SILVERAXIS - TODAY IN SILVER

Not so fast, said the U.S. dollar today as it rose strongly once again from the ashes. Gold could not withstand the assault, and the possibility of an extended price disconnect quickly faded into fantasyland. While silver once again bore the brunt of the decline when it comes to monetary metals, if we look at the other white precious metals, silver is actually holding up the “best”. Specifically, platinum has broken $1,000 and looks soon to trade at par with gold after rising as much as 125% higher earlier this year. And poor palladium is getting absolutely destroyed as it falls under $200, reaching a nearly 70% loss from the peak just a few months ago. An equivalent decline in silver would have it trading around $7.

Here is a reader question:

If $/USA is equivalent to stock/company, why would the dollar be rising when our country is so mismanaged, spends more than it makes, borrows from everyone, dilutes its dollars by creating more?

And my answer:

The dollar is rising because there is still an impression in the global marketplace that the U.S. Treasury market is the ultimate safe haven. You need dollars to buy U.S. Treasuries. Why are the global markets thinking this way? If we look at the USA as all the assets in the USA denominated in dollars (stocks, bonds, other investments, real estate, intangible assets, military capability, etc.), then we can see that even with bad debts and all, the USA still dwarfs the next largest group of assets denominated by currency (being the Euro). In a deflationary scenario, which is what the market is currently looking at, there is safety in size, diversification and longevity (the Euro has never been tested by a true crisis). You also need dollars to pay off debts. And ironically, the more debts you have, the more dollars you need, and the more demand there might be for the dollar. Moreover, if you think House and Senate Republicans and Democrats are far apart on how to deal with this crisis, just wait until we see how the Europeans deal with their version of it (the last one resulted in World War II). Meanwhile the Japanese and their Yen have their own problems, and nobody in their right mind would trust the currency of a nation (already) run by dictators (China). Thus, the U.S. dollar, and more specifically the U.S. Treasury market, is currently being viewed as a lessor of most evils. These things will all work themselves out in due course (to the benefit of gold, and silver) but in the short to medium term the above considerations are dominant.

[I have been struggling with the Wordpress software and server all day, not being able to post except for what you've seen. Finally it looks like I've figured out something that works. So, here is the second part of the post that was originally meant to go with the update on "Is There Danger?" posted earlier today.]

Okay, let’s get back to ‘reality’. Fortunately for silver, if it weren’t for its monetary affinity to the Midas metal, it too might have been in meltdown mode on this wild day because industrial users were likely offloading it along with every other metal, commodity and hard asset. Both the investment and business world are back in liquidity and liquidation mode. Industrial users do not differentiate silver as a monetary metal, it is purely business to them. They will not stockpile silver - even if prices are soaring - as long as the future business climate looks horrid. And while investment demand may be incredibly strong and could overwhelm any shortfall in industrial demand, that is not yet demonstrably the case.

If and when investment demand does overwhelm the silver market (specifically the wholesale market in the same manner as the retail market), watch out! Under the right circumstances, silver prices could easily double in just a few days. Back in the Spring of 2007, I believed we were actually pretty close to that happening (because I saw the possibility of investment demand overwhelming the wholesale market), but the incipient demand fell apart by the early summer. My sense this time is that it could take as little as 25-50 million ounces of net investment demand (between ETFs and private buyers) to overwhelm the wholesale market. That might seem like a lot, but it is actually tiny: less than $1 billion at current silver prices. For comparison purposes, let me point out that the U.S. Treasury securities market likely had a volume of tens, if not hundreds, of billions of dollars today. In other words, the silver market could not withstand as little as 1% of a single day’s worth of safe haven buying of U.S. Treasuries without a substantial price rise. Indeed, even just a minor re-allocation of gold safe haven buying to silver could have a tremendous effect on investment demand for silver.

Before we get carried away, however, let me point out that none of this is a given. In truth, there is simply no way to determine which way the axe will swing next or where it will strike. The situation in the markets is extremely fluid because the failure to pass the $700 billion bailout package — or any package — has created a huge crisis of confidence. Until some semblance of order is restored, the markets will continue to be very wild and it would be risky to take large position bets, much less leveraged ones. My only positions in the silver/gold markets right now are bullion, some options, and gold/silver mining companies (many of them held with some regrets).

My primary short-term outlook with respect to the construction of my silver/gold investment portfolio is that silver tends to lag gold in the early phases of a PM run, only to catch up in a spectacular fashion as the rally starts to peak. I’ve kept a few call options in gold over the past several months and have started to take profits off the table during the recent run up. I am now thinking about switching some of my remaining December gold call options to silver. Should the financial system continue to unwind in the manner it has over the past few days, there might be some good risk-reward in the December 2008 $16 to $20 strikes.

