Desperate times call for desperate measures, and since situation is developing quite fast on some charts that we track (and several Subscribers asked us to comment on the backwardation in silver), we have decided to provide you with a mid-week update. The descriptions below charts are going to be short, but they will include the key details.

Let’s begin with the gold market.

From the USD perspective, gold moved to its support level, which means that perhaps we are looking at a local bottom. The RSI indicator confirms that, because it is now at the level that used to mean significant bottoms each time it was reached in the past 2 years. That was not necessarily a final bottom (December 2009), but the price moved higher soon thereafter either way.

From the non-USD perspective, the support level has been reached as well.

Here, the support is provided by the 200-day moving average, which has been important in the past. Please note that even if this is a beginning of a bigger downswing, we are still likely to retrace about 50% of the decline first, as it was the case previously.

Another short-term bullish factor comes from the silver market.

On the above chart we can clearly see that not only is price (on the above gold charts) a bullish factor, but that is also the case with time, as silver is very close to its cyclical turning point. Should it reverse soon, gold and mining stocks would likely rally as well.

Another bullish signal comes from the analysis of the Gold Miners Bullish Percent Index. Actually, not much changed in the past few days, and comments made in Friday’s Premium Update are still up-to-date.

Namely, the above index suggests oversold status. This, by itself is nothing extremely bullish, however the fact that the market has been in this state (in terms of the above chart) virtually since the beginning of the year implies that at least a temporary turnaround is very likely.

Finally, we have just seen a long-term buy signal from our SP Gold Bottom Indicator.

Previously we have seen it at the end of July 2010, right before the over-$200 rally, and before that we have seen it on May 21st, 2010 (another local bottom) Dec 9th, 2009 (insignificant bottom, however prices still moved briefly above it before the decline was over), and April 9th, 2009 (almost precisely at the bottom).

As you may see, we don’t get this signal very often, but when we do, it’s worth taking it into account. The implications here are – of course – bullish.

Now, in order to remain objective, let’s take a look at the most bearish factors present today.

In this case, it is the silver:gold ratio that provides us with the most bearish news. Virtually every previous rally (taking major rallies into account) ended in a similar fashion – silver moved up sharply, also relative to gold. The size of this phenomenon makes it hard not to notice.

Based on that factor alone one should consider closing their silver position immediately (please don’t proceed before reading the following part of this update), because once the rally stopped, the decline following it was even sharper than the rally itself. This might be where we are today – the ROC indicator (second from the top) has just moved below its moving average and also the key signal line close to the 25 level. The silver:gold ratio itself also moved below its moving average. The situation appears bearish.

The most bearish fact about this ratio is that it managed to move lower even though stocks have been rallying. Silver is generally positively correlated with the general stock market because it has many industrial uses, and recently silver was not able to move higher even taking into account the positive support that it got from stocks. It declined also relative to gold. That is clearly a bearish factor.

Consequently, if silver is moving lower even without a negative influence coming from the silver market, the white metal could really plunge if stocks do so as well, and the situation on the general stock market is not too bullish right now.

In the latest Premium Update, we wrote the following:

According to the classic Dow Theory the signals form the industrial average should be confirmed by the ones seen in the transportation average. Without that a signal does not mean much.

Here, we are using this divergence in a slightly different way. In the past few days we have seen a sharp decline in the Dow Jones Transportation Average, without a similar action in the Dow Jones Industrial Average. In order to isolate this relative phenomenon, we have included a transportation:industrial stocks ratio below the price chart. Here, we clearly see that the ratio moved quickly lower recently.

Since this signal is quite clear, let’s take a look what it meant in the past. The fact is that in the past it was an early warning about the coming decline. In the past, declines such as this were seen to continue for days or even weeks. The implication here further confirms the short-term bearish case for stocks.

Since we posted the above, the divergence has become even more visible, which does not bode well for stocks in the near future.

Given the above contradictory signals, it’s not simple to come up with a conclusive strategy (cynics would say that if it the situation on the market appears simple, it means that one hasn’t done enough research), however we believe that one of them covers all bases.

