Will the S&P 500 decide silver’s fate this week?
While the S&P 500 suffered a material correction on Jan. 20, silver continued its sideways price action. However, as time passes and silver stagnates, its 50-day moving average continues to rise. As a result, the white metal needs to rally soon, or a breakdown could occur in the coming days; and with the latter more likely than the former in our view, an S&P 500 drawdown could provide the necessary fuel.
For example, while we’ve warned about this on numerous occasions, Morgan Stanley’s Chief U.S. Equity Strategist Mike Wilson wrote on Jan. 30, “Investors seem to have forgotten the cardinal rule of ‘Don’t Fight the Fed.’”
He added:
This is “just another bear-market trap,” and “all the good news is now priced in,” which means “the reality is likely to return with month-end, and the Fed’s resolve to tame inflation.”
In a nutshell:
“We think the recent price action is more a reflection of the seasonal January effect and short covering after a tough end to December and a brutal year…. We think it’s important to note that typically when forward earnings growth goes negative, the Fed is actually cutting rates. That’s not the case this time around, [which is] an additional headwind for equities.”
So, while the crowd has been happy to ignore these developments, eventually, sentiment will collide with the fundamentals; and since the latter often wins out over the medium term, the momentum should reverse sharply in the months ahead.
Please see below:
To explain, the blue line above tracks the National Association of Active Investment Managers’ (NAAIM) net exposure, while the gold line above tracks the S&P 500. If you analyze the relationship, you can see that registered investment advisors (RIAs) often chase stock rallies because they can’t afford to miss out on bullish performance. Consequently, RIAs’ recent allocation is more about FOMO than fundamentals.
Second, if (when) the S&P 500 suffers its earnings demise, the economic slack that often occurs alongside these events could trigger a volatility spike and push the USD Index to new highs.
Please see below:
To explain, the blue line above tracks the YoY percentage change in Morgan Stanley’s forward earnings per share (EPS) model, while the gold line above tracks the U.S. unemployment rate. If you analyze the relationship, you can see that sharp YoY declines in S&P 500 EPS often result in major spikes in unemployment. Therefore, the next iteration should be no different, and the volatility could weigh heavily on the silver price.
Please see below:
To explain, the red line above tracks the U.S. unemployment rate, while the green line above tracks the Cboe Volatility Index (VIX). As you can see, the last three spikes in unemployment coincided with panic bids for the VIX; and with the USD Index often a significant beneficiary when crises erupt, a rate-hike-induced reset of the U.S. labor market could haunt silver over the medium term.
Overall, there are so many moving parts this week that the short-term outlook is unclear. However, the fundamentals continue to support higher interest rates, and the loosening of financial conditions has only made inflation worse. As a reminder, Bridgewater Associates co-CIO Bob Prince summarized the argument on Jan. 6. We wrote on Jan. 17:
5%+ wage inflation is not consistent with 2% output inflation; and while we have warned about this for many months, the ramifications are far from priced in. As a result, the crowds’ disdain for the details should upend several risk assets, including gold, silver and mining stocks, in the months ahead.
All in all, a profound shift in sentiment should occur over the medium term, and silver should trade materially below $24 before it’s all said and done.
Are investors wrong to ‘fight the Fed?’ What do you think drove the recent equity rally? How will silver respond if Wilson’s prediction proves prescient?
Alex Demolitor
Precious Metals Strategist