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April 30, 2004

Silver Corrects or Crashes?
by Adam Hamilton

Almost 25 years ago Professor Roy Jastram wrote an outstanding book on silver, which he called "Silver: The Restless Metal". It is hard to imagine a more appropriate title for a classic study on the famous white metal, as its extreme volatility profile usually dwarfs that of every other major commodity.

In the last few months, silver has certainly lived up to Dr. Jastram's prescient moniker. Since the beginning of February, silver has exploded from near $6 to over $8 only to plummet back down under $6 again. To put this into perspective, a similar percentage swing in gold would have yielded a jaw-dropping spike from $400 to $545 to a subsequent swift collapse back down under $400, all since early February! Wow.

In light of such extraordinary volatility, it is no wonder that silver investors and speculators are feeling dazed and tired these days. To be wrenched from the greatest psychological high in many years to the depths of despair after silver collapsed in only a matter of weeks in April is enough to leave one reeling. Silver never was for the faint of heart.

Now that the recent sharp silver spike and its subsequent sudden collapse are indelibly carved in the charts, a post-mortem analysis is in order. There is a growing debate among speculators whether the events of April were a silver correction or a silver crash. This is an important distinction to make, as it greatly affects the outlook on silver's fortunes going forward.

If April's carnage proves to be merely a particularly vicious silver correction, it is great news for the silver bulls going forward. All bull markets advance and retreat, carving awesome new highs before temporarily reversing away from their primary trends and consolidating. These periodic corrections are very important to help bleed off temporarily overbought conditions and they grant perfect opportunities for investors and speculators to add new long positions.

A crash, on the other hand, is an entirely different ballgame with heavily bearish implications. Crashes usually happen from long-term secular market tops, peculiar moments in time when the public begins chasing a particular investment class and foments an unsustainable speculative mania. Think NASDAQ 2000. Since crashes utterly destroy the thundering herds of new speculators buying in right near the top, they usually herald long, ugly bear markets.

Interestingly, at the time they happen sharp corrections and full-on crashes can be indistinguishable. If the markets head higher in the years following a price collapse, soon it fades into technical triviality due to rising prices. A $2+ drop in silver feels big now, for example, but how will April's events look on a chart if silver breaks above $50 in the years ahead? If the silver charts scale up to challenge multi-decade highs, April's $2 slide won't even be noticeable anymore and will be forgotten.

On the other hand, if silver was to grind down under $4 from here in a renewed bear market in the years ahead, April's $2 collapse would stick out like a sore thumb on the charts for years to come. Technical analysts would look back to this month and remember it as the month silver crashed. When the NASDAQ crashed a few years ago few were willing to consider it in crash terms at the time, but in hindsight the spring 2000 collapse was indeed a crystal-clear classical index crash.

So, the proper interpretation for April's events really depends on what happens to the silver price in the years ahead. If silver marches higher the recent unpleasantness will be all but forgotten as just another sharp correction within a powerful bull market. But if silver flounders lower from here April 2004 will be remembered as a silver crash that ushered in a newly energized bear.

As investors and speculators today, however, we do not have the luxury of waiting until 2005 or 2006 to decide on the correct interpretation of this silver price collapse. While we cannot know for sure yet what will unfold in the months ahead, we can analyze the clues and make a good guess on which thesis the probabilities currently favor, the bullish silver correction or the bearish silver crash. We'll begin with a simple price chart.

The hefty magnitude of the awesome silver upleg since October is readily apparent in this year-long price chart. While last summer's silver upleg only managed a modest 18.8% gain, the magnificent specimen that topped in April roared up a breathtaking 71.5%, almost four times as large. It was not only the scale that was different this time, but the actual technical fingerprint of these two uplegs differed dramatically.

Last summer, the bottom support zone of silver's upleg was a single line, drawn in black above. This classical linear support zone is exactly what market technicians expect to see in a typical upleg. A price rises gradually over time, but the slope of its ascent does not continuously accelerate. There may be one slope change within the upleg, but usually not multiple slope changes.