Currently, we believe that it would be best to switch most of one’s long-term silver holdings to gold. At the same time, we think that speculative capital should be used to bet on higher prices of precious metals in the short run.

The above could change as the situation develops, for instance if gold, silver and mining stocks continue to slide, and should that be the case, we will send a follow-up.

The action related to the long-term capital takes into account the current situation regarding the silver:gold ratio and prepares your portfolio for a possible correction in the main stock indices (silver would most likely be hit much harder than gold). The speculative bet on higher prices in the short-term takes into account the bullish points made earlier including the important signal from the SP Gold Bottom Indicator. Please note that both actions will not make you particularly hurt in case the market turns against you. You remain invested in with your long-term holdings (so you’re not risking missing the boat regarding any major upswing – again, in tune with the SP Gold Bottom Indicator), but in case the market moves lower your losses are likely to be much lower than if you remained in silver with most of your capital.

Please note that the above does not concern the physical bullion in your possession that you own as a form of insurance against the meltdown in the financial system in general – these holdings should not be sold at this time.

Another note – by switching from silver to gold we do not mean selling silver and holding cash.

There’s one more thing that we would like to comment on – the backwardation in silver. Several Subscribers asked us to comment on James Turk’s recent alert about silver’s backwardation. In short, backwardation means that futures prices are lower than spot prices, which is supposed to be an extremely bullish factor for silver, and the proof is that we’ve seen silver rally after a similar development in the past.

Sounds really encouraging at the first sight, but if you’ve been in the precious metals market for years than you are probably used to regularly hearing about factors that are supposed to cause silver price to truly explode, after which you see the market moving in tune with previous trends. While we are very bullish on silver in the long run (yes, we believe it could easily move above $100 in the next several years), we prefer to stay skeptical about most extremely bullish factors.

Let’s begin with the analogy to the January 2009 (by the way, you can check the data here), when we’ve seen silver in backwardation previously. It’s supposed to suggest that a similar action is likely to follow also this time. Please take a look at the following chart.

We’ve marked the moment when we’ve seen backwardation in silver with the red vertical line. It was neither close to any bottom nor top – it was seen more or less in the middle of a post-bottom rally. The price of silver was extremely low just a few months earlier, which – taking into account positive fundamentals present on the silver market - is by itself a factor suggesting that a rally has to take place. Consequently we’ve seen a rally and when the backwardation was observed no change in the trend was seen. It did not accelerate, nor did it pause. In fact, if we didn’t mark it with the red vertical line, we doubt that anyone viewing the chart would notice any effect of the backwardation.

Secondly, let’s take a look if there is another explanation of the silver backwardation other than the one featured above. It is. Below, we would like to quote Mr. Matthew C. Shelley, Commodity Broker:

(…) forward metals trading is an interest rate driven market and will continue to be so unless or until the current financial structure vanishes completely. With current interest rates, forward vs. physical might, and only might, have blips of a penny or so in regard to silver deliveries. That would not be considered anything as a sign of anything in the markets other than a headache for some of the arbitrageurs who deal in very large amounts to squeak out very tiny percentages. [As a proof] (…) calculate the silver price ladder of futures price settlements vs. the broker loan rate. (…) the prices match.

Summing up, while the silver market is still likely to move much higher in the long run, the silver backwardation is not really a “buy all the silver you can and borrow money to buy more” factor, which is likely to have a short-term impact on the price of the white metal. Therefore, if silver moves higher from here, we would attribute this rally to bullish factors mentioned in the first part of this essay, not to the silver backwardation phenomenon.

The next Premium Update is going to be posted on Friday, Jan 28th, 2010.

Thank you for using the Premium Service.

Sincerely,
Przemyslaw Radomski

P.S. On a personal note - your Editor has just passed the Level 1 CFA Exam, having achieved highest calculated performance range (over 70% of correct answers) on the following topic areas: Alternative Investments, Corporate Finance, Derivatives, Economics, Equity Investments, Ethical & Professional Standards, Financial Reporting & Analysis, Fixed Income Investments, and Portfolio Management.