By Amine Bouchentouf
Silver’s recent price surge exemplified its ‘risk on/off’ nature, which can be tricky for investors.
One of the big stories in commodities the last few weeks has been silver’s meteoric rise. The metal, which was sleepy and anemic throughout the summer, began to shrug the summer laziness in late July and has skyrocketed 28 percent since the beginning of August.
Many investors are wondering why silver experienced such a surge and, just as importantly, why it traded flat throughout the summer. These are equally important questions that we will answer in this column.
First Among Equals
Before delving into the specifics of the silver market, it’s important to frame silver’s performance within the broader commodities complex. The third quarter of this year was an exceptionally good one for commodities across the board. More than a half-dozen commodities increased by double digits since the quarter began, with many more in single-digit, positive territory.
To be sure, silver was definitely the best performer in the commodities complex in the third quarter, but key agricultural and energy commodities also performed well: Wheat was up 22 percent and corn 12 percent, while natural gas and Brent crude were up 16 percent and 14 percent, respectively. Even gold posted solid numbers, having returned almost 11 percent for the quarter.
To understand silver’s performance, it’s important to get a grip on the drivers at play in each of the commodity markets. Seasonality aside, this was one of the best years for agricultural commodities in a very long time. Indeed, while silver performed best during the quarter, agricultural commodities had the best overall performance for 2012: Wheat is up 38 percent YTD, while soybeans are up almost 33 percent YTD. This is primarily due to the effects of one of the most severe droughts experienced in North America and in other key agricultural markets.
As for commodities in the energy complex, Brent has had a solid year, which is quite remarkable given all the market dislocation going on in the world. Despite the slowdown in European economic growth, a “soft landing” in China and stagnant economy in North America (which make up the bulk of the crude consuming world), Brent crude has been in constant demand. Part of the reason is that despite the economic slowdown, industrial demand for crude has remained very robust globally. This is a testament to the inelastic demand for crude oil and its derivative products, which provides sellers of crude oil a large cushion of safety.
As for natural gas, the commodity had reached such low levels that it was only a matter of time before we saw a rebound; in fact, The Commodity Investor had predicted such a rebound during the summer.
Contrarian Investors Only
Which brings us back to silver and its recent performance. Unlike agricultural and energy commodities, which have heavy industrial usage and large commercial customers that are active all year round, silver is primarily a financial commodity. Sure, silver has some industrial uses, but those are relatively small and aren’t large enough to be significant market drivers.
It is my analysis of the markets based on the available data that silver is the quintessential “risk-on/risk-off” trade. And contrary to popular wisdom, The Commodity Investor argues that investors tend to dump silver during times of unease and anxiety (risk-off), and load up on it when the mood is positive (risk-on). This is contrary to analysts’ claims that investors view silver (and gold) as a safe-haven asset.
Let’s take a look at the recent market activity as an example. Silver started out on a positive note for the year, up more than 27 percent during the months of January and February. Remember at that time there was talk of a large-scale European bailout package, positive numbers coming out of the U.S. and China, and talk of coordinated actions among the world’s central banks to stimulate growth. The investment mood was bullish and this helped push silver prices near the $40/oz. mark.
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As we entered the final stages of the first quarter and into the second quarter, the mood became quite somber with talk of a “hard landing” in China, a worsening outlook for emerging markets, and a gloomy outlook for Europe: Many analysts even predicted that the euro may experience a breakup if economies such as Spain and Italy didn’t get their fiscal house in order. This gloomy talk wasn’t encouraging to investors, and silver prices suffered as a result.
Fast-forward to today and you see that silver prices have been on a tear. The reason? Bullish investor sentiment has a big role in silver’s latest rise. Investors certainly cheered the Federal Reserve’s “QE unlimited” and they expressed their appreciation by putting on more “risk-on” trades; indeed, not only have silver prices benefited, but equities (the ultimate risk-on trade) also have been performing very well as a result of this improved sentiment.
What’s An Investor To do?
Trying to time the markets is a dangerous thing, and no one is advocating doing that here. However, there are certain indicators investors must monitor, and investor sentiment is a key indicator. The Commodity Investor argues that silver is the ultimate risk-on trade, so when investors are feeling bullish, silver prices will most likely benefit.
To trade on this sentiment, I recommend two instruments that are very reactive to and reflective of silver price moves. The first is the iShares Silver Trust (NYSE Arca: SLV) and the second is Silver Wheaton Corp (NYSE: SLW). SLV is the essential silver ETF used by institutional and individual investors alike to get liquid and instantaneous exposure to the silver markets, while SLW is a silver streaming company that gives you enhanced returns on silver mining activities.
Both of these instruments can be used to express your view of the silver markets, whether you’re a contrarian or not.
Disclosure: The author holds no positions in the stocks mentioned.