Sunday, May 15, 2011

The Silver Bear Market: Don't Get Burst Bubble on your Face

If you're on either side of the silver trade, you're wondering the same thing: is this a bull market correction or the beginning of the reversion to the historical inflation adjusted mean? ($10.83 according to the

In fact, looking at the nice but slightly dated graphic the Silver Coin Trader has created, we haven't seen inflation adjusted price action like this in silver since the Hunt brothers tried to corner the market:

While likely feeling stepped on after the approximately 30% stumble silver took the week of May 2nd, bulls have remained rather resilient and have typically kept the price above $32 since the fall.  Using logic and psychology, I'll explain why this is only the beginning of the silver bear market, even if the price stays stable over the short term.

The Bear Market Short List

Here are the reasons we will continue to see silver deflate:

1. Strengthening of the dollar, potentially catalyzed by the euro crisis and lower realized inflation
Will Greece need to restructure their debt?  Doesn't really matter, because either way the dollar will continue to strengthen.  If they do, we will see funds pour in to dollar denominated assets as investors shift away from the euro, and if we see risks rising in Europe we'll likely see outflows from emerging markets as investors trade to safety.  If they don't, and there is no other bad news on the PIIGS front we'll still see the dollar strengthen as a slack job market prevents the kind of wage increases needed for the inflation commodity markets appear to be pricing in.

2. "Out of the woodwork" supply creation
The meteoric rise in silver from $18 to $48 took place in less than a year, with the biggest push upward in the last three months or so.  This was far too quick of a run up before we saw supply-side really respond, but you better believe if these silver prices continue where they're at we're going to see money flood in to mining companies and mining sites with economics that didn't make sense at $18 but do at $35 an ounce.  A similar process took place during oil's major rise in the summer of 2008.  Whether it be recycling, existing supply or new mining, supply creation will continue to weigh on silver if it stays where it is.

3. Demand destruction
One pro silverbugs will give you regarding silver is that it has industrial applications.  That may be true, but I guarantee you those using silver now are scrambling to find alternative commodities or other processes altogether to avoid it.  Over the short- to intermediate-term this likely won't have much impact as this isn't something you can change overnight, however if silver stays at its currently levels we will see practically all industrial applications for silver disappear as other processes are developed or silver is substituted with cheaper alternatives.

4. Price Benchmarking and the fear of losing
If you bought at $40 when silver was still climbing, how stupid did you feel when it crashed 30%?  Now how likely would you be to buy again if it hit $40?

And in there lies the problem.  For the price to climb above $40 again, someone would have to buy at that price, and continue buying above that.  In markets where it's felt that the price can only go up, when there is a sudden plunge it spooks the slow money that was just getting to the party.  This was the money that was going to pump the market to further levels, and now it will likely sit on the sidelines after getting burned once.

We've already seen volatility rise in silver, as serious retail investors start to leave through the door many hedge funds already exited through.  With that volatility will bring in the traders, which will likely continue to shake investors out.

The Moral of the Story

If you're still long silver at this point, you're really just picking up nickels in front of a steam roller, since the factors I laid out above will unravel the price over a long enough time horizon.  So even if we see silver for some unknown reason rise above $40 again in the near future, it will be short lived, and will only make the fall that much sharper.

Disclosure: long ZSL