With the exception of one brief down period, silver has been in a permanent bull market for the past ten years, rising from under $4.5 an ounce in March, 2001 to $37.52 last Friday. The steepest jump came in the last twelve months, when the price more than doubled. To many exuberant retail speculators, silver at $50, and often much more, is a foregone conclusion.
Largely responsible for this run up are silver ETFs through which small investors can hold the metal. Since its inception in 2006, SLV, the largest of these funds, has increased its holdings nearly seventeen fold to 10,960 metric tons. It isn't alone either. According to a report by the U.S Geological Survey, these relatively new funds had acquired the equivalent of 68% of last year's worldwide mine output by last November. They aren't done yet, either. SLV added fifteen tons last week.
The surge in investment demand and commensurate run up in prices, however, has obscured weakening fundamentals. Industrial demand for silver, which now accounts for only about half of total demand, fell sharply in 2009. It continued to slide in the U.S last year, in spite of the economic recovery, according to the USGS report. And it could fall further as rising prices encourage substitutes, such as tantalum and titanium in the medical industry, aluminum in reflective surfaces, and stainless steel in flatware. While non-investment demand is falling, production is rising. Mine output increased 400 tons last year. With prices rising both for silver and for metals such as zinc and copper, from whose extraction it is a frequent by-product, there is no reason to expect that trend to reverse.
The less predictable trend is the direction of investment demand. Silver is in a speculative bubble, but bubbles tend to expand before they pop and it is entirely possible that prices will rise further. Silver is not a huge market, the wildly popular SLV does not even rank in the top twenty-five ETFs by assets. As a result, small inflows or outflows of cash can create large price movements. This is especially so on the futures markets, where positions can be leveraged 20:1 in some cases. A few starry-eyed investors, dazzled by silver's recent surge, can still drive prices yet higher, as can the odd lot of conspiracy theorists who think the metal will soon be the only acceptable currency when the apocalypse arrives.
Eventually, however, the apocalypse aficionados will be amply prepared for doomsday and retail demand will be saturated. Because industrial demand only accounts for half of total demand, investment will not have to fall that much for the trend in prices to reverse. Mathematically, the situation resembles a Ponzi scheme. New investors, impressed by spectacular returns, are pouring money into silver, rewarding existing investors with artificial demand. At the moment, the inflows are sufficient to pay off old investors who want to cash in, while simultaneously growing inventories.
Even many silver bulls recognize this situation. Greg Ho, president and COO of Spring Mountain Capital, identifies silver as the asset towards which he is most bullish, even implying that the metal could more than double in price. However, he attaches an interesting caveat to this optimism:
Silver's current price level is, I believe, the result of unprecedented investor demand, and if that demand were suddenly to disappear, I would not be surprised to see the price of silver return to the mid- to high-teens.
Rising prices cannot last forever. Sooner or later, enough people will want out, or be forced out by margin requirements, and investment demand will no longer be able to absorb surplus supply. When that happens, prices will decline, dramatically. Spooked investors will run towards the exits, and no one will be there to buy. Speculators who purchased silver with borrowed money will be left scrambling for cash, accelerating the decline. The market is not liquid for everyone. The same factors which enabled the rise in prices; the size of the market, the use of leverage, and the herd mentality of retail investors, will facilitate its collapse.
At present, silver ETFs and other investors contribute to net demand. They are constantly acquiring more bullion. When prices fall, however, they will become net suppliers, dumping thousands of tons onto a saturated market. The longer the run up in price continues, the more silver they will have to unload when the crash inevitably comes.
Capitalizing on that situation, however, is much more difficult than identifying it. It is hard to know exactly when the music will stop playing. Silver at $50, or beyond, may well become a self-fulfilling prophecy. Bold investors, who realize that silver is in a bubble, may nonetheless wish to speculate that it will continue to advance before pulling back. Two ETFs: the iShares Silver Trust (NYSEARCA:SLV) and the double leveraged ProShares Ultra Silver (NYSEARCA:AGQ) provide long exposure.
Unfortunately, the only fund on the short side of this metal is the double leveraged ProShares UltraShort Silver (NYSEARCA:ZSL). Because this fund tracks double the inverse of silver's daily performance, a spike in silver prices followed by an identical fall would still leave its investors in the red. That is a losing situation for a fund that tracks an asset prone to frequent gyrations in price. ZSL's 96% loss since inception underscores the risk. Like all Leveraged short positions, ZSL brings to mind John Maynard Keynes’ caution that “markets can remain irrational longer than you can remain solvent”. Since an unleveraged fund does not exist, conservative bears should try to short SLV. Another option would be to buy deep, long term out of the money puts and hope that the bubble pops before the contracts expire.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in ZSL over the next 72 hours.