Silver in SPX Selloffs
Source: Adam Hamilton, Zeal Research (3/18/11)
"As a hardcore lifelong speculator myself, I love corrections."
Initially this thesis, that falling stock markets could drag down silver with them, seems alarmist. Over the long term, silver prices are ultimately determined by this metal's balance between global supply and demand. If demand growth continues outpacing supply growth worldwide, silver prices will continue rising on balance. So as long as silver's fundamentals remain bullish, who cares what happens in the stock markets?
The problem is selloffs in anything (stock markets, silver, whatever) are events driven by sentiment, not fundamentals. Whenever traders get emotional, fundamentals quickly flee from their minds. The extreme case-in-point was 2008's once-in-a-lifetime stock panic. In less than 3 months the flagship S&P 500 stock index (SPX) plummeted 42.2%, while silver lost 53.4% in just over 4 months. Was this fundamental?
No way. Silver's supply and-demand situation between July and November 2008 was at least as bullish as it has been in this past year. Yet silver was sold aggressively during the stock panic regardless. Extreme fear bleeding out of the stock markets tainted psychology among silver investors and speculators, scaring them. So they dumped silver with reckless abandon despite no fundamental reason to do so. It wasn't like a flood of gigantic new silver mines were coming online during that panic!
Provocatively during those panic months silver often made new lows and bottomed, and then bounced, on the exact-same days the SPX did. And while we won't see another stock panic for decades, they are exceedingly rare, silver still has a long history of getting sucked into lesser general stock market selloffs. We are talking about the common conventional pullbacks and corrections within cyclical stock bulls.
And since the SPX has been in one of these mid-secular-bear cyclical bulls since March 2009, the last couple years have seen plenty of pullbacks and corrections. To gain insights into how silver is likely to behave through today's SPX selloff, all we have to do is analyze how it has done in the other ones so far in this stock bull. There have actually been seven of these material selloffs since this bull was born.
Material selloffs are pullbacks and corrections, and this distinction is simply one of magnitude. For the headline stock indexes including the S&P 500, a pullback is a material selloff of less than 10% while a correction is one greater than 10%. The threshold for declaring a pullback is around 4%, as anything less isn't material. And once a selloff exceeds 20%, in most cases it is actually a new bear market.
As of the middle of this week, the SPX was down 6.4% from its latest mid-February interim high. So we are definitely in pullback territory now. And as I warned about back in late January, the probabilities heavily favor today's selloff growing into a full-blown SPX correction. So traders with any silver exposure at all (especially silver stocks) really need to consider how this SPX selloff is likely to affect silver.
This next chart is similar to one I ran a couple weeks ago discussing stock market selloffs' impact on gold stocks. Silver (blue) is superimposed over the S&P 500 (red). Every previous SPX pullback and correction of this cyclical bull is highlighted in red. During each of these material selling events, silver's performance from the exact days marking the beginning and end of each SPX selloff is noted. For comparison gold's performance over these exact SPX-selloff spans is shown in yellow.
Now I'm a silver fundamentalist too. I first started recommending physical silver coins to our newsletter subscribers as long-term investments way back in November 2001 when silver traded just over $4. Since then, we've realized 108 silver stock trades in our weekly and monthly newsletters, with average annualized realized gains across all of them of +45.3%. I really wish the general stock markets didn't affect silver, as trading it would be a lot easier. But this chart doesn't lie.
Whenever the general stock markets fall fast enough to spark some fear, this bearish sentiment spills over into silver. I call it "sentiment splash damage." General stock selloffs change the way traders everywhere view the near-term future. As the SPX falls, traders want to get capital out of harm's way in what is known as the "risk-off trade." And hyper-volatile silver is one of the riskiest commodities in existence. Its traders have proven they can't weather and withstand the bearish psychology spawned by an SPX selloff.
The SPX's first pullback of this bull ran 7.1% over just under a month ending in July 2009. This wasn't severe in stock market terms, a garden-variety pullback. And gold, which is usually the primary driver of silver prices, was much stronger with a minor 2.8% loss over this span. Yet silver still plunged 14.6% with the SPX, topping one day before the stock markets and bottoming the very day the SPX did. Why?