Contrast this conservative typical upleg with the dazzling silver action since October. As silver powered higher from its early October lows, the slope of its short-term support line shifted no less than four times. These four different support zones are also rendered above with black arrows. While prices climbing in a constantly accelerating upslope are great fun for speculators at the time, they are also unfortunately unsustainable.

As the slope of an uptrend gets steeper and steeper, eventually a price is traveling almost vertically. Just like the physical world, however, the steeper a hill gets the more difficult the fight against technical gravity grows. While it doesn't take a lot of buying power to start a new upleg, the amount of silver buying necessary to sustain an ascent as it approaches a vertical slope balloons tremendously.

It is kind of like those four-wheel-drive hill-climbing contests. A driver starts on a modest upslope and has no problem accelerating up a hill. But once the driver nears the crown of the hill, his machine is pointing nearly straight up and the horsepower required to continue clawing ahead grows exponentially. All the drama unfolds near the driver's goal when he either flips over backwards and careens down the hill or ramps into the air off the crown before landing safely on the top of the hill.

In technical analysis these continuously accelerating upslopes are known as parabolic ascents. When a price carves a pattern on a long-term chart that looks like a parabola on the verge of shooting vertical, it is often a classical indicator of a mature bubble. The most infamous example of a major parabolic ascent in modern times is certainly the NASDAQ bubble of 2000. Once its parabola reached its vertical phase no amount of buying could push it higher and it soon collapsed under its own weight.

Now the silver pattern above is nowhere near as extreme as the NASDAQ bubble. Great bubbles in history only happen at the climax stage of great bull markets running a decade or more. Silver's bull market is very young and the public is certainly not involved yet, so there is no way we have just witnessed a classic silver bubble. Yet, silver's recent upleg did exhibit telltale signs of a short-term miniature parabolic ascent.

Silver's four successively steeper support zones were starting to form what I call a linear parabola. This shape, which is shown above in the graph inset, has fascinated me since I was a child doodling with a pencil and paper. If you draw a series of evenly spaced straight lines with constantly increasing slopes, these straight lines quickly form the curved surface of a parabola. The small example above consists of only eight straight lines, yet its curved parabolic ascent looks just like silver's four-support-zone linear parabola.

Parabolic ascents in prices are always unsustainable, whether they happen over many years as in the NASDAQ or in only a relatively few months as in this silver example. The only way for the vast majority of these parabolic ascents to be resolved is by a sharp drop in prices. In silver's case, this was a brutal 28.4% correction in only a matter of weeks. Sharp plunges following a parabolic ascent are all but inevitable.

This resulting collapse in prices is very important as it bleeds off speculative excesses. As you recall in early April, the excitement in silver was reaching a fever pitch over the short-term. Calls for $10 silver by the end of April were everywhere and the precious-metals community was falling all over itself to praise silver. Greed was multiplying tremendously and fear was elusive. A drop in prices was necessary to temper these growing speculative imbalances.

Thus, in light of the vertically accelerating parabolic pattern that silver had carved on its charts, it should not have surprised anyone that the silver price needed to retreat and regroup. In the April issue of our Zeal Intelligence newsletter for our subscribers, on April 1st before silver collapsed I wrote, "From a short-term speculation standpoint, silver's chart does look rather toppy at the moment. The metal is accelerating to the upside and is on the verge of going parabolic, a telltale sign of being short-term overbought."

It wasn't only price patterns that were flashing warning signals to speculators to be cautious on silver over the short-term. While silver soared from early February to early April, the major silver stocks refused to confirm its new highs. Some silver miners just consolidated sideways, while others ground modestly lower in the very same recent months when silver was soaring. When metals stocks don't confirm metals moves, it is a sign that speculators are cautious and skeptical and are not yet convinced that a particular metals move is real and sustainable.

