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Tactical Silver Trends 5

Adam Hamilton
Aug 18, 2006

This year has been the most exciting witnessed in silver for decades. The fabled white metal entered 2006 below $9, blasted up to challenge $15 by early May, and has since retreated back near $12. The sheer magnitude of these moves has created something of a speculator wonderland in this restless metal.

Over the long term, in the probable remaining decade or so of our current secular commodities bull, silver's performance is likely to be dazzling. As it did last time around in the 1970s, I expect silver to once again ultimately dwarf the performance of every other major metal. Silver sports a unique combination of long-term supply and demand fundamentals that remain unparalleled in other commodities.

On the supply front, world silver above-ground stockpiles are rapidly dwindling. Most silver mined today is a byproduct of mining other metals like copper, zinc, and gold. High silver prices will not lead to more byproduct silver being mined. And primary silver mines take years to bring online. Thus silver's supply is simply not in a position to be able to rise rapidly to quell high prices.

On the demand front, silver is the best metal available for a broad array of industrial applications. And most of these only require small amounts of silver per unit, so high silver prices are immaterial to final finished-good costs and hence won't affect end-product demand. And silver jewelry, regardless of how high silver goes, should always be cheaper than gold, platinum, or palladium. There will always be a socioeconomic niche for silver as adornment.

The real rocket fuel under silver is not industrial demand, which grows slowly, but pure speculative demand. Since there is no major metal that moves faster than silver or has more promise for vast gains, speculators perpetually love silver. When speculative interest in this volatile metal starts spreading beyond its usual traders into the mainstream, silver's price can rocket vertically.

And silver's speculative demand curve is inverted. In normal goods, higher prices retard demand. A restaurant would sell far fewer hamburgers at $50 each than at $5 each. But the higher silver prices rise, the bigger the number of speculators who want to buy in. Nothing begets speculative interest like rising prices! In the right market conditions, rocketing silver prices entice in ever-increasing capital creating a virtuous circle that feeds on itself and spirals higher.

While silver's ultimate potential is well known and unassailable, it does still behave like a typical bull market on balance. Silver doesn't rise in an uninterrupted straight line for the typical 17-year duration of a major commodities bull, nothing does. Instead silver flows and ebbs, taking two big steps forward in massive uplegs and then falling back a step in sharp corrections.

These periodic and healthy corrections, far from being nuisances as naïve silver traders often believe, offer tremendous opportunities for investors and speculators. The best time to buy, whether you are adding additional silver investments you plan to hold for a decade or leveraged silver stocks you only plan to hold for a single upleg, is during silver's periodic corrections.

Thus it pays big to deepen our understanding of silver's bull-market rhythms. Discerning silver's likely path in the next few months, regardless of its long-term potential, could make the difference between a stellar buy-low entry point or a lackluster buy-high entry point for new trades. To gain perspective, we have to examine silver's phenomenal 2006 run in the context of its bull to date.

Silver's massive 2006 upleg stealthily emerged from the ashes of a long consolidation almost exactly one year ago. The fabled restless metal then proceeded to first rally and then rocket higher over the subsequent 177 trading days, or eight months. Ultimately it soared an incredible 124% higher by early May, a mighty move for a single upleg by any standard. Then it promptly crashed, as silver is wont to do from time to time.

Understanding these technical silver price movements in bull-to-date context is very important. Every day silver closes at some price, and at that moment in time that particular price represents world silver supply and demand balancing. All participants in the global silver markets, acting in their own best interests, collectively drive silver to its close which reflects the aggregate of the best information available to all traders on that day.

Thus daily silver closes charted across the seas of time represent a steady stream of the best-available information on silver, collected worldwide and distilled daily into one number. Studying these datastreams is not the financial-market equivalent of voodoo as some deride, but instead a priceless window into the force that truly drives the markets over the short term, psychology. Greed and fear create the individual flows and ebbs within silver's strong secular bull. The best proxy for observing this group psychology is the silver price.

And if there is one thing that studying market history teaches, it is that trader psychology never changes. It is forever oscillating between greed and fear and back again, creating short-term sawteeth within long-term uptrends that astute traders can harness to our advantage. Since these basic human emotions never change, they tend to manifest themselves over time in roughly repeating patterns that are quite tradable.

