Has the momentum turned on the white metal?
While we warned that silver was headed for a breakdown below its 50-day moving average, the negativity continued on Feb. 6, as the S&P 500 ended the day in the red. Likewise, with the white metal hitting its 2022 lows alongside the U.S. equity benchmark in September and October, more stock market pain could push silver below its 200-day MA.
For example, while Morgan Stanley’s Chief Investment Strategist Mike Wilson confronted plenty of criticism throughout 2021 and 2022, he remained focused on the bearish fundamentals rather than following the narratives; and with the latest example present in January, he told clients on Feb. 6 that “the door is still very much open” for a meaningful drawdown. He wrote:
“What makes this analysis more powerful is that, historically, the majority of the
price downside in equities comes after forward [earnings per share] EPS growth goes negative. In other words, this earnings recession is not priced, in our view,”
Please see below:
To explain, the blue line above tracks the S&P 500, while the brown line above tracks the index’s forward EPS growth implied by Morgan Stanley’s model. If you analyze the vertical black bars, you can see that when the model-implied EPS growth turned negative, the S&P 500 suffered major drawdowns in 2001, 2008 and 2020 and a mild drawdown in 2015. Although, the latter occurred with only a small decline in the brown line.
In contrast, the brown dotted line on the right side of the chart annotated with “Our Earnings Forecast Path” projects a malaise that rivals 2001 and 2020. Therefore, a realization should result in an S&P 500 drawdown that rivals those periods, not 2015.
Thus, while the S&P 500 has confronted some selling pressure, the drawdown has been mild relative to the EPS deceleration that could occur in the months ahead. In the process, silver could suffer a similar fate.
Also highlighting the positioning imbalance, the spread between the average BBB corporate bond yield and the 90-day U.S. Treasury Bill yield highlights investors’ disdain for risk management.
Please see below:
To explain, the orange line above subtracts the 90-day U.S. Treasury Bill yield from the average BBB corporate bond yield. When the orange line declines, it means that short-term Treasury yields are rising at a faster pace than corporate bond yields; and if you analyze the right side of the chart, you can see that the spread is near zero, and is more than one standard deviation below its long-term average.
In other words, the crowd is buying BBB corporate bonds at a nearly identical yield as Treasury Bills despite the heightened default risk.
More importantly, prior iterations of near-zero-to-negative spreads have resulted in sharp reversions that rattled the financial markets. Remember, the spread can only rise if the Fed cuts the FFR or if corporate bonds sell off and their yields rise; and with the latter more likely than the former in our view, mean reversion should inflict plenty of pain over the medium term.
As another ominous indicator, the equity risk premium (ERP) has not budged, and a sharp spike should occur before this bear market ends.
Please see below:
To explain, the blue line above essentially tracks investors’ willingness to take risk. When the ERP rises, it means that investors demand a higher return to own the S&P 500, which also influences demand for assets like silver and mining stocks.
If you analyze the vertical pink bars, you can see that the last three recessions resulted in ERP spikes of 400 to 700 basis points; and with higher discount rates often leading to lower stock prices, the events are highly bearish.
Furthermore, with the reading on the right side of the chart lower than the post-GFC lows, the crowd views high inflation and a hawkish Fed as immaterial risks. In contrast, we view them as substantial headwinds, and the demand destruction that should occur as the Fed tames inflation should shift sentiment in the months ahead.
Finally, Steve Eisman – who is famous for shorting the housing market in 2008 – told Bloomberg on Feb. 6 that a regime change is occurring. He said:
“Paradigms change over time. Sometimes those paradigms change violently, and sometimes those paradigms change over time because people don’t give up their paradigms easily; and I think we’re going through a period possibly like that again.”
From “2010 through the beginning of 2022, if you were a company that had no earnings but strong revenue growth, people dreamed the dream. When the revenue growth slows, people stopped dreaming the dream, or a combination of that with higher rates and the discounting mechanism takes down the stock.”
So, while we have long warned that the post-GFC playbook is no longer applicable, the crowd continues to hold out hope for a return to pre-pandemic monetary policy. Yet, with resilient inflation and higher interest rates poised to end that “dream,” a wake-up call could hit silver as the drama unfolds.
Do you agree with Wilson’s assessment? When could we see a sharp rise in the ERP and/or the BBB-T-Bill yield spread? How important is the stock market’s performance when analyzing silver?
Alex Demolitor
Precious Metals Strategist