While silver's parabolic price pattern and non-confirming silver stocks did provide plenty of warning to prudent speculators that a silver correction was due, these factors alone are not sufficient enough to weigh the probabilities that silver just witnessed a bullish correction or a bearish crash. To make this determination, we really need to consider long-term fundamentals and psychology.

April's price collapse notwithstanding, in fundamental terms is the current case for silver bullish or bearish? If it is bullish the healthy correction interpretation has more weight, but if it is bearish the crash interpretation will take the lead. Fundamentals are everything when trying to determine whether an existing bull or bear market will continue to travel along its primary trend for some time to come.

Price is ultimately determined by supply and demand, the most foundational of all fundamental drivers. In silver's case, the supply and demand imbalance continues to be very favorable for this restless metal. Global industrial and investment demand for silver is soaring year after year, yet mined supply just cannot keep up. The majority of silver mined is merely a byproduct of mining for other metals including lead, copper, and gold, so most mines cannot significantly increase their silver production in response to rising prices. Growing demand and flat supply is a very bullish omen.

In addition, the global above-ground stocks of silver have been tremendously depleted in the past decades of low silver prices. Unlike gold, there is no giant central-bank hoard of silver hanging over the markets. If mined silver cannot meet global silver demand each year, then the silver price will have to head higher. For a far deeper discussion of silver's bullish supply and demand fundamentals, you may wish to skim a silver essay I wrote a few years ago called "Lagrimas de la Luna".

Fundamentally, since silver demand greatly exceeds its mined supply each year and there is no other place to get more silver in quantity besides mining, its bullish case remains rock-solid. There is no other market response possible other than rising prices in this situation, where demand growth far outstrips supply growth and there is no relief in sight for years to come.

While nowhere near as important as supply and demand, long-term psychology is another fundamental driver of silver prices. While the dedicated precious-metals community was getting excited about silver in early April, the general public certainly was not. Silver prices didn't make the evening news, CNBC wasn't talking about silver every 10 minutes, and odds are your neighbor wasn't putting a third mortgage on his house to buy silver bullion. A popular mania it was not!

If the silver collapse in April represented a transition from bull to bear, we would expect to see some level of public involvement and excitement leading up to the silver top. As far as I can tell, outside of the commodities world silver's spectacular upleg remained largely unknown. Without abundant popular euphoria for silver even among mainstream investors, there is no psychological evidence that this silver bull should be ending.

Thus, in light of continuing very bullish supply and demand fundamentals and a lack of mania psychology outside of the usual precious-metals crowd, silver's price collapse looks infinitely more like a healthy bull-market correction than a devastating crash leading into a bear market. In fact, I continue to believe that the awesome silver rally we just witnessed is the first major upleg of a glorious new bull market in silver.

Indeed, when silver is compared with its important 200-day-moving-average major bull-market support, its overall behavior does continue to look very bullish. This next graph adds a Relative Silver (rSilver) line, which divides silver by its 200dma. Relative Silver normalizes the distance between silver and its crucial 200dma and renders it in perfectly comparable constant-percentage terms over time.

No bull market, including this young one in silver, advances in a straight line forever. Bull markets flow and ebb, advancing and retreating. Over time the bull market carves a classic series of higher highs and higher lows, but these gains are gradual. As I have discussed in gold recently, the 200dma is the key technical anchor from which these bull market advances generally launch and to which these periodic corrections generally retreat back.

The 200dma is rendered as the heavy black line in these graphs. It is not at all surprising that silver's awesome upleg launched in early October from its 200dma as this is textbook bull-market behavior. As the red Relative Silver line above shows, rSilver actually traded down to 1.007 before silver's rally launched. From these low levels only 1% above its 200dma, silver powered higher into early January. It reached levels 31.4% above its 200dma before it began retreating for a few weeks.

As rSilver reached this initial interim top in January, I was closely watching silver to see how far above its 200dma it would stretch. As discussed in "Trading the Silver Bull", it would be valuable to gain an understanding of the general rSilver trading range in a typical major silver upleg. If we can figure out about how far silver tends to run above its 200dma in an upleg before it retreats back down to its 200dma, it will help us better time silver trading entries and exits.

