Silver (NYSEARCA:SLV) just completed its second major correction this year after its parabolic rise and peak in April. The second decline that occurred over the last month has led silver to shedding nearly half its value. The decline over the last six months has pushed our silver indicator to the second most oversold value in a decade. Is this a major buying opportunity or are investors now catching a falling knife? The answer to that question hinges on what the dollar (NYSEARCA:UUP) does over the next several weeks.
Silver Deeply Oversold
Given the sharp selloff in silver over the last few months it’s not surprising to see silver in oversold territory, but how oversold is it relative to prior corrections? To show how extreme silver’s recent oversold condition is, our silver risk indicator below shows that silver is at its second most oversold reading in the past decade, with 2008 the only exception. Quite the whipsaw after our indicator showed the most overbought condition in silver in April, with our silver indicator exceeding the 2004, 2006, and 2008 peaks, and then to see the second most oversold reading six months later. Given the deeply oversold condition silver finds itself in, is now a good time to take advantage of the recent price decline? Yes and no.
If you compare the average path of the 2004, 2006, and 2008 corrections we should be putting in the final low for silver here and we could witness a sizable Q4 advance that sees silver rally north of $45/oz. My silver correction composite below suggests silver may trade sideways into middle October as it puts in a bottom before making a sizable run heading into the end of November. That said, I would recommend against throwing caution to the wind and scooping up silver right here.
2008 Analog May Hold the Key
Looking at the most recent major correction in silver, the 2008 top, suggests some caution as of the three prior major corrections (04, 06, 08), the 2008 correction shows the closest resemblance to silver’s 2011 correction. As shown below, if silver continues to trace out its 2008 top, it may embark on a further correction beginning next week that could take it to the low $20/oz level heading into November.
What makes watching silver over the next week or so incredibly important to its performance for the rest of the year is that the 2008 analog is holding quite strongly across other asset classes and thus stresses caution for precious metal investors as I suggested earlier in the year (Echoes of 2008 Suggest Caution for Precious Metals Investors). For example, the S&P 500 (NYSEARCA:SPY) is tracing out its late 2007 to early 2008 top in virtually identical fashion and suggests the stock market may get a bid into year-end as it works off its oversold condition.
All Eyes on the USD
But more importantly to silver and precious metal investors is that the USD is tracing out a similar path to what transpired over 2008. If the 2008 analog holds, we are likely to witness a short-term top in the USD and then a surge heading into the end of this year.
Looking at the global strength of the dollar tends to confirm a short-term top is likely forming. Below is a table of foreign currency returns relative to the USD over various time frames. As seen in the left two columns, foreign currencies are firming relative to the dollar on a short-term basis and likely hint of a temporary pause. However, the last four columns show the USD has been strong against nearly every world currency except for the Yen, Chinese Renminbi, and the Thai Baht. This suggests that the low put in by the dollar over the summer was a solid low from which it should stage a cyclical bull market rally in the context of its 2001-present secular bear market.
The likely catalyst for the dollar's rally — as with the 2008 advance — is that the global economy is slowing (see World Economy Hanging By a Thread) in which foreign central banks are likely to cut interest rates to revive their economies. When foreign central banks cut rates relative to U.S. short-term interest rates, it makes foreign currencies less attractive as the interest rate differential with U.S. rates falls. The USD’s advance in 2008 was discounting the foreign central bank rate cuts to come and the current advance in the USD is likely doing the same as the deceleration in global growth is likely to elicit central bank rate cuts ahead.
If the USD is to continue its advance after it cools off for a bit, we are likely to see precious metals continue to selloff or trade flat at best, and thus give silver some time to prove itself before throwing caution to the wind and trying to bottom tick buying silver. The key will be to watch how the dollar performs in the weeks and months ahead. Right now, the USD Index is above its 200 day moving average (200d MA) as well as its 50d MA, both of which are converging near $76 and would represent strong support on a short term correction in the USD Index. For the all clear to be signaled for silver, we would likely need to see the USD Index break below $76. As long as the USD remains above its 200d MA I think playing defense for precious metals is the proper strategy.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.