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Chart Pattern Suggests New Lows for Silver


Here, examining a live chart pattern for silver alongside the use of quantitative analysis in an attempt to time silver's collapse.

Does technical analysis work? It is difficult to answer this question with confidence. The main reason for this uncertainty is many chart patterns are difficult to quantify. For example, how does one define a head and shoulders pattern so you can test it on a computer? Having issued this disclaimer, today we are going to take a walk on the wild side to the dark netherworld of technical analysis. We will examine a "live" chart pattern for silver. We will still use quantitative analysis as you will soon see, but we will use a chart to assist us in timing silver's collapse.

Now it may very well be possible to quantify this indicator. However, rather than spending a couple of hours devising a formula, it is considerably easier to just show you the chart. The pattern is as follows: Silver has a big spike up. It then has the inevitable crash. Silver then rallies in an attempt to retest the previous high. It doesn't quite reach its prior high.

In other words, the dead-cat bounce. The pattern is marked on the following chart by downward sloping blue lines at the two tops at 1974, 1980, 1983, 1987, 2004, 2006, 2008 and 2011.

Click to enlarge

Silver got annihilated after its failed test in September 1980 but didn't do so bad in 2004. How can you tell which scenario will unfold?

The answer is valuation.

Let's look at 1983 as an example. After tripling in eight months, from Feb 15, 1983 to March 7, 1983, silver went down 32.8%. It then staged a 37.1% dead-cat bounce rally to test its February highs but did not quite get there. The price patterns and valuations then are very similar to the current situation. From its May 18, 1983 peak to February 22, 1991 silver went down 75.1%.

The middle columns have "Valu." on top which stands for Valuation. All valuations are with respect to silver at its dead-cat bounce high. The stocks and real estate columns (click on links for details) are actually monthly indicators since we don't have daily data for stocks in the 1800s and any daily real estate data. So these are as of the month of the second high. The third indicator is a daily indicator. There has not been an article written yet about this indicator. The Valu. Average column is the average of the three indicators. The penultimate column is the valuation average put in grade format with respect to how much attention one should pay attention to the signal. This column is placed conveniently next to the second leg down so you can compare how effective valuation is in predicting the severity of the decline.

There is a strong correlation between the valuation grade and the subsequent second leg down. The only one that didn't fit well was 1974 which only went down 39%. However it took 4.6 years for silver to recapture its 1974 high. Note the first and third highest readings had 75.1% to 85.7% declines for silver from its dead-cat bounce high. At this point in time, the secondary high is August 22, 2011 at $44.12. A decline halfway between those two would imply a bottom of silver at $8.66. Interestingly enough, the 2008 low for silver was $8.47.

Those hoping for a 2004 or 2006 repeat may be disappointed. Silver is radically overvalued now which was not the case in those years. With cost of production far, far, far below today's price, there is tremendous motivation for people to mine for silver. They will. And the euphemistically named "investment demand" has already started to wane. Silver isn't the belle of the ball that it was in March and April when it took the baton from former commodity leader cotton (which has already collapsed 57%). Gold has now captured the attention of investors shaken by silver's 34% decline in two weeks.

How do you know when the dead-cat bounce is over? Of the seven prior instances, six lasted less than 4.1 months. We are already past that now. Only in 2004 did the rally last longer. Note that silver was undervalued in 2004. Silver has already had a 10.8% correction since its August 22 high. This would suggest the dead-cat bounce is probably complete.

There is also a blue line at the bottom of the chart (currently at $5.94). That is a lower channel trend line from 1920. As you can see we are way above it. There also seems to be a correlation between the severity of the decline and the distance above this trend line.

For everybody who is expecting a late 1970s repeat, keep in mind that in silver's final blow-off top from April 3, 1978 to Jan 21, 1980, it did not have a single 11% correction. So the current situation is not anything like 1979 at all. This is perhaps the most important paragraph in this article.

The Fed will print money and we will have inflation as we have had every year since 1954. However, this new money can go into other asset classes. The dead-cat bounce pattern coupled with silver's high valuation suggests this reallocation is already well underway.

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