Short Squeeze

Dr Richard Appel
Apr 28, 2006

April 23, 2006 - A series of disparate events have coalesced that have set the stage for generational price spikes in not one, not two, but in three major metals. For those who have steadfastly held their gold and silver positions through the difficult, trying and heart-wrenching past five plus years, it appears that our foresight and suffering will soon be rewarded. Similarly, for those who early recognized the explosive potential of the copper market, they too are participants in what I believe will be viewed as an historic short squeeze.

For new investors to the stock and commodity markets, a speculator who believes that an item will go down in price has the ability to sell it without owning it. This is called shorting a market. If he is correct he will profit by the difference between where he initiated his "short", and the price when he "covered" or closed out his position. A short squeeze begins when a number of individuals or entities have "shorted" a market in a substantial fashion, and find themselves on the wrong side of the trade. In their haste to purchase the item and exit their trades, they literally fall over one another and markedly drive higher its price.

A good example occurred in the silver market between late1979 and early 1980. Prior to the summer of 1979, Bunker and Herbert Hunt of the Hunt oil family, accumulated an enormous silver position. As I recall, it was largely completed by the summer of 1979, when silver was under about $8 an ounce. Prior to and during this period many commercial interests, traders, and speculators shorted a huge number of silver future contracts as it rose in price. They believed there was sufficient readily available physical silver to offset their positions. If they were correct they would pocket the difference when the market declined under the pressure of their massive shorting efforts, as it had done so many times before. Unfortunately for the shorts, this time they were dead wrong.

By September, 1979, silver broke above $10. This attracted world-wide buying of the white metal by investors and speculators who had been watching from the sidelines. They had seen silver languish, but grudgingly trend higher for a number of years.

The metal traded below $1.50 an ounce early in the decade. By the mid-1970's, it worked its way into the $5 range. When it finally broke through $10, few interested onlookers wanted to continue "to miss the boat". Investor after speculator then plunged into the market in order to secure their silver.

This pressured the shorts! With each up-tick in the metal's price their positions went deeper into the red. Finally, by December, 1979, silver surpassed $20. When this occurred the shorts who had not yet exited the market began to panic. They had already scoured the globe attempting to find adequate silver stockpiles to cover their positions. However, the Hunt brothers had beaten them to the act. The Hunts had left few stones unturned in their effort to purchase all of the world's available silver. They had "cornered the market".

This placed the shorts in an untenable position. They had already sustained enormous losses, and were now faced with bankruptcy if the white metal continued higher in price.

By now the shorts had joined the excited, greed-driven buyers of the metal. The purchasers were fearful of missing further profits, and the remaining short players were trying to fend off their financial Armageddon. By early February, 1980, only a few brief months later, silver peaked at $52.50 an ounce on the New York Commodity Exchange. When that price was struck the only direction for the market was down. By this time numerous shorts were devastated.

Some background. In the early 1960's, the United States government possessed a silver stockpile of about 2 billion ounces. During the latter part of that decade our leaders decided that it no longer needed such a substantial amount of silver, and began to sell most of it into the market. Their weekly sales ended early in the 1970's decade, and only left our country with a limited strategic stockpile earmarked for our national security.

Beginning in the mid-late 1980's and running to date, the world incurred an annual silver supply deficit. Yearly demand exceeded production and silver recovery from all sources by 50 to150 million ounces. The difference was made up from above ground known and secreted sources.

Several years ago it became obvious to me that at some point the world would run out of sufficient silver to supply its needs. I stated my belief that when that time arrived silver would skyrocket in price. I believe that we have now arrived at the demarcation point where all of the readily available silver has been all but consumed.

Of possibly greater importance is that the future of silver's price will be further impacted by another factor. That is the enormous short position that is currently in place.

For the past few decades it has been a safe bet for various commercial interests, bullion banks and others to short silver whenever it ran up in price. They understood silver like few others because most of them were major daily players in the white metal's market. This group repeatedly profited on the short side because from experience, they knew that they would eventually be able to access sufficient silver supplies to offset their sales.

To their detriment this group was apparently lulled into complacency due to their earlier successes in acquiring silver in a timely fashion. They ignored the fundamental ongoing supply deficit that would one day upend their lucrative trade. I have read statements that there is a overhanging world short position in excess of 1 billion ounces of silver. Where will it come from when the shorts need it?

Turning to gold, the yellow metal has been in an annual supply shortfall for about 15 years. It is presently running at about 1,000 tonnes annually. Further, it has been stated by Frank Venerosa and the Gold Anti-Trust Action Committee (GATA) that the world's major governments have loaned out as much as half of their stated 30 thousand tonne gold hoard. This gold has been sold into the market but must one day be repaid to their rightful government owners. Additionally, there are additional millions of ounces of the yellow metal that has been shorted on the commodity exchanges, or are otherwise owed via naked call options or other derivative methods. These are on the books of various bullion banks, gold mining companies and other entities who underestimated the great groundswell of demand that would one day target the eternal metal.