This past year's mighty silver upleg, for example, was very similar in many ways to another huge silver upleg that straddled 2003 and 2004. Over 208 trading days ending in April 2004, silver soared 84% higher. While not quite at the same scale, this is nevertheless similar in pattern to the 124% run over 177 days that just ended in May 2006. But as both these uplegs proved yet again, when silver hits an interim apex and decides to correct it usually does it fast and hard, taking no prisoners.

Back after the April 2004 interim silver top, the white metal plunged 33% in just 24 trading days. After the recent May 2006 interim top, silver plummeted 35% in only 23 trading days. You don't have to be a statistician to see that these correction/crash episodes are remarkably similar despite being separated by years. Why is their standard deviation so low? Because fear in 2006 manifests itself the same way fear did in 2004 or even in 1904 for that matter. Psychology drives markets and is hence reflected by prices.

Interestingly this 23-day correction duration is evident in the only other silver upleg of its bull to date, a rather anemic 45% run higher over 141 trading days in 2004. After this run topped in early December 2004, silver plunged 20% over 23 days. What does this tell us? When silver speculators start getting scared after a major interim top in silver, they tend to stampede for the exit in just four to five weeks. Thus next time a silver interim top seems to have arrived, be wary because the inevitable correction will probably be fast and hard.

This oft-forgotten mediocre second upleg in this silver bull leads to another key observation. Silver has had three uplegs in its bull to date, two massive uplegs and one consolidation upleg. So far in silver's young bull these uplegs have alternated in a massive-consolidation-massive pattern. If this pattern holds true to form, traders shouldn't expect dazzling things from silver's next upleg, instead just a modest run up to interim highs under May's bull-to-date highs.

Does such a strange pattern make sense in psychology terms? And is there precedent elsewhere for it? Yes and yes.

After a massive run higher, such as we witnessed earlier this year, silver establishes what seem like radical new bull-to-date highs at the time. A year ago we were all conditioned to accept $7 silver as being normal, an equilibrium price level. But when $15 was first challenged in May after a parabolic rise heavenwards, it felt too high technically to all but the most rabid silver zealots. As such, after major new highs are achieved prices often need to trade sideways for a year or more to reset the average trader's expectations of "normal" prices.

This phenomenon is very evident in 2004. Silver soared from an old sub-$5 norm to $8 levels, which seemed very high in early 2004. So after silver achieved these bold new $8ish levels and crashed, it started grinding sideways in a long consolidation wedge. For over a year silver meandered sideways within a consolidation zone established between its April 2004 upleg high and its May 2004 crash low. Its next upleg was modest and remained within this consolidation zone.

The net result of all this sideways action is silver traders gradually got used to higher prices. Where $4 to $5 used to be the comfortable norm in 2004, by 2005 silver increasingly gravitated to much higher equilibrium levels near $7. And it wasn't until speculators were comfortable with these new levels and a technical base was established that silver mustered the strength to enter its next massive upleg, the one we saw this year.

So after a parabolic surge higher to what feel like stellar levels at the time, it naturally takes awhile for traders to grow accustomed to the new levels. Once they do, then they can rally prices again to even higher levels and begin this cycle anew. This massive-consolidation-massive upleg phenomenon has also happened, without fail so far, in the much older HUI gold-stock bull market. The greed and fear that drive short-term flows and ebbs within bull markets are universal.

What does this mean for silver investors and speculators today? We ought to moderate our expectations for the next silver upleg. We were just blessed with a massive upleg to unprecedented new highs within this bull, but now the markets have to get used to silver trading at these higher levels. Our next silver upleg has a fairly good chance of being modest, a consolidation upleg following early 2006's massive one.

This new consolidation zone will probably unfold between the May highs and the June lows, or about $9.69 to $14.94. The middle of this is $12.32 today. Thus it looks like there is a good probability that silver is going to need to establish a new base around $12ish before our next massive upleg carries us up another 100% or so. Such consolidations are very valuable though, as they grant us many opportunities to load up on silver and silver-related plays at relatively low levels near silver's 200-day moving average.

