Metals Market Setting Up for Trend-Changing Short-Covering Rally

Global Supply Deficit Widens Dangerously; David Smith Says Soon “Could Be Too Late to Take Advantage”

Mike Gleason Mike Gleason
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December 11th, 2015 Comments

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Welcome to this week’s Market Wrap Podcast, I’m Mike Gleason.

Coming up we’ll hear from our good friend David Smith, Senior Analyst at The Morgan Report and regular contributor to  David touches on some key events and potential developing scenarios in the metals markets right now… including the potential for a default on the exchanges, the possibility that the stage is being set for a massive short covering rally in silver futures, and how much longer the market can withstand massive physical demand in the face of an ever-constricting supply.  Don’t miss an incredibly important and informative interview with David Smith coming up after this week’s market update.

Well, as terror alerts are raised around the world, investors appear to be more focused on the signals that are being sent by the oil market.  Crude oil prices are plunging this week to their lowest levels since 2009 and are now on the verge of taking out those crisis lows.

Are falling oil prices just a reflection of increased oil production?  Or could they also be indicating that the economy is heading south?  That’s a question that both investors and Federal Reserve officials will have to consider.  Major cyclical declines in oil prices often correlate with economic contractions.  So far the U.S. stock market isn’t following oil’s path lower.

But to a large extent, precious metals are.  Gold and silver prices were unable to build on their pop from last Friday.  They now find themselves back near the lower end of recent trading ranges.  Gold prices currently come in at $1,074 an ounce, for weekly decline of 1.3%.   Meanwhile, silver has dipped below $14 now and trades at $13.91, down 4.6% on the week as of this Friday morning recording.

Low precious metals prices, low oil prices, low prices for virtually all commodities suggest that disinflationary pressures are likely to spread through the economy in the near term.  It would be an odd backdrop for the Fed to begin raising rates, especially when its own inflation gauges are running well below its 2% target.  It would also be odd for the Fed to raise while its major counterpart – the European Central Bank – is slashing rates ever deeper into negative territory, as it did last week.

That’s not to say that Fed officials won’t raise rates when they meet next week.  Futures markets seem to think there’s a good chance they will.  Whether Janet Yellen and company hike may come down to how strongly they feel about the need to save face.  The fact that they have talked and talked… and talked and talked… about raising rates this year puts them in a bit of bind.  They lose credibility by not raising.  If they lose credibility, then they’ll lose some of their ability to influence markets.  The financial media may finally start to notice a pattern of their words and forecasts not ringing true.  And that probably scares Fed officials more than any risks they see in the economy.    

Maybe they’ll come up with some creative way of raising rates on the one hand while providing stimulus on the other.  Or perhaps they’ll raise rates but by less than a quarter of a point.  All the speculation will be put to rest by next Wednesday when the Fed announces its decision.  Anything less than a quarter point hike would likely be viewed by the market as dollar bearish.

Those seeking diversification away from the dollar and into hard assets have to be prepared for unpredictable price swings, whether caused by the Fed or other forces operating in the markets.  Over time, though, gold and silver can be expected to maintain their purchasing power regardless of what they are priced at in terms of national currencies. 

The same cannot be said for all hard assets.  Some people hoard diamonds in the belief that they are as good as gold.  That’s just not true anymore.  These days, diamonds can be manufactured in laboratories.  And these aren’t fake diamonds we’re talking about.  They’re the real thing.

News reporter:  Lab grown diamonds now starting to hit mainstream jewelry stores. Although they cost 20-50% less than mined diamonds, make no mistakes, these aren't fakes. They're real and indistinguishable from mined stones. You may not find a lab grown diamond at your local jeweler today, but more than likely it won't be long.

Gemologist: Now we're at a place where it's ready for prime time because, first of all, the
quality is good enough, the supply is starting to emerge. And more than that, the consumer, I think, they want to get more value for their money.

While it’s possible to create synthetic gold at the atomic level, it’s extraordinarily costly to do so.  There is no practical way to create something as substantial as an ounce of gold in a laboratory.  Unlike a diamond, which is just carbon compressed by earthly forces, gold is a basic element that was created from exploding stars.  For all practical purposes, the amount of gold available to be extracted is finite.  By contrast, there is no fixed limit to the number of diamonds that can be produced.

