Bulls, Do Not Lower Your Guard

Thu, Apr 21, 2011 - 3:00pm

One of the ways I like to disengage my fellow managing staff at PFS Group from their emotional connection to an investment is to run multiple unmarked charts in a meeting to determine whether they’d buy or sell a stock based on the chart of the investment. I remove stock name, price, and dates. There’s no emotional connection. It really isn’t surprising some of the responses I get. If something has run up a lot, I typically get comments they’d sell it or hold – certainly not buy. If it looks like an investment is breaking out of a basing pattern and launching a new bullish trend I get comments they’d buy. Sounds intuitive right? Well, it’s time to look at a few charts to see how you would respond.

Door #1: Buy or sell?

I’ll give you a few moments to think it through. Queue Jeopardy tune. Price was rising in parabolic fashion through the period. The bands around the price are Bollinger Bands, which place a price point 2 standard deviations higher and lower than the moving average (50-day smoothed average in this case) creating a line above and below. There are some warning signs on this chart that are flagging a possible top the trained eye can see. 1) The security is following the upper channel in parabolic fashion. 2) The RSI (top indicator) created a lower high despite a new price high in the security, called bearish divergence. 3) The same kind of divergence also is showing up in the MACD (below indicator). If you didn’t guess what it is, the next chart should spell it out for you.

Now oil in 2008 is an extreme example, with a lot of extenuating circumstances that surrounded such a dramatic reversal in price; however, I think you get the idea that buying the first chart was a high risk undertaking. I’m sure there were a lot of people still buying oil stocks between May and July of 2008 because that’s what was doing well when the S&P 500 was down 15% from the October 2007 high.

Here’s Door #2: Buy or Sell?

This security is having a parabolic move on the chart. I don’t show the date and price because this could be anything at any time. The point is would you buy it? And if not, would you sell it? The RSI is telling us it is overbought. There’s no divergence so there’s no hint of weakness. Volume is rising with price as it should. The question, however, is whether volume is peaking, which it tends to do near tops and bottoms. The Bollinger bands tell us that the security is trading more than 2 standard deviations away from the 50-day moving average. In a normal distribution (bell-shaped curve) of a sample of data, about 95% of observations fall within 2 standard deviations. It’s rare when a stock price moves beyond two standard deviations from its mean, which is the 50-day moving average in this case.

The stock above is the chart on SLV, the iShares Silver Trust ETF.

Silver has far outperformed its peer commodities. It’s trading up 73% from the January low. Silver mining stocks are underperforming, probably as retail investors and fund managers sell their miners and pile everything into silver bullion. The chart below shows SLV outperforming versus five well-known silver mining companies. There are some extenuating circumstances, such as the property possession scare last week for Pan American Silver and Coeur D`Alene in Bolivia as well as Silver Wheaton’s CEO departure. Don’t forget that oil is now above 0 and the higher it goes, the more costly to transport and dig for silver and gold, squeezing margins. Why own a miner with all the issues I stated above when we can just own the metal itself? How many fund managers and retail investors do you think have come to that conclusion already, looking at the relationships below?

I took a look at the Commitments of Traders report that comes out once a week from the Commodity Futures Trading Commission (CFTC) to see what the futures and options activity looks like across the different types of investors: commercials (producers), hedge funds and profession managers, and retail small traders. Typically, you see hedge funds and professional managers leave a long investment just as the small retailer is piling on more longs. Such is the case in silver last week.

Net Change in Long Exposure (1 contract = 5,000 troy ounces) – April 12th

  • Commercials: +653 contracts (4.9%)
  • Swap Dealers: +96 contracts (0.5%)
  • Managed Professionals: -2,772 contracts (-7.3%)
  • Small Traders: +1,125 contracts (+9.6%)

Here’s a chart showing the historical net exposure between the three main categories I listed above:

The Commitment of Traders Report will be released tomorrow for this week. You can go to their website here tomorrow evening to check out this week’s results; however, it seems pretty clear that hedge fund managers and professional money managers have been selling into strength thereby decreasing their long exposure since February 15th.

