Don’t Get Caught in the Silver Trap

by Ivan Martchev | May 10, 2011 11:03 am

As I have discussed with you here, I wasn’t surprised at the recent U.S. Treasury market rally[1], the U.S. dollar index surge due to the euro’s decline[2] or the precious metals sell-off.[3] This week, I want to focus on the big pullback in silver and share a few thoughts.

It looks to me that the first leg of the sell-off has been completed and we are in the middle of the proverbial “dead-cat bounce” — after which a second leg will ensue. This is because there is a huge amount of leverage in the silver futures market, and traders who get greedy tend to pyramid their positions and tighten stops, pushing the market beyond the level it otherwise would go to without such leveraged strategies.

When too many traders lean on one side of the market, it increases the chances of a violent move in the opposite direction — magnified by the very leverage that caused the price to soar to unwarranted levels.

The conspiracy theorists say that it was the exchanges that hiked margin requirements for futures that caused the sell-off, and of course, the exchanges say they’re only protecting themselves from losses that would result in the event of a market sell-off. The same process repeats over and over in the futures markets, but it is sad that so many people get caught on the wrong side of the market every time.

Silver is not the only metal that is prone to violent moves, but because the market is so tiny in financial terms compared to its more expensive cousin gold, it can move at literally twice the rate to the upside and the downside.

Sprott Physical Silver Trust (NYSE: PSLV) Chart

At one point, the Sprott Physical Silver Trust (NYSE: PSLV[4]) was trading at a near 29% premium to its NAV, which is a ludicrous price to pay and an indication of too much bullish sentiment (a contrarian signal of sorts). Nonetheless, PSLV is a highly innovative product that allows buyers to cash in their shares (as long as they meet certain minimum levels) in exchange for physical silver bullion.

What buyers of those innovative securities fail to keep in mind is that unless they hold the necessary minimum amount of shares, they cannot cash them in. It is true that there is audited physical gold and silver bullion in those trusts sitting in a vault in Canada, but paying a 29% premium for that certainly is not how smart investors should approach precious metals.

We had a similar situation with the Sprott Physical Gold Trust (NYSE: PHYS[5]) last year when it was originally launched. PHYS traded to nearly a 24% premium to cash gold. Then, we saw a slow erosion of the premium resulting in the PHYS shares trading sideways while the gold market rallied to close the premium gap to the current 1.8% — and I think the same may happen with PSLV.

In addition to the extreme bullish sentiment in the silver market, we have notable negative seasonality in precious metals in late spring and summer that typically ends in the fall. It does not happen every year on the same date, but I have seen more than one intermediate-term top in precious metals put in right around where we saw the top in silver this year.

A one-week decline is not enough, in my view, to cause a healthy correction and “shake out the weak hands” from the market so that we can have a healthy bottom in gold and silver bullion. Historically, such corrections have taken about four to eight weeks to complete (not counting 2008) after which point a long trading range ensues, which would perfectly fit the pattern of negative summer seasonality in precious metals.

After this sell-off is over, we could see a triple-digit price for silver in the next five years due to the tiny size of the silver market compared to gold and the tendency of the metal to rally in tandem. The bullish fundamentals for gold bullion are still very present — negative real interest rates, foreign exchange reserves for many emerging markets that are too large, as well as unorthodox (and highly controversial) monetary policies in several developed markets.

I recommend that you do buy silver — but only when everyone is largely done selling it. And please avoid paying a 29% PSLV premium.

  1. U.S. Treasury market rally:
  2. U.S. dollar index surge due to the euro’s decline:
  3. precious metals sell-off.:
  4. PSLV:
  5. PHYS:

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