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January 14, 2005

Does Technical Analysis Work in the Silver Market?
by Yi-Chang Wang

Recently, there had been questions raised regarding the effectiveness of using technical analysis in the silver market. The central theme of such questioning resides on evidences that the silver market is under heavy manipulation. As a result, silver prices do not represent free market. Douglas Kanarowski had written an excellent article, "One Dozen Silver Investor Mistakes," succinctly stating that "both a sustained and large price distortion" renders technical analysis meaningless in the process of analyzing silver charts.

I also expressed doubts about technical analysis in silver market in a former article. However, upon closer examination of this issue, I had a revision of my earlier view. This article will focus on some evidences that support and refute the use of technical analysis. I hope that readers will have a balanced view on this controversial subject at the end of the article. (All charts in this article courtesy of BigCharts.com)

Silver to Zero

Long time readers of Ted Butler's column know that there are large amount of evidences of silver not in a free market. I, like many who had taken time to think through Mr. Butler's proposition, do find it hard to refute his claims. However, I do have a point to raise: "To what extent is silver free?" One can also phrase this question differently. To what extent is silver un-free? And to what extent does the COMEX silver dealers wolf pack have influence over the price of silver? Are their influences absolute? Or are their influences close to absolute and waning?

My contention is that the influence is decreased, perhaps significantly, if one focuses on the interplay between fundamental factors and price charts, especially long-term charts. Below is a monthly chart of silver showing the "flag" formation, with a clear upside break-out in July of 2003.

While you are gazing at the chart, I like you to ponder on these words:

"[S]ignificant price appreciation would not exhibit itself until the physical silver supply was clearly nearing zero inventory...I just do not see silver prices rising until the actual physical bullion supplies reach critically low levels. Because of my research I was able to predict that the critical time frame would be the summer of 2003. This time frame was first discovered by me over twelve years ago. Of course, each year the new data was studied I performed the calculations again. Year after year it appeared that the critical time frame was the middle of 2003.[emphasis added]"

These words were written by David Morgan in his October 23, 2003 article, "Silver to Zero Re-visited."

"Flag formation" is a technical pattern indicating decreasing volatility, which tends to precede periods of large market movements; though such formation does not indicate direction of the subsequent movements. On the above monthly chart, readers may have noticed a pull-back occurred in October, which is always healthy. And by the end of December, slightly more than one month after David Morgan published his fundamental research, the silver price had confirmed the upside break-out and on its way to make one new high after another.

Referring to the above chart again, astute readers may have observed that throughout 2004, silver prices held above the entire 12-month long flag formation. Even at the bottom of the two crashes (in April-May and currently in December), silver prices held above the flag!

Yes, I'm aware that silver is under price-suppression scheme perhaps for more than two decades. It's one thing to suppress the price. It's another thing to manipulate the price of a security or an asset to the point of path-dependent!

Capital markets are spectral, rather than binary. Let's use the concept of market efficiency to illustrate this point. The efficient market hypothesis is an analogy case to price manipulation. There are plenty of academic researches documenting the so-called semi-strong form of efficient market theory. That consistent excess returns relative to a benchmark are impossible in the long-term and often assigned to the status of statistical fluke. On the other hand, a significant number of "Money Masters" and "Market Wizards" (for example, as profiled in John Train and Jack Schwager's interview books) seem to support the contention that skills, knowledge, and experience can perhaps deliver consistently superior returns. There are also increasing number of researches that focus on so-called "market anomalies" and behavioral finance topics.

Similarly, while evidences of silver price manipulation are abundant, one must not overlook the fact that it takes an impossibly large amount of capital to have a path-dependent manipulation, on a long-term chart, and over a long period of time like more than two decades. Thus, it's reasonable to assume that important fundamental events, like "silver to zero," may very well be accompanied by a technical signal.

Weird Crash

On the other hand, I also like to point out graphical evidences supporting Mr. Kanarowski's claim that relying on technical analysis may lead to erroneous investment decision in silver.

The following two weekly silver charts indicated out of six technical indicators, only one and a half of them showed divergence from price preceding the last year's April-May crash.

The most powerful divergent indicator, the MACD complex, failed. In fact, all three lines (MACD, MACD EMA, and Divergence bars) climbed higher with silver prices from December 2003 to late April of 2004. Only the "Ultimate Oscillator" and the "slow %D" line (but not the "fast %K") of the "Slow Stochastic" shown divergence. This usually doesn't happen.

I need to point out that each technical indicator represents different way of crunching the numbers. Therefore, their behavior, in relation to each other, can range from slightly differently to very differently. It's quite rare to get a very lopsided conclusion for one direction (in this case, non-confirmation of a top should point to continuation of rising price action) with opposite (and extreme!) price movements immediately following the conclusion.