As all bull markets flow and ebb, they tend to soar above their 200dmas in uplegs and retreat back to their 200dmas in corrections. I've developed a trading methodology based on this tendency called Relativity. As a general rule, traders have the best odds of buying at relatively low prices if they add long positions in a secular bull when prices trade near their 200dmas. Silver's bull-to-date behavior relative to its own 200dma is very revealing.

After its first massive upleg topped in April 2004, silver rapidly fell under its 200dma. Then it spent a quarter or so grinding on its 200dma, oscillating slightly above to a bit more slightly below. After its next consolidation upleg that topped in December 2004, silver again fell under its 200dma. And yet again it ground sideways on top of its 200dma for about a couple months. This is typical in other bull markets too, after a correction a price usually tends to linger around its 200dma and consolidate for a period of months.

But after silver's latest crash bounce in June 2006, silver didn't even fall below its 200dma. Instead it just bounced off of it for a single trading day and then sailed back higher. In history such a fast rally off of a full-blown crash often proves to be a suckers' rally. While possible, it is very rare for a correction to end without a price grinding around near its 200dma for a considerable period of time. 200dma grinding indicates increasingly poor psychology and the end of the pre-correction euphoria, both of which are necessary prerequisites for the next upleg to launch.

So from a pure psychology standpoint, silver's price action since its June lows strongly suggests that much euphoria, bullishness, and greed remains from silver's parabolic surge despite its sharp 35% crash. This is a problem because major new uplegs always tend to launch from points of despair and apathy. Long after the initial fear spawned by a plunge fades, sideways-grinding prices create increasing amounts of other negative emotions like despair and apathy. Sans these crucial upleg seeds, we aren't going to see the next upleg.

This phenomenon can be observed another way by comparing silver's 50dma to its slower-moving 200dma. Prior to all major uplegs of this silver bull launching, silver's 50dma had fallen down to and slightly under its 200dma. This can only happen when silver prices consolidate sideways long enough to obliterate remnants of greed left over from previous major tops.

Note above that silver's 50dma wasn't even close to its 200dma back at the June bounce, and its 50dma is still not close to its 200dma today. It would be extremely odd for silver to rally in a major new upleg without this universal pre-upleg condition being met first. Such a 50dma/200dma convergence happened before every major HUI upleg too. As such, realize that the technical odds are against today's popular thesis that silver's next upleg is already underway. It is more likely a consolidation bounce, nothing more.

Finally in this first chart, there is one more revealing technical phenomenon to consider, retracements. After a major silver upleg, the subsequent correction drives silver's price back down effectively retracing some percentage of the upleg. If silver rallied from $8 to $10, a $2 surge, and then fell back $1 in a correction, this would be a 50% retracement. Retracements are typically proportional to their preceding uplegs, bigger and faster uplegs often see larger retracements.

After silver's 84% massive upleg in 2004, its sharp correction retraced 72% of its previous upleg's gains. Even silver's modest 45% consolidation upleg in 2004 saw a rather large 64% retracement. But silver's latest sharp correction ending in June merely took silver down far enough to retrace 63% of massive upleg three's gains. Since this latest upleg was not only the largest but also a fast one, it is surprising that silver hasn't retraced farther.

Will it? I don't know. There are competing technical crosscurrents here. If silver escapes with a relatively modest 63% retracement, meaning the June lows hold, it will be lucky. This is certainly possible. Supporting this possibility is the behavior of all previous silver corrections in this bull. In every case, silver's initial low carved 23 to 24 days after its respective interim top was able to hold through the subsequent consolidation. By this standard June 14th's $9.69 ought to hold, even if it does only represent a 63% retracement.

But in other bull markets such as the HUI, initial correction lows have not held if retracements were too small. While I don't know how this one will play out in silver, I just wanted you to be aware that the latest correction in retracement terms was not big enough to be comfortable. Due to this ambiguity, I'd assign even odds that silver does or doesn't make a fresh interim low below $9.69 before the next major silver upleg begins.

This final chart zooms in on just the past year or so, the life and death of silver's latest and greatest upleg. Interestingly this upleg was two-pronged. For its first 129 trading days, it rose in a well-defined uptrend channel that was rational, its upslope was moderate and hence sustainable. Silver went up 53% in this initial ascent. But then in March, where silver just might have topped without euphoria, euphoria captured the silver market with a vengeance.

