Defensive notes on the margin: UPDATE

Following large declines in prices and increases in margins, in this brief note I update my calculations of risk-adjusted margin, or RAM, for a selection of major commodities.

Two weeks ago I cautioned that “investors should always be wary of markets in which speculation appears excessive.” I singled out silver as a commodity that might be attracting a large amount of speculative attention due to its comparatively low risk-adjusted margin, or RAM.

Although the CME had been hiking margins on silver in the preceding weeks, in risk-adjusted terms these had not been sufficient to keep up with the rising value of the silver contract. Indeed, silver’s RAM had declined to a level well below that of gold and even below that of industrial commodities.

That was unusual, and it was an indication that silver was overdue a correction of some sort. What I did not expect was that the correction would be so spectacular.

While gold also sold off hard, silver’s decline was far larger. (At time of writing, precious metals prices continue to fall, if somewhat more gently.)

Does a bear market beckon?

So, is this the beginning of a bear market in precious metals? Or just a necessary washing-out of speculative positions?

I believe it’s the latter. Precious metals prices have good, fundamental reasons to have risen so strongly over the past two years. But even the best of fundamentals cannot offset the natural swings and occasional “overshootings” in the financial and commodities markets.

This begs the question as to whether the speculative situation with silver and other commodities has now largely corrected itself or not. And so, let us return to my metric RAM for some indications in this regard. (If you’d like to revisit why I find RAM such a useful metric, please see my previous post on the topic here.)

Here is a table of selected commodities and their exchange margin requirements:

What stands out above is that, following multiple increases, the percentage margin requirement for silver is now the highest of the lot. NatGas comes close, which makes sense given how volatile gas prices can be, especially when a big winter storm comes round as one did last week.

For the other commodities, however, margins are not currently particularly high in percentage terms. But now let’s take the additional step of adjusting margin requirements for the implied volatility (or risk) of each:

Now, what do we see? Well, viewed in RAM terms, silver’s margin requirements are not particularly high; rather, close to the sample average. Silver’s RAM has also increased slightly from about 12% two weeks ago to over 13% now.

That’s not a particularly large increase in RAM terms. But recall that two weeks ago silver’s RAM was far below not only gold and copper but also crude and gas. Now it is more or less in line.

In my opinion, that’s significant. Silver is no longer an outlier. Others RAMs have declined on average over the period but that’s due primarily to the large increase in volatility in both precious metals and industrial commodities.

Industrial commodity catch-up?

While it is too early to conclude whether or not the current correction in metals prices is over, RAM calculations imply that to the extent there was relatively more speculation going on in the silver market than other commodities, this has now probably been corrected.

For those investors, such as myself, who continue to see fundamental value in precious metals, this unusually large correction offers an opportunity to add to positions. However, as I also wrote two weeks ago, there is a strong case to be made that crude oil and certain other industrial commodity prices have room to catch up somewhat to the huge precious metals rally of the past two years, if in less spectacular fashion than we have just seen.