Now, please allow me to address the claim that it is silly to speculate on options (or other ‘fiat’ investment vehicles) because there will be a market default, especially if the dollar collapses, and I’ll never get paid even if I win big. And if I do get paid, it will be with vastly depreciated dollars. Well, I have a simple if (purposefully) naive answer: I have a mortgage on my house denominated in dollars, and I would be more than happy if my option speculation were to “merely” pay off that mortgage regardless of how depreciated the dollars will be. Perhaps you’ve heard of the Texas hedge (buying long futures on cattle to hedge the price on a herd headed for market)? Well, I call this the California hedge (carrying mortgage debt with the expectation that it could be paid off by holding appropriate investments during a bout with deflation and hyperinflation). Of course it is risky–a true deflation could result in all assets including gold and silver losing value relative to the fiat dollar–but it is a calculated risk: (1) I’m still relatively young; (2) I have some expertise in corporate bankruptcy, which presumably would be in demand during a deflationary period, hopefully keeping me gainfully employed and able to make mortgage payments; (3) I have copper put options; and most importantly (4) I have a position in physical gold and silver. Unless you are in a similar situation, the California hedge might not be appropriate for you.

Speaking of copper put options, they are finally coming into their own. Copper fell about 20 cents today and is now sitting right on support at the Nov-Dec 2007 lows. If this fails, the next stop will be the $2.40-$2.50 area marked by the early 2007 lows. Below that there is nothing until about $1.50. It might be worth noting that copper is the last metal–other than gold (and aluminum, which ‘only’ gained 100% or so during the bull market)–that has not yet suffered a 50% or greater drop from the peak. My expectation is that a “matching performance” could come in a big hurry, if it comes. That would mean copper declining to somewhere around $1.50 - $2.00. One of the few attractive things about the copper put option on the COMEX is that each dollar move in copper translates to $25,000 per option. Not so attractive is the fact that COMEX copper is a very thin market. For example, I personally hold over 10% of the options in March 2009 COMEX copper (the second most active month) and about 2% in December 2008 (the most active month). Of course, that is easy to do when the total number of options outstanding can be counted out using fingers and toes. I just hope that the Ted Butler-equivalent in copper doesn’t come after me for short manipulation!

My question about danger last Friday wasn’t with respect to the economy or financial system. The answer to economic and financial danger is more than obvious and we didn’t even need today’s defeat of the $700 billion bailout package or the market reaction to it in order to figure that out.

Instead, my question was with respect to gold and silver: Is there danger that the monetary metals will get taken down once again by the market turmoil? So far, the answer in the case of gold is ‘no’ whereas for silver it is ‘not sure’. Of course, silver was under pressure today as just about every commodity and industrial metal was clobbered. Meanwhile, gold behaved like the classic safe haven that it is, along with U.S. Treasury Bills. The result was a price disconnect of gold from the U.S. Dollar, and it could last for a while. At the same time, should U.S. Treasuries begin to lose their own safe haven cachet (there was recently a rise in the cost of credit default swaps on Treasuries), we could very quickly see the dollar start to fall again while gold continues to soar.

This is the perfect scenario that I’ve been looking for: rising gold, falling dollar and falling energy/commodities. Initially, silver might not seem like a winner under such circumstances, but patience will reward the silver investor. For one, as several readers have already pointed out, low zinc, lead and copper prices will reduce base metal mining. Since over 50% of worldwide mine output of silver is a by-product of zinc, lead and copper mining (the rest is a by-product of gold, or is primary silver), there would be a reduction (at least in theory) in silver mine supply. This reduction would not occur immediately but if base metal prices remain depressed for a substantial period of time, then we might start seeing the effects by late 2009.

At the same time, here is something that might be worthwhile to look into (and we will be doing just that as part of The Metal Augmentor service): how vulnerable are companies like Silver Wheaton and Silverstone Resources to a downturn in base metal prices considering many of the mines from which they receive their ’silver streams’ are not receiving full credit for their silver by-product while at the same time their revenues from base metals are declining? In other words, is it possible that the mines themselves might be shut down and therefore Silver Wheaton would be deprived of the ’silver stream’ itself? I don’t have the answer and it will require a very detailed analysis, but if you have a large position in one of these companies it would be worthwhile for you to look into it. The way you would do so is to run a price sensitivity analysis on the mines themselves using an assumption of lower long-term base metal prices. Or, you could wait until we address this issue in The Metal Augmentor once it is launched.

