The recent plunge in silver prices provides lessons for all investors, regardless of whether you invest in commodities or not.
As I started writing this on Thursday morning, iShares Silver Trust ETF (NYSEARCA:SLV) was down by 5.7%. Though significant by itself, the decline was just the latest in what has been a very bad month for SLV shareholders. Since the start of May, the ETF has fallen from $46.88 to this morning's $32.42, a drop of nearly 31%. The drop is even worse when you consider that SLV hit an intraday high of $48.35 on April 28.
Chart courtesy of FreeStockCharts.com
Notice the volume bars at the bottom of the chart. Interest in the ETF has surged over the past six weeks. Any time a security jumps in price on high volume without a fundamental basis for doing so, trading becomes nothing more than a game of hot potato. Anyone who is simply trying to get in on the price action is banking on the greater fool theory -- the hope that someone will pay an even higher price for the asset. Historical records going back to at least the 17th century Dutch tulip bulb bubble show the fallacy of such a strategy.
To be fair, the rally in silver was started in large part by the combination of the weaker U.S. dollar and fears about future inflation. As these concerns pushed gold prices higher, silver prices rose too. The theory is that a comparable valuation exists between gold and silver. The problem with this line of thinking is that over time the ratio of gold to silver prices has varied. The variance in comparative values between the two metals makes it difficult to pinpoint a magic ratio that suggests one metal is cheap or expensive relative to the other. Furthermore, when people have economic fears, they reach for gold; when people fear werewolves, they reach for silver.
Silver does have more industrial uses than gold, which mostly just sits there and glitters. The rise in silver prices was in no way justified by increased demand, however; a simple look at the economic data shows that. Rather, higher gold prices and speculation accounted for the overwhelming majority of the gains in silver.
This brings me to an important point: If determining a valuation is difficult and price movement can't be tied to changes in demand, then figuring out when to buy and sell becomes nothing more than a guess. The reason I don't own SLV, or SPDR Gold Shares (NYSEARCA:GLD), is that I have problems valuing something with no cash flow associated with it. It's always safer not to invest in something you can't value, rather than guessing when to get in and out.
Precious metals do have a role as a hedge against currency devaluation. They have stored worth and tend to be uncorrelated with stocks over long periods of time. A broad basket of commodities may actually work even better for diversification purposes (I personally hold a small position in a commodity ETN), though I cannot emphasize enough the importance of having a thorough understanding of what you are investing in.
Finally, if you do use price momentum to gauge when to buy into and sell out of a security, consider the fact that many other people are looking at the same charts as you are. So take the extra step and carefully evaluate the fundamentals. A security with a fundamental reason to appreciate (valuation, rising earnings, strong financials, etc.) is less risky than one that lacks a fundamental reason to rise.