Correction In Silver Is A Longer-Term Opportunity

Includes: PSLV, SIVR, SLV
by: Mark Thomas

As the author of, I'm now advocating accumulating a large overweight position in silver relative to gold. First of all, just like stocks, high-yield bonds, and most investment asset classes, I think precious metals peaked in price short term right after the Fed QE3 announcement. That is why my subscribers and I chose to take profits at the beginning of the fourth quarter, and reduced our precious metals ETF model portfolio exposure from the equivalent of 140% invested down to only 50%. It is also why I was taking profit gains in the mining stocks at the end of the third quarter. Since I now believe there is more opportunity in the silver market over the next two years relative to gold, and my subscribers and I have cash, the 7.4% correction in silver in the last two weeks has been welcome.

However, there are three very important things that you must understand about the silver market before purchasing an overweight position in this commodity:

  1. The most important thing you need to know about the silver market is that it will trade with about 300% more volatility than gold does. This means if gold is up or down 1%, silver will probably be up or down 3%.
  2. The total silver market is a fraction of the size of the gold market in dollar amounts, so the market is less liquid. Relatively small amounts of money in or out of the market will produce sharp price swings.
  3. Because there are only a few large institutions, such as JPMorgan and HSBC that dominate the market making of silver and are also the custodians of the large inventories, it is an easily manipulated market.

So before entering the silver market, you have to be prepared mentally for the volatility you will be exposed to. If you take a large position like I'm doing, the swings in your profit and loss will test the nerves of even the strongest believers in silver. So only you can decide what overall percentage of your assets you are comfortable with in regard to volatility and the risk you are comfortable taking. I'm a very aggressive investor, especially when I think I have an edge and the odds are in my favor. However, as a former stock investor, I rarely had ever endured the kind of volatility that exists in silver.

Normally, these traits would make me avoid this investment, and especially against putting a larger bet on it. However, in this case, because over the long-term there is such a great demand vs. supply situation developing, these same traits are what have recently and will continue to cause silver to outperform gold dramatically in the next few years.

Another important thing you need to understand about the silver market is you won't know what's about to happen ahead of time when the large players really move the market, and you will have to just endure it if it goes against you. Therefore, it is essential that you don't use leveraged ETFs like my subscribers and I did last quarter, because the volatility will intensify. It is difficult enough to endure the volatility without using a leveraged non-physical backed derivative to trade it.

Also, do not trade silver futures, because of the high leverage and the way the exchange can change your margin requirements overnight. They can crush you and force you to liquidate at the worst time. Do not do anything that might force you to sell except when you intend to. Many speculators found this out the hard way in 2011, when the price of silver approached $50 and the exchange tripled margin requirements. This is supposed to protect the exchange and it does, but the real reason was to try to crush the longs and staunch the losses of exchange members, who had shorted and were literally losing hundreds of millions of dollars.

There is also a clause in every futures contract that it can be settled in cash, and not actual physical delivery. So if silver soared so much it was bankrupting exchange members, they could declare the market is in "liquidation only" mode like in 1980. This would shortchange the investors on the right side of the trade. Of course conveniently, this is never done when average investors are on the wrong side of the trade, but only when members of the exchange and large institutions are hemorrhaging cash. Another thing you want to do when accumulating your silver position, especially if it is correcting, is be patient and average into your purchases very, very slowly.

I'm also changing strategy somewhat. Friday, I began buying a new 10% position in Sprott Physical Silver Trust (NYSEARCA:PSLV). This vehicle trades more like a closed end fund than an ETF although it is technically neither. It currently trades at a 4.16% premium to its net asset value, which basically means you pay $104.16 for only $100 of physical silver, which seems illogical when in the other ETFs, you pay very close to Net Asset Value. However, it does have some advantages over the other major ETFs, like the iShares Silver ETF (NYSEARCA:SLV) and ETF Securities (NYSEARCA:SIVR). The iShares Silver ETF uses JPMorgan as its custodian in New York, and because JPMorgan is the largest manipulator of the silver market, I would never invest in this ETF. The ETF Securities Physical Silver ETF is stored by HSBC in London, which is also a large market maker in the silver market. I trust the actual physical backing of SIVR more than SLV, and I like the fact the silver itself is stored outside the U.S., so I prefer SIVR over SLV. At the same time, the silver being stored in London troubles me somewhat. However, since that is where gold and silver has always primarily been traded, I don't think they would ever do anything to jeopardize confidence in their market.

By far, I feel the safest place to store your metals holdings is to physically possess them, and I strongly advocate that. However, metals are difficult to store safely for your retirement accounts, and if I trade them more frequently, it is almost impossible. So by far, I feel Canada is the best place to have your metals stored when you use exchange traded funds or trusts. It is a country with a long history of mining and natural resources, and most of the companies involved in the sector are located there, so it is probably the safest country from government confiscation. They have different and easy to invest vehicles for their own and foreign citizens to own gold and silver, like the Central Gold Trust (NYSEMKT:GTU) and the Central Fund of Canada Limited (NYSEMKT:CEF). These are long-term vehicles with extra precautions, like storage at mints, and they are even insured.

Going back to the issue of paying a premium of 4.16%, I have personally purchased PSLV before at a 5% premium and had it go to a 10% premium. So I earned another 5% gain in addition to the corresponding increase from the rise in the price of silver. Obviously, the premium or discount can work both ways, and the premium can go down and you can lose principal, even if silver prices are flat. The premium or discount basically follows sentiment. When prices and demand are falling, the premium declines; and if prices and demand are rising, it usually increases. There is one other factor that is different with a closed end fund and PSLV. A closed end fund can't ever issue additional shares to raise new money, yet PSLV has that right, and frequently does issue new shares as assets in the fund increase. In the past, this has crushed the premium from 10-12% to 2-3%. This always angers the long-term holders, but as long as you understand the effect, it is usually a temporary issue I can live with.

The link below goes to a chart that shows the historical premium level at which the fund has traded. This is the main reason I will accept this extra trouble for investing in PSLV.

You will notice it usually trades at between a 5-10% premium, but right now it trades at the low end of its historical premium range. Now past performance is no guarantee of future results, however, it is a guide and insight to investor psychology in the recent past. I know the big question you must be asking: If there are other ETFs that trade at NAV without a premium, why do you and other investors pay a premium for this one? The main reason is this is the only ETF that actually allows physical delivery of silver from the trust. As a small investor, you probably won't meet the minimum qualifications to invoke this feature. However, for larger individual and especially institutional investors, this is a very important security feature.

One of the things you will learn about the silver market is that the paper silver market (all outstanding futures and derivatives) is many times larger than the actual physical silver market. That means if a significant percentage of paper silver investors demanded actual delivery, the price would rocket higher when the shorts in the market couldn't fulfill their obligations. That is a fundamental flaw in the structure of the silver market. As time goes by and demand increases along with very tight supplies, it will force silver prices to increase much more than the gold market. That is also why you need to be concerned if you actually physically possess your silver, and make sure you are using the best ETF possible to profit from the huge increase in higher prices. When you own this silver trust, you know it is physically backed and can deliver the silver. So if there is a breakdown in the silver market structure, the premium for this trust would skyrocket. If the market was caught short of silver, the shorts could bid PSLV to a much higher premium to meet their obligations.

Disclosure: I am long PSLV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.