Getting back to the U.S. dollar, no other currency appears immune to the financial mess so perhaps we shouldn’t necessarily expect the dollar to fall off a cliff immediately. In the long term, however, the dollar has a long way down given the amount of dollar-denominated debt that must be paid back, defaulted or inflated away.

Speaking of ‘inflated away’, I know that we are still looking at a bunch of Alices in Wonderland when we hear legislators, bankers, economists and other ‘experts’ still questioning whether or not the $700 billion bailout package or an alternate government-sponsored ’solution’ will be inflationary. HELLO!!! The U.S. government has debt on the books of $10 trillion with another $30-40 trillion in obligations, while the private sector has close to $20 trillion in debts. At the same time: (1) demographics will start to drag on gross domestic product in the U.S. starting 2011 (when the Baby Boomers begin to retire in earnest); (2) there is more and more competition from emerging economies (reducing developed economies’ share of worldwide economic growth); (3) natural resources are being constrained by production peaks and depletion; and (4) interest rates cannot continue to go down forever.

Without some type of transition to a gold-based monetary system (and even with it), there are only two outcomes here: (1) Inflate the debts away (which will cause substantial financial harm to all ’savers’ including China and other countries holding U.S. denominated debt) or (2) Die (a total collapse of the financial system with a restart likely from a ‘caveman’ scenario). Anybody who thinks there is the possibility of ‘muddling through’ or ’steering a course’ for long term prosperity while this debt-laden monster continues to roam is crazy. There is always a chance something could work for a while, even a few years. Throw in a world war or other catastrophe that boosts economic output out of sheer necessity (bullets and war machinery need to be constantly replaced during a major war, infrastructure needs to be rebuilt, etc.) and perhaps the status quo of massive debt overhang could be stretched for a decade or longer. But when the fat lady finally sings, it will still come down to inflate or die. And while I sure as heck don’t want to experience hyperinflation, I want to see my neighbors turn into cavemen even less. Of course if you are a saver, the answer to all this is relatively easy: ’save’ in gold (and silver).

Washington Mutual, the largest Savings and Loan in the U.S., was taken over last night and immediately auctioned off for a song to the highest bidder, JPMorgan Chase (the annointed “last too big to fail” bank standing at the end of the row of dominoes).

Several other banks now teeter on the edge of collapse, apparently because there is a “run” on these banks by panicked depositors (Washington Mutual had lost $18 billion in deposits over the past few days and was essentially insolvent).

In the past few days, the final two major independent investment banks, Morgan Stanley and Goldman Sachs, sought “safety” in the arms of regulators by requesting a change in their charters to Bank Holding Company.

The SEC has banned new short sales on all financial institutions.

There are no reasonable quantities of gold and silver bullion available to retail investors anywhere near reasonable premiums.

And of course as I write this, the Washington politicians are wrangling over the second largest (after Freddie Mac and Fannie Mae) bailout in the history of the world.

Against this backdrop, gold closed the week near $880 and silver around $13.30.

If one is to believe Treasury Secretary Paulson, the world as we know it will be over if the $700 billion bailout package is not passed immediately. If the package is written into law, it would be phenomenally bullish for gold and silver. If one is not to believe Paulson’s dire prediction and/or the package is not passed, it is still phenomenally bullish for gold and silver. So, why are gold and silver not shooting for the moon? Does anybody even know from which direction is the danger approaching?

I’ll let you answer in the comments section, and I will be back later with an update containing my own thoughts.

The Wall Street Journal reports that CFTC Relents and Probes Silver Market to find out if there is anything nefarious behind the large COMEX silver and gold short positions built up by 2 or 3 U.S. Banks sometime between July and August and right before the monetary metals took a dizzying fall. Many people are not holding their breath, but this could be an opportunity to once and for all set the record straight (or at least straighter) with respect to the commercial short activity in COMEX gold and silver. As I stated when I first discussed this issue (”Mr. Butler’s Naked Gun”), it is of paramount importance that the CFTC look into this matter regardless of considerations given how bad it looks on the surface (sort of like put options on airline stocks before 9-11).

