver market don't make much sense. I understand that prices (investors) can often be irrational, sometimes for extended periods of time, but what we're seeing in the silver market has been going on for years and defies logic. My intention here is not to speculate as to why these dislocations exist, but simply that they exist. I believe that fundamentals will ultimately win out in the end which is why I continue to follow and post on this phenomenon.
First, Steve St. Angelo, author of the SRSrocco Report, has been closely following Chinese silver inventories at the Shanghai Futures Exchange (SFE). About a week after my original post, Steve published a great article outlining the continued dramatic draw down in SFE silver inventories.
Steve's graph above shows silver inventories going back to January 2013. You can see the peak in March 2013 at 1,143 metric tons. Now compare that to the inventory as of July 2014. There has been a huge 87% reduction in silver stocks over the last 17 months!
Now refer back to my original post where I demonstrated that demand for physical silver has been incredibly strong over the same period. This coincides perfectly with the draw down in SFE silver. Further, Steve points out in his article that "most of the silver and gold contracts at the COMEX are settled in cash, whereas the vast majority of contracts on the Shanghai Exchanges are settled in physical metal." One can make the assumption, therefore, that the SFE has been feeding silver into the market to satisfy wholesale demand.
Demand for silver has been setting records for the past 18 months while physical inventories are down 87% at the SFE over the corresponding period. This all makes sense. What doesn't make sense is the following graph:
Silver inventories at the SFE peaked in March 2013 at 1,143 metric tons. Silver, at the time, was trading around $29/oz. Eighteen months later, the price of silver has fallen 33% while silver inventories at the SFE have dropped 87%. So what we have here is demand going up, supply going down, and dramatically lower prices. This makes no sense "in a competitive market."
I understand that the SFE is not the only wholesale source for physical silver. That being said, the price action implies a huge glut of physical metal coming onto the market from somewhere, but the research just doesn't support that notion. Something just doesn't add up.
Moving on to my second data point, I wanted to bring your attention to an interview Andy Schectman did with Wall Street for Main Street that was published yesterday. Andy is the President and Co-Founder of Miles Franklin, a precious metals retailer and educator. In his interview, Physical Supply Problems Coming, Andy talks about the supply and demand dynamics of precious metals over the past 25 years. He spends quite a bit of time, in fact, describing the extreme supply chain disruptions during the 2008-2009 financial crisis where premiums for physical metal were as high as 100%.
The reason I mention Andy's interview in this post is because he offers a very interesting explanation for why the law of supply and demand seems to have been suspended for gold and silver these past 7 years. He makes the claim that the Chinese saw the writing on the wall during the 2008-2009 financial crisis and made the decision to diversify away from the US dollar and into physical commodities. As such, they have been huge buyers of physical metal since that time all the while capping prices via the paper market (ie. COMEX). He believes there will be a point in time when the Chinese reveal their covert actions through the unveiling of an asset-backed currency to compete with the dollar. It will only be then that the price of gold and silver reflects the true underlying supply and demand fundamentals. He goes into great detail on how the Chinese are accomplishing this and I encourage you to listen - it's well worth your time.
I've read many comments from frustrated investors who say that supply and demand fundamentals just don't matter for gold and silver. My response to them would be, "They don't matter yet." What happens when those SFE silver inventories fall to zero? Do you think the Chinese will be satisfied to settle in cash? I don't.
This graph comes to us courtesy of Adam Hamilton of Zealllc.com. From his July 25 article titled Gold Price Strong Season Starts, he shows through statistical analysis how gold price behaves throughout the year. Mr. Hamilton explains his methodology:
"The results charted reveal gold’s seasonal tendencies over any calendar year. Limiting this study to gold’s secular bull is important because prices behave very differently in secular bulls and bears. And it is essential to index each year individually before averaging them to ensure percentage comparability. With gold averaging $311 in 2002 and $1409 in 2013, its raw unindexed prices just aren’t equivalent.
Every calendar year’s gold prices are indexed off the final trading day’s close of the previous year, which is set to 100. If gold is up 10% at any time during a year, its index will read 110. These indexed percentage moves are always perfectly comparable regardless of gold’s absolute price level. Every year’s since 2001 individual index is then averaged together, yielding this unique and indispensable gold-bull seasonality chart."
It is clear from the chart above that June and July are the weakest months as the price of gold, on average, has fallen 2-3% during this 14-year secular bull market. What's encouraging for the bulls, however, is that from August through year-end, the average price move has been a gain of about 10%. Hamilton explains in much more detail the underlying factors that are driving the price in the back half of the year and I would encourage you to check it out. My point here is simply to show that from a longer-term seasonality perspective, gold bulls should have the wind at their back for the remaining 5 months of the year.
