Is Silver Set Up For A 'Generational Trade'?

| About: ProShares Ultra (AGQ)
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I am still of the mind that we are close to a silver price bottom of some great significance and that the investment risk/reward ratio in silver has rarely been more attractive than it is currently. It is important to recognize any imaginable price lower is vastly exceeded by the potential amount silver will move higher in price eventually. The essence of successful investment is to place funds into the thing least likely to lose money and most likely to show great gains. In this instance, silver is it. - Ted Butler, "Investment Rarities Newsletter"

The current correction in the precious metals has not been the worst in the last 12 years (see 2008), but it certainly has been the most painful in terms of duration and impact on sentiment. Anecdotally, I have never received as many emails as I have this week from long-time precious metals investors who are in a state of panic and emotional duress.

Putting aside indicators that are hard to quantify, I want to present some actual market data that give me cause to believe that not only is silver setting up for another huge move higher over the next several months but, in fact, this could be one of the best risk/return opportunities I've seen in a long time.

First, there has been a large divergence between the actual physical demand for silver by investors and the price of silver. The mint sold 15 million oz. of silver eagles in Q1 this year. That is by far a record amount of silver eagles for any quarter going back 27 years to when the program was started. In addition The metal holdings by SLV increased by 20 million oz. in the 1st quarter. Q1 also saw the largest quarterly reduction in short interest of SLV - 10 million shares - on record. In other words, the divergence between the paper market and the physical market is extreme.

The second key indicator that a big move in silver has been set up is the long/short structure of the Commitment of Traders report. I showed in an article here, physical vs. paper, that the bottom of cyclical price corrections in gold/silver occur when the hedge funds have a comparatively low net long position/high short position and the commercial traders have a relatively low net short/low gross short position. In other words, when the hedge funds take extreme positions in Comex gold/silver, they are notoriously and egregiously wrong.

Based on this model, currently the hedge fund category of trader has, by far, its largest gross short position and smallest net long position in the history of the disaggregated COT reporting (2006). The disaggregated COT reports started in 2006 and you can download this data: D-COT report. I went ahead and did that and as of last Tuesday, the "managed money" category (the hedge fund traders) were short a record 22,405 silver contracts. In fact, each successive week since the beginning of March has produced a new record gross short position by the hedge funds. The previous record was 17,575 on July 24, 2012. I've marked on the chart below points at which the hedge funds previously held comparatively high short positions in Comex silver.

The average weekly short position by the hedge fund category of trader over the time period is 6,287. As you can see, the extreme high level of hedge fund short positions indicated by the red arrows above corresponds nearly perfectly with market bottoms. The same correlation also holds true for when the commercial category of trader (big bank market makers on the Comex) has an extremely low net short position, derived by an extremely low relative gross short position. Currently the net short position of the commercial category of trader is the lowest on record (see the DCOT link above).

So what does all this mean? The previous "cyclical" price correction occurred from March 2008 to early November 2008. Silver dropped 60%. The current price correction started in May 2011 and silver has dropped over 47%. Assuming that we have hit a bottom - a bottom which is currently being tested for the 3rd time and corresponds with what is by far the largest hedge fund short position in Comex silver on record - in all likelihood the next move higher for silver will be at least proportional in duration and degree as the last big move. The last big cyclical move higher lasted from November 2008 to April 2011 and silver went from $8.75 to $50 - a 570% move. To be sure, I will not go on record predicting that silver will go from $26.35 to $150, but I will not rule out that possibility.

Regardless of where you want to believe that the next move higher will take silver, based on the current extreme measures of sentiment, the unprecedented physical demand - as seen in mint silver eagle sales and SLV buying - and the record level of hedge fund Comex silver short interest, there is a high probability that silver is about to embark on a huge move higher from here. The best way to take advantage of this would be to start building a position in AGQ. AGQ is leveraged 2x to the percentage change in the price of silver. If indeed silver makes another cyclical 570% move higher, a long-term buy and hold of AGQ would yield an 1,140% gain. I think by anyone's standard that would be considered a "generational" trade opportunity.

Disclosure: I am long SLV, AGQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The fund I manage is long physical silver and AGQ