What’s the catalyst for a top in silver? Well, the parabolic move in silver is the first catalyst. Mean revision, hysteria, too many bulls, and eventually nobody left to support lofty price levels is what typically reverses securities that get ahead of themselves. The second possible catalyst is a rise in the dollar. We saw that happen on Monday when market concerns shifted back to Europe for the first time since May 2010. Comments from little ol’ Werner Hoyer, Germany’s Minister for European Affairs rocked the credit markets when he suggested that a restructuring of Greek debt would not be a disaster. Interestingly enough, those concerns wiped away losses in U.S. Treasuries and caused the U.S. dollar to rise amidst the Standard & Poor’s stern warning regarding U.S. debt! Credit default swaps have been on an uptrend for some time now (see below). The ECB just raised rates. Doubts have been cast on the move due to the two-tiered economy in which peripheral nations are still struggling to turn their economies around while the developed countries fear inflation.

Source: Bloomberg

As a big chunk of the U.S. dollar index, if the Euro falls, the U.S. dollar should rise, even if it’s falling versus a bajillion other currencies solely due to the large weighting (56.6%). Many currency traders are looking at a .50 top in the Euro and so it should likely see some significant resistance there.

I bought four silver mining companies in August of 2010 because they were under-owned and unloved. During the fears of a double-dip recession, industrial metals were slammed more so than gold during that time. When Bernanke made his famous Jackson Hole speech late August, it was game on for silver and other inflation-themed investments. What happened? Leading economic indicators started to rise again and people stopped talking about the Hindenburg Omen and double-dip recessions. A silver bull trend was born.

In February of this year, I told clients that I intend to sell silver completely the next time it rises in parabolic fashion, which I estimated would occur towards the seasonal peak in precious metals – typically April or May. That period would also line up with the end of QE 2.0 if the program was seen through to its end. Seems rather simple when you line it up like that doesn’t it? However, when an investment is seeing new highs every day, it’s hard to disassociate from the emotional attachment one gets from something I call uptickitis - a hypnotic trance caused by new highs.

“Investors who have had a run of success, whether from short-term trading or long-term investment, have a tendency to relax and lower their guard, because they have not recently been tested by the market. When profits have been earned with very little effort, they are not appreciated as much as when you have to sweat out painful corrections and similar market contortions. Part of this phenomenon arises because a successful campaign reinforces our convictions that we are on the right path. Consequently we are less likely to question our investment or trading position even when new evidence to the contrary comes to the fore. We need to recognize that confidence moves proportionately with prices.” Pring, Martin, Investment Psychology Explained, p.35

Pride of opinion paired with overconfidence can be deadly for a portfolio. I’m not saying silver is the top and you should sell. I’m not saying that at all. Timing the absolute top is for the greedy. I’m saying, be on your guard. Ever hear the concept you sell into strength? This is what strength looks like. Our proprietary intermediate term indicator is telling us we’re near a significant top (see below) as the indicator pointed out in 2004, 2006, and 2008. Hedge funds and money managers are trimming their positions and hedging (shown in the COT’s spread data). Credit default swaps are spiking on Greece and the PIIGS again. The U.S. dollar has broken key support recently; however, an intermediate top in the Euro would likely spell an intermediate bottom in the U.S. dollar. Thing is, merely a consolidation in the euro and small consolidation in the dollar could really wreck silver due to the highly bullish sentiment and parabolic nature of its price performance over the past few months.

Reversion to the mean is a strong force in the market, don’t ever ignore it. The title of this market observation should have been Silver Bulls, Do Not Lower Your Guard, but I didn’t want to spoil our little game at the beginning. My main warning goes out to small retail traders placing initial trades into silver now. I’m deeply concerned over the timing of new long positions at this point in time; however, it is no surprise to me when I see and talk to new investors piling into silver now. It’s human nature.

About the Author

Chief Executive Officer
ryan [dot] puplava [at] financialsense [dot] com ()