That said, I do have a few related observations to make (surprise, surprise). First, I think the use of the term “relents’ in the title of the WSJ article somewhat misses the point. The CFTC’s Division of Market Oversight has made a “special” investigation of the silver market on at least two prior occasions, the last one being rather comprehensive. This is in addition to its normal market oversight, which admittedly isn’t ideal at times. Still, the most recent special investigation dealt with the key allegations leveled by Ted Butler, and while the conclusions were not supplemented with names of large traders and other internal data (as Mr. Butler would have liked), the arguments were properly laid out and presented a strong counter to Mr. Butler’s allegations. It was only a matter of time (and it was a rather short time) before the CFTC was going to launch an investigation of the present situation involving the 2 or 3 U.S. Banks that are holding large short positions in COMEX silver and gold. One reason for why I was fairly certain it would happen is that not only the normal tinfoil hat crowd had urged the CFTC to quickly get off its duff this time around but also a number of people from various more-or-less credible corners of the silver market (including me).

Second, we need to view all this in the bigger scheme of things: market regulators are facing additional sensitivity and scrutiny as all the markets are going nuts with volatility, not just silver. For example, see the CFTC Statement Regarding Today’s Trading in Crude Oil. Then of course there is the politically-motivated intervention by the SEC on behalf of companies to protect them against the supposed evil ravages of short sellers. I haven’t yet addressed the ridiculous ban on short selling of 700+ financial stocks, but it is a perfect example of the knee-jerk nervousness the bureaucrats are now experiencing. Yet most market analysts agree: a ban on short selling will do little to nothing in keeping the share prices of financial stocks from falling to the level they deserve to fall. On the other hand, the ban does reduce liquidity and increase volatility.

Third, it is worth emphasizing that apparently the Division of Enforcement and not the Division of Market Oversight is leading this latest investigation into the COMEX silver market. The Enforcement Division reviews specific allegations or instances of illegal activity and market manipulation. It has police-like powers and tends to conduct an investigation like “cops and robbers”. Market Oversight is more like academics studying an economic model.

Fourth, I’ll make the not-so-bold prediction that regardless the outcome of this Enforcement investigation, there will still be a bunch of dissatisfied people who will always continue to believe the COMEX silver market is a den of thieves and deserves to be shut down once and for all. In the alternative, they would prefer the COMEX ban shorts just like the SEC. (!!!)

Fifth, I thought the following explanation of how the silver market works from Jeff Christian of CPM Group is a rather appropriate if not amusing juxtaposition here:
mms://media.kitco.com/kitco/CPM_Silver_2008-09-16.wmv.

I’d like to clarify the password-protected posts about the BASIS, one of which was from today and the other from a couple of weeks ago. These posts are meant as advance material for those who have registered to attend GSUL 5 in Canberra, Australia on November 11-14 AND who are paid Founding Members of The Metal Augmentor service (www.metalaugmentor.com). GSUL stands for Gold Standard University Live and is (or was, until Mr. Eric Sprott withdrew his sponsorship) the educational arm of Professor Fekete’s teaching empire.

You cannot get the password by registering on this blog (though you should because soon I will probably be forced to allow comments only by registered users given the proliferation of spam).

You cannot get the password by (only) subscribing to The Metal Augmentor (though you should subscribe to make sure you will be able to claim a Founding Membership if you are not already on my list). While The Metal Augmentor will include detailed discussion and analysis of the basis, it will not cover it in the same depth and to the same extent as the GSUL 5 session. I will be available to answer Founding Member questions and help get Founding Members past “sticking points” in their understanding of the basis and all that it entails, but Founding Membership cannot possibly include extensive one-on-one guidance because there is only 1 of me and just 24 hours in a day. The limited nature of GSUL attendance, however, does allow me to personally assist each participant.

You can get the password as well as one-on-one access to me as needed if you register for the GSUL session through me and if you are also a paid Founding Member of The Metal Augmentor. To sign up for The Metal Augmentor, please go to www.metalaugmentor.com and purchase the “Mining Equities Report”, which comes with a one-year membership. Founding Memberships are still available but probably not for long. To register for GSUL, simply get in touch with me by e-mail and I will send you payment instructions. Don’t worry if you cannot actually attend the session in person as I am arranging for a “remote participation” option whereby you will have access to each day’s lecture by streaming video/audio over the Internet. I only need 4 more registrants to make this happen. Through the remote participation, you will have the ability to ask questions about each session by e-mail and these questions will be answered by the Professor and/or his assistants as appropriate. To find out more about GSUL 5, please visit www.professorfekete.com/gsul.asp or www.feketeaustralia.com.

The latest figures are out from Barclays’ silver ETF, SLV, and it now holds just shy of 221 million ounces of silver, up 70 million ounces for the year and up almost 20 million ounces since early August. This is a lot of silver buying, not to mention bargain hunting, and speaks to the fundamental demand that continues to exist despite the commodity selloff and the silver price collapse that resulted from the selling of paper silver.