There is also no limit to the number of bonds or equity shares that can be issued.  No limit to the number of dollars the Fed can create.  And no limit to the how high the national debt can grow.  We’ve seen that the so-called debt ceiling is mostly a farce, because it always gets raised at the demand of the administration in power.  The fact that gold is and will always be scarce is why gold is and will always be a sought after store of value.

Well now, for more on precious metals scarcity, massive physical demand and the possibility of the cyclical bear market in gold and silver prices finally coming to an end in perhaps the very near term, let’s get right to this week’s exclusive interview.

Mike Gleason: It is my privilege now to be joined by David Smith, Senior Analyst at The Morgan Report and regular contributor to David, it's great to talk with you again and it's good to have you back on. How are you?

David Smith: It's good to be back Mike. I'm feeling great and watching the daily moves in the market; interesting as always.

Mike Gleason: Well David, perhaps the biggest news right now in the gold and silver world that you and I live in is the extreme leverage we're seeing in the major exchanges in London and the U.S. in recent weeks. For instance, there are now more than three-hundred ounces of paper gold on the COMEX for every one ounce of physical metal backing those contracts. Now, December is usually a big delivery month and a few observers have said that we are nearing a point where the exchanges could see a default, but there's been talk about potential defaults for years and they haven't happened so what are your thoughts about what's going on with the trading exchanges in the West?

David Smith: Well sometimes it seems like a Chinese water torture, you know, where there's just a drip, drip, drip, but I really think that the fundamental underpinnings are really changing as investors, like the people that talk to you every day on the phone and buy metals from Money Metals, they are buying more of the physical and putting it away and so the physical is coming more and more to be where the price discovery is. It's not there yet, but it's well on the way rather than the futures traders which buy and sell paper metal. They never take delivery of it and they have extreme leverage, as you mentioned.

If you can imagine someone coming to you Mike and buying fifty-thousand (ounces) of silver and they would have to pay, you know, the full amount for that, but imagine somebody on the futures exchange ... they was going to buy the same fifty-thousand ounces but they put up one twenty-eighth as much, about three percent of the cost. They can control twenty-eight to thirty times as much silver as that person that had to pay the full amount and so they go in and buy these contracts and sell them and move the price up and down like a yo-yo to make money on it and they can do it with a very small down payment.

Now, of course, if they're wrong on the direction they have to reverse course and they take, you know, a small profit or a large loss if they're wrong, but over time what they do is they make it a lot harder for those of us that buy and hold the physical to understand what the true price is and the thing with that is that when they make these large moves people that are trying to buy the physical sometimes have to pay a lot more because the premiums go up.  So it makes it complicated and it's an unfair deal, but it's the way it is, but the thing is with the purchase, more and more of physical, it's taking it off the market. At some point the paper traders aren't going to be able to push prices around, because price discovery will move to the physical markets, such as what they are doing in Shanghai and Dubai, rather than the paper pusher markets that we see in the COMEX and New York and Chicago.

Mike Gleason: That kind of leads me right into my next discussion point here. I want to read you an excerpt from our Monday market update from this week and then get your comments. In it our colleague Clint Siegner writes…

"Skyrocketing leverage in the COMEX isn't the only extreme for metals investors to pay attention to. The positioning – long versus short – of swap dealers (who are largely represented by the bullion banks) relative to managed money (largely comprised of hedge funds and other speculators) is also in uncharted territory. And it may be good news for the bulls.

Managed money has been building toward a net short position in recent weeks, providing much of the push for lower spot prices. In the most recent CFTC Commitment of Traders report, dated Dec. 1st, this crowd was positioned a record 55.1% short. Six weeks ago, this number was only 17.3%. Meanwhile the bullion banks (swap dealers) have been going long – a record 64.2% long to be exact.

What does this mean? Well, if history is a guide, it means the bullion banks are about to take the speculative shorts out to the woodshed.

Data shows that when managed money and the swap dealers build extreme positions in opposing directions, a change in price trend is likely coming. And the swap dealers – banks – rarely, if ever, lose."

You've been following the metals and commodities markets for a long time David, comment on this statement and fill us in on your experience about what this sort of thing means.

