August Silver Recap
Well there was another fun month for silver investors!
Perhaps not yet time to go out and buy the new luxury car, although after the trading action of the past few years, certainly a welcomed relief. As silver rallied from it’s $16.23 on its July 31st close to $18.34 on August 30. Which is an extension of the rally that began on May 29 at $14.37, and closed at $15.28 at the end of June.
Last month I talked a bit about how while there were factors suggesting continued strength going forward, the COT positioning was indicating an increased probability of a near-term sell off. So far the long side has won out.
Because while we have seen some spikes down, such as the one in the chart below from August 13th, they continue to be shorter in strength and duration than what we have witnessed repeatedly in past years.
(chart courtesy of kitco.com)
Part of the strength in the silver price was due to the Federal Reserve cutting interest rates at its July meeting. And now only a month later, several central banks around the globe have cut rates as well, while talk of quantitative easing continues to grow. This time even from President Trump.
Of course this also is in the midst of one of the more mind-boggling trade wars in history. That’s seemingly escalated by Donald Trump's Twitter feed on an almost hourly basis. Which may be a contributing factor to the rally. Although even if Trump and China reached a deal tomorrow, that wouldn’t change anything about the bigger factors driving the silver market.
As is detailed in this month's report, with more money printing on the way, continued demand pouring into the silver ETFs (that has already reached shocking levels), and retail dealers reporting significantly more money going into silver purchases than gold, I continue to see silver rallying throughout the end of the year.
As perhaps most importantly, it seems that there are enough factors powering the bids, that they continue to overwhelm the paper offers. Which we will talk more about in this report. As while I don't think that’s the optimal way for any asset market to trade, it does remain in my opinion the single most important factor in determining the silver price.
SLV and Silver ETF Inflows Continue To Surge
While rate cuts and quantitative easing may well in due time be driving the silver market, perhaps more relevant to what's been moving the price is that someone has been buying an incredible amount of silver.
We're not talking about something that could hypothetically happen in the future. But over 120 million ounces in 3 months have been added to the silver ETFs!
(chart courtesy of Nick Laird’s www.goldchartsrus.com)
This is in a market that already had a 29 million oz deficit last year. And is seeing the mining supply further decline, largely in response to the low price making many projects uneconomical.
This is the floor that silver investors have in their back pocket. Because while the price has gone lower in recent years, the natural laws of economics lead to a reduction in supply, which is playing out now. So in the short-term in a market where the price is often determined by the paper positioning, extreme things can happen. Or even over what sometimes may feel like the long-term.
But we have now reached the point where supply is actually going offline. And remember that one of the key differences between silver and gold, is that while most of the gold is still out there being stored for investment purposes, the majority of the silver is consumed.
So while I can handle debates either way about whether gold or silver will be used as money, or whether they should be used as money, the big difference with silver is that it has such a large industrial usage.
The Silver Institute has last year's fabrication demand at 578 million ounces, while the supply was just over 1 billion. So to have over 120 million ounces of ETF demand over a three-month period, at the same time supply is falling, is my best guess of why the price has been rallying so consistently. While the counter moves downward continue to have less impact.
For the past decade I have come to assume that the price will be controlled by the paper trading, until there's some break in the pattern. Possibly when enough people show up and request metal, forcing some variety of failure or cash settlement. I don't know that we're at that point just yet, although when I think about the amount of silver that’s being reported into the ETFs, and all of the central bank easing that's on the way, it at least seems like it’s not going to get easier for anyone who shorts with the intention of driving the price lower.
To the degree that this pattern has gone on as long as it has, in my trading and my pricing of the distribution I don't go as far as to put the probability of a more severe paper smash at 0. But I feel like it has to be somewhat lower than it’s recently been. As we haven’t seen silver trade like this (especially rising in the face of the large short position) perhaps since 2011.
