Profit From Silver's Sudden Weakness

Investors who dipped their toes into silver for the first time as the metal's price spiked near $50 per ounce might be pretty terrified by its current volatility. But if they stay too focused on the metal itself, they might miss out on an even better opportunity to profit from the folks who mine it.

Consolidation fuels long-term fire
First, don't panic about the ups and downs of silver prices. In an ongoing bull market like the one silver's enjoying now, occasional reversals or breathers in the metal's rising price can healthily help shake out excess speculation and leverage.

After all, ever since the COMEX futures exchange signaled a powerful short squeeze and a rare condition of backwardation, the long side of this market has gone into an absolute frenzy. Silver skyrocketed from less than $27 in late January to nearly $50, in just 3 months! As the metal's price approached the psychological $50 barrier, a slowdown became both likely and downright critical to long-term silver investors' interests.

Commodity guru Jim Rogers said it best: "I own silver, but if it keeps going up, it could turn into a problem if it goes parabolic." He continued: "I certainly hope silver goes down for a while. I say it as somebody who owns it because if it goes down, I hope I would buy more and if it goes up too much too fast, then I have to sell."

I agree wholeheartedly, and I welcome recent weakness, particularly in silver mining stocks, as an enticing opportunity to redeploy gains that I locked in along the way.

Silver's hypercharged arbitrage
Prices for gold and silver may have risen over the past few weeks, but stocks of the companies that mine these metals haven't matched their respective commodities' gains. Silver Wheaton (NYSE: SLW  ) has swung from trading at a well-deserved premium to the price of silver to a substantial discount.

While the iShares Silver Trust (NYSE: SLV  ) tacked on some 25% during the month of April alone, the Global X Silver Miners ETF (NYSE: SIL  ) essentially flatlined. Fools were not the only investors who noticed that growing disparity.

Hedge fund manager Eric Sprott caused some short-lived confusion Monday by liquidating $34 million worth of his own firm's Sprott Physical Silver Trust (NYSE: PSLV  ) holdings. "We haven't lost our enthusiasm for silver," Sprott explained. "Every dollar of money that was raised by selling shares of [the Trust]... was reinvested in silver or silver equities."

Traders had bid Sprott Physical Silver Trust to a significant premium beyond its net asset value. With quality mining shares trading at irresistibly low prices, Sprott clearly chose to make the most of the difference between the two investments' relative values.

The golden strategy for long-term silver gains
The market's way too bumpy to make any reliable short-term bets on which way silver's headed. Any investors who try to do so will likely get burned. Silver has arrived at a crucial crossroads that could drive serious near-term volatility in its price.

On the one hand, Federal Reserve policy has plunged the U.S. dollar dangerously close to a historic retest of the dollar index's all-time low of 71.32 from 2008. On the other, a renewed focus on Europe's huge debt concerns could give the greenback a timely reprieve, although I believe it'll eventually keep falling. In the past, a falling euro has often propped up precious metal prices, but confusion can set in when the world shifts its preference back and forth between the dollar and the euro. Don't forget the wild card that is the Japanese yen, either.

Meanwhile, I believe that COMEX traders have recently and increasingly started to distinguish between actual physical silver bullion and the leveraged paper proxies that trade in its stead, representing many multiples of the available global physical supply. The speed of silver's recent run might be a distress signal, in which increasingly emboldened long investors called the effective bluff of silver's leveraged paper supply. To corroborate this theory, note that backwardation in silver -- basically, the farther ahead in time we look, the lower the price for silver futures contracts gets -- persists today, even after the latest decline.

Because futures contracts are highly leveraged on both sides of the battle, the CME Group's third margin increase within the past two weeks triggered a sudden flushing of speculative volume, and may have triggered silver's near-term reversal. You can't rule out further margin increases going forward, so forecasting the timing of a rise through $50 remains highly problematic.

Finally, for the first time in financial history, we're just two months away from seeing what happens when a $600 billion program by a central bank to purchase its own debt is suddenly fixed at that level, even though daunting economic headwinds remain. With the Dow Jones Industrial Average topping 12,750, I think that the end of the Federal Reserve's QE2 might throw a serious monkeywrench in equity markets' upward march. Still, in our complicated economic landscape, I don't think anyone can be entirely certain of any one scenario.

With those and other highly unpredictable factors in play, I encourage Fools not to bother speculating on silver's short-term moves. I'd rather increase my silver exposure in a disciplined manner over the course of this increasingly volatile period. Coeur d'Alene Mines' (NYSE: CDE  ) San Bartolome silver mine, and Pan American Silver's (Nasdaq: PAAS  ) San Vicente mine, for example, have reportedly been cleared as potential targets of nationalization by Bolivia's Morales administration. And low-cost powerhouse Hecla Mining (NYSE: HL  ) , trading below $8.25 per share at the time of this writing, stands less than $1 per share above the stock's 2009 high -- back when silver traded for less than $20 per ounce!

You get the idea. I strongly encourage Fools to countenance this silver correction with conviction regarding the long-term trend, and to follow Eric Sprott's example in seeking hyper-charged arbitrage among the miners of silver.

Fool contributor Christopher Barker can be found blogging actively and acting Foolishly within the CAPS community under the username TMFSinchiruna. He tweets. He owns shares of Silver Wheaton, Hecla Mining, and Coeur d'Alene Mines. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 03, 2011, at 5:35 PM, reinman60 wrote:

    Good article

    While silver has staged a huge advance in the last several months, it was actually quite orderly. In fact, I was quite surprised at how relentlessly orderly it had been. While the COMEX maintains that the increases in margin requirements were due to extreme volatility, the extreme volatility we are now witnessing in the markets was actually caused by the increases.

    That this volatility is to the downside must come as a relief to the COMEX. With silver still in backwardation, and registered silver in the warehouses continuing to decline, they are clearly concerned with default, either actual or implicit.

    You mention the longs calling the bluff of the paper shorts. That's exactly what they're doing.

    Although they have gained a reprieve in the last several days, the ultimate end of this saga is yet to be written. It will be extremely interesting to watch how this high stakes game plays out in the weeks and months ahead.

  • Report this Comment On May 04, 2011, at 7:02 PM, rfaramir wrote:

    Great article, but no need to focus on the US Dollar Index: "dollar index's all-time low of 71.32 from 2008"

    It is a measure of the value of the dollar IN TERMS OF OTHER FIAT CURRENCIES! Since they're all in a race to debase, not one among them backed by a physical commodity of any kind, it can only show a RELATIVE level of quality. It has no meaning relative to the price of gold or silver. The only reason to include it is because it is something the Fed looks at, as it is a measure of how much they stick out from the fiat pack. But the whole pack is descending into currency hell, so who's leading the pack is irrelevant.

    (Sorry to yell a little. I'd normally *emphasize* with asterisks, but it was too long a phrase.)

    [Also, according to wikipedia (not the greatest source :-), it has been "as low as 70.698 on March 16, 2008, the lowest since its inception in 1973." Maybe it's a close versus intraday discrepancy?]

  • Report this Comment On May 05, 2011, at 7:27 PM, jargonific wrote:

    Now that the dollar has recovered somewhat with the falling oil, gold and silver prices, what do you make of trading on silver at this point?

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