After misguided pivot optimism helped push the silver price higher, investors’ overenthusiasm makes the risk-reward highly unattractive.
With the S&P 500 suffering on Nov. 28, liquidity-fueled assets have succumbed to traders’ wrath; and with the silver price declining sharply as well, the price action highlights how the crowd is often the most bearish at the bottom and the most bullish at the top. To explain, I wrote on Nov. 15:
While CNN’s Fear & Greed Index signals greed, though, it’s still below extreme greed, the materials sector is on another level.
Please see below:
To explain, the blue line above tracks the percentage of companies in the materials sector trading above their 50-day moving average. For context, metals and mining make up roughly 14% of the sector. If you analyze the right side of the chart, you can see that the figure stands at 100%, which is a sizable shift from the 0% present in late September.
As a result, the data highlights why we’re likely much closer to the top than the bottom ; and notice how abnormally high and low readings are nearly impossible to sustain? This is because periods of too much pessimism and optimism often revert to the average when investors take a thoughtful look at the fundamentals.
Therefore, since the metric can’t go any higher, a material reversal should result in substantial declines for gold, silver and mining stocks over the medium term.
So, while a substantial decline should commence in the months ahead, the fervent flows into the materials sector was a bearish sign that often haunts the momentum investors.
Please see below:
To explain, the candlesticks above track the silver futures price and the vertical gray line represents the price action on Nov. 14. As you can see, silver hit an intraday high on Nov. 15, and the upward momentum has stalled ever since.
Thus, while bearish positioning and short covering helped ignite the recent upswing, the backdrop is now materially different, and the bullish trade has become crowded. Furthermore, if (when) hawkish realities weigh on risk assets, the silver price should be a major casualty.
As further evidence, the materials sector's outperformance of the S&P 500 this month is one of the greatest since 2006 (as of Nov. 25).
Please see below:
To explain, the blue bars above track the monthly change in the performance spread between the materials sector and the S&P 500. If you analyze the right side of the chart, you can see that the former has outpaced the latter by 7%.
More importantly, the horizontal yellow line at the top shows how the magnitude of the monthly outperformance is the second-largest since 2006. As such, it’s another example of how investors’ overenthusiasm had them piling into assets like silver even as the fundamentals remained profoundly bearish; and since great dispersions often precede great reversions, the silver price is highly vulnerable to a sharp decline if (when) sentiment shifts.
Also, please remember that rate hikes are not the only fundamental problem confronting the silver price. With quantitative tightening (QT) continuing to accelerate, the Fed’s balance sheet hit a new 2022 low on Nov. 23 (updated on Nov. 25). Consequently, while record low real interest rates and unprecedented liquidity helped fuel the silver price in the summer of 2020, the current fundamental environment couldn’t be more different.
Valuation Matters
While the S&P 500 sold off on Nov. 28, the damage is relatively mild when considering the recent rally. However, I’ve noted the importance of real interest rates for many months, and the bearish implications for the S&P 500 and the GDXJ ETF remain the same.
Please see below:
To explain, the blue line above tracks the S&P 500’s forward price-to-earnings (P/E) ratio, while the tan line above tracks the inverted (down means up) U.S. 10-Year real yield. If you analyze the relationship, you can see that a higher U.S. 10-Year real yield often results in a lower S&P 500 forward P/E.
In addition, the gap on the right side of the chart shows that the S&P 500’s forward P/E should be closer to ~13, not ~17; and while seasonality is bullish, the medium-term fundamentals are highly bearish because the U.S. 10-Year real yield has likely not seen its peak. For context, I wrote on Oct. 7:
The U.S. 10-Year real yield often peaks alongside the FFR (or near it). As a result, with the Fed poised to raise the FFR by at least another 1.25% (to reach 4.5%), the U.S. 10-Year real yield should have more room to run, which is bullish for the USD Index.
Please see below:
To explain, the red line above tracks the U.S. 10-Year real yield, while the green line above tracks the FFR. As you can see, a higher FFR supports higher real interest rates. Also, when the FFR hit ~4.5% in February 2006, the U.S. 10-Year real yield reached a monthly high of 2.14%, and it occurred with a YoY CPI at roughly half the current rate.
Therefore, while the U.S. 10-Year real yield is still a long way from 2.14%, please remember that the Fed needs higher real interest rates to curb inflation. Consequently, the S&P 500’s already overvalued forward P/E should come under more pressure in the months ahead; and as earnings decelerate due to the Fed’s war on demand, a lower P/E multiple and weaker earnings should make the bulls extremely uncomfortable in 2023.
On top of that, the equity risk premium (ERP) is another important metric that highlights investors’ misguided faith in the Fed.
Please see below:
To explain, the blue line above tracks the change in the ERP relative to its 24-month low. If you analyze the annotations, you can see that historical crises often result in sharp spikes in the ERP. However, the low reading on the right side of the chart shows how the ERP is priced like we’re in a bull market with little fundamental risk.
As a result, with a recession poised to commence in 2023, and prior recessions seeing material spikes in the ERP, investors’ sanguine attitudes should vanish as the fundamentals continue to deteriorate.
Finally, while Morgan Stanley sees the S&P 500 ending 2023 at 3,900, Chief U.S. Equity Strategist Mike Wilson expects plenty of volatility before a bottom materializes in Q1 2023.
Please see below:
To explain, Wilson’s base case 3,900 target for the S&P 500 at year-end 2023 assumes a slide to ~3,300 in Q1, as recession fireworks erupt. In the bear case, the low could approach ~3,000, and in the bull case, ~3,500. Thus, while he remains relatively optimistic about the long-term outlook, the S&P 500’s valuation imbalance makes the medium-term outlook much more treacherous.
The Bottom Line
While risk appetite wobbled on Nov. 28, the dip buyers are unlikely to go down without a fight. But, with the medium-term technicals and fundamentals still profoundly bearish, their resolve should wane as reality sets in. Moreover, with the USD Index and the U.S. 10-Year real yield both rising on Nov. 28, their strength supports lower prices for gold, silver and mining stocks; and with tighter financial conditions needed to cool inflation, the USD Index and the U.S. 10-Year real yield should hit new highs in the months ahead.
In conclusion, the PMs declined on Nov. 28, as the pivot narrative continues to unwind. Furthermore, while I warned that the prospect of a dovish 180 was ridiculous, asset prices are still far from reflecting this fundamental reality. Therefore, more downside should confront the PMs before long-term buying opportunities emerge.
Alex Demolitor
Precious Metals Strategist