5 Reasons Why Silver Prices Move


 

02/19/11 – 08:28 AM EST

Silver prices have a reputation of being manipulated, volatile and less liquid. Silver hit a record high of $50 an ounce in 1980 after the famous (or infamous) Hunt brothers bought the metal aggressively for 7 years; at one time owning more than 200 million ounces of silver.

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The silver bubble burst soon thereafter shedding 50% of its value almost immediately, and over the last 30 years the metal has traded as low as $4 and as high as $31.79 an ounce.

Along with gold, silver prices are at the mercy of investment demand, safe-haven buying, inflation fears, momentum trading and price manipulation. The one thing that silver prices have going for them that gold doesn’t are oodles of industrial demand.

Indeed, silver can be found in a plethora of products, from iPads to cars to solar panels, making it the perfect metal for those wanting a hedge against currency debasement as well as exposure to a global economic recovery.

David Morgan, founder of Silver-Investor.com, says he could see silver prices as high as $45 in 2011 “and if things get really crazy we could go beyond that.”

Silver is also at the mercy of stocks. When equities plummet, investors are often forced to sell silver for cash, but any significant dip can trigger a wave of buying as investors purchase silver at “cheaper” prices, resulting in a strong tug of war. Because fewer people own silver than gold, the market is smaller, which results in violent price action.

Here are five fundamental factors that will contribute to silver’s strong price moves in 2011.

5. Price Manipulation

Price manipulation is the most controversial theory that has circulated among gold and silver bugs for 20 years. Some argue that precious metal prices have been illegally suppressed over the last two decades by central banks, governments and trading houses. The Gold Anti-Trust Action Committee, or GATA, is the biggest complainant and mainly points to the “hugely disproportionate short positions,” according to Chris Powell, secretary and treasurer of the organization.

The manipulation headline has been gaining traction of late after trader Brian Beatty filed lawsuits at the end of October against JPMorgan(JPM) and HSBC for conspiring to “suppress and manipulate” silver prices on the Comex.

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The allegations are particularly noteworthy because HSBC and JPMorgan are custodians of the physically backed exchange-traded funds like the ETFS Physical Silver(SIVR) and iShares Silver Trust(SLV), which means the big banks, in charge of storing the metal investors are buying, are being accused of manipulating the prices.

Bart Chilton, commissioner of the Commodity Futures Trading Commission, is pushing the commission to prosecute a two-year investigation into the silver market. According to reports, the CFTC is also looking into JPMorgan and possible silver manipulation trading.

The drama continues. A Chicago law firm, Cafferty Faucher, filed a law suit at the end of December against HSBC and JPMorgan accusing the two of using their positions as silver holders to purposefully suppress the silver price so they could profit from their short positions.

JPMorgan had been trying to combat these allegations by reducing its huge silver short position. George Gero, senior vice president at RBC Capital Markets, said it was mostly done in the physical market in London and was finished by now. The move by JPMorgan could have been part of the reason why silver prices rallied from $24 to $30 an ounce in November and the first half of December. Any more unwinding initiatives could result in modest silver price rallies.

GATA goes one step further in the silver-manipulation story and proposes that central banks are buying the metal on the sly to suppress prices. The idea behind the suppression is that the world looks at gold and silver as barometers of the health of economies — gold more so than silver, but both are “de-facto” currencies. The suppression theory means that global economies are in worse financial shape than investors think.

Powell argues that silver has often been an official currency, even more so than gold, “so it would be hard to dispute a central banking interest in silver today.” To embroil JPMorgan even further into this quagmire, Powell says that the investment bank is often the agent of the Federal Reserve in the markets and could be helping the Fed intervene in the silver market.

The convention wisdom among those who adhere to the manipulation theory is that if silver manipulation comes out of the market or is brought to light then prices would pop much higher.

The opposition, however, is just as passionate. “There’s no vested interest on anybody’s parts to suppress prices here,” says Jon Nadler, senior analyst at Kitco.com. “The allegations remain at that level, simply allegations.”

Nadler argues that despite the rumored manipulation, prices have still climbed. “If this is suppression, I think it’s completely ineffectual, and let me have more of it,” Nadler says.

Philip Klapwijk executive chairman of GFMS Research Group, says there is “nothing to these allegations.” He thinks they will continue to be chatter for silver prices in 2011 but that they will just be a lot noise. “If there was a massive short position, the degree to which those shorts are under water is now quite extraordinary.”

4. Gold and Silver Ratio

Many investors use the gold/silver ratio to determine where silver prices will head. The ratio refers to how many ounces of silver it takes to buy one ounce of gold. If the ratio is high it means that silver prices have slipped. If the ratio falls, silver prices are outperforming gold.

