The Disturbing Truth About Silver's Rally

 |  About: iShares Silver Trust ETF (SLV)
by: Lou Basenese

If the bull market in silver could pick a soundtrack, it would probably go for something like M.C. Hammer’s “U Can’t Touch This.”

The “other” precious metal is on an absolute tear, with the price surging by 126% over the past year. Meanwhile, gold is only up 26% over the same period.

Most pundits now predict silver’s momentum will propel the price into record territory above $50 per ounce.

But I wouldn’t be so quick to believe it. Or rush to invest in silver at these levels. Here’s why…

Can You Say, “Lopsided Investment Demand?”

The latest data reveal that the primary driver behind silver prices hasn’t been economic supply and demand. Instead, speculators are moving the market.

According to researcher GFMS Ltd., world investment demand in silver blasted 40% higher in 2010, to 279.3 million ounces. Industrial demand, a more predictable driver, only increased by about 21%.

I get that investors consider precious metals “safe havens” and a monetary alternative. And in light of recent world events, it’s obvious why demand is perking up. Especially for silver, as the run in gold prices makes it the more affordable precious metal.

However, investment demand is notoriously fickle. If it wanes even the slightest for silver, look out below. I say that because silver supplies aren’t exactly limited right now. On the contrary, in fact… a surplus exists.

Surplus Lures Speculators… But Beware the Fallout

At the end of last year, silver’s surplus – defined as the difference between supply and fabrication demand – checked in at 173.4 million ounces. Looking ahead, Barclays Capital estimates 2011 to be “another year of record supply,” thanks to increased mining activity.

Simple economics lend credence to the prediction, too. As market prices increase for any commodity, so does the incentive for producers to generate more. And with primary silver mining cash costs checking-in under $6 an ounce, I’d say there’s ample incentive to ramp up mining efforts.

As Philip Klapwijk, executive chairman of GFMS, said, “There’s no convincing economic reason for why this [silver rally] is happening. It’s still a market with a very large surplus.”

And that’s precisely why investors should proceed with caution.

A Correction Could Be Swift and Severe

According to The Silver Institute, investors plowed $5.6 billion into silver in 2010, almost doubling 2009’s total. But there’s no reason why this money that poured in can’t stampede out just as quickly.

Case in point: When the financial crisis hit in 2008, silver tanked almost 50% in just four months time. (By comparison, gold prices fell about half as much).

The fact that the bulk of silver investments are currently being made in highly liquid, exchange-traded products, like the iShares Silver Trust (NYSE: SLV), increases the odds of a swift and severe correction. (Last year, investors bought 494.98 million ounces of silver via exchange-traded products versus 101.3 million ounces of coin and physical silver.)

And if ever there was an indication of at least a short-term peak in prices, it’s “cash-strapped people lining up to sell their silverware,” as Barron’s reports:

In New York’s diamond district on Friday, a scrap-silver dealer had his arms full. “We’re getting more business than ever before,” he said, as he emptied the contents of a garbage bag one customer brought in – silver bowls, cups, a platter, an ashtray, forks, spoons and more.

Not to be overlooked, a number of large hedge funds have “joined the [silver] party,” according to Ole Hansen, a senior manager at Saxo Bank. Remember, hedge funds aren’t invested in silver as a safe haven. They get paid to speculate. And when they go from being net buyers to net sellers in order to cash in on the profits, other investors are bound to follow suit.

Bottom line: Investment flows have been the largest driver of silver prices over the last year. And when it comes to putting my hard-earned capital at risk, I prefer to put my confidence in compelling fundamentals, not the fickle whims of other investors.