Speaking of which, open interest in COMEX silver futures has now declined under 105,000 contracts as the short covering continues. The open interest is now approaching the lowest levels we have seen since this bull market started in 2003. In other words, most of the speculative money has now been squeezed out. More to the point, the increase in SLV holdings (as well as the holdings of other silver ETFs, not to mention the recent placement announced by Central Fund of Canada) of physical silver is a stark contrast to the decrease in the COMEX paper silver positions. Should this trend continue, it could represent the bleeding edge of a major positive fundamental shift in the silver market: out with the paper, in with the physical.

Meanwhile, open interest in COMEX gold futures seems to be stabilizing around 375,000 contracts, which is still 100,000 contracts above the open interest level from earlier in the bull market (2003-2005). To the extent this represents a ”discrepancy” requiring resolution, one possible outcome would be a decline in the gold-silver ratio from the current level near 70 back toward 50. This could occur with the silver price rising (or not falling as fast), the gold price falling (or not rising as fast), or some combination thereof.

With not much paper silver left to sell and physical buying continuing to be robust, there appears to be less price resistance to the upside than the downside, but some risks to silver still remain. For one, the recent advance appears to have been spearheaded by short covering, and a period of consolidation may be required to digest the gains. I am currently looking for some technical targets that could serve as support levels to be tested ($12.50 might be one, but it is too obvious to be of much value). Second, market sentiment can easily shift back and forth over the next few days and weeks as the $700 billion bailout package is thrown around Washington like a hot potato. Wild market swings can be expected and there is even a possibility that the anti-commodity sentiment could return (temporarily, I would think) if the politicians are able to pull off a magic trick that fools the populace until the next crisis brings them back to their senses. Third, the dominant short-term trend is still down in commodities even with the impressive rally by crude oil, copper and a few others. Even if silver were to otherwise stay strong, it probably would not go on an upward tear if/while the commodity sector resumes the sinking habit it picked up in late July.

The bottom line is that I believe accumulation of silver and related investments is still appropriate at this point with reasonable risk-reward potential across most investment time horizons. Until some key fundamental factor argues against it, I am planning to maintain my August 8 shift to being positive (change from yellow to green flag) on the short term prospects for silver (for the first time since October 2007). I made this shift right as silver was closing for the week near $15, but the very next week an investor would have purchased silver anywhere between $12-14 (call it $13 on average). As I write this, silver is again trading around $13, having come full circle. So, according to my somewhat tortured logic, I’m about breakeven on my August 8 flag change.

I only state the above for the record because lately I’ve gotten a few nasty e-mails saying how I had totally blown any shred of credibility by being an unrepentant silver bull all the way down from $21 to $10. I’d beg to differ given that I’m one of a few big mouths in the silver market who actually makes calls like this (instead of the typical wishy-washy stuff that can be interpreted 1,001 ways to Sunday). Not only that, I’ve been more accurate while also being more precise and I’ve done it for free (up until now, but not much longer), disproving the old adage, “you get what you pay for”. Yes, some of you have pointed out that Jon Nadler, Mark Hulbert and some others were correct in the strict sense while just about everybody else including me was wrong, but their kind of “right” isn’t typically far off from the ”broken clock” kind.

The media is starting to ask scary questions about the financial mess: What if the $700 billion bailout package fails? What then? Well, nobody seems to have any answers but there are actually some options. One would be for the U.S. Treasury to use the U.S. Gold Reserves (assuming the gold is still there in Ft. Knox — something I believe is the case but one cannot know 100% for certain). I started talking about this a couple of years ago and so far Jim Sinclair has been the only one to seriously take up the discussion. His version is the “Federal Reserve Gold Certificate Ratio”. While this could be one way to go about it, I don’t believe it is very workable.

In the next few days, I will be writing an expanded article on the subject of “What Next?”. In this article, I will be revealing what might possibly be the only approach that has a chance to stop the complete destruction of our financial system. It involves gold and that little known piece of U.S. law called the Gold Clause Resolution of 1933. It appears that when Ford lifted the ban on private gold ownership in the U.S. at the end of 1974, this law remained on the books until amended in 1977 (thanks for the correction, Qwerty). And it could be used by the U.S. government to put in place a new gold-based system that could avert total monetary collapse. How? I’m still working on the detailed explanation. It won’t be very pretty but it could be the one thing that might actually work.