A Prisoner’s Dilemma For The Shorts
In Ted Butler's columns over the past month (which are highly recommended reading in my opinion), he's mentioned something that I've been thinking a lot about. As it fits into the theme that the longer we see silver go up without a significant spike down to bail out the shorts, the more troubling of a situation they find themselves in.
In particular Ted has mentioned how some of these banks do have to post margin. And in an interview I did with him, he mentioned how he thought Bear Stearns was getting a margin call on their silver position. Which very well may have contributed to their final demise.
So while we hear all the time about how there's this large short position, when prices are rising, the shorts are losing money. And the larger the short position, the larger of a loss when the price goes up. So with money being printed around the globe, adding to a short position that may or may not work out is a risky proposition when you’re already in the hole.
It's hard to know by exactly how much, as that information isn’t public, and it's near impossible to know the true derivative position of any of these precious metals trading desks. Yet someone is short the metal, and keep in mind that if you're shorting something primarily because you believe you can drive the price lower, once you reach the point where you can no longer successfully accomplish that, there's essentially no reason to add any additional shorts. Instead, it creates a prisoner's dilemma if you’ve reached that conclusion, where you really want to exit your position before somebody else does.
Now whether the banks that short silver have any awareness of the fundamentals is something I often enjoy wondering about. Perhaps they’re shorting silver because they’re looking at a different set of data than I am, or maybe something in the chart suggests that it could go lower.
But you would have to think that the banks that are shorting silver on a large scale are at least aware that they’re taking a risk in a market where the amount of paper outstanding can never be satisfied. And if that's the case, that would sure provide a powerful incentive for one of the banks to jump ship if they do come to the conclusion that they can’t drive the price lower with additional paper.
It was interesting to see the bank commercial short position reduced from 83,000 contracts to 65,000 contracts between July 23rd and August 6th on higher prices. Which is perhaps not yet enough evidence to signify that one of the large shorts is running for the exits. But it is the type of sign that I would expect to see when something like that is occurring.
Ultimately, you have this dynamic where the incentives for the shorts to drive the price lower is greater than ever. While at the same time, the higher the price goes, the more attention and momentum funds that come into the sector. And as the price rises, that also increases the losses for the shorts. Which is why it feels like a lot of these longstanding imbalances may be finally starting to come to a head.
I discussed this with silver guru David Morgan this month, and he comments on the short position reduction at the 23:09 mark in the video below.
Perhaps the difference between now and the silver rally of 2016 is that the narrative about the central banks is completely different. Because while it was possible to see years ago that the Fed was going to have a hard time if it ever tried to raise interest rates, now it's become clear enough that the rest of the world can see. As a result, I’ve been adjusting my trading positions in anticipation of a further rally between now and the end of the year.
Perhaps that's to the $20 mark, which isn't really that far away anymore. Although it could be greater than that. On the other hand, I'm also reducing my probability of silver trading significantly lower by December 31st. Maybe it could trade lower at some point in between now and then, but again with all of the money printing that’s now coming from around the globe, it just seems harder to believe that silver will be significantly lower four months from now. Unfortunately as we’ve learned in the past decade, not impossible. But in terms of constructing a probability distribution, this is what I’m currently pricing into my option model.
Under $17: 10%$17-$20: 30%$20 - $25: 40%$25 - $35: 15%$35+: 5%
Arrests For Precious Metals Manipulation Continues
As many are now aware, last November, former JP Morgan trader John Edmonds plead guilty to “spoofing” the precious metals markets. While also stating that it was done with the knowledge of his supervisors, and was widespread practice throughout the firm.Since then, two more traders have reached similar deals. One of whom was a former Scotia Capital and Bear Stearns trader.
Corey Flaum was one of two former precious metals traders who separately Thursday agreed to settle regulatory charges filed by the Commodities Futures Trading Commission for a banned market manipulation strategy known as spoofing.
That strategy involves placing trade orders with the intent to cancel them before they can be executed. The goal of spoofing is to affect the price of the commodity and thus benefit a preexisting trading position.
The other of whom was another JP Morgan trader.
