THE ANATOMY OF SILVER´S DEEP DIVE / BARRON´S MAGAZINE ( VERY HIGHLY RECOMMENDED READING )

The Striking Price

THURSDAY, MAY 5, 2011

The Anatomy of Silver's Deep Dive

By STEVEN M. SEARS

The metal is hostage to market forces that add multiple dimensions to its sickening four-day decline.


Silver is now radioactive.

The options market is pricing the iShares Silver Trust (ticker: SLV) as if the exchange-traded fund will experience daily moves of about 4%.


But if that kind of volatility seems sickening, get this: The ETF is actually declining by almost twice that rate Thursday amid extraordinarily heavy trading volumes. Several increases in margin rates are clearly forcing many speculative investors to sell silver.


Since Friday's close, the iShares Silver Trust has lost 25% of its value.


Some investors may view silver's remarkable decline as a buying opportunity, but that is likely a costly mistake.


Sharp stock declines are often followed by a pause, and often bounce higher -- at least temporarily. The iShares Silver Trust chart offers no indication the price will stop falling. The implied volatility of SLV's options is up some 11% Thursday, indicating that even the options market, which is expert in pricing risk, is unsure how to price silver.


Back when silver broke toward $50 in the late 1970s, and then declined, the metal only traded in the futures market. Since then, the Securities and Exchange Commission has allowed financial engineers to create exchange-traded funds that hold commodities like gold and silver. This has made it possible for anyone to invest in commodities in the stock market without opening a separate futures trading accounts.


Commodity investing is now as easy as buying stock. But the decline in silver is proving that is not really true.


Silver's price is influenced by futures, equity derivatives and stock trading. The action in all the different markets weighs heavily on silver's price. Selling pressure now stretches across three markets -- the futures, stock and options. The selling is exacerbated by an ultrashort exchange-traded fund loaded with derivatives that sharply increase in value if silver prices decline.


Trading volumes are immense. SLV's three-month average daily trading volume is 53 million shares. On Wednesday, 185 million shares traded. Already, SLV has traded almost 164 million shares.


The pressure aligned against silver was exacerbated by Wednesday's release of data from the Institute of Supply Management, which measures U.S. economic growth and frames business cycles. The weak report prompted many institutional investors to push the "risk-off button" and even exit silver trades that so many first bought a few years ago in anticipation of a U.S. economic recovery.


Wednesday's ISM report was the weakest relative to expectations since 2008, and the sixth weakest since 1999, according to Bespoke Investment Group. ISM's index slipped to 52.8 in April, from 57.3 in March. The April consensus was 57.0. One report does not automatically change institutional investment strategies, but it prompts profit-taking and begins the process of re-evaluating portfolio allocations.


David Kostin, Goldman Sachs' portfolio strategist, told clients Wednesday that ISM's acceleration rates have slowed to neutral compared to last year's reading. "A high level of growth argues for continued cyclical exposure while deceleration suggests a more defensive posture in Standard & Poor's 500 sectors," he advised clients in a research note.


To be sure, silver was a momentum trade predicated on U.S. economic growth.


Kostin told clients that the decline in developed-markets industrial production is occurring as emerging-markets production shows early recovery signs. "That shift in the timing/balance of growth in favor of developing economies favors a shift into U.S. equities with higher international sales exposure," he said.


Indeed, many investors first bought silver in 2009 to benefit from the U.S. economy emerging from the credit crisis of 2007. Silver is an industrial and precious metal. If the economy improved, silver would increasingly be in demand by industrial concerns that made batteries, electronics, medical applications, and even solar energy.


At the time, SLV was around $17, and gold was the rage as a hedge against the Federal Reserve's decision to lower interest rates to help jump-start the economy. The SPDR Gold Trust (GLD) soon rallied to new highs, while silver quietly attracted institutional investors. Silver's price rise ultimately attracted less sophisticated investors who helped fuel the metal's rapid rise.


Silver has returned 42% more than gold during the past six months, but the tide has now turned.


Silver's price reversal is dramatic and international. Silver first collapsed some 12% on Sunday in Asian markets. On Thursday, silver broke below $40 – it recently traded around $36 – as recently euphoric investors increasingly panic. Each day brings darker news, and pushes SLV further from its late April 52-week high of $48.35.
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