Tuesday, March 26, 2013

Revisiting Silver and Macroeconomic Forecast

For a while there I wasn't posting very actively...on anything really but particularly on financial, economic,and trading matters. Mostly it was due to exhaustion - having our first child and working grueling jobs. I thought it would be fun to revisit the price of silver and gold.

Disclaimer: There are some specific strategies listed below which are not recommendations. I repeat there are no recommendations in this post. What is below is only a collection of my musings and is meant for your entertainment and for provoking thought. Money management decisions must be made on an individual level, and I bear no responsibility for your decisions. Particularly if you follow my strategies and I am wrong.

Precious Metal Strategy
Re-reading my last gold post in fall 2009, I said that 2 of the 3 conditions were met for a sustained gold breakout. The third condition didn't occur until well into 2010, when silver broke through $21.5 and gold stocks broke to new highs. For anyone who follows this market, you know that silver then advanced to $50 and gold to $1900. In retrospect I got a number of predictions wrong though...namely the timing of the breakout took longer than I expected, and I didn't foresee just how quickly and monotonically silver would rise from $20 to $50.

Now we have gold trading around $1600 and silver around $29, and they have been B-O-R-I-N-G. Laugh out loud. Super boring. In the immediate past, it appears that there is very heavy buying of silver between $28.5 and $29 and likewise quite a bit of interest in gold around $1600. I have been bearish on silver for quite a while now and remain fairly certain that we will revisit the $22 range again, although I don't know when.

The move away from the dollar is occurring glacially, and Europe is managing to cobble together a bit more extend and pretend, although I think the writing continues to be on the wall for the Euro-zone. This is, however, a sort of optimal time for weakness in precious metals as the immediate term appears to feature slow growth (meaning, commodity prices will remain subdued) and no crisis (as long as there is slow growth, we can extend and pretend). Thus, I remain bearish in the medium term.

That being said I think you have maybe $7 of downside on the price of silver and unlimited upside so any strategy you might have needs to keep that in mind.

For specific trading strategies I would say:

Low risk, easy: Just stay on the sidelines beyond a core holding of precious metals. Actively buy a comfortable amount at $22 if we get there.

High risk, easy: Short silver from current levels. Cover and reverse long at $22 if we get there. Stop out and reverse $35 if you can - the risk of discontinuities means you have essentially unlimited risk with this strategy.

Medium Risk, more complicated:
Short silver and look to reverse in the low $20 range. Buy some protection with OTM calls since implied volatility on silver options are near decade lows. Be net delta short, but construct your deltas so that you would be net long at levels above $35. You are most likely just going to spend money on theta (time decay) with silver calls, but it is worth having the protection IMO and like I said IV is super cheap right now. I'd be thinking 12 month options rolling every 6 months to minimize theta losses. I'd be net short silver until we reach the low $20s at which point I would become aggressively long, perhaps including calls depending on implied volatility at that time.

Macroeconomic Comments - with Precious Metal focus

I believe both fast growth and recession would lead to a leap in gold and silver and my reasoning is thus:

Case 1: Fast growth would create two conditions: first, it would increase inflation and inflation expectations which is supportive of gold; second it would create more industrial demand for silver (which is obviously supportive of silver); third, it would increase interest rates which would be destabilizing; fourth, it would spike the price of oil which would create a snap-back recession or depression.

Case 2: A recession would increase instability in debt payments and make an already impossible debt repayment situation in Europe look all the more hilariously untenable. The true test of the Euro experiment would be if Germans became convinced that they are not only paying for PIIGS in the past 5 years, and paying for them now, but also will be paying for them indefinitely into the future. They will refuse - the only reason they continue to agree for now is that they are under the delusion that the situation will improve. The fact that the PIIGS continue to run deficits ex interest payments is all the evidence one needs that true change hasn't been dialed in. Another global recession for whatever reason would almost certainly require large write downs in debt and very likely a break up of the Euro zone. The former (large write down in debt) would then create a domino effect to other sovereigns including Japan, the UK, and the US. The US is in the best position to avoid this given our economic tailwinds (shale gas and a healthier bank sector) but the problem is an order of magnitude too large. Although debt write-downs are in theory deflationary, in this case they would be catastrophic enough that their main effect would just be chaos which is an environment in which gold and silver thrive. Further, countries who control their money supplies (perhaps ex Germany) would just print to cover nominal debt and force the loss in real terms.

I think these cases are probably pretty well thought through at the Federal Bank lever which makes them less likely, all else equal. But it is a bit unreasonable to expect that central banks have within their control the ability to deliver moderate growth indefinitely...history shows otherwise. What are some scenarios that are beyond CB control?

Japanese interest rates are the most obvious ones: nobody really knows what happens when we have an aging demographic paired with an immense internal debt, and a monetary authority bent on creating inflation. To say this is a powder keg is an understatement since it might take Japanese elderly a while to realize that the value of their savings ultimately rely on the output of their youth. While this problem has been predicted to occur for literally decades, this is a problem that would be new, large, and outside the realm of previous CB experience. Google Kyle Bass for numerous eloquent interviews explaining this issue.

Oil price spike. Believe it or not we remain extremely tight in oil supply, despite the booming production in North Dakota and Alberta. And while natgas production increases total available energy, the world remains reliant on the price of oil in a crucial way for at least another few years/decades. The obvious choke-points and dangers remain the same as they have been for the past 7 years - mainly the uninterrupted flow of oil from geo-politically unstable countries or potentially unstable countries. To the obvious list of Iraq, Iran, Nigeria, Libya, Algeria, and Angola, I would add Saudi Arabia, UAE, Kuwait, and Venezuela to potentially unstable countries. The Arab spring should have provided ample evidence that unrest in these countries is possible, and while individual countries have a low probability of occurrence (I'd put probability of serious disruption in SA on the order of 5% in any given year) there is a huge supply that is susceptible to potential problems. Essentially 30 million barrels a day are susceptible to interruption with an average of 5-10% likelihood in each case. Over the next 5 years, I would predict therefore an average of 1.5-3 million barrels of oil are offline due to geopolitical issues. Currently, we're losing "only" about a million barrels due to Iran sanctions...but the point is that these outages will come in highly irregular chunks while demand is generally a very smooth line up. It is only a matter of time until we have a significant outage (> 3million barrels) and we simply don't have spare capacity to offset this.

Thus, I would be 75% confident that at some time in the next 5 years, oil prices will go up at least 50% from current levels to roughly $200. While this is a pretty wimpy prediction, the effects of such an occurrence would be anything but wimpy, and is another example of something beyond CB control.

Cheers, cheers, cheers. LoveIsAllYouNeed and there is a silver lining to all of this. May you find it in your life.

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