Christian Trunz, who earlier Tuesday resigned from his position as an executive director at J.P. Morgan, said he “learned to spoof from more senior traders, and spoofed with the knowledge and consent of his supervisors,” according to the Department of Justice.
J.P. Morgan declined to comment. The Justice Department is conducting multiple criminal investigations into big banks with the cooperation of traders who have pleaded guilty to spoofing-related crimes.
Trunz’s guilty plea makes him the second former J.P. Morgan precious metals trader to admit to spoofing in the past ten months.
John Edmonds, 37, pleaded guilty in October in Connecticut federal court to working with other “unnamed co-conspirators” to manipulate the prices of gold, silver, platinum and palladium futures contracts between 2009 and 2015 while employed at J.P. Morgan.
What’s interesting is that the article mentions that Trunz was employed as an executive director at JP Morgan until August 20. Which can only make you wonder if him or any of the supervisors who were showing him how to “spoof” were responsible for how the price of both gold and silver spiked downward on August 13. At the exact same time, on no known news or fundamentals that I, or any of the other silver experts that I regularly interview on my show have been able to identify.
One week before Trunz was arrested.
(chart courtesy of kitco.com)
(chart courtesy of kitco.com)
Especially as a former equity options market maker, this pattern that we’ve seen so often always struck me as odd. I was specifically trained to never execute an order like that. Because if you have a large order to trade, you want to get the best price possible. Not move the market significantly.
Often when we traded an option position and were left with a delta, we would hedge it with an offsetting stock position. But if it was a large position in a thin stock, we would often use a Vwap program that would essentially just randomly trade smaller lots over time so as to not move the price of the stock. So if I bought some calls, and hedged them by selling stock, I would be going out of my way to avoid the exact outcome you see in the charts above.
Additionally, when I was thinking more about this, it reminded me of something Bart Chilton said in the interview I did with him. When I asked him about the mechanics of how the manipulation is carried out, and he talked about spoofing. And what he says really does fit with what we see in the chart, and what these traders are getting arrested for.
Bart even confirmed that at one point JP Morgan had a position that was 40% of the market! And some of the traders who have been involved in this are apparently still at the firm. Based on how Trunz was still working there when he was arrested.
Of course from a trading standpoint, the real challenge is in distinguishing between what’s “spoofing” and what’s just normal legitimate trading. Because manipulated or not, any asset is going to have times where people sell and the price goes down. Although I’d be willing to bet an ounce of silver that these particular circumstances aren’t complete coincidences.
Also of note is that both cases mentioned that the traders are cooperating as federal prosecutors continue ongoing probes of major banks.
Edmonds, who has yet to be sentenced in his criminal case, and several other traders who likewise have pleaded guilty to spoofing-related crimes are also cooperating with federal prosecutors in ongoing probes of major banks.
Last February, J.P. Morgan first mentioned the legal actions in a financial disclosure: “Various authorities, including the Department of Justice’s Criminal Division, are conducting investigations relating to trading practices in the precious metals markets and related conduct. The Firm is responding to and cooperating with these investigations.”
There could be more serious charges forthcoming, as what the agency has released so far suggests that they are aware that there are people higher up in the chain involved. Whether this leads to any significant change in the market structure is still an open question. Although I do know that there is an investigation now ongoing in British Parliament as well.
In the August 30th COT report the commercials were short 81,681 contracts. Up from 70,863 the previous week. So while the short position had been reduced for 2 weeks in a row on higher prices, the last two weeks have shown an increase.
The Fed Meeting On September 18
The next Federal Reserve meeting on September 18th is rapidly approaching, and will likely be influenced by what happens between now and then.
At Jackson Hole, Federal Reserve chairman Jerome Powell said that the July cut was not necessarily the first of many. But also mentioned that the trade war was one of the factors that could weigh on that.
Of course shortly afterwards president Donald Trump was tweeting that American businesses in China should start closing up shop. Before going on to ask whether Powell or Chinese leader Xi Jinping was a bigger enemy of the state. And then increasing tariffs after the close.