To further confirm the underpinning of gold's strength is its recent price action. As I discussed when gold first attacked the $500 mark, it should have been met with great overhead resistance! However, the fact that it overcame that level and continued skyward with nary a pause, indicates the great global thirst for the metal.

Each price reversal was met with enormous buying. It appears that numerous substantial entities have given up accumulating the yellow metal in an orderly fashion. They now seem to have thrown in the towel and are rushing to purchase whatever quantities they can on any price dip. If this is the correct analysis, it is the reason why any price weakness will likely be muted in time and depth as gold trends higher in its current upwave.

Finally we have copper. In my November, 2005 issue of Financial Insights I discussed copper in depth. I mentioned the usual obvious reason for its great global demand; the insatiable demand from China, India, Brazil, the United States etc., its supply vs. demand shortfall, as well as the continuing decline in its above ground stocks. These seemed likely to be the underlying factors supporting its theretofore meteoric rise, and suggested to me even loftier future prices.

However, what peaked my interest and compelled me to discuss this metal was the actual decline in the net commercial short position. Copper had risen from the low $0.60 range in late 2001, to its then price in the mid-$1.80's. Yet with copper posting new all-time highs, the shorts were nowhere to be seen. It was as if they were afraid to bet against its advance.

The situation clarified a few weeks later. A rumor surfaced that China's major copper trader was short between 100,000 and 200,000 tonnes of the metal. I stated in my December, 2005 newsletter that, "It remains to be seen what the outcome will be. However, I believe that it is likely that there is a massive short position overhanging the market, that has the potential to drive it significantly higher".

With gold and silver, their fifteen year to two decade long supply deficits have created an extremely tight market. Copper's supply deficit has only existed since 2003. However, the overwhelming copper demand appears to have quickly consumed literally all of the above ground stockpiles.

This does not even take into account the amount of physical gold that is being taken from the market by the gold exchange traded funds (ETFs), and that will be purchased by the first approaching silver ETF and future ones. Further, the potential explosive price advances, that the supply deficits for each of these metals has the ability to engender, may be greatly extended if the great short positions unwind in one or all of their markets.

Another item that will further propel these markets higher is the recent action of the U.S. dollar. As depicted by the U.S. Dollar Index, it appears to be on the verge of finally breaking down! This indicates the potential for new lows. If this index breaks its earlier support of just over 0.80, be prepared for a new burst of strength in all of these metals. It will raise the yen, euro, pound, yuan and all other currency prices of these metals, and further attract speculators from all nations into the fray. Additionally, it will signal potential domestic inflation and a flight from the dollar.

The final piece to the puzzle appears to have fallen into place. It is the action of the open interest on the commodity exchanges for each of these markets. The open interest indicates the number of outstanding contracts for a given commodity. During important bull advances the open interest tends to expand as an increasing number of investors and speculators enter the market. However, in the recent cases for gold, silver and copper, they have contracted.

Gold's open interest on the New York Commodity Exchange (Comex) peaked when it was trading at about $475. Silver's struck its highest level when the white metal traded at about $8. For copper, it's open interest posted its high when the red metal touched $1.50.

Gold, silver and copper are now trading at over 33%, 50% and 100% respectively, above the points where they posted their peak open interest levels. This can likely only indicate one thing! And, that is the trapped short-sellers are running for cover, and are exiting the market.

When an earlier short seller makes a purchase to close his position, he must be replaced by a new seller. This is because every commodity market contract must have a buyer for every seller. The reason why the open interests in these metals are not expanding is because the short players are closing their positions as fast, if not faster, than new traders can enter the market. Had the short sellers not been covering their earlier sales, the new buyers would create an increase in the total open interest.

If my analysis is correct the fireworks have just begun. We will likely continue to experience violent price movements in all of these metals as we experienced late last week. As waves of short-covering end, new short sellers will pound the markets. Conversely, when one or more major shorts panic in their effort to limit their already enormous losses, these metals will soar.

Gold suffered a major $20 plus decline and silver gave up over $2 last Thursday. These serious price reversals should normally require a few or more weeks for the metals to recover and overcome the technical damage done to their markets. If they shortly post new highs it will confirm that a short squeeze is indeed likely in progress.

It is impossible to predict the timing or the heights to which gold, silver or copper will spiral before the final shorts cover their positions. However, beware of a rule change on the Comex. In early 1980, the board of governors of the Comex changed the rules for silver when it was exploding higher. They announced that only liquidation orders would be accepted. With that edict silver plummeted limit down for nearly two weeks and trapped the longs. Numerous long players with substantial paper profits were decimated while many short-sellers were spared from annihilation.

Finally, I anticipate when gold, silver and copper post their highs the stage will be set for a prolonged secondary correction in each of their markets. If we have a repeat of the1970's price action, we will have to endure an extended decline that may see these markets lose 50% of their peak values. However, do not despair. When the lows arrive they will present those who sold within 20% of the market peaks with great profits. These can be utilized to reposition oneself and profit, when these three major secular Bull Markets again reassert themselves. This, on their way to their ultimate, higher peaks a few or more years later.

The above was excerpted from the May 2006 issue of Financial Insights ©April 23, 2006.

Dr Richard Appel
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