The second ascent of silver took it up another 52% in just 45 trading days in an unsustainable parabolic ascent. In the first few weeks of April, silver soared 27% higher! It was sheer craziness. Such vertical moves are absolutely mathematically guaranteed to soon fail, which is one reason that it amazes me how easily people let themselves get caught up in the euphoria of the moment. The math is just so absurd at these points in time.

This particular 27% move happened in only 12 trading days. A typical calendar year has 252 trading days, or 21 12-day periods. For silver to sustain such steep gains, it would have to continue gaining 27% over every subsequent 12-day period. If this happened, if 27% gains were compounded every 12 days for a year, silver would have been trading at $1739 per ounce in April 2007! Yeah right.

It just ain't gonna happen as I warned our subscribers back in April, silver's silly vertical parabola was destined for inevitable doom. Not even the most enthusiastic silver zealot at that time was projecting a one-year silver price so high. And believe me, I think I know them all since they were harassing me without mercy back in April and May due to my increasingly unpopular warnings that silver was due to correct hard and fast. It was not that I didn't like silver, it is just that parabolas are never sustainable. They all collapse.

This chart also shows our bull-to-date Relative Silver, silver divided by its 200dma, buy and neutral zones. We've been throwing long silver when it has traded at less than 0.99x its 200dma, under the green bar. Last August before our latest massive upleg began, silver was trading as low as 0.941x its 200dma. In its ever-so-fleeting June bounce, silver just touched 1.004x its 200dma for a single day. This is not the technical rSilver signature typical before a major upleg, but the technical signature typical of a minor consolidation bounce.

On the top side our old rSilver neutral band of 1.25x may still be reasonable despite silver surging much higher over 1.70x relative before it gave up its ghost. I am debating on raising it or not. On the pro side, silver's massive uplegs have now topped at 1.448x and 1.704x silver's 200dma, so perhaps our rSilver neutral zone should be higher. Since you want your neutral signal before tops, 1.40x is a potential new target.

But on the con side, at 1.25x rSilver went neutral just as the normal rational ascents of the two massive silver uplegs were ending and their final parabolic ascents were beginning. Since parabolas can fail at any time without warning, perhaps it is best to get neutral as a parabola begins rather than halfway up it. All neutral means is existing silver positions are held to ride the wave higher until they are stopped out. I'd much rather be adding silver positions when silver is near its 200dma than when it is 40% above it. Risks balloon tremendously at that stage.

So I haven't decided what to do with the rSilver trading band yet. I'll certainly let our subscribers know if and when we make the decision to raise it higher to better fit the two massive silver uplegs we have seen so far in this young bull market. Incidentally, our subscribers all have access to large web versions of a broad array of charts including Relative Silver. Our rSilver chart is updated twice a week so our subscribers can monitor silver's progress.

And we are certainly looking forward to an extensive redeployment into elite silver stocks again once silver technicals look highly bullish. We try to minimize our risks and maximize our potential gains by waiting until technicals overwhelmingly point to a new upleg being imminent, such as last summer. While today is not that day as this essay revealed, every day that silver consolidates brings the next great buy opportunity closer.

If you want to stay on top of silver and be ready to mirror our coming trades in elite highly-leveraged silver stocks, please subscribe to our acclaimed monthly newsletter today. While I don't know exactly when silver is going to look technically irresistible again, I know it will inevitably happen sooner or later. We will seize this crucial opportunity when it arrives and position our capital to multiply in silver's next major upleg.

The bottom line is silver, despite all the excitement remaining in it following its amazing upleg, still looks like it is merely consolidating. Technically the odds are sure in favor of silver being in one of the periodic ebbings within its bull, a consolidation that is absolutely necessary to make traders comfortable with its new higher prices.

Nevertheless, silver remains one of the highest-potential metals of this commodities bull and its ultimate bull-market gains should be staggering just as they were last time around in the 1970s. As such, it is important to keep an eye on silver even as popular interest fades in this young consolidation. Once its new base is established, silver should leap back into the limelight with a vengeance.

Adam Hamilton, CPA

August 18, 2006

Thoughts, comments, or flames? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I will read all messages though and really appreciate your feedback!

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