Although the indicators overwhelmingly point to the continuation of the rising price trends. And yet, we had the biggest crash over the past ten years!

As indicated by the above monthly chart, the 2004 April-May crash was even larger in magnitude than the post-Buffet acquisition price decline in May 1998.

Caveat Emptor

At this point, I must point out that although I believe technical analysis can continue to play a role in the silver market, I am skeptical that such form of analysis can replace a good understanding of the silver's fundamental dynamics. Rather, technical analysis can be a tool to assist the analytical process. In addition, other forms of analysis, such as the dynamics of COT reports, do play a very important role in understanding the silver market.

It's my position that both Mr. Butler and Mr. Morgan had spent a lengthy time, and possess great experiences, in the areas of understanding the COT reports and trading positions of the bullion bank dealers. Therefore, the best value-added types of analysis that others can provide the silver investors community may be in other areas (for example, technical observations, the impacts of macroeconomics on the silver markets, etc.). I must emphasize that such types of analysis are not meant to be replacements, but rather additions.

Furthermore, the sustained price distortion on silver and such distortions' impacts on technical analysis should not be underestimated. Markets maybe spectral. But price actions can polarize, sometimes rapidly.

Silver Market Update

My hypothesis: As the bullion banks' price suppression scheme battles against the upward-price pressure of continuing supply deficits, it may create a "saw-tooth" formation on the long-term price chart.

As silver's supply deficits continue unabated, the bullion bank dealers may grow more desperate in terms of suppression and may even desert the ranks. The AIG's May 2004 announcement of relinquishing the LBMA silver price fixing business is a case in point. Dual, contrary forces are at play here. Desperation can further lead to extreme form of price suppression tactics (downward price pressure) coupling with increasing desertion of the ranks (upward price pressure). This will intensify the "saw-tooth" formation of violent upward movement followed by almost equally violent crash.

I suspect that this interplay of dual, contrary forces are being registered on silver's price chart now:

Note that silver's monthly chart seems to be on it's way to form another flag that's almost equal in duration as the last one that signaled Mr. Morgan's Silver-to-Zero theory. For simplicity, let's assume the duration of this new flag is approximately the same as the last one, 12 month long, the break out this time around would be about March or April.

On the fundamental side, in his most recent article, "Same As It Ever Was," Ted Butler reported:

"...I had been expecting a further 10,000 contract reduction in this week's report, indicating a major low-risk buy point. Instead, the report indicated only a 2500 contract reduction in the net dealer short position and no decrease in the tech fund long position. This is obviously speculation on my part...I think that the tech funds were completely liquidated in silver, but the reason the latest COT report doesn't reflect that, is because some other large (non-technically oriented) traders took their place. I base my speculation on daily price, volume and open interest data for the time period covered in the report. If my speculation is correct, it could mean that some very strong hands have come into the silver market. This would be a sudden and very bullish development. Accordingly, I see very little reason not to embrace a full bullish tilt towards silver. This is another mother buy point, maybe The Buy Point."

And if my speculation of the contrary, dual forces is correct, we might see the aforementioned flag pattern forming before the huge price break-out.

As for the macroeconomic fundamental, "deflation scare" maybe coming as detailed by Steve Saville's recent article, "The Coming Deflation Scare". I have also speculated on the same concept by suggesting a possible silver play in my article, "Silver and the US Dollar." I stated:

"The housing bubble is becoming a popular topic again. My guess is that somewhere in the near future, there may be a "deflation scare." However, a monetary system central bank with paper fiat money, which is what we have now all over the world, deflation can never occur. Only more and more inflation."

Unfortunately, my call was too early. That article was posted on the Second of August last year. However, I want to re-emphasize that the symptoms of deflation, actual deflation, or signs of recession and actual recession will have a good probability to lead the global central bankers into another bout of reflation. This is especially the case if one consider the track-record of the central bankers' performance during the nineties, namely, print more money or create more credits to solve any problem. Probability favors, but not guarantees, re-emergence of inflationary bail-out actions.

Conclusion

I'll conclude with the following recommendations:

•  Avoid leveraged positions for silver.

•  If you haven' own any physical silver, use any decline now to accumulate a position you feel comfortable.

•  If you already own silver, hold through the current low price and do not pick the top.

The last advice maybe the most important since it's very difficult to estimate the highest price of a "saw-tooth" formation.

Yi-Chang Wang

DISCLAIMER: The author is not a registered stockbroker nor a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliability of his own credible sources. Of course, the author recommends that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.

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