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Silver’s Destiny with 200

Fri, May 6, 2011 - 4:01pm

It’s not every day that you get to witness a four standard deviation event. Last week was one of them. If a stock moves 4 standard deviations above or below its mean you know that there is a 99.994% chance that it should reverse. Last Thursday our silver technical indicator flashed a warning that we were 3.97 standard deviations (just a hair shy of four) from historical averages, slightly higher than the last peak 5 years ago. Now, looking at prior parabolic moves in silver, what most likely lies ahead is silver’s destiny with its 200 day moving average (200d MA) which currently rests at $28.79 an ounce.

Bob Farrell’s Rule # 4

Bob Farrell was a Wall Street legend who began his career in the late 1950s and sat through the last secular bear market of the 1970s and the secular bull market that began in 1982. Out of his experiences came Farrell’s 10 “Market Rules to Remember,” and his fourth rule is quite pertinent to silver’s meteoric rise this year.

Rule # 4 - Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.

Silver’s run this year has caught many by surprise and even when you thought it would peak it just kept going higher and looked like nothing could stop it. It’s at this time that a move usually exhausts itself and corrects sharply in the opposite direction. By now its obvious silver is doing just that and looking at prior corrections may prove useful.

The 2004, 2006, 2008 and 2011 advances in silver took our silver risk indicator more than two standard deviations above its mean, with the 2006 and 2011 cases showing the most overbought conditions (see below). Looking at those corrections we saw our indicator fall at a minimum to one standard deviation below the mean, which may also be expected in the present case, possibly leading silver into a corrective/consolidative mode well into summer.

pfs group silver indicator 

To filter out the noise seen above I smoothed the data out to form the chart presented below and while the non-smoothed indicator above shows silver’s correction has gone a long way in relieving its overbought condition, the smoothed data indicates that silver is still 2.5 standard deviations above the mean, which is again why I expect silver to trend southwards into summer.

 silver indicator smoothed

What is important to note is that in looking at prior corrections in silver we see that each had a destiny with its 200-day moving average (dotted lines below). Currently, this rests at $28.79 an ounce.

 silver corrections

Taking the 2004, 2006, and 2008 corrections to come up with a composite shows silver may put in a bottom later in the month just north of $30 and then retrace a majority of its decline before heading back down and consolidating for a few more months and finally bottoming in August, right on par with its normal seasonal pattern.

silver composite 

One of the catalysts that I think may weigh on silver and commodities in particular is an oversold bounce in the USD. It appears a short term low is in for the greenback as it has been rallying relative to more than 50% of world currencies, and over the last five days only 12% of world currencies and precious metals are up relative to the USD given its strong rally of late. Its recent strength can be seen when looking at the table below which shows the returns relative to the USD for 30 world currencies and four precious metals. Of note is the red on the far left columns that shows considerable weakness in world currencies relative to the USD, though the far right columns shows how weak the USD has been on a longer time frame.

world currencies

I think we may be witnessing a repeat of history here where in the 1970s the USD broke a key support line that connected the 1973 and 1975 lows (upper panel below). When the USD Index broke below this support line it fell sharply and then retested the underside before heading lower, ultimately falling more than 15% after its brief bounce (see below).

 usd bounce

In the lower panel above we see a similar pattern developing in the dollar presently and I expect a small relief rally to test the underside of the trend line connecting the 2008, 2009 and 2010 lows. If past is prologue, the 15% correction seen in 1978 after the dollar's countertrend rally ended would put the USD Index at roughly 65. This current relief rally will likely keep a lid on precious metals which normally peak around this time and are weak well into the summer. If the dollar does repeat history by following a similar pattern to what occurred in the 1970s, then this summer might present a major buying opportunity in precious metals which could be fueled by a sizable decline in the USD similar to the 1978 decline.

While silver has already corrected a great deal, past corrections suggest waiting before bottom fishing as catching a falling knife is rarely a wise strategy. A likely bounce in the dollar would only weigh on silver and precious metals and a better buying opportunity may come in the months ahead. Looking at the 2004, 2006, and 2008 corrections strongly suggest silver may have a destiny with its 200-day moving average, and with it rising I would expect silver to put a bottom in roughly near $30 an ounce. If the USD does end up peaking during the summer and traces out a similar pattern to the 1970s it would hit record lows and it’s quite likely with such a move that both silver and gold will make new all-time highs. As always, time will tell.

About the Author

Chief Investment Officer
chris [dot] puplava [at] financialsense [dot] com ()
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