Silver Buying Only Starting
Silver has enjoyed a fantastic week, awakening from its bottoming slumber to surge with gold. And this strong silver investment demand is likely only starting. American stock traders and futures speculators control two of the world's largest pools of capital active in the silver market. And the former group still remains woefully underinvested in silver, while the latter still has massive short positions left to cover.
The global leader in fundamental silver analysis is the venerable Silver Institute, a think tank primarily funded by the world's biggest and best silver miners. Every year, it publishes excellent comprehensive data on global silver supply and demand. Last year, total worldwide silver demand ran 1067m ounces. But investing in silver coins, bars, and ETFs only accounted for 197m, less than 1/5th of total demand.
Silver investment's relatively small slice of that demand pie implies it isn't important, but nothing could be farther from the truth. Silver's two largest demand categories are industrial fabrication and jewelry, weighing in at about 4/7ths and just over 1/5th respectively. But these are very inelastic, they just don't change much regardless of silver's price. This is readily evident in the Institute's past decade of data.
The average silver price in the last 10 years has been a roller coaster, skyrocketing from just over $7 in 2005 to over $35 in 2011 before collapsing back down near $19 in 2014. Yet global industrial demand was 639m ounces in 2005, 628m in 2011, and 595m last year. There is often no substitute for silver in manufactured products, and they use so little per unit that companies really don't care what silver's price is.
But silver investment demand varies dramatically with the shifting whims of traders' sentiment towards this volatile metal. Over the past decade it has ranged from 52m ounces on the low side in 2005 to 289m on the high side in 2008, an incredibly volatile range! And since any market's prices are effectively set by marginal new buying and selling, nothing is more important for silver prices than investment demand.
The past decade's average annual silver investment demand was 196m ounces, which 2014's 197m is dead on. For our purposes today, let's round that to 200m ounces per year. That works out to under 17m per month. This basic background knowledge of global silver investment demand is essential in order to understand just how bullish silver looks today since this latest round of buying is likely only starting.
Traditional silver investing in physical coins and bars is the largest category of investment demand, averaging 136m ounces per year over the last decade. But it's challenging to track, since the myriads of silver dealers and investors around the world don't have to report their transactions. Silver ETFs, on the other hand, report their holdings daily and are easily collated. Their demand averages 67m ounces per year.
The world's flagship silver ETF is the mighty iShares Silver Trust, which trades as SLV in the States. Its holdings this week were nearly 324m ounces, the equivalent of about a year and 2/3rds of worldwide investment demand. Launched in April 2006, it is the easiest, fastest, and cheapest way for American stock investors to gain silver exposure in their portfolios. This opened silver up to vast new pools of capital.
Silver has always had a zealous hardcore base of investors who decry any type of "paper silver", which includes ETFs. If it's not physical silver in their own possession, they want nothing to do with it. While I've always personally used and recommended that classic method of silver investing, it's not for everyone. A lot of investors ranging from hedge funds to institutions legally can't buy or don't want the hassles of physical.
And silver ETFs are a perfect alternative for them. These investors buy ETF shares for a trivial fraction of what the premiums run on physical silver, and SLV in particular tracks the silver price perfectly. This can only happen because SLV is a conduit for stock-market capital to flow into and out of physical silver bullion. SLV's managers have to constantly adjust SLV's holdings to keep their ETF's price mirroring silver's.
When stock traders buy SLV shares faster than silver itself is being bought, they threaten to decouple to the upside. So SLV's managers issue enough new ETF shares to offset this excess demand. Then they plow the proceeds directly into physical silver bullion held in trust for their shareholders. Thus any differential buying pressure on SLV shares directly bids up the underlying global physical silver market.
And just as silver is on the verge of a major breakout following this week's sharp rally, American stock investors owning silver via SLV are still woefully underinvested by recent standards. This first chart looks at SLV's silver-bullion holdings, with SLV's price superimposed on top. And it reveals big room for new SLV buying, which will shunt stock-market capital directly into silver and accelerate its price gains.
Despite the very weak silver prices in recent years and resulting extreme bearishness on this precious metal, SLV's holdings have actually risen on balance. They have enjoyed an exceptionally well-defined uptrend channel in the last several years, which seems pretty amazing. But realize that as silver's price dropped, the amount of stock-market capital invested in SLV shares still contracted though its holdings grew.
