TED BUTLER COMMENTARY

September 23, 2008

Time Out or About Time?

(This essay was written by silver analyst Theodore Butler, an independent consultant. Investment Rarities does not necessarily endorse these views, which may or may not prove to be correct.)

The unprecedented financial crises have given way to extraordinary proposed solutions. Some leave me skeptical, such as the government throwing unimaginable sums of money at problems, including the new $700 billion mortgage purchase scheme. Other emergency solutions seem more straight-forward and reasonable, like the money market guarantee edict to stem a run in that important sector.

Perhaps the most effective solution to preventing a stock market meltdown was the order temporarily banning all types of short selling in certain stocks, enacted by market regulators in the U.K., U.S., Australia, and elsewhere. Alert market observers have correctly identified the short selling ban as the real cause behind some of the largest rallies in stock market history. At the risk of sounding immodest, this was exactly as I predicted and suggested.

Two months ago, in "A Modest Proposal," (http://www.investmentrarities.com/07-21-08.html) I explained why all types of short selling should be banned and how such a ban would result in a huge rally in the stock market. I am not so naïve as to believe the market regulators took action based on my proposal. It was, undoubtedly, a remarkable coincidence. But there are some new lessons to be learned here.

The temporary elimination of both types of new short selling, namely, naked (no borrowing of shorted shares) and covered (shorted shares borrowed first), is an issue characterized by strongly held opinions, both for and against. Most vocal are those against any restrictions or, certainly, the outright banning of short sales of stock. Generally, those complaining about the temporary ban have a vested interest of some type. Those in favor of the temporary restrictions, including the regulators, view it as a "time out" to prevent a stock market crash, but to be rescinded at the first opportunity. A very few, like me, call for stock short selling of all forms to be banned permanently

In any event, the opposing strongly-held opinions are unlikely to be changed in the short run, so let’s agree to disagree on whether short selling in stocks should be allowed. Let’s instead focus on fact, not opinion.

The key fact is that both the regulators and short sellers have learned something important this past week. What they learned was that any restriction on short selling causes an immediate rally in stocks. This was first learned this past summer, when temporary restrictions were placed upon 19 financial stocks. The lesson was reinforced this past week when short selling restrictions were placed upon 799 U.S. financial stocks. Some day, maybe restrictions will apply to all stocks (as it should). I don’t think this lesson for regulators and short sellers will be forgotten any time soon.

We can argue endlessly about the merits of banning short selling. What we can’t argue about is its effect. Do away with short selling on some stocks, get a big rally. Do away with short selling on more stocks, get a giant rally. Do away with short selling on all stocks and Katie, bar the door. But still, we have only scratched the surface.

Remember, the short selling restrictions, limited and temporary as they are, have to do with restricting new short sales. There was never any suggestion of banning existing stock short sales and forcing short sellers to buy back the many billions of shares previously sold short over the years. But isn’t it inconsistent to ban new short selling and allow old short sales to remain in force? In my opinion, a true outright ban on new and old short sales would cause the stock market to double or triple in a short period of time.

That thought is, or should be, running through short sellers’ heads. Maybe it is running through the regulators’ heads as well. For the shorts, it should be like suddenly looking into the abyss and realizing they could face instant financial ruin if the regulators really crack down on short selling. For regulators, it should be like suddenly discovering the most powerful weapon ever against a stock market crash. And it doesn’t cost a penny of taxpayer money. That meaningful restrictions can come at some time in the future is suddenly a real possibility. I say it’s about time.

The Sensible Swiss

This week I received an e-mail from a Swiss money manager, a friend and trusted source. He informed me that a very large and conservative Swiss bank had informed a number of their clients that they would no longer be offered paper gold or silver certificates in the bank’s name. It seems the bank had previously granted the accounts because it was able to protect itself against an upside move with a derivatives contract with another financial institution. Due to the financial turmoil, the bank was no longer comfortable with the counterparty risk from the other financial institution. Instead, the Swiss bank informed its clients, all paper transactions had to be converted to physical or physical ETF positions (There are Swiss ETFs for gold and silver). My friend informed me that other Swiss banks were likely to follow this bank’s lead.

As long-time readers know, the issue of bank silver certificates that were not backed by real metal is one I have written about frequently

http://www.investmentrarities.com/10-01-02.html

http://www.investmentrarities.com/10-29-02.html

In essence, the banks that issued such certificates were short the metal, and taking an enormous risk in the event of a sharp price rise. Because they had been issued for decades, the cumulative amount of the short position in silver amounted to, perhaps, billions of ounces. This was a short position separate and distinct from the massive COMEX short position.

