Silver Demand Theory Debunked

Includes: CDE, GLD, SLV, SLW, ZSL
by: Nigam Arora

Silver is now closing in on an all-time high. Here's why I am happy about it:

As the chart shows, our subscribers allocated 20% of their assets to silver when silver was $17.73. This was the highest allocation to silver we have ever seen. As the diagram shows, we start an allocation to an asset class or a sub asset class when the risk is small, and the reward is high and increasing. Allocation is increased as there is more confirmation of the trend and the thesis. The model reduces the allocation as the risk increases even if the rewards are increasing. The model removes the allocation to the asset class as the risk goes higher even if the rewards are going higher.

Now we are advising to take profits on silver and exit the position completely. The annualized return on this tranche is 236.80%.

The same models that got us in to silver heavily at $17.73 are now flashing sell signals with silver near the all-time high.

Our adaptive model automatically adapts to the changing market conditions. For the buy signal, the model gave heavy weight to fundamental economic leading indicators that showed rising inflation in emerging markets, weakening dollar and pent up industrial demand from the recession.

The silver bulls are predicting that the present trajectory of silver’s run will continue. Bulls make the following six arguments:

  1. Industrial demand is rapidly increasing.

  2. Retail investors in India and China are buying silver like there is no tomorrow.

  3. Central banks in India and China are buying silver.

  4. Demand for silver jewelry is exploding.

  5. Silver will become a substitute for paper currencies.

  6. Silver is rising due to inflation.

I am hard nosed about being driven by cold hard data and in the process forsaking all prejudices, opinions, preconceived notions. Estimates of silver demand over the years have varied widely, depending on the source. In 2001, silver demand was in the range of 850 -900 million ounces. By 2009, silver demand was in the range of 875-925 million ounces. This was not a meaningful increase when compared to the Global GDP rise for the period.

In 2010, pent up demand from the recession materialized, pushing up silver demand to the 1025 -1075 range.

Unfortunately, for the silver bulls, the data does not support any of their six arguments. Our qualitative screen shows the fair value of silver to be $34.00 under present global macro-economic conditions. This valuation is based purely on fundamental data.

We estimate that the industrial demand in 2011 will be 500-550 million ounces compared to 540-575 million ounces in 2010. This is a decrease in the silver demand in 2011.

In a series of upcoming articles, I will debunk the bullish arguments that have driven silver to the $50.00 range. Traditionally, 75% of the silver demand has been for industrial uses and jewelry. There is no hard evidence yet of reduction in demand, but the anecdotal evidence shows that if the present prices persist, the silver demand for industrial uses and jewelry will fall to 50%. This conclusion is also supported by the increase in the amount of holdings of silver ETFs.

In this article, I will answer the more urgent question of what is driving silver prices up now, not a month or two ago. The answer is American speculators – it is not industrial demand or India and China or inflation.

Let us now explore the data that conclusively proves the point.

iShares Silver Trust (SLV), a silver ETF traded in the U.S., now holds about one third of all silver bullion on earth. There are several other silver ETFs that trade in North America and if their assets are taken into account, the percentage of silver held in American ETFs goes much higher. Even silver bulls agree with me that the silver held in American ETFs is neither being used for industrial demand nor is it being bought by India and China.

The lame argument and the only argument bulls have come up with is that the silver in the American ETFs is for investment purposes and it is highly unfair to call the owners of these ETFs speculators. Once again the data does not support the bull’s argument. The data clearly shows that the recent rise in silver is because of speculative buying and not because of investor demand.

Lately, about half of the total capitalization of SLV is traded every day. On some days, the volume in SLV exceeds that of SPY – a widely held ETF that represents the S&P 500. Clearly, investors are not out there trading half of the capitalization of SLV every day. This is the result of speculative frenzy. The chart shows the increase in SLV volume.

Not only is there speculative frenzy in SLV, the volume of the options on ETFs and futures has gone up dramatically. Most of this volume is in the options that expire in the near term. Is there any precedence in the history of investors trading in and out of near term options this heavily?

ZSL is a double inverse ETF on silver. Take a look at the increasing volume on the chart. Is there precedence in history for investors to trade this heavily in the shares of a double inverse ETF on a commodity? Traders? Yes, I can see that. Investors? No.

If a reader is still not convinced, take a look at the exploding volume of near term options on a double inverse ETF.

Those who study historical patterns will find that even in extreme circumstances, investors drive prices linearly. A good example of a steep linear movement is the recent price of gold (GLD). Please see the chart to compare the price movement of of gold and silver. From the tulip mania to the internet bubble, when prices rise parabolically, it has always been the speculators and not the investors.

There is additional clear and convincing evidence that this run up in silver is neither related to demand nor inflation. Take a look at the chart comparing the rise in silver prices to the prices of two of the largest silver miners Coeur d'Alene Mines (CDE) and Silver Wheaton (SLW).

Most estimates of the average cost to mine silver range from $11.00 to $14.00 per ounce. Investors recognize that production of silver will increase significantly if high prices persist.

From the chart we can clearly see that the investors understand the silver miners will not be able to take advantage of this run up – because the run up will be short lived.

I started this article by stating that silver has made me very happy. First, because we made a lot of money on the long side. Second, because now I have an opportunity to make money on the short side, and third, we are able to use a publicly traded vehicle to sell silver at prices 20% over the market price.

Silver is a short at current prices. I will be documenting some of my trades here on my blog.

Disclosure: I am long ZSL.

Additional disclosure: I was long on silver from $17.73 and recently sold it at $45.72. Now in addition to being long ZSL, I am short on silver futures and also short on a publicaly traded vehicle that allowed me to sell silver at prices 20% over the market price.