The Silver Price Is on Thin Ice

If the S&P 500 melts down, will it sink silver?

It was a sea of red across the financial markets on Dec. 5, and it’s no surprise that the S&P 500’s weakness coincided with sharp declines in silver and mining stocks. Moreover, I’ve noted on numerous occasions how the pair is more correlated to the S&P 500 than gold, which makes the index an important variable in our medium-term thesis.

However, with stock prices in la-la land, little to no fundamental risk is priced in despite the ominous fundamental backdrop.

Please see below:

To explain, the blue line above tracks the S&P 500's equity risk premium (ERP), which is calculated by subtracting the U.S. 10-Year Treasury yield from analysts' consensus 12-month earnings yield. In a nutshell: when the blue line declines, it means that the U.S. 10-Year Treasury yield is increasing at a faster pace than corporate earnings as a percentage of their stock prices.

Furthermore, if you analyze the right side of the chart, you can see that the blue line has sunk like a stone. Therefore, stock prices haven't declined enough, and investors are paying a premium for an asset with more risk.

Consequently, the data highlights investors' willingness to overlook inflation, higher interest rates, and the potential for a 2023 recession. But the sharp spikes in the blue line highlight how quickly things can change. Even if we exclude the COVID-19-induced rise, less treacherous fundamental environments culminated in ERPs that exceeded 450 basis points; and with the current reading closer to 200 basis points, the metric should have plenty of room to run.

On top of that, while bear market fatigue often creates pathways for short-term rallies, the S&P 500's mauling is still relatively immature.

Please see below:

To explain, the blue line above tracks the number of days it took the S&P 500 to reach its previous high when historical downtrends occurred. If you analyze the right side of the chart, you can see that the current bear market has lasted a little more than 200 days.

Yet, historical readings show that plenty of downtrends lasted 400 days or more, and the severe bear markets of ~1974, ~2000, and ~2008 lasted more than 1,200 days. Also, with the current inflation backdrop similar to ~1970 (~800 days) and ~1974 (~1,900 days), it’s laughable to assume that the bear market is over when inflation is at a ~40-year high and the unemployment rate is at a ~50-year low.

As such, with the metrics poised for a reversal of fortunes in 2023 (high unemployment needed for low inflation), silver should suffer mightily before it’s all said and done.

In addition, while the crowd assumes that inflation will decelerate with little economic damage, history implies that a much higher FFR is needed than currently expected.

Please see below:

Source: The Daily Shot

To explain, the Taylor Rule opines that the FFR needs to hit ~7.5% to curb inflation, assuming real GDP growth of 1.7%. For context, Q3 real GDP growth came in at 2.9%, so the metric is already above that level.

More importantly, the dark blue bar in the middle shows how the FFR would need to hit ~6% even if a recession occurs; and with every inflation fight since 1954 ending with a recession, it's the most likely long-term outcome.

So, with investors underpricing the peak FFR and the odds of a recession, the silver price is unlikely to respond well to a 6% FFR and an economic malaise. Consequently, more downside should confront the PMs in the months ahead, and silver and mining stocks should be the hardest hit.

Overall, the fundamental backdrop remains profoundly bearish, and silver's sharp sell-off on Dec. 5 highlights investors' anxiety. With bullish seasonality the only thing supporting higher prices, sentiment has driven the recent rally, and it often has a short shelf life. Thus, when the algorithms turn, the silver price's slide could be climactic.

Alex Demolitor
Precious Metals Strategist