The ratio has come down from over 60 to the mid 40’s even touching 45/44. According to 2010 closing prices the ratio was 46, meaning it took only 46 ounces of silver to buy one ounce of gold. At the beginning of 2010, the ratio was 65. It is currently 43.

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In 1980, a previous high for both metals when gold was $850 an ounce and silver was $50, the ratio was as low as 17. Some bullish experts say that if gold and silver were to reach that ratio again, silver should be north of $80.

“If you moved to [even] 30:1, you would have a considerable swing in the value of the silver properties relative to gold,” says Rob McEwen, CEO of U.S Gold(UXG), who, with two silver and gold deposits in Nevada and a silver deposit in Mexico, has a vested interest in higher metal prices.

Klapwijk says that the current ratio of 46 actually makes silver expensive in comparison to gold. This ratio is “not sustainable level in the long run” and will move up over time to up to 50. That doesn’t necessarily mean that silver prices have to sell off, it just means that silver might not outperform gold but instead will lag the yellow metal.

Randall Warren, chief investment officer at Warren Financial Service, also thinks this ratio could correct in the short term and provide from headwind for silver prices. He argues that the 100 year average is about 50. If that ratio were to resume at 2010 closing prices, silver should trade around $28.42.

Warren is much more bullish on the ratio over the long-term, however, and is confident that the commodity bull market will recover and prosper. He thinks the ratio could hit 30 by the end of 2011, which would imply “longer-term higher silver prices by the end of 2011.”

3. Currency Debasement

The most popular reason to own silver is as a hedge against inflation.

The theory is as paper currency loses value, silver will retain its purchasing power, making it a safe place to preserve one’s wealth.

While many investors talk about silver’s inverse relationship to the U.S. dollar, BullionVault’s head of research Adrian Ash prefers to categorize it more broadly as “anti-currency.”

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The same applies to gold. “They are stateless, they don’t have the burdens of debt, which any multinational currency has. They are a long-term story,” Ash said, in describing their attributes.

Echoing Ash, Philip Klapwijk says that all three major internationally-traded currencies: the euro, yen and dollar, have generated some degree of “suspicion” from investors amid sluggish economic performance, “very” unattractive short-term interest rates and growing, massive sovereign debt obligations.

Despite its recent rally, Chuck Butler, president of EverBank World Markets, expects the U.S. dollar to show another round of weakness in 2011, providing continued support for silver. Some analysts like Oliver Pursche, portfolio manager of the GMG Defensive Beta Fund, are even calling for the possibility of QE3 and QE4.

Even ‘dormant’ inflation is picking up in the U.S., with core consumer prices up 1%, versus a year ago, 1.6% if you count food and energy, which every other country does. Producer prices are even higher, up 3.6% year over year.

Inflation in the eurozone is up 2.2% compared with 1.9% in December. The U.K.’s reading came in very hot at 4%, Brazil is at 5.99% and China is at 4.9%, not as high as expected but steeper than the 4.6% December reading. Global food costs rose 3.4% in January, according to the U.N.’s index.

The biggest threat to silver’s inflation thesis is if central banks around the world decide to raise key interest rates. The People’s Bank of China is the latest and recently raised the deposit rate by 25 basis points to 3% for the third time since October.

Higher interest rates make it more appealing to keep money in the bank and a higher lending rate makes it less appealing to borrow. Both might hurt consumer demand for silver as well as industrial demand.

Ash, however, was unfazed arguing that central banks would have “to raise interest rates by a long way before it really makes a difference for cash savers.”

The negative real interest rates, the interest rate minus the inflation rate, is still 1.9% in China, making precious metals more valuable than paper currencies.

2. Industrial Demand

The industrial demand behind silver prices is expected to be strong in 2011 but not remarkable.

Industrial demand staged such a big comeback in 2010 from 2009 as the global landscape recovered, that this year’s levels will pale in comparison.

“This year, this type of news will not be quite as unequivocally good,” GFMS’ Klapwijk said. “We’ve had such a significant rebound in industrial demand for silver that gains will be somewhat harder to come by this year compared to 2010.”

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Meanwhile, BullionVault’s Ash has heard complaints about high silver prices from industry representatives, because the pass-through of these high prices are hurting their customers.

Ash wonders whether the industry will begin looking for silver substitutes, especially in newer uses such as solar panels and chips — if prices become unfavorable.

“Has silver gotten over the fact that it’s an industrial metal primarily?,” asked Ash.

EverBank’s Butler sums up his expectations of industrial demand for silver this year as “steady — nothing phenomenal, but nothing that’s weak.”

The one thing silver does have going for it is a slew of new products never before imagined that use the metal, like iPads. “We’ve seen in the last year the growth in that type of use increase about 18%,” says Phillips Baker, CEO of Hecla Mining(HL), one of the largest silver producers in the world.

