A Melman Minute — May 6, 2011

It is one thing to attempt to predict the direction of where a given market will head, a task which might be undertaken knowing that markets can offer genuine surprises. However, it is another thing to ignore when markets speak clearly, as they did yesterday by inflicting severe damage to the short term charts of many commodity items. In fact, while few if any long-term bullish trends were threatened, several intermediate up-trends were either threatened or actually breached.

While we are mainly concerned with the world of precious and base metals, we cannot ignore decisive action in other commodities since the overall price structure is of great concern to our evaluations, and there indeed was particularly intense selling in several previously high-flying food items.

Sugar is an excellent example of the intense selling which has hit the softs in recent weeks, with the sugar (#11) having fallen from above 35 cents per pound to barely 20 a loss of almost half the value of the contract. Both short term and intermediate support levels have been broken.

However, our main focus is the metals and the most spectacular performance and the sharpest subsequent decline has been turned in by silver. As can be noted, silver rose swiftly and almost without interruption from about $18 per ounce to near $50 with the most dramatic segment taking place during the past few months when it almost doubled from just above $25 to near $50.

Then, in a change of direction mildly reminiscent of what happened in 1980, silver plunged, virtually in a straight line descent, to the $33.00 level. We believe two specific factors were at evident in this decline.

First, there is a natural tendency in markets to have return moves which mirror the preceding ones, particularly in terms of rate of change. Swift rallies are usually followed by swift declines and, in opposite form, swift declines are usually followed by swift rallies. In the case of silver compared to gold, silver had rallied in a much more dramatic manner than gold and this is demonstrated by examining the gold/silver ratio, as we did initially in our Melman Minute of this past Wednesday but the figures have moved even further in golds relative favour during the past two days. As of the closes yesterday, gold stood near $1,475 while silver was about $35 or an Au/Ag ratio of about 42:1 versus 31:1 just a few trading days previously. Therefore, when a correction did arrive, it came more rapidly than might have been anticipated.

The second factor which exacerbated the selling had to do with a change of margins on the silver commodity contracts. As recently as January, the margin on a silver contract was just above $11,000 but that has been raised now to $18,900 and another increase to $21,000 is scheduled for Monday! The net effect on silver traders has been devastating for two reasons which relate to the requirement to mark to the market on a daily basis. In other words, traders must balance their books and meet margin requirements at the end of the trading day or enforced sales will take place the next morning.

First, the simple losses on a 5,000 ounce contract which accumulated as silver fell from $50 made it impossible for some traders to come up with sufficient cash to make up for their losses if they were long silver and some forced sales resulted from this factor. In addition, the new margin requirements demanded even greater cash outlays by traders and many failed on that count as well, thereby adding to the selling pressure.

This double whammy clearly accounted for much of the selling as the greatest concentrated falls in the past couple of days took place shortly after each days openings when forced sales were transacted.

The great question is whether these sudden price breaks constitute new and major bearish trends or if they are to be contained within overall bullish trends.

The markets will give us their answers and we will be watching closely.

Americas latest jobs report provided some very contradictory information. On the one hand, new job creation for April came in at a surprisingly high 244,000 jobs, but at the same time the Unemployment Rate for America rose to 9.0% from 8.8 the previous month. But there was much more.

It is difficult to reconcile the strong April job creation figure with the just-released information that new claims for unemployment benefits rose in the same month to the highest levels since last summer. It is also difficult to reconcile the demand for new hires, implicit in the just-released job creation figure, with recently-reported diminishment in the rate of salary increases and a decline in the Hours Worked category. Also, the Labor Department reported a sharp drop in service sector activity during April.

So, we are expected to accept at face value the strong jobs numbers of this morning with other official reports showing job weakness in several important categories. Something clearly isnt adding up.

However, the financial markets appeared to be rejoicing in early trading and the Dow Industrials shot up by over 160 points within two hours of the market openings.

In terms of monetary policy, we believe this collection of reports will convince the Fed that stimulation is still necessary, that the Quantitative Easing programs will continue and new funds will be added as required to keep short term interest rates near rock bottom. In our view, these considerations augur well for the long term outlook for the monetary precious metals despite the sudden increase in gloom and despair.

As of 9:20 AM PDT, financial markets continue to rally on the jobs report with the Dow Industrials still ahead by 115 points and the TSX Index up by 95. Precious metals are retreating from early gains with gold now up only $6 to just under $1,490 and silver is off by almost $1.00 from yesterdays commodity close and is now quoted at $35.04. Base metals are relatively quiet after their own recent sharp selloffs and mining share indexes have gained about one percent on balance.

In other markets, crude oil is (barely) back above the $100 per barrel mark, the US Dollar is trading quietly in currency markets and most interest rates are little change so far this morning.

All quotes US$ unless otherwise indicated.

Next Melman Minute scheduled for Monday, May 9, 2011

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