Silver Bull Market Intact But Risk-Reward Outlook Deteriorating

by | Aug 18, 2020 | Silver

With the Fed and Treasury’s monetary debasement experiment showing no sign of ending and the bullish trend remaining intact, we could easily see silver explode higher to the USD50 area should the USD30 level give way. That said, given the substantial gains we have already seen in recent months, we caution against adding to long positions here. When we turned bullish on silver back in March at a price of around USD13 we called for a doubling in prices over the next 12 months. The metal has since more than doubled in less than half the time we expected, and is no longer cheap on our fair value measure. Meanwhile, speculative sentiment has turned worryingly feverish as was the case at the 2011 peak, suggesting chasing the market is becoming increasingly risky.

A Break Of $30 Would Put $50 In The Crosshairs…

After a sizable pullback last week, silver has regained its poise and the August 7 high of USD29.86 is back in focus. A break above here could trigger fresh buying momentum ushering in the next leg of the advance. The chart pattern shows a clear resemblance to the 2011 period when the metal went on to almost double from current levels amid relatively tighter fiscal and monetary policy. The scale of debt issuance and money printing is unprecedented, while the deterioration in the social fabric across much of the Western world suggests that fear could continue to bid up the metal even after the substantial gains already seen.

Spot Silver, USD/oz

Source: Bloomberg

…But The Risk-Reward Picture Has Deteriorated

That said, the upside case has deteriorated since our last silver update (see ‘SLV: Key Resistance In The Crosshairs‘) owing entirely to the fact that prices have risen so sharply. After a 45% rally in just over a month, the risk-reward profile for the metal has naturally worsened despite the still-supportive macroeconomic backdrop. Silver has shown a strong tendency to ignore the fundamentals once upside momentum gathers steam, but even if we see a repeat of the 2011 rally, the bulk of the metal’s gains appear to have already taken place.

Fair Value Model Shows Silver No Longer Undervalued

One of the key tactical drivers of our bullish silver view over recent months has been the metal’s undervaluation relative to the fair value price implied by its historical correlation with gold prices and the broad commodity complex. As we have noted on a number of occasions, silver prices tend to track both the general commodity complex, reflecting industrial demand, and gold prices, reflecting investment demand, which in turn is driven by expectations of real interest rates. Despite a strong rally in the commodity complex and gold prices, silver’s surge has meant the metal is no longer meaningfully undervalued on this basis, removing one pillar of our previous bullish view.

Source: Bloomberg, Author’s calculations

Surge In SLV Holdings Is A Contrarian Concern

Another reason for caution is the extreme rise in bullish speculative sentiment in recent weeks and months. SLV ETF holdings have risen 65% since their March low. Daily sentiment index readings have also been in the 90% area in recent weeks. The fact that investors on balance are so bullish towards silver does not by itself suggest prices cannot rise further, but it does suggest that even the slightest deterioration in the fundamentals could lead to outsized declines.

Outperformance Vs. Commodity Complex Suggests Caution Warranted

Silver’s rise has far outpaced that of the broad commodity complex, with the metal hitting new multi-year highs relative to continuous commodity index. Based on the incredible close long-term correlation between silver and the CCI, the metal is trading at more than 100% above its long-term average. As we noted in a recent article on gold (see ‘Gold’s Rally May Be Getting Ahead Of Itself) the surge in both metals has come despite relatively little upside pressure on consumer or commodity prices as investors have bought in anticipation of rising prices in the future. While we expect to see consumer and commodity prices rise sharply over the coming years, the wide gap that has emerged suggests that precious metals may be getting ahead of themselves.

Article originally seen on SeekingAlpha

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