Silver tends to amplify moves in gold, as traders flock to silver when gold is strong and flee when gold is weak. The fortunes of gold dominate psychology for the entire precious-metals realm. While silver's leverage to gold varies considerably, in general 2-to-1 is a decent baseline. Silver ought to at least double any meaningful move in gold. So gold's own decline back in the summer of 2009 suggested a 5.6% silver selloff was to be expected. But silver instead plunged 14.6% with brutal 5.1x downside leverage!
Silver's fundamentals were great then, just as they were through all the past couple years' SPX pullbacks and corrections. So the only place such negative psychology could have come from since gold was relatively strong was the general stock markets. Traders everywhere get bearish whenever the SPX sells off. They start seeing every market, even totally unrelated ones, through a more-pessimistic lens. They figure the stock selloff portends a weakening global economy, so they sell commodities aggressively. And since silver is so darned risky in the best of times, it is often the first to go when fears flare.
Now if silver fell in just one SPX selloff, we could blow it off as an anomaly. But every SPX pullback and correction has affected silver negatively to varying degrees. The second one of this bull was about as mild as pullbacks get, just a 4.3% SPX selloff across less than 2 weeks. And once again gold, which in stark contrast to silver is one of the least-risky headline commodities, was relatively strong with a trivial 1.2% decline. So a 2.4% silver selloff would have been justified, but instead this metal fell 5.8% (4.7x).
The third SPX pullback ended in November 2009, another mild one at just 5.6% over less than 2 weeks. Again gold weathered this well, edging just 1.7% lower. But silver fell sharply, down 8.2%, which is 5.0x downside leverage to gold. Check out the sharpness of silver's selloffs during the second and third SPX pullbacks in the chart above. Out of nowhere in a beautiful uptrend, silver still fell sharply.
The SPX's fourth pullback of this bull ending in February 2010 also happened to be its largest at 8.1% over less than 3 weeks. Gold fared worse in this one than most, falling 6.6%. And with both gold and stock markets weak, silver didn't stand a chance. It plunged by 19.9% even though it had just corrected significantly (12.7%) in December 2009 soon before this particular SPX pullback started. Yet still, the stock market is selling scared silver traders into exiting already-weakened silver.
All traders can't help themselves but to pay attention to the general stock markets, even if they are trading things that have nothing to do with the SPX. When the stock markets are rising we all feel good, bullish and optimistic about the economy and the future of our trades. This leads to a risk-on dynamic where everything including silver is bought. Conversely when the stock markets are falling we all feel worse, anxious and pessimistic about the economy and future of our trades. So we sell everything, risk-off, including silver. The state of the general stock markets colors sentiment universally.
The only SPX correction of this bull (and fifth selloff) so far climaxed early last July. The SPX lost 16.0% over about 10 weeks, a serious decline. And in comparison silver looked like a rock star, only falling 2.0%. This episode appears to break the model, arguing that silver can indeed sometimes manage to resist getting sucked into a general stock selling event. Not so fast!
Check out what gold did over this exact SPX-selloff span. It rallied 4.8%, a large move higher over such a short timeframe, and achieved nearly a half-dozen new all-time record highs! So to see silver down 2.0% with this bullish gold backdrop was actually horrendous performance for this white metal. It was torn between following its usual driver, gold, and the deluge of negative sentiment from the stock markets assaulting it. Silver ought to have rallied at least 9.6% over this span thanks to gold, not fallen 2.0%.
It looks even worse when you consider the meat of that SPX correction. It originally bottomed in early June, as its secondary early July low was a short-lived anomaly driven by a rather curious and irrational China scare. Fully 6/7ths of this selling event's total losses occurred by early June 2010. At that point, the SPX was down 13.7% and gold had soared 7.4% to close at a new all-time high the very day the SPX bottomed. How did silver do? Down 0.3% despite the fact gold's surge should have driven it up at least 14.8%. Even during exceptionally strong gold rallies, silver gets hammered by material SPX selloffs!
The SPX's sixth selloff happened in late August, pretty significant at 7.1% across just under 3 weeks. This was kind of a strange selloff though, as it was late summer (low volume, traders on vacation) and anxiety was already high (remember that silly Hindenburg Omen crash scare?). Gold was actually strong during this span, up 3.0%. Yet still the best silver could muster, even heading into its big autumn rally I was predicting, was a 3.5% gain. Gold's strength argued for at least 6.0%. Though this was silver's only advance during an SPX pullback or correction, it was still heavily retarded by bearish SPX sentiment.