David Smith: Well these reports that you just mentioned Mike are published on a weekly basis and they're a tool, they're a diagnostic tool, but they're an important one to show the mentality of the markets at any given time, what do the players think is going to happen, and of those players what categories tend to be right the most often. As you mentioned, the swap dealers, the people that actually move this metal around and don't just move it by paper, they have a pretty good track record, especially at major turns, and when they're massively short, say silver, it indicates they feel it is going to go lower before it goes higher and if they're flat or if they're been on the long side or quite a bit long it can mean the opposite. And some of the statistics you quoted of the swap dealers on being on the long side some of these statistics are the bet they've been in 14 years, since before the silver bull market originally got underway and so this is very bullish.

It doesn't mean you should go out and mortgage your house to buy silver, but what it means is that the underpinnings and infrastructure of the silver market are becoming internally stronger even though when you look at the price on a chart we can't say for sure that that's the case.  So the hedge funds and the public money it tend to be money that follows the herd and they tend to be wrong at major turns and then they have to get taken out and the guys on the other side deprived them on their money so I feel pretty confident that what's going on here with these swap dealers is something that's really important to pay attention to and to my thinking it really lowers the risk-reward of adding to a person's position in here, because we're near major support and we had this very strong rally last week on Friday which is begrudgingly giving it up a little bit each day, the prices have been soft this week.

But the point being is that it's having to chew down through support and so it's going to be interesting to see how things get handled here, even tomorrow (Friday), but certainly in the next week, because we're in a month that can be very volatile and to my way of thinking the risk-reward really favors people that want to either initiate new physical positions by buying the precious metals, both gold and silver.  And/or who wish to add to their positions while the price is a little bit on the quiet side and the spreads tend to shrink a little bit and all that can be helpful in enabling you to get a better price than it would be if you bought after a big announcement day where the gold is, up $25 or $30 and silver is up 75 cents.

Mike Gleason: Yeah. It definitely does seem to be a lot of value in here and we do appear to be building quite a base of support, going back for a while now, maybe double, triple bottom even, in silver around $14 and we've heard the term "short covering rally." Is that sort of what we're talking about here with the potential for all these speculators to be forced to get out of their positions and that just drives the price up higher; is that the definition of a short covering rally or what could be a short covering rally?

David Smith: That's part of the crowd-feeding behavior that takes place when prices turn and when the shorts go, and this is kind of arcane for a lot of people to study, but it's basically if you go in on the short side you're selling something you don't own and the way to offset the position to put you to neutral is to buy it back at the end.

The other way, of course, is to buy something that you would like to own and then you have to sell it in order to get back to a neutral position.  So the sorts have to cover at some point and they have to buy back what they sold, which adds further fuel to the market when it's moving up and if it's already moving up in a strong way then that can make it very explosive on the upside so the bigger the short position you have into support like this, the more volatile it can become if the shorts are wrong and they turn around.  And so a lot of the public that's trading these futures markets think the price is going to go down and they tend to be wrong at major turns and if they're wrong they have to cover quickly and you add physical buy into that where people go out and go “oh the paper price is rising so I'd better buy some physical” and then you have the spread widen(ing) and it becomes kind of a contagion that feeds on itself.  So you're correct that the short-covering rally is a significant element in what can cause a very strong rally to develop and it could even be strong enough to change the major trend back to a bullish market that's been in a kind of a cyclical bear trend for the past four years.

And there are a couple of analysts that I follow closely that feel that this is exactly what has the potential of developing. There is never a guarantee, but when the probabilities favor you you can feel more comfortable in going ahead with what you would like to do, even if you're a little bit cautious about doing it than if you're just not sure.  But the tea leaves are starting to look better and better and I do think when these metals make a real sustained move to the upside that suddenly becomes a trend that doesn't turn around and go down again it's going to change the whole tenor of the market, perhaps for a long long time to come.

Mike Gleason: Yeah, I guess it was late 2010, early 2011 the last time we saw really ferocious short covering rally and it can be quite explosive and interesting just to sort of sit back and watch. It will be neat to see if that finally does happen again; long time coming for a lot of precious metals investors if we do finally see some sort of event like that.

