While the bulls continue to bid up the silver price, is this just another bear market rally?
Though actions speak louder than words, investors have decided that the latter will guide their investment decisions in the short term. Therefore, with Fed officials signaling a “slowdown” in the pace of future rate hikes, market participants deem the shift as bullish.
However, with sentiment clouding their judgment, the bulls don’t realize that 50 basis point rate hikes are still profoundly hawkish . As such, while the silver price has rallied as the faith intensifies, the fundamentals are trending in the opposite direction.
Please see below:
To explain, the blue bars above depict the monthly change in the FFR over the last ~40 years. If you analyze the horizontal red line near the top, you can see that 50 basis point rate hikes don’t happen all that often.
Consequently, while a deceleration from 75 basis points has given investors a false sense of security, the reality is that 50 basis points are far from dovish, and the sentiment uplifting the silver price contrasts the fundamental backdrop.
To that point, the S&P 500 has a material impact on silver and mining stocks, and not only are the latter two more correlated to the index than gold, but they’re also much more volatile. Thus, with the S&P 500 still highly overvalued, a sharp decline could spell trouble for the silver price.
Please see below:
To explain, the black line above tracks the S&P 500’s 12-month forward price-to-earnings (P/E) ratio. If you analyze the right side of the chart, you can see that the metric is close to 18x.
But, the blue and pink lines above represent the S&P 500’s fair value forward P/Es given the current values of the U.S. 2-Year Treasury yield and the U.S. 10-Year real yield. In a nutshell: when less risky assets offer higher returns (interest rates), the S&P 500 should command a lower multiple, given its higher potential for capital losses.
So, with the U.S. 2-Year Treasury yield implying a forward P/E of ~14x and the U.S. 10-Year real yield implying a forward P/E of ~15x, investors are paying an inflated price for a suboptimal asset.
Furthermore, the P/E measures use analysts’ expected 12-month earnings, which have not been adjusted for a potential recession; and with every inflation fight since 1954 ending with a recession, the current P/E overvaluation and the potential for a sharp decline in 2023 S&P 500 earnings are profoundly bearish for the silver price.
On top of that, UBS’ risk model indicator signals a high probability of a 5% or more drop in the S&P 500 in the near term.
Please see below:
To explain, the red line above tracks the S&P 500, while the blue line above tracks UBS’ risk model indicator, and the blue horizontal dashed lines represent +1 and -1 standard deviations from the average.
If you analyze the right side of the chart, you can see that the blue line is near its 2022 lows, and prior readings of this magnitude have culminated with sharp drawdowns of the S&P 500. Therefore, while the index remains elevated right now, downside risk has intensified from a fundamental, technical and sentiment perspective.
Overall, the silver price has benefited from the same false narrative uplifting several risk assets. After being shocked by 75 basis point rate hikes in 2022, the crowd believes that a step down to 50 basis points is akin to a dovish pivot. However, for those that understand history, 50 basis points are still highly hawkish.
As such, the crowd is trying to create the perfect investment recipe with imperfect ingredients.
Alex Demolitor
Precious Metals Strategist