Prices for precious metals and other commodities, like silver, are beholden to many crosscurrents. There's demand, as silver has many uses (industrial, jewelry, photography, etc), and supply (how much is mined, sold by governments, scrapped, etc). However, the basic supply/demand market is then distorted by speculation, and also by investment for purposes such as inflation hedging.
I postulate that speculation and inflation hedging have significantly distorted the spot and futures markets, driving silver prices into a bubble.
Supply and Demand
On the demand side, China is a big factor. As China's economy takes on greater significance, and the global economy improves, industrial silver demand is going to increase.
Now, take a look at GFMS's 2010 Interim Silver Report.
The supply side shows that photographic demand has been in a secular downtrend because of digital photography. With pawnshop and other scrapping businesses booming due to high unemployment, that also increases supply. Supply from mine production and scrap is in the middle of a long-term and rather sharp, increasing trend. Fabrication demand has been flat to down over the last decade. It is picking up significantly as mentioned above, but supply is still outpacing demand (for the moment).
Score one for supply surplus, suggesting lower prices.
Here's where the speculation and investment factors come into play. Inflation is going to be held in check, primarily due to the output gap. Speculation on silver is about to end, as improvement in the global economy is going to send investors back to stocks.
Meanwhile, as GFMS's graphs show, net investment in silver has skyrocketed, seen as a more economical alternative to gold. But demand has been significantly driven by Europe's debt crisis (temporary), fears of inflation (unfounded), low interest rates and a general trend towards using commodities as an asset class in and of themselves. Simply put, people are waiting for inflation which never seems to arrive (much of this has to do with the output gap), and are realizing that an improving global economy means they can flee precious metals and climb back into stocks.
GFMS also makes a key point: the silver market supply $19 billion, compared to $170 billion for gold. This small market means silver is "very highly geared to growth in investor inflows", and higher volatility. I'm sensing a move away from silver investment. Less investment means lower prices.
Also have a look at GFMS's Gold-Silver ratio. It has contracted significantly, as one would expect with the skyrocketing investment inflow of the later graph. This trend will eventually revert back to the mean. That either means higher gold prices or lower silver prices, or both.
We've seen this before -- the oil bubble of 2008.
Parabolic Bubble in Silver
One of the greatest gifts to traders is the parabolic blow-off top, a signal that an asset bubble is about to burst and money can be made on the short side. Often, there is a huge last burst of buying, followed by a gradual sideways move that climaxes in a huge drop in price. Other times, the dramatic conclusion of buying is immediately followed by a dramatic decline in price. We may be seeing exactly such a pattern forming in the price of silver.
I mentioned oil. Take a look at the monthly chart for Light Sweet Crude Oil, courtesy of DecisionPoint.com. Note how the monthly chart really demonstrates the steep rise in oil that had far outstripped the true supply-demand reality.
Prior to topping, the price climbed along the 20-day EMA, occasionally dipping to touch of temporarily breach the 50-day EMA. Once the 50-day was breached, I opened a half-position in the PowerShares DB Crude Oil Dble Short ETN (NYSEARCA:DTO), along with a 7% trailing stop. I then added to the position once the 200-day EMA was broken. From there, I felt convinced the selling was on in full force, which it was. Also courtesy of DecisionPoint.com:
Is silver showing the same behavior? Here's the monthly chart, courtesy of DecisionPoint.com. Note the last time silver went parabolic and how it resolved.
Silver has breached the 20 and 5-day EMA's, and is a hair away from busting through the 17-week EMA. Breaking that longer-term support line also can signal a longer-term downtrend, as we saw with oil. So I've opened up a half position in ProShares Ultra Short Silver (ZSL). I am watching for a drop to the 200-day EMA at $23.20, which would mean a 16% slide from here, which would mean a 32% potential return on the ZSL. I'll keep careful tabs on that support line, because the 43-week EMA and 10-month EMA are also right about there. If that is breached, I'll go full throttle on my ZSL short. There's no telling how low a parabolic collapse may run, so I'll keep my 7% trailing stop in place.
How is this actionable?
The technicals seem to support my thesis that speculation and investment have driven silver prices far beyond what supply and demand would bring to the market.
Those who find value in this analysis can consider shorting silver by going long the ProShares Ultra Short Silver ETF (NYSEARCA:ZSL), which aims to double the decline in silver price. Traders could also hedge a position by going short the Central Fund of Canada (NYSEMKT:CEF), which holds the physical metals of gold and silver at a ratio of 0.5 oz silver to 1.9 oz. gold.
Disclosure: I am long ZSL.