Now, silver is a byproduct of other mining with much of it mined in conjunction with say, copper and zinc and lead. Now, those base metals have been taking a beating and you have to think that, even though the mining stocks are finally starting to show signs of life, there is significantly less exploration going on right now as these miners are having a rough go of it, for the most part. How is this likely to affect silver production and silver supply in the coming months and years given the current price environment, talking specifically about the base-metal mining and the fact that, what is it?  Seventy-five percent David, is ... of silver is mined as a byproduct? Is that about right?

David Smith: It depends, but it's ... it runs around sixty-five to seventy percent. About two-thirds of the silver that's mined every year comes from production of base metals: copper, lead, and zinc and sometimes gold, which is not a base metal of course.  But what this does, it means that when these companies cut back with, for example, copper prices being low and zinc, is that less silver is being produced, by definition. In addition, as you mentioned, a longer term concern because we actually looks like we're going to have a silver deficit this year in relation to production versus demand, and a bigger one next year is that the exploration for new deposits is cut way back and the last figure I saw for the mining sector in general is something like five to six billion dollars in further exploration costs projected to have been cut back over the next few years and so this means there's going to be a lot less exploration, a lot less extra delineation of deposits that are already known and that's going to crimp the supply even more. So these elements of cutting back on the available supply and the demand from investors continues to stay strong. You're going to see that gap widen and then that's what causes more price volatility and ultimately leads to substantially higher prices in the metal that's being affected, in this case silver, and to a certain extent gold as well.

Mike Gleason: In the last few months we've seen a bit of a disconnect emerge between the miners and metals. The mining sector looks to be building considerable internal strength when you look at the charts. Even as the physicals are moving sideways and even down what's going on there?

David Smith: The mining stocks themselves, not across the board, but as a category and especially looking at the stronger miners who have cut their costs and kept their production in line and things like this, they're forming very interesting chart patterns.  Some of them are making double and triple bottoms, some of them are moving in the classic definition of a bull market, which is higher lows and higher highs and on days when the physical prices are driven down by the paper traders that we discussed earlier today, their stock gives ground only begrudgingly, if at all.  And there is an indication that strong hands are moving in to buy these stocks and hold onto them, because they know that the turn is coming and it's already evolving and that when this things gets underway, by the time it becomes obvious to the public that the mining stocks will be substantially higher and, of course, the price of the physical will be as well so, to me, this is a very positive development and it's one that evolves over time, but it's one that's continued to take place, really over the last few months, even as the physical prices have kind of struggled in here.

Mike Gleason: You've been teamed with David Morgan for a while now and you guys obviously take a very close look at the mining sector and find those value plays and it's really good advice that a lot of  people can get by following that and then also The Silver Manifesto. I know we are both big fans of that book, a fantastic work there by David Morgan and Chris Marchese. A lot of this stuff is discussed in depth, these sort of subjects we're talking about today and I guess a lot of what people can learn about the silver market they can find in that book.

David Smith: They really can and David and Chris did an excellent job on this book and it's been very well received, as you mentioned, and , we were at the Silver Summit here just in late November, there's a lot of interest in the book and a lot of interest in talking to all of us on the team about the silver story and the thing about, you know, The Silver Manifesto this time of year, heck it makes a great Christmas gift or just a great gift giving. My brother was born two days after Christmas so it doesn't have to be a Christmas gift, it can be a birthday gift, and it'll arm people with the knowledge that they need to feel more comfortable about moving forward in either acquiring a precious metals position or adding to one that they already have, because don't think of it when you buy gold and silver, the physical, don't think of it as spending money to buy something like you're going to buy a boat or a fishing pole.

You're exchanging a form of fiat money that doesn't have any backing to it and has other claims on it for real sound money that's been around for thousands of years that has no claim on it other than the person, being you, that's holding it in your hand. And this is something that when you start looking at it a different way you don't see yourself as “oh I'm stocking up on cases of pork and beans.” I'm actually buying money that holds its value and that has only the claim on it of me holding it in my hand and it causes you to look at the silver story in a much much different way.

Mike Gleason: Yeah. Tremendous amount of meat in that book and yeah, definitely urge people to check that out if they haven't already.