That the large and conservative Swiss bank is seeking to reduce or eliminate it’s short exposure to silver at this time makes sense. The bank has seen that silver prices can move sharply higher and that counterparty guarantees can vanish in an instant. It is sensible and practical that it would take such actions now, after silver prices moved sharply lower.

The resultant move by former paper owners of silver into real metal is destined to put additional pressure on the existing supplies of metal. It is hard to imagine a more critical time for this to occur than now. Every indication is one of tightness in the physical silver supply. The potential creation of a brand new source of silver physical demand could be profound.

Raptors Revisited

About a year and a half ago, I started writing about the Raptors, the smaller commercial traders who were developing into formidable competitors to the T. rexes, biggest commercial traders on the COMEX. http://www.investmentrarities.com/05-22-07.html Since that time, the raptors have generally behaved as I wrote back then. They have been able to buy low and sell high, becoming the most profitable segment of traders in the futures world. They did this by mimicking and out-maneuvering the Big 4 and 8 largest traders. Now I see evidence that suggests a major change may be developing.

The most recent Commitment of Traders Report (COT) indicated little change in the market structure in silver for the reporting week. But a more detailed analysis revealed a potentially significant development. While the total commercial net short position was basically unchanged, there was a notable shift within the commercial category. It seems the T. rexes (Big 4) bought some 2500 contracts net, from the raptors. This was very unusual and something I have been privately anticipating for some time.

I am convinced that the severe sell-off in gold and silver from the end of July was solely intended to liquidate every margined long position holder as possible. This allowed the dealers to buy as many futures contracts as could be bought. The big 4 and 8 commercial shorts bought back and covered as many of their short positions as they could, while the raptors bought and added to their long po0sitions as much as they could. The T. rexes and raptors hunted side by side, sharing the common food supply of liquidating margined longs.

Once the food supply of panicked leveraged longs was exhausted, the group hunt ended. The raptors in gold and silver then held a record long position (especially when factoring options), while the big 4 held a reduced, but still large net short position. The only way the largest T rexes could further reduce their short position was to turn to the only available source of potential selling - the heavily long raptors. But the raptors behave differently than the leveraged longs who just liquidated on the downside. The raptors only sell on price rallies.

I think the T. rexes know this well, and they now intend to buy back additional short positions from the raptors on the upside. I don’t think the big 4 care much about paying higher prices to cover their short positions, as their main concern is to buy as many contracts as possible. Complicating matters for the big 4 is the fact that, as prices move higher, competition will develop from outside traders motivated by the price increases, including many who just liquidated at lower prices. So the challenge for the big 4 is to buy as many contracts to the upside from the raptors, before the outside buying competition kicks in.

One way to effect this would be with sudden, sharp price rallies, intended to induce the raptors into selling, while causing new buyers to hesitate, fearful of equally sudden price declines. This would enable the T. rexes to buy as much as possible from the only selling source available, the raptors. This thinking went into my suggestion last week that we were structured for a rally of the explosive variety.

To say that the silver market is set up and has the real potential of exploding in price is an understatement. In fact, it’s hard for me to conceive of a single real bearish factor. And it’s not just that there are many bullish factors present in silver as much as it is the extreme condition of all those bullish factors. That physical supplies are as tight as they are, at the same time the market structure is set up so well, at such depressed prices is a wonder to me. I never thought such conditions could exist at the same time.

Buy The Right Brand of Premium

Last week, I made the analogy of buying gas before a hurricane to retail investors, unable to secure desired forms of silver due to unavailability, would increasingly turn to the wholesale industry standard of 1000 oz bars. There are clear signs that is occurring, and I would like to add a postscript and suggestion.

The ideal way to hold 1000 oz bars of silver is through professional storage. While I encourage all who can store silver in personal possession to do so, that doesn’t apply to 1000 oz bars. These bars weigh some 70 lbs., making them very difficult to even lift, to say nothing of shipping for the purpose of purchase or sale. Besides, if one actually takes personal delivery of these bars, please be aware that re-assay will be required at the time of sale, necessitating added expense and perhaps long delay in selling. Any new buyer of such a bar would rightly insist on testing (at the seller’s expense) to insure that the bar wasn’t tampered with. Be forewarned.