Sunday, June 5, 2011

Silver Lives up to Reputation for Volatility


Gold and silver exchange traded funds have proved hugely popular by offering easy access to hard assets at a time when investors’ confidence in paper money has been badly undermined by the global financial crisis.

Silver ETFs have been particularly successful in attracting large numbers of retail investors who have been unable to afford to buy gold.

Analysts had warned for some time that a correction was likely.

Suki Cooper, precious metals analyst at Barclays Capital, says the silver market had become entirely detached from its fundamentals, with the buying of coins and bars by retail investors reaching unprecedented heights even as mine production and scrap silver supplies were running at record levels.

The price correction was triggered by three increases in margin requirements for silver futures trading by the Chicago Mercantile Exchange.

The CME was concerned that the Comex market was becoming too volatile* after a rise of 180 per cent for spot silver over the previous nine months.

Retail investors, however, were unlikely to have been aware of any warning signs flashing, such as price volatility rising and big increases in the costs of out-of-the-money call (right to buy) options.

The increase in margin requirements forced many leveraged investors to sell positions in silver futures. And from a 30-year high of $49.51 a troy ounce, silver prices sank 34.7 per cent to a low of $32.33 in mid-May.

The value of holdings in silver ETFs also dropped sharply, down from a record $24bn to about $15.9bn (the latest available figure, from May 23).

That represented a huge wealth hit to retail investors, who account for 72 per cent of holdings in the largest silver ETF, which is run by iShares. Hedge funds hold 21 per cent.

By comparison, retail and hedge fund investors make up 47 and 38 per cent in the State Street Gold Trust, the largest gold ETF.

The difference is important, as retail investors have gained a reputation for being “sticky” as they are far less likely to trade in and out.

Even during the worst of the financial crisis in 2008, retail investors proved extremely reluctant to sell their ETF holdings.

October, when Lehman Brothers imploded, was the only month in 2008 when silver ETFs registered net outflows, a modest 52 tonnes (data from Barclays Capital). There was much more selling by speculative investors on Comex.

That downward pressure on prices from selling by speculators helped to reduce the value of silver ETFs from a high of $4.3bn in mid-July to a low of $2.3bn in late November 2008.

But in spite of the selling pressure on silver prices, retail investors continued to make allocations to silver ETFs, which ended 2008 with holdings of 8,253 tonnes, up 52 per cent from 5,418 tonnes at the start of that year.

The scale of outflows from silver ETFs during the recent sell-off has been much greater than anything experienced in 2008.

Holdings have fallen from a peak of 15,775 tonnes on April 25 to 14,111 tonnes on May 23. Such large outflows have raised the question of whether silver investors’ “sticky” reputation might now be slipping.

James Steel, precious metals analyst at HSBC, says that the price correction could boost interest in silver, particularly for coins and bars but also in ETFs, given the uncertain outlook for the global economy and fiat currencies.

Mr Steel has doubled his estimate for silver ETF inflows this year to 2,488 tonnes. He has also revised up his 2011 average silver price forecast from $26 to $34 an ounce.

He cautions, however, that the silver market will remain vulnerable to any changes in investor sentiment.

The correction for silver did prompt selling elsewhere in commodity markets, which leads to the related issue of whether there might be any implications for gold.

However, liquidity and market depth are much greater in gold than silver. Price volatility in gold is also much lower. So the correction for gold prices was much more modest. From a record $1,540.39 an ounce in early May, gold dropped 5.1 per cent to a low of $1,462.40 before recovering to close at $1,516.70 on May 23.

The impact on the value of holdings in gold ETFs has also been limited, falling from a record $106bn at the end of April to $102bn. Outflows in volume terms have been similarly modest at 20 tonnes, reducing holdings to 2,096 tonnes.

“Investor interest in the gold market has proved relatively more resilient amid the recent correction as longer term economic concerns continue to support safe haven buying whereas weak fundamentals have exacerbated the selling that materialised in silver,” says Ms Cooper.