- The Wall Street Journal – Silver Slips Below $40, Spooks Other Markets
Silver plunged for a third consecutive day, ending below $40 for the first time in almost a month as investors continued to bail out of the market due to higher trading costs. Silver prices have lost 19% since Friday, when CME Group Inc. said it would raise the amount of money traders had to have on hand, known as margins, for the second time that week. The exchange raised margins again on Monday, and on Wednesday announced two more increases which come in to force at the close of business on Thursday and on Monday. “It’s a continuation of the higher margins squeezing traders out,” said Rob Kurzatkowski, senior commodities analyst at optionsXpress. As expected, the increase in margin requirements has driven weaker traders out of the market. However, the exodus has also pulled silver prices down. - The Financial Times – Lex: High-low silver!
The leading vehicle for US retail speculation, the iShares Silver Trust, has traded the equivalent of nearly 2bn ounces since the beginning of April – close to three times the annual new global supply from mines. The sudden enthusiasm for silver may be explained by the fact that it was somewhat late to the precious metals party. For investors who felt they had missed the boat with gold, or wanted to get in on the ground floor for the next big thing, silver beckoned last year. The ratio of the price of gold to silver dropped to around 32 by last week, well below the 20th century average of 50. The ratio is useful only as a gauge of relative froth though. Just based on relative rarity in the earth’s crust it should be around 16 times, but silver, as both a precious metal and an industrial commodity, is more useful than gold.
Comment
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Motivated Sellers Of Silver
As the chart above shows, when the price of silver broke down this week, sellers of the SLV came out in droves. These motivated sellers of SLV pushed its price to a substantial discount to silver bullion prices, violating the 1:1 ratio. This is shown below.
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When motivated sellers cause a significant discount to bullion prices, the ETF manager buys SLV shares in the open market. He pays for these shares by selling bullion and then retires these shares, causing the number of SLV shares outstanding to fall. So, when this happens, the ETF is a seller of bullion and a contributor to lower bullion prices. This has been happening this week as the first chart above illustrates.
Conclusion
There is an assumption in the market that the public has been a huge, irrational buyer of silver via SLV. If this were the case, we would have seen the price of SLV trade at a significant premium to bullion, causing this ETF manager to sell new SLV shares into the market, increasing shares outstanding and using the proceeds to buy bullion. This has not been the case.
Instead we have seen the opposite. Few signs of irrational buying of SLV were visible during silver’s advance, but now that prices broke sharply to the downside we have seen motivated SLV sellers. They have pushed the price of SLV to a significant discount, prompting the ETF manager to buy SLV, thus reducing the shares outstanding, and sell bullion to pay for them.
The public was never really an irrational buyer of SLV, but the signs now point to them being an irrational seller of SLV during this week’s downturn. Throughout the rally this year, those that incorrectly assumed that the public’s irrational buying of SLV pushed bullion prices higher wanted to make a contrarian bet to sell silver. Month after month the price of silver bullion rose, more than doubling in a few months, proving this idea wrong. We believe the reason was that the public was not a motivated buyer of SLV. The speculative/irrational buying of silver during this period was coming from sources away from SLV (professional traders, hedge funds, the Chinese, all of the above). We also recently concluded that these speculative flows are not coming from managed futures funds and “other reportable” traders.
In reality, the irrational bet by SLV investors (read: the public) is shaping up to be selling. If so, the contraraian bet now might be to buy SLV looking for these motivated SLV sellers to wind up on the wrong side of this trade.
Last week the volume of the iShares Silver ETF (SLV) topped that of the S&P 500 ETF (SPY) on multiple occasions. Despite this sign that is often taken as rampant speculation, we argued that speculation in the SLV fund was not to blame for the massive runup in bullion prices (pages 5 and 6). Our argument was based on the fact that SLV’s holdings of bullion (red line below) were essentially unchanged from the year-end 2010 levels. In other words, SLV was not a buyer of bullion despite the rally from under $30 to nearly $50 this calender year.
If SLV was experiencing a rapid influx of new money, the price of the ETF would trade well above the price of bullion. In this scenario, the ETF managers would sell these buyers new “over-priced” shares and use the proceeds to buy new physical silver for the fund. This is done to keep the ETF’s price as close to a 1:1 ratio with the price of silver as possible. Because the amount of physical bullion (red line below), as well as the number of shares outstanding, have essentially remained relatively stable, we can assume the demand to own SLV is being offset by an equal number of willing SLV sellers at current prices.
So long as this supply/demand balance in SLV shares exists, the ETF manager of SLV is not forced to buy bullion in the physical market. If the price in the physical market soars, as it has this year, we cannot blame the ETF for pushing the physical market higher in price.