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March Malaise: A near-term forecast for silver

 
By Joshua Enomoto, Founder of ContangoDown.com and CrushTheStreet.com Contributor
 
In the most recent edition of CrushTheStreet.com’s Weekly Market Wrap-up, I stated that spot-silver will likely enter a consolidation phase before eventually pulling out to make significant gains from a percentage basis. I did not, however, provide a time frame to which precious metals investors can look forward to the aforementioned upside swings and this will be the main purpose of this article.
 
Before we begin, it’s important to note the distinction between a retail market and a so-called “paper” market. Retail markets operate under the classic supply and demand model where the realization of price, or the price that real buyers are willing to pay for a product, is discovered within the retail market. While Ford may wish to sell their Fiesta lineup of econo-cars for $100,000, the stark reality is that outside of rare occurrences, such as auctioning programs for charities, an extreme few would be willing to pay such a price. In the paper markets, much of the same supply and demand dynamics are evident: normally, investors refuse to put up money for shares or commodities that are priced out of their comfort level. However, the key difference is that the retail markets find their price realization through the end-user, essentially people like you and I. For paper markets, price realization comes through investors, traders, algorithms and exotic financial instruments (aka derivatives or options). For silver in particular, its derivatives market is massive: on any particular day, there are millions of trades occurring in both the market proper (such as the SLV) and within the plethora of derivative instruments that base their valuation on the underlying market. Therefore, examining the derivatives trade can provide a near-term forecast for future price action.
 
Let’s start by analyzing the put/call ratio for volume and open interest in the SLV options (derivatives) market:

SLV (03022013)

While the number of traders holding bearish (put) positions are outnumbered by those remaining bullish (call), the put volume in April has significantly increased over prior weeks. Another alarming trend from the perspective of the silver bug is that open interest is substantially leaning towards bearish sentiment, especially for May contracts. Subsequently, bearish volume for June is massive, with nearly twice as many puts as there are calls. While traders nowadays can jump in and out of these contracts like flies on dog-stink, the overall sentiment in the derivatives sector is bearish.

How will this play out in the underlying market? Unless Eric Sprott and his entire management team decide to move full bore into the market, it’s unlikely that we will see a move to $50 next week. Bearish options trade will constantly pressure silver for the next several weeks and the FOREX sector based on the fundamentals of Europe and the American sequester will add a few wildcards of its own.

Let’s take a look at the technicals (1.5 yr daily chart) for the SLV: 

SLV chart (03022013) B  

Since the peak achieved on the back of the Federal Reserve’s announcement of QE3 (Sep 13, 2012), the SLV has been declining in a consistently bearish trend channel, charting a series of lower highs and lower lows. While it certainly is not a pleasant picture, we can take heart that the decline has been orderly and predictable despite the negative posture in the derivatives market. Indeed, the floor, while shaky, has not been taken out from underneath our feet and therefore, our predicament is very much workable from a technical point of view.  

 

However, we need to be alert: while I seriously doubt that silver will drop into the high-teens, a realistic scenario is that we will bounce around within a 7% consolidation range between 27 and 29 dollars in the SLV, or roughly equivalent to 28 and 30 dollars in the spot market. Based on cyclical analysis, this range could last until early summer before we see a significant directional move.  

 

Speaking without emotions, we should expect the precious metals sector to be a bit of a snoozer for the next few months. Rationally, we are left with two choices: if you no longer believe in hard assets, you should exit this sector, but you may want to do so at the top of the consolidation range, which also coincides with long-term support/resistance. If you still believe, as many of us do, then you can either hold or add to your position. However, with only a 7% realistic upside, the margins are too thin to be ultra-aggressive: personally speaking, I would rather let the irrationalities of the derivatives trade play out and fish for a better deal.   

As an alternative to the actual asset, savvy investors may want to consider buying shares in reputable mining companies. While spot-silver was hit with a -18% loss since QE3, some mining companies are seeing losses of nearly 50%! From a value perspective, this is an unbelievable opportunity that deserves serious consideration. The most highly regarded names are taking some of the biggest hits, which is indicative of a market excessively over-sold: a regression to the mean would foreshadow substantial percentage moves up.

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