Now, kind of hitting on the investor psychology here a bit since you're very good on that subject and have written a lot about it over the years and always appreciate your insights and just your discipline and your even-keel approach to investing. One thing that people often don't keep in mind is that if you're looking to buy physical metal, and let's focus on silver here for the sake of this discussion and if we're sitting here at say $14 an ounce, give or take, and someone is saying well I'm going to hold out for silver to get to $12 and then buy the physical then. Only problem is that with there being such little margin on the supply side we would see premiums skyrocket, not to mention lead time issue as well developing and a bullion investor is more than likely going to end up paying the same or possibly even more for, Silver Eagles, for instance, even if we had a price drop like that on spot prices, because the premium could rise just as much as the spot price went down. Talk about this dynamic.

David Smith: Well you know Mike, that's already happened a couple times this year, most pronounced in the junk silver market, the 90%  junk silver bags of dimes and quarters and fifty cent pieces that used to circulate in our pockets when we were growing up, and it sure had a different feel then than the stuff you do now, you almost hate to look at it.  At any rate the premiums, as you mentioned, can widen very quickly and get to almost absurd levels so that if you said, “oh, you know, I'll wait till silver drops to twelve,” assuming it ever does, well it might drop to twelve, but you still might pay the same premium you would if you bought it today.  So you wouldn't be saving anything, and not only that, it assumes the product is even available there.  So it really makes sense to buy over time in tranches or portions and it makes sense to buy when it's hard for you to do it.

If it's really easy and you're absolutely certain that you're going to make a killing it might not be the best time, but if you're a little bit nervous but you think, I still believe in the story and I know that what I'm doing is right and I'll buy a portion of what I need, you're going to find over time that your dollar cost average put you in a much better position, you can sleep better at night, and you'll have what you want without paying an inordinate price for it.  And I really think that these spikes in premiums that we've seen a couple times this year not only with junk silver, but with the American Silver Eagles and the bullion rounds themselves, these are important things to come.

These price spikes are going to become more frequent, they're going to become more pronounced, they're going to get bigger, and they're going to be harder and harder for individual investors and the sellers themselves to deal with, because they're going to be on a bigger scale and they're just like the tremors of an earthquake before a major quake; you have a lot of these little quakes that are trying to release pressure.  And that's what's happened in the pressure of the supply and demand in the silver market and when the really big tremor hits people are going to go “oh my gosh, now I really should have done something", but it will be too late so take advantage when the little tremors subside and add to your position and don't try to time it, because nobody gets it right. Some of the best people in the business are wrong quite a while before they get it right, but boy when the payday comes down the line they really happy that they did what was the right thing and over time their wealth can increase in a very big way by doing that type of a thing.

Mike Gleason: Yeah, certainly dollar cost averaging, keeping some powder dry, and checking your emotions at the door when buying is all good advice and cheap is cheap, there's only so low it can go and if you're going to buy the physical you're likely to see long delays and sky high premiums if spot prices drop much further. Always something to keep in mind.

Now, we've certainly seen unbelievable physical demand this year, you alluded that a moment ago, and you have to think that something is going to give. At what point does massive demand in the face of dwindling supply become an explosive event for higher prices, David?

David Smith: Nobody can predict that exact point Mike, but you know, when I look at the fact that India is going to be buying more than 40% of the world's production of silver this year and China by definition has purchased more gold than was produced this year. Those two entities alone, that's a huge consideration and it's a trend that just keeps getting bigger and bigger and then you look at (the fact that) there's going to be a record set this year, if it has not already done so, in American Sliver Eagles and Canadian Silver Maple Leafs and the investors are really stepping up to the plate and there are a very small percentage of American investors and Canadian investors right now, but that is growing.  And so there's so many reasons why this trend has got a long ways to go and when the trend turns prices are going to be higher, probably for years at a time after they've lowered and I think people try and quibble and here in waiting, “oh maybe it'll drop fifty cents or a dollar or two dollars.” I mean, the upside is so enormous to worry about something on the downside especially if you're not buying on margin. I mean, we're not futures traders where we're leveraging twenty-eight times our money.