So essentially Powell warned that an escalation of the trade war could lead the Fed to become more dovish, and the rest of the day Trump was escalating the trade war.
Only to follow that by seeing the markets sink when they opened the following Sunday night in the east, until Trump tweeted that he had received 2 phone calls from China about wanting to negotiate again. That there’s increasing skepticism about whether they even occurred.
The market has been pricing in a 95% chance of a 25 basis point cut, and a 5% chance of a 50 basis point cut. I think 25 bp’s may be more likely, although personally I would be a buyer of a 5% chance of 50. Given what's going on in the world, I think if you played this situation out 20 times the Fed would cut 50 basis points at least more than once. I also think we will see quantitative easing in the US before the end of the year.
There are reports indicating that the European Central Bank is going to do its own quantitative easing in September, and that it's already purchased so many of the bonds, that they’re running out and actually thinking about buying stocks now!
“Olli Rehn said the slowing global economy would see the ECB rolling out fresh stimulus measures that should include “substantial and sufficient” bond purchases as well as cuts to the bank’s key interest rate.
“It’s important that we come up with a significant and impactful policy package in September,” said Mr. Rehn, who sits on the ECB’s rate-setting committee as governor of Finland’s central bank.
“When you’re working with financial markets, it’s often better to overshoot than undershoot, and better to have a very strong package of policy measures than to tinker,” Mr. Rehn said.
Mr. Rehn said he didn’t rule out a move to purchase equities under the QE program, but that would depend on the assessment of ECB staff.”
So with ECB getting ready to print, and Trump and Powell claiming that the US economy is strong yet simultaneously begging for QE and lower interest rates, I suppose you could debate how much they’ll do in September. Although especially with the massively inverted yield curve, it’s a good bet that a lot of credit is going to be added into the system between now and the end of the year.
Which I expect will continue to draw more interest into both gold and silver. Which is why it’s a risky time to have a large short silver position. That’s easier to manage when the Fed is talking about raising rates and ending QE. But I think the world is finally realizing that the experiment of the last decade has failed and that once again the central banks are resorting back to the printing press.
And what often gets lost, is that many people look at gold and silver reaching their nominal high’s in 2011 and think the price went down because the Fed was unwinding. But when you look at the actual numbers, that's not the case. As you can see, the St Louis Fed’s adjusted monetary base is still well above 2011 levels.
So I still think the metals have a lot of catching up to do. Even before factoring in what the central banks might print going forward.
This Month’s Trading Update
For those looking at silver bullion as a form of savings or long-term investment, even despite the recent rally, $18 still seems incredibly cheap to me. So to the degree that you are investing for the long-term, and also want to be hedged against all of the political and monetary insanity, I don't know of anything else that offers as much upside potential with as little downside risk over a long-term horizon.
Maybe uranium. Where the cost of production is around $50-60 per pound while the price is around $25. Although a couple of silver bars are probably a little easier to store at the location of your choosing.
So given the accelerating rate of monetary expansion that I believe we're about to see, not only do you have a good chance of seeing physical bullion valued at a higher dollar price in the near-term, but if the money printing really gets out of control, that's when silver really provides it's true benefit as a store of value.
My good friend Jeff Clark even wrote a great article showing how you can expect the price of real estate to go down in terms of how many ounces of silver it will cost you to buy.
While a lot of the mining stocks are up quite a bit since the beginning of the rally (First Majestic Silver has almost doubled going from $5.55 to $10.88), I still like owning them at these levels. Primarily because if the price of silver continues to rise, these stocks are going to continue to go up. And by a higher percentage than silver.
One of the reasons why I like trading First Majestic so much is because I often look back to how when silver went from $14 to $20 in 2016, First Majestic went from $3 to $18.