The SPX's seventh selloff before today's was also its mildest of this entire cyclical bull, only 3.9% across just over a week in November. Gold was pretty weak too, down 3.7% over this span because it had just carved new nominal all-time highs again in early November. Amazingly, indeed breaking this model, with just a 4.5% loss in the face of this kind of gold and SPX selling silver was actually pretty strong. But you have to remember that minor November selloff was so short and mild it generated no meaningful fear.
It's kind of funny, as in February 2011 I was warning our subscribers about the imminent danger the next SPX correction posed for silver. And as the SPX drifted lower after its latest interim high in mid-February, silver continued powering higher over the next couple weeks. I heard from many silver enthusiasts claiming this meant silver was so strong it would ignore any SPX selloff. But it is crucial to remember that this was a slow-paced SPX selloff (as they usually are early in corrections), which spawned very little fear.
The first serious fear spikes of today's SPX selloff happened on Thursday March 10th (before the Japanese earthquake) and Tuesday March 15th. On those days the benchmark VXO stock market fear gauge shot up about 15% (surging above 20 absolute) and 14% (above 23). And though the SPX only fell 1.9% and 1.1% those days (not too extreme), silver plunged 2.4% and 4.1%. Within any SPX selloff, including today's, the actual driver of silver weakness is surges in fear. Until the SPX falls fast enough to generate real fear, silver can indeed hold its own for a short season.
And obviously if today's SPX selloff continues to mushroom into a full-blown correction as the indicators have been warning it will, the great majority of the fear is yet to come this time around. This puts silver in an exceptionally precarious position today. This is magnified tremendously by silver's own super-overbought technicals, which I discussed in depth last week. Once the falling SPX turns silver sentiment negative, which it almost certainly will, silver is likely to plummet like a rock.
Now if you own silver bullion, its flagship SLV ETF, or silver stocks as long-term investments, a short-term correction is meaningless. All markets flow and ebb and silver is no exception, being more violent than almost all others. But if you have any silver related trading positions, including silver stocks you aren't holding for the long term, an SPX-sparked sharp silver correction could rip you to pieces. No matter how much people like silver today, precedent is very clear that a stock market correction will spill into silver.
And man, silver corrections are unbelievably sharp and brutal off of highs following major uplegs. We are talking about silver plummeting by an average of nearly a third in less than 6 weeks! Last week I explained this precedent in depth. And silver stocks tend to amplify the losses in silver, even if the general stock markets don't happen to be correcting. If we see a major silver correction coincide with a major stock market one, which is increasingly likely, the short-term damage to silver stock prices will be huge.
As a hardcore lifelong speculator myself, I love corrections. Our goal in both investing and speculating is to buy low and sell high. And the best times to buy low within ongoing bull markets are just as major corrections mature. If silver never corrected, then we would never have the opportunity to add new silver stock positions at relatively low levels. Corrections offer perfect opportunities to sell high just before they happen, then buy low in the best highest-potential silver stocks once they've run their courses.
At Zeal, we use corrections to build our shopping lists. What silver stocks have we wanted to own for intrinsic fundamental reasons? It is important to research silver stocks before the correction's bottom hits, as it won't persist for very long. A few months ago we published our latest comprehensive fundamental report on our favorite silver stocks. We researched the entire universe of publicly traded silver stocks in the US and Canada, whittling them down to our dozen favorites. All are profiled in a fascinating 34-page report now available for just $75 ($55 for subscribers). Buy yours today, be ready when the buying op arrives!
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The bottom line is general stock market selloffs adversely impact silver. If gold is also weak during these selloffs, silver plunges rapidly to often greatly exceed the losses in gold and the stock markets. And even if gold is strong during a stock market selloff, silver's performance is still very poor. It tends to lag gold's tremendously, caught between following its usual driver and being sucked into the selling psychology.
And sentiment is exactly why this happens, fundamentals are irrelevant. Silver falls when silver traders get scared, and time and time again history has proven that material stock market selloffs spook silver traders just as much as everyone else. Thus, prudent silver traders have to watch not only silver's own technicals, but also keep an eye on the S&P 500's. General stock selling quickly bleeds into silver.
Adam Hamilton, CPA
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