While we have been blessed with excellent success using this same Relativity technique in trading gold and gold stocks, at this stage in the silver bull it is still just too early to get a good sense of the rSilver trading ranges. Since silver has had only one major upleg in its bull to date, the graph above is really all we have to work with.

Prior to this first major upleg maturing and ending, we had been running a tentative rSilver range of interest of 1.03 to 1.20. This means that whenever rSilver trades under 1.03, or silver within 3% of its major 200dma bull-market support, a buy signal will flash indicating it is time to throw long. Whenever a bull market retreats back down near its 200dma, it is generally oversold and often bounces near there before heading higher in a new upleg. With rSilver back down near 1.007 again today, we are now looking at the most favorable silver buying opportunity since last autumn!

The old top end of our rSilver range, 1.20, was obviously far too conservative in light of this first major upleg. I am going to raise our level of interest for future major silver rallies to 1.30 for now. This means that when silver advances more than 30% above its major 200dma bull-market support, we will consider it short-term overbought and go neutral.

In the graph above rSilver reached 1.314 in January, retreated for a few weeks, and then blasted higher to phenomenal 1.448 rSilver heights. It is hard to believe that silver was able to climb almost 45% above its 200dma before it entered this healthy bull-market correction! To put this into perspective, in gold's own bull market that has already witnessed several major uplegs, the highest that gold has traded above its 200dma has only been 18% or so. Silver's parabolic ascent really was amazing!

So if silver can stretch so incredibly far beyond its 200dma, why only use an rSilver 1.30 level to define the top of a trading range? And why call this neutral rather than an outright sell?

The goal of trading signals is to help us recognize major turning points in advance. It is better to be conservative and start paying attention early at a lower level than holding out for a very short-term overbought extreme that may not be achieved in silver's next major upleg. As this chart shows, it is best to get prepared for the end of an upleg in advance since silver can collapse so rapidly.

Calling an rSilver 1.30+ level a neutral zone rather than an outright sell signal helps protect us from selling out too soon before a future silver upleg ends. Once we enter into neutral territory in rSilver terms, all we have to do is ratchet up our trailing stop losses on silver stocks and stop adding new positions. Since bull markets have the highest probability of surprising to the upside, going neutral and tightening stops keeps us exposed to the primary bull trend for as long as possible in each upleg while still providing some protection for our capital.

If you are interested in using rSilver and other indicators to trade silver and silver stocks, trying to buy near the periodic bottoms of silver corrections and go neutral and get stopped out near the interim tops of silver uplegs, you may wish to consider subscribing to our acclaimed monthly Zeal Intelligence newsletter.

In the upcoming May issue to be published in early May for our subscribers, I am going to discuss the current silver scene as well as specific silver stocks I am recommending on this silver 200dma convergence. With silver getting hammered so mercilessly in recent weeks, it sure feels like we are near an ideal moment to go long silver and silver stocks again for its next major upleg.

It is important to realize that the silver price collapse we witnessed this month was probably not a bearish crash, but just a healthy bull-market correction from short-term overbought conditions. Even though silver was entering the early phases of a parabolic ascent, this particular example differed greatly from historical bubbles leading into major bear markets.

Silver's foundational supply and demand fundamentals remain extremely bullish worldwide, there was no popular mania surrounding silver and silver stocks leading up to the April interim top, and its bull market is still far too young to be entering a mature climax stage. With the absence of these key elements to bubbles and crashes that mark the end of a bull and birth of a bear, silver's behavior in April, while unpleasant, was not a crash.

As Dr. Jastram wisely pointed out decades ago, silver always has been a volatile fast-moving metal by its very nature. Silver investors and speculators ought to expect and psychologically prepare for sharp moves in both directions.

With extreme volatility just par for this course, odds are that April's price collapse was just a bull-market correction leading to a fantastic buying opportunity to add new long positions in silver. Get deployed!

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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