(chart courtesy of kitco.com)
(chart courtesy of www.marketchameleon.com)
Of course there's no guarantee that just because that happened then, it will happen now. But given the leverage to the silver price that some of the miners have, if silver continues to rise, I think there will be points where you will see gains in the mining shares similar to that example (although keep in mind that when the price of silver goes down, the price of the silver miners can go down faster as well, which is why keeping an eye on silver moves to the downside remains so important).
I also think there's a degree to which many silver investors are still feeling somewhat cautious about whether this is another false start. And understandably so.
Keith Neumeyer, the CEO of First Majestic Silver talked about this in an interview with Daniela Cambone of KITCO. And I also had a chance to catch up with Rick Rule of Sprott Global this month and talk about that. As well as how in previous precious metals bull markets, traditionally gold rises first, then silver, and then the silver mining shares.
And how what’s accounted for the really big moves we’ve seen in the past in the price of silver is when western investment demand kicks in.
While there are different risk parameters between physical silver and mining stocks, on a day-to-day basis, there are times when it seems as if the shares are lagging behind. Which I like to use as entry points. So especially if you see a day when gold is up, silver is up, and the shares are down, while there are no guarantees, if you consistently use those situations as entry points, I think you’ll be getting edge in the long-term.
As always I will issue my usual disclaimer regarding options. I do comment on options because my background is as an options trader, and for the informed speculator they can be a useful tool. But this is a risk level not suitable for most people, and do please consult your investment advisor before making any trades of this nature.
With that said, I continue to hold my slightly out of the money First Majestic Silver calls. Which include October 12’s and January 11’s. On some of the moves up I have been placing offers for about 10-20% of those positions in hopes of reducing my size on a rally, and having cash to buy on dips.
I'm not too aggressive on these offers, as even if I don't get filled, I still have a position that I'm comfortable holding until expiration. I got close to getting filled at the high’s this week, although was a dime away and missed out when the stock declined on Thursday. It's not an exact science, and to some degree my goal is to try not to get too cute and outthink myself. Which is why I do this more so as a risk management technique.
Given my outlook for silver over the next four months, I’ll be looking for selective spots to add to January OTM call option positions. And I would use the same parameters as described in the mining stocks section.
Which perhaps is even more relevant to option trading, as one of the differences between trading options and the underlying asset is that you're introducing the time parameter. Which fundamentally changes the nature of your trade.
With physical silver or even mining stocks, if you’re prepared to hold for the long term, the timing isn’t quite as important. Because it will still just be the same share or piece of metal, and you can ignore the short-term fluctuations.
However options do very much involve that time component, which means that your entry point can make a big difference. And in the current environment, being selective can increase the probability of the trades that you win on. And also the amount that you win on them.
Should we see a significant sell-off in silver down to the $15-16 area, I would even be looking at purchasing LEAPs (long term options) that expire in January of 2021. Because even if silver went down that far and killed the interest in the sector for a while, especially if the large ETF buyer keeps buying, and the central banks are printing, I like having that position on and taking my chances over the next 16 months.
I realize that I have an underlying bias. There's a large part of me that “wants” silver to go up. Maybe even for personal reasons, as I did have a large position on in 2011, and often wonder if the dollar system was close to going off the rails back in. But was held in check when the metals prices got hammered and money just flowed into the equity sector.
Maybe it's also because I do think that what's being done is a blatant violation of the stated rules that everybody is supposed to abide by to maintain integrity in the market. And that's just something that personally I've never liked.
Yet in the end, what's beautiful about trading is that much like poker, success is usually found in separating your emotions and feelings, and simply focusing on what is likely to happen given all of the available information.
So this report is written with that intention in mind, and hopefully it’s been of value in your research.
I did discuss all of these topics in more depth in an interview with Rob Kientz of Gold Silver Pros last week, so should you want to take a listen, you can do so here.
As always, you’re welcome to message me with any questions, and it should be an exciting month!
September 5, 2019
Arcadia EconomicsSilver Research, Trading, and Strategywww.ArcadiaEconomics.com
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