Silver could gain significantly in coming months

Update 3/5/12: Michael Arold sold out of his SLV position entirely on Friday, March 2.

Author: Michael Arold

Covestor model: Technical Swing

The model portfolio started the year on a positive note, gaining 5.7 percent in the month of January.

In January, it paid to not focus too much on headlines and instead evaluate market internals. Stocks behaved very similar to earlier market bottoms: volatility had been declining for weeks, new leading stocks emerged and their number grew with every trading day. In a healthy market, indices not only move higher, but more and more stocks are participating as well. The challenge however is that headlines are usually still negative during this phase, so one has to ignore market pundits on major TV channels (it pays to always ignore them anyways).

Granted, stocks appear overbought going into February. But consider what Mark Minervini, a highly respected trader who was interviewed in the investment classic Stock Market Wizards, has to say: Minervini recently characterized the latest price action as a “Lockout Rally.” Such a move can be challenging because it offers no major pullback opportunities to enter the markets. Psychologically, it can be very difficult to buy new highs, but that’s exactly what traders need to do in such a phase.

A game changer for the markets was the FOMC statement on January 25. Even though economic numbers came in better than expected in recent months, the Fed seemed to maintain a pessimistic stance. Bernanke was laying the groundwork for more quantitative easing (“QE3”), which is bearish for the dollar but bullish for commodities and basic materials. I therefore focused on related stocks: going into February, the Covestor model portfolio is long Freeport (FCX), Potash (POT) and Molycorp (MCP).

I’m also long Silver (SLV), which is in an extremely interesting technical position and could gain significantly in the coming months. Here’s greater detail on my reasons for going long Silver at this stage, as I stated on February 1:

Essentially, SLV just broke out of a gigantic “declining wedge” formation, suggesting sellers are exhausted. The size of the wedge is fairly big: it took SLV over six months to create the formation. Edwards and Magee suggest that prices usually do not take off immediately after bullish wedges, so there is still time to get in or increase the position on pullbacks. In general, one has to manage position size especially with Silver because the metal can make very violent moves and the trade can raptly go against you.

Another driver, believe it or not, could be the Euro: a record number of futures are held short by large traders, which is usually a contrarian sign. My position is well known: politicians (especially German) will do everything to keep the Euro alive, due to well known events in recent history. In fact, negative news from Europe at the end of the month barely affected U.S. stocks and was obviously considered a buying opportunity by market participants. Correlation between the S&P 500 and the Euro has been very high, so a stronger Euro could mean higher stock prices.

Overall, underlying investor mood is not overly bullish yet, which points to potentially higher prices ahead. I am tracking a handful of sentiment indicators, but none of them is showing that the crowd is overly excited about recent stock price gains. I would sell more aggressively when investors begin to think that “only the sky is the limit.”