The QE Fallacy and Precious Metals

Markets have a funny way of providing us with the exact opposite of what the masses believe will be seen.  This is why contrarians often outperform the masses.  And, the precious metals market is not immune to this phenomena.

Back in 2012, when the Fed announced QE3, many were not just viewing it as a positive factor for the metals market, but almost everyone was quite certain it would cause the metals to rally to the moon.  I remember it all too well, since I was suggesting shorting silver at the time.  I was warned time and again about how “foolish” I was for suggesting this trade.  Many even warned me that “it would completely ruin your career as an analyst,” and they strongly urged me to reconsider my perspective.   I was told many times that “this was possibly the worst trade you could ever suggest.”

At the time, silver was in the 35/36 region, and I was looking for a drop towards the 22 region, with the potential we could drop as low as 12.75-14.  Yes, everyone looked at me like I was crazy.  Not only was I suggesting some “ridiculous” targets on silver, but I was doing so in the face of a “certain” moon shot about to be caused by QE3.

Needless to say, QE3 came and went, and we now find ourselves in the 14 region, with our sights clearly being set on the 12.75 region next. 

Moreover, we now have been through the ECB QE program also, yet, the metals have continued their decline.    So, the appropriate question to ask is “what went wrong?”

You see, the common misconception is that the Fed and ECB are able to control the market at their whim through QE, thereby causing inflation as they desire, which would then have positive effects upon the metals.  But, there are many issues with this commonly accepted fundamental perspective.

First, many do not understand how QE really works.  So, please allow me to present a very quick synopsis.  The Fed has several tools at its disposal to supposedly combat issues in the marketplace.  The first method is a direct one, wherein they can flood the system with actual printed greenbacks, thereby directly creating a greater supply of money, and, thus, devaluing the dollar.  This is a pure supply/demand play, assuming that the demand for the dollar remains constant, or decreases.  But, it can potentially wreak havoc on the bond market, so the Fed shies away from this method.  Furthermore, history has shown that this does not always work, such as Irving Fisher noted after the Great Depression.

The other method at their disposal is to dangle a carrot in front of the marketplace through an indirect method, and that is what quantitative easing represents.  It is not meant to flood the system by printing more actual dollars, as the great majority of the market wrongly seems to believe.  In fact, no greenbacks are printed through the QE process.  Rather, QE is only meant to provide more available debt.   So, if there is demand for debt in the marketplace, greater debt being made available to meet such demand will have the same effect as printing actual dollar bills, as debt is a form of money.  

Understand that, in order for this more indirect method to be successful, there must be an appetite for the additional debt being made available.  Therefore, even though the Fed increased the supply of available debt, lack of demand for that additional available debt is why QE failed.  The demand simply did not exist to the extent the Fed needed for QE to be successful.  This is also why so many were wrongly calling for the death to the dollar, while we were correctly expecting a multi-year dollar rally.

So, how did we know this from simply looking at a chart?  Well, the silver chart, at the time of the announcement of QE3, was in a corrective state.  It was setting up for lower lows, which told us that the demand for silver was about to drop, as sentiment for silver was clearly going to take a strong dive, at least based upon our opinion at the time.  For those that read inflation expectations from the action in the metals, one could claim that the silver chart was telegraphing what the demand for additional debt would be, thereby forestalling any possibilities of additional inflation.

Moreover, the long-term dollar chart was set up for a strong rally over 100 in the DXY when we recognized it back in 2011.  And, the dollar would not be in a position for a strong rally if inflation was truly going to be seen.

This brings me to the second fallacy in the assumptions above, and that is that metals only rise due to inflation.   This is another accepted “fact” which is simply not true.  Please note that history clearly proves that metals have risen and dropped during periods of inflation AND periods of deflation. 

Even if one were to look at how the metals market acted during the 2008/09 financial market debacle, which exhibited the strongest deflationary pressures seen since the Great Depression, we saw the metals rallying strongly during part of that period of deflation, and also declining strongly during that period of deflation.  So, one is simply not able to conclude that inflation or deflation is the driver of the metals at any point in time.  Rather, too many analysts pick a point in time that they see inflation, see the metals rallying, and assume that inflation is what caused the metals to rally.  But, as we have discussed many times in the past, correlation does not imply causation.

I have now presented you with very specific reasons as to why the common fundamental perspectives failed the metals market over the last 4 years, and not because of manipulation, as the uninformed continue to claim.  Rather, their underlying assumptions of what controlled the market were simply wrong, so they had no choice but to turn to their manipulation theories, as they were simply lost for reasons.   Since their understanding of QE was sorely limited, it has further proven the old adage that a little knowledge is dangerous.

This is why I continually harp on focusing on market sentiment rather than fundamentals if one wants to glean directional cues about the metals.  And, since sentiment has been a clear driver of the metals, and following sentiment has kept us on the correct side of this market for many years, I have had no need for fundamentals, or any of the manipulation theories as an excuse as to why fundamentals failed. 

Now, there are many that have claimed that I do not have a grasp of the fundamentals of this market, and that is why I only follow sentiment and technicals.  However, I started my investment career purely on fundamental analysis, but sought out more accurate and reliable methods when I recognized early on that fundamentals fail at the most crucial times around major market turning points.  And, what I think should now be clear to you is that I do maintain a solid grasp of the fundamentals, even as compared to the “fundamentalists,” but have made a conscious, and seemingly wise, decision to ignore them.  Sentiment and sentiment alone has been the clear driver of this market, and if one knew how to track sentiment, then one would have been able to ignore everything else and maintain on the correct side of the market the great majority of the time.

As an investor, the question before you now is if you feel compelled to maintain the same perspective which has failed for years simply because “everyone else is doing it,” or are you willing to open your mind to a different perspective in the metals which has been successful during the most trying period investors faced in the metals in decades?

Again, just something to think about.

Avi Gilburt, Esq.

www.elliottwavetrader.net