We're paying physical cash for it, we're taking delivery, it's not on margin. Nobody's going to give us a margin call and you can sleep at night and you put that product away in a safe place and you kind of keep it to yourself that you own it and you just wait for the inevitable change to take place and then at some point down the line, probably a number of years when you have a public mania like we saw in 2000 with the dot com mania and the real estate mania in 2006, then you can sell some of your product into the market and you can make a very good profit while other people are lining up at the door to buy what you have to sell and that's how you come out ahead in these markets.

Not to mention it's an insurance policy.  And the last time I heard nobody complained that they had car insurance last year and they had to pay but they didn't have wreck, because they know if they had a wreck that insurance can keep them in a safe position financially and that's part of what you're trying to do when you buy the metals. It's insurance first and profit second. The story is so compelling that it looks to me like both of those comparatives are going to be satisfied with people that add to their positions anywhere in the price range that we've been seeing over the last six months or so.

Mike Gleason: Definitely seems like the risk-reward possibility here is very bullish to the reward side.

Well, finally David before we close, what are you expecting as we begin to turn the calendar and move into 2016? What do you think the new year will bring for metals prices and metals investors? Will we finally see an uptrend after a few rough years?

David Smith: I really think that after four years of this water torture and prices giving way to lower support, and you know this looks so much like what I experienced in the late 1970s when, you know, gold dropped in value by half and silver gave up most of its gains that it made the last couple years and there wasn't any indication at all that things were going to be any different and then suddenly prices started moving upward in a way that was absolutely amazing. I remember when silver went to twelve dollars and people were just thinking that was amazing and then it was eighteen and then next it was in the twenties and it topped out around fifty dollars. This is going to happen again.

Richard Russell, who passed away recently, who's the doyen of newsletter writers, I think he wrote a letter for like fifty-three years, he said, "I have never, ever seen a bull market that did not end with a speculative third phase”.  And that third phase becomes a public mania. Whether it's dot com stocks or real estate, it's going to be the same in gold and silver and we have not had that third phase yet.

We've had the second phase which ended in April and May of 2011, but that third phase is on the way, it's building its base right now and when it takes off it's to be really something, it's going to be one for the record books.

This is something that David Morgan has said is going to happen, has long said, and the evidence supports it and he also mentions that his research, which is supported by deep work that has been done by the whole Morgan Report team, indicates that up to eighty or ninety percent of the entire profit potential of the full bull market will be realized in the last ten percent in time of that price rise.  So we'll see prices go up substantially from here and then at some point they're going to go vertical and I think people will be shocked when they see the potential that happens during that vertical phase. So I'd love to see and hear that everybody listening to this had some way to participate, even if in a very small way in what's coming… buy your metal in trances, pay cash for it, put it away in a safe place, and then just wait. Don't obsess every day and follow the charts every day, but know that that first leg is going to be underway at some point and when it is you're going to be very happy that you've been able to participate rather than to just watch.

Mike Gleason: Well thanks very much for your time, David. Always excellent insights and a calming voice. I love speaking to you, you've got a way of making things make sense for a lot of people and we certainly look forward to talking with you again real soon. Hope you have a Merry Christmas and also enjoy your weekend my friend.

David Smith: Well thank you Mike, and you know I always enjoy speaking with you guys and it helps me clarify my own thoughts and positions and I'm fully supportive of what is going on now with what we're doing and I think it's the right thing, I think it's the honorable thing, and I think it's the financially prudent thing to be doing so you have a great holiday season at your group as well.

Mike Gleason: Check out any of David's insightful columns. Just go to the news section on or type in “David Smith” in the search box and you'll get links to all of his work. Be sure to check all of that out.

Well, that will do it for this week. Thanks again to David Smith, contributor to and Senior Analyst at The Morgan Report. And check back here next Friday for next Weekly Market Wrap podcast. Until then this has been Mike Gleason with Money Metals Exchange. Thanks for listening and have a great weekend everybody.
Mike Gleason

About the Author:

Mike Gleason is a Director with Money Metals Exchange, a precious metals dealer recently named "Best in the USA" by an independent global ratings group. Gleason is a hard money advocate and a strong proponent of personal liberty, limited government and the Austrian School of Economics. A graduate of the University of Florida, Gleason has extensive experience in management, sales and logistics as well as precious metals investing. He also puts his longtime broadcasting background to good use, hosting a weekly precious metals podcast since 2011, a program listened to by tens of thousands each week.