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Major Market Event Ahead?
By Theodore Butler
(The following essay was written by silver analyst Theodore Butler. Investment Rarities does not necessarily endorse these views, which may or may not prove to be correct.)
I’ve had this thought I’ve been thinking a lot about lately. It concerns an upside major market event in silver. I’ve had these thoughts from time to time, about different markets, but I confess that lately, it’s been mainly about silver. Certainly, my premonitions about impending major market events don’t always come to pass, but sometimes they do. One such previous premonition, in particular, might be instructive to review, even though it involved a different market and a different price direction. I’m talking about the market event that occurred 15 years ago, when the stock market fell 25% in one day, on Oct. 16, 1987.
Since there was no Internet for me then, you’re going to have to take my word that I “saw” it coming. Certainly, I didn’t profit (didn’t lose, either), so I’m not trying to pat myself on the back. What I am trying to do, is to explain why the stock market melted down on that day, and why the very reasons that it did are applicable for a melt up in silver soon.
First off, the reasons have nothing to do with value and/or fundamentals, in a practical manner. Fundamentals can’t change that quickly. In the stock market melt down, I claim it had nothing to do with the dollar, or earnings, or interest rates, or public pronouncements, at that time. (Of course, others would argue with me, but I’m talking about my premonitions, not theirs). The stock market crashed on that fateful day, due to one reason and one reason only – portfolio insurance. What portfolio insurance (also called dynamic hedging) promised was the limiting or removal of downside risk from a stock portfolio through the use of short sales of S&P 500 index futures (which had barely existed for about 5 years in 1987, meaning there wasn’t yet developed a large knowledge base or general experience. At the time, the market was plagued by extreme volatility, due to program trading, but no restrictions were yet put in place).
In fact, portfolio insurance, until Oct. 16, 1987, basically existed only on paper, as the sales of S&P futures were to take place only after the market had declined by a predetermined amount (said to be 10% from the top, according to its leading proponents, Leyland, O’Brien and Rubenstein Associates.) Since the market had been in a marked bull phase throughout 1987, reaching a then all-time high of over 2700 on the Dow, in August (from a bear market-low of under 800 in 1982), the 10% market decline trigger point was not reached until Friday, Oct. 13, 1987. The reason the proponents of portfolio insurance waited until a predetermined sell-off amount before starting to sell futures, was because to sell sooner would have eliminated any upside to a stock portfolio, something highly undesirable in a bull market. The portfolio insurers (these were almost exclusively institutional, as retail investors wouldn’t have been this dumb), thought they had found the Holy Grail, a way to participate on the upside, while eliminating risk on the downside. They believed it so much, that many institutional investors increased their bullish bets aggressively in 1987, comforted by the fact that they could limit the downside on a moment’s notice. They were sadly and grievously mistaken. When the fateful moment of truth for portfolio insurance came, on Oct. 16, 1987, the question became one of Wall Street’s old-time clichés’ – sell to whom?
The morning of Monday, Oct. 16, 1987, began with many tens of thousands of S&P futures contracts offered for sale, “at the market” by the institutional portfolio insurers. The problem was that the portfolio insurers had not thought to question themselves as to what would happen if the insurance became super-popular and every one decided to utilize the insurance at the same time. There were nowhere near an equivalent number of contracts to be bought. We hit a buying vacuum, and the stock market dropped an historic 25%. Afterwards, controls were put in and people rethought the whole concept of, basically, waiting until your house was on fire, and then rushing to buy fire insurance.
The premonition that I, and others, had about portfolio insurance wasn’t any great insight. It was just listening to what the portfolio insurers said they were going to do, and then contemplating what the market effects would be if they did just what they said they would do. The portfolio insurers never stopped to think about what would happen if 50 or 100 thousand futures contracts (enormous at that time) were simultaneously offered for sale. This was strictly a mathematical and mechanical exercise, but something that the sellers never took the effort of doing. Strictly mechanical.
What’s this got to do with silver? Well, looking at silver, through the same strictly mechanical eyes that offered a premonition to the great stock market crash, there are some shocking similarities that suggest that we may soon see a major market event in silver, although the expected direction is up, not down. I’m basing this on the same thing I’ve been writing about forever – the Commitments of Traders Report (COT). Please hear me out.
As I have recently written, for the first time in almost a year, the dealers have been able to reduce their outrageously-large short position in COMEX silver, by almost 60,000 contracts, net. That’s the equivalent of 300 million ounces of silver. They did this by first engineering the long liquidation of some 25,000 net long contracts held by the technical funds, then luring the tech funds onto the short side by 25 to 30 thousand additional contracts. (The balance was caused by some liquidation by small speculators.). Now that the technical funds are short 25,000 contracts or more, there exists the possibility of a market event, on a strictly mechanical basis. Here’s why.
There are some things we can say about the technical funds. One, they operate strictly on mechanical price signals. When a price target (usually a moving average) is hit on the downside, they sell (either to liquidate or establish a new short position.) When a price target is hit on the upside, they buy (to liquidate a short or establish a new long position.) I’ve seen them skip, or pass on, establishing a new position (long or short), if the price moves too extremely. But I’ve never seen them not liquidate an existing position, no matter how extreme a price move, as that would violate their own money management rules. We also know that the tech funds are strictly paper traders, in that they don’t ever get involved with physicals. The conclusion – when the tech funds are short, it is a certainty that they must buy back their short positions, regardless of price, as they have no possibility of making delivery. This is why I say the market is in a bullish structure when the tech funds get short big – because it’s just a matter of time before they buy. It’s a certainty. That is why I had recently written that the silver market structure looked positive (“Here We Go Again”). The only question is at what prices the tech funds will buy back their shorts? Or, another way of stating that question is at what price the dealers will sell to the tech funds, when the funds move to buy back their shorts. After all, it is the dealers and funds buying and selling to each other that sets the price (I claim that is manipulation and a clear violation of US commodity law, but let’s save that for another day).
But there is a difference between a bullish market structure and a major market event. The difference is this – we will get a somewhat bullish move (say to over $5) if the dealers let the funds out of their short position gracefully, and sell aggressively into the tech funds short-covering. We will get a market event, if the dealers decide that they should, or have been told to, stop manipulating the price of silver. In that case, the dealers may just keep their hands in their pockets, and literally do nothing, when the inevitable tech fund short-covering buying comes in. Then, by doing nothing, the dealers will launch the price of silver into a major market event. 25 or 30 thousand tech fund buy “at the market” orders will find no sellers. Just like there were no buyers of the tens of thousands of S&P contracts on Oct. 16, 1987. Additionally, there will be tens of thousands of various call option contracts to be covered, along with OTC shorts. Just so I don’t beat around the bush, how would I define, price-wise, a major market event in silver? A five to ten dollar move in a day, or more. Certainly, the COMEX price limit regulations allow for such a move.
Of course, I can’t tell you when such an event might take place, just like no one knew in advance, even if they knew all about portfolio insurance, the exact day the stock market was going to crash. But I can tell you that it may happen at anytime the funds are ultra short. Like now. I can tell you that it won’t take a lot – just the dealers NOT selling. I can tell you that strictly mechanical market structures have caused major events in markets bigger and more closely followed than silver. And I sure as hell can tell you – it’s long overdue in silver. At least, that’s my premonition.