One of the first things you learn when studying economics is the law of supply and demand, defined as follows: "In a competitive market, prices are determined by the interaction of supply and demand: an increase in supply will lower prices if not accompanied by increased demand, and an increase in demand will raise prices unless accompanied by increased supply." This is ECON 101 and it's a fairly simply concept to grasp.
Now let's take a look at the silver market with this concept in mind. With regard to physical demand, we see that silver has been incredibly strong both on an absolute and relative basis. Over the past 12-18 months we've witnessed the following:
So we can see that demand for physical silver is booming around the world. Has this demand been accompanied by an increase in supply? Let's take a look.
According to the Silver Institute, the worldwide supply of silver has been flat over the past 10 years and in a steady decline over the last four. I made this quick graph of their supply data for your viewing pleasure.
Not exactly a production boom I guess you could say. So it's easy to see that silver supplies have been in a very clear downtrend since 2010 and essentially unchanged year-over-year since 2004.
I ran across this chart recently from SNL Metals & Mining and all I can say is "wow." Gold discoveries in 2013 don't even show up! I'll point out the obvious that there has been a dramatic decline in new gold discoveries over the last 20 years. Which leads me to ask: How much longer before that "world mine production" line collapses?
It's common knowledge that the price of gold is far greater than the price of silver. In fact, as of today, the price of gold is almost 63 times the price of silver (aka the GSR or gold-silver ratio). Knowing nothing else about gold or silver, you, the rational person you are, would likely conclude that silver is about 63 times more abundant than gold. But what if I told you that isn't the case. What if I told you that silver isn't even 50 times more abundant than gold? Or 25 times? And what if I took it another step further and told you that above-ground silver is actually more scarce than above-ground gold? I wouldn't be lying.
According to the latest available research, there are currently about 1 billion ounces of silver sitting above ground on the entire planet earth. And gold? How about 5.5 billion ounces. Yep, that's right.
Now in terms of "gold-in-the-ground" vs. "silver-in-the-ground," gold is indeed rarer by a factor of about 8:1. Each year, it is estimated that approximately 800 million ounces of silver is mined compared to 100 million ounces of gold. Then, once you take into account silver recycling (jewelry, silverware, etc), the total annual supply of silver is in the neighborhood of 1 billion ounces.
What makes silver special, and therefore much rarer, is its value as an industrial metal. According to Kelly Mitchell, author of Gold Wars | The Battle for the Global Economy, "Silver is the most useful industrial metal ever found. Obviously, far greater quantities of iron and copper are used, but silver enjoys more varied applications due to its properties. More important, these applications use only trace amounts of silver, so there is no question of recuperation by tapping large concentrations. The amount used by industry - electronics, solar power, mirrors, health care (antibacterial), lasers, even clothing - exceeds annual mine production."
Another point of view comes from silver analyst Ted Butler of Butler Research. He asserts that, "Simply put, so much new silver mine production is already earmarked and spoken for by industrial consumption and other fabrication needs, that only a small percentage (10%) of current silver mine production is available for investment."
Whiles Messrs. Mitchell and Butler have slightly different numbers, the conclusion remains the same. Once industrial demand is satisfied, there is very little silver remaining for investment. The world needs to keep annual mine output at 800 million ounces or more just to keep up with industrial demand.
So to wrap this up, 100 million ounces of gold are pulled out of the ground each year - effectively all of which is available for investment. After taking into account industrial demand, there are approximately 100 million ounces annually of silver available for investment. You don't have to be Stephen Hawking to see that 100 million ounces = 100 million ounces. And yet gold is 63 times more expensive than silver - something which makes absolutely no sense on a fundamental basis. I understand there are reasons why gold will probably always be worth more than silver, but 63 times more?
This chart, courtesy of Casey Research, shows the inflation-adjusted price of gold since 1970 using the CPI as calculated in 1980. To understand why this is important, I encourage you to read this article from Casey Research.
As you can see from the chart, the inflation adjusted price of gold peaked just shy of $9,000/oz using the 1980 CPI formula. If you were to use today's CPI formula from the US Bureau of Labor Statistics, then the inflation-adjust price of gold in 1980 peaked around $2,400/oz. Does it make sense now why "they" have been tinkering with the inflation formula?
In 1980, the rise in gold price was largely due to supply and demand from western nations as many Asian countries, particularly China, had not yet opened up their economies. I would argue that today's macro environment is much more favorable for gold as China, India, Russia, and others have been overtly (and covertly) accumulating massive amounts of gold over the past five years.
So now take a look at today's price of gold - it sits right at $1,310/oz. If you believe, as I do, that today's environment is even more "gold-friendly" than back in 1980, then it makes no sense for the price of gold to be where it is currently. How many other commodities are still trading at a fraction of their inflation-adjusted highs?
Bottom line, regardless of which CPI formula you use, gold seems hugely undervalued at its current price.