Baker, in fact, credits steady industrial demand with keeping silver prices afloat as investment demand ebbs and flows.

1. Investment Demand

Traditionally, silver investing was reserved for the fringe precious metal buyer, who thought global wealth would be eradicated and that silver and gold would be the only currencies left standing.

However, as the financial crisis rocked global markets at the end of 2008, a trend started to develop of regular investors allocating a certain amount of their portfolios into precious metals, although mostly gold, silver was included.

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The biggest physically backed silver exchange traded fund in the U.S., SLV, held 6,524.93 tons the Friday before Lehman Brothers declared bankruptcy and how holds 10,411 tons, or 333 million ounces.

The SLV added 1,428.60 tons just in 2010 alone while its smaller competitor the SIVR grew its holdings 81% to 16,627,688.2 ounces.

The advent of physically backed silver ETFs over the past five years has given investors an easy way of speculating on silver. One share of the SLV is equal to one ounce of silver.

If investors start piling into the ETFs, the funds must add more silver, taking more silver out of the open market and triggering higher prices. But the reverse is also true. If investors sell gold ETF shares en masse and there are no buyers, there will be inflows of silver into the market, which will weigh on prices.

Large swings in the silver price can also point to buy orders or sell stops. When the silver price sinks to or rises to a certain level, a trader will be forced to sell or buy silver. This trading restriction is set up to protect the trader from losses and to protect gains, but often can accelerate sell-offs and rallies.

Rumors are also circulating that Asian buyers are planning to take delivery of shares of the SLV, or trade in their shares for the metal. They would have to do so in 50,000 share lots, which could cost as much as $1.5 million. IShares reserves the right to cancel a redemption if it is too large a request to meet. Currently the ETF holds 10,411 tons, down 510 tons since the beginning of 2011.

There have been reports of a physical shortage of silver. Whether the shortage in production lags or too much demand from these Asian buyers remains to be seen.

There are currently 16.1 million shares sold short of the SLV and they might go running scared over fears of iShares having to deliver a massive amount of silver to these Asian buyers, especially if rumors of a supply crunch are true. The combo, logically, would push prices higher.

On the flip side, if any of these rumors are debunked, traders might ditch silver for other assets, which illustrates the volatility of prices and the fickleness of investors.

Despite using silver as a trading vehicle, most retail investors still don’t own it, which is one of the fundamental reasons silver bulls think the price will skyrocket.

“We’re going to go into a period like the high tech market where there is a mania,” says Rob McEwen, CEO of U.S. Gold, who thinks the market is about half of the way there.

There have been other signs that investment demand is on the prowl, which was critical to silver’s killer rally in 2010.

According to Patricia Cauley, director of metal products at the CME, open interest in contracts for silver grew 9.2% in 2010 versus 8.6% for gold. Open interest contracts illustrate the new buyers in the market.

Average daily trading volume was 76,000 contracts for silver in the fourth quarter of 2010 , which doubled from the third quarter and is up 82% from the same period a year earlier. Cauley says this points to a “renewed interest in silver…. As we see the price of gold keep going up. The poor man’s gold has come back.”

David Morgan says that during gold’s 80% rally, rumors were plentiful as to who was committing new money to the metal, even famous poker player, Amarillo Slim, made the list. Morgan believes that it was more the spread trade that had investors piling into the market.

“Once [silver] reached the $20 level, the trade for large fund managers was the spread that was short gold, long silver.”

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The silver trade might hit some more snags over the long-term.

First of all, investors are paying almost three times as much for an ounce of silver than they did in the beginning of 2009, so the “easy” money has already been made. The monster rally might scare off those who haven’t bought the metal yet.

Silver prices are also very volatile. Because the market is thinner, a big buyer or hoarder can really affect prices. Silver’s industrial component can also leave it vulnerable to signs of an economic slowdown especially in emerging market countries.

There is also a lot of pressure on investor demand to support high silver prices. The above ground supply of silver is increasing annually. According to Randall Warren, new mines in Mexico coming on stream could trigger a silver rush in 2012.

Although industrial demand and new products are sopping up some supply, “heavier lifting is called for this year from the investor community just to keep the game alive,” says Klapwijk. He estimates that several billion dollars of investment inflows are needed.

According to the World Silver Survey, net investment demand grew by $1.3 billion in 2009, the year with the most recent data available, to $2.6 billion. These calculations factor in an average price target of $14.67, which was considerably higher in 2010.

Billions of dollars of new investment inflows at recent record prices isn’t impossible just daunting and puts a heavy burden on investors and traders to keep silver prices afloat.

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