Should the white metal be afraid of its fundamental shadow?
While the S&P 500’s downtrend has intensified, the index’s weakness contrasts investor sentiment. For example, the Cboe Volatility Index (VIX) – which measures the S&P 500’s expected volatility over the next 30 days – declined on Dec. 16, even as a sea of red flooded risk assets.
Likewise, while the S&P 500 declined by another 0.90% on Dec. 19, the VIX retreated by 0.88%, as fear has largely gone extinct across the financial markets. For context, we wrote on Dec. 19:
The green line above tracks the S&P 500, while the red line above tracks the inverted (down means up) VIX. If you analyze the relationship, you can see that spikes in volatility often occur when the S&P 500 falls.
When the S&P 500 was near 3,850 in June and September/October, the VIX was north of 30. In contrast, the metric declined on Dec. 16, and stands near 23. As a result, investors don’t fear a higher FFR, an earnings malaise or a potential recession, and the complacency highlights their misguided faith in the Fed.
But, while the crowd takes the index’s slide in stride, the damage beneath the surface is highly ominous. For example, the ARK Innovation ETF (ARKK) sunk to a new 52-week low on Dec. 19; and with liquidity-fueled assets suffering mightily since the FOMC released its economic projections, silver’s relative strength looks a lot like February/March 2022.
Please see below:
To explain, the gray line above tracks the silver futures price, while the red line above tracks the ARKK ETF. If you analyze the relationship, you can see that the pair have followed a similar long-term path.
Moreover, both benefit from a similar fundamental environment. With silver, lower interest rates reduce the appeal of bonds and increase the appeal of non-yielding assets that benefit from higher inflation. With the ARKK ETF, profitless companies benefit from lower interest rates because it’s cheaper to finance their operations. Essentially, they can plug their negative free cash flow holes by issuing new debt and/or equity.
Conversely, when interest rates rise and liquidity evaporates, profitless companies lose even more money as their interest costs rise. As such, the ARKK ETF is a QE beneficiary, and silver has similar characteristics.
Now, if you focus your attention on the right side of the chart, you can see that the silver price has risen dramatically even as the ARKK ETF hits new lows. Yet, a similar development occurred in February/March 2022 when the Russia-Ukraine war uplifted the silver price and sunk the ARKK ETF. Although, it wasn’t long before the white metal plunged to new lows.
So, while silver may seem invincible, the plight of other liquidity beneficiaries should result in a profound drawdown over the medium term.
To that point, while the crowd has been programmed to await dovish pivots, their faith in the Fed should come under immense pressure in 2023. For context, we added on Dec. 19:
Not only are U.S. households holding their positions with little anxiety, but the imbalances built up before this recessionary bear market were at an all-time high. Yet, since the crowd assumes another post-GFC pivot will send stocks soaring, they’ve been trained to wait for the Fed to save the day. However, unanchored inflation is a different animal, and the Fed can’t solve this problem by printing money.
As a result, with the Fed stuck between a rock (inflation) and a hard place (potential recession), the fundamental backdrop makes the central bank's challenge extremely troublesome.
Please see below:
To explain, the blue line above tracks U.S. private sector financial assets as a percentage of U.S. GDP. During the peak of the pandemic-induced bubble, the metric hit an all-time high of 6.2x before declining to 5.4x as the 2022 bear market unfolded.
Yet, if you analyze the vertical gray lines on the right side of the chart, you can see that the Fed and the ECB always stepped in post-GFC to provide a liquidity buffer; and unsurprisingly, risk assets rallied and pushed the blue line higher.
Also, the metric is still above the highs set during the GFC and the dot-com bubble, which highlights how the value of financial assets has risen beyond what’s supported by their underlying economics. As such, with great dispersions often leading to great reversions, a normalization of the metric could have a profound impact on silver.
In addition, Morgan Stanley’s Chief U.S. Equity Strategist Mike Wilson told clients on Dec. 19 that his bear case of $180 per share in S&P 500 earnings seems increasingly likely (the consensus expects $231). Therefore, he sees an earnings recession that rivals the GFC, and a realization could send risk assets into a nosedive.
Please see below:
Source: Bloomberg
Overall, the white metal has kept its cool despite falling stock prices and rising real interest rates. However, the silver price is highly volatile, and when sentiment shifts, epic drawdowns typically occur. Thus, while it may seem like a safe place to hide right now, we’ve seen this movie before, and the climax is often profoundly bearish.
Alex Demolitor
Precious Metals Strategist