Over this chart's span, silver peaked just under $37 per ounce in late February 2012. That day SLV's holdings of 313m ounces were worth $11.6b. Silver's brutal bear market finally looks to have bottomed in early November 2014 at just over $15 per ounce. By that day SLV's holdings had grown to 343m ounces, but this hoard was only worth $5.3b. So the SLV holdings' uptrend is not as counterintuitive as it seems.
Though SLV's holdings climbed 9.7% between silver's two extremes of recent years, the value of that silver plummeted 54% which was right in line with silver's 58% loss over this span. So American stock investors certainly haven't been hot on silver. In the middle of this week, as silver surged 3.8% to retake $17, SLV's holdings were worth just $5.5b. That is vanishingly small, a trivial drop in the stock-capital bucket.
For comparison, of the 500 companies included in the benchmark S&P 500 stock index, only 26 had market capitalizations of $5.5b or less as of the end of last month. So American stock investors still have virtually nothing invested in silver. As silver continues rallying, they will start getting interested and then excited and buy in. And that differential buying will catapult silver higher, accelerating its rally and allure.
Only time will tell how much SLV buying we're going to see, but it has the potential to be really big. This ETF's peak silver holdings of just over 366m ounces came back in late April 2011 as silver was rocketing up over $48 in a speculative mania. That day SLV's holdings were worth $17.2b, or 3.1x higher than this week's levels! But it could take massive silver gains over years to fuel such a big jump in stock capital invested.
More interesting for the near-term is the SLV-holdings uptrend. Silver has remained epically out of favor since its dismal bottom late last year. Since then its price has largely languished in a super-low trading range, mostly grinding listlessly sideways. So American stock investors have had no incentives at all to up their silver exposure. But this week's young rally is already starting to change that bearish psychology.
SLV's holdings around 324m ounces in the middle of this week certainly reflect the universal apathy and antipathy towards silver. As sentiment shifts from extreme bearishness back towards neutral, SLV is likely to see serious differential buying pressure on its shares. Remember that if stock traders bid up SLV shares faster than silver itself is rallying, SLV's managers have to issue shares to buy more silver bullion.
Today the upper resistance of SLV holdings' uptrend of recent years is around 352m ounces. Regaining that level would require over 28m ounces of differential buying. And even in silver's dark recent years, SLV has witnessed multiple holdings surges from support to resistance that didn't take much time at all. They happened in early 2013, mid-2013, and mid-2014, and each only took a couple months or so.
So the near-term silver buying potential from American stock traders is great. They remain woefully underinvested in silver right as it's starting to surge, and they are likely to buy SLV shares aggressively enough to force a holdings build on the order of 28m ounces in a couple months. Remember that global monthly investment demand averages under 17m, so that's a colossal boost from SLV buying alone.
Running these numbers, enough SLV differential buying merely to return its holdings back up to recent resistance would boost global silver investment demand by 85% for a couple months! That's one major reason why I suspect the recent silver buying is only starting. And the really bullish and exciting thing is nothing begets buying like buying. The more silver rallies, the more investors will notice it and start to chase it.
But despite that large pool of capital by silver's standards deployed in SLV, there's another pool that just dwarfs it. There's no one on the planet that moves more capital into and out of silver than the American futures speculators. They aggressively trade silver's flows and ebbs with extreme leverage, exerting the greatest influence on silver's daily price action. And their short positions are the key to silver's near-term fortunes.
This next chart looks at the total levels of long and short silver futures contracts held by these dominant American futures speculators. This data is published weekly by the US Commodity Futures Trading Commission in its famous Commitments of Traders reports. And the latest read current to last Tuesday reveals high short positions remaining in silver futures. These large bets will soon have to be covered.
While silver's long-term price levels are ultimately a function of global supply and demand, in the short term American futures trading is the whole game. Note the super-strong inverse correlation between the SLV price in blue and speculators' total silver-futures short contracts in red. Silver plunges when they aggressively short it, and then rallies when they subsequently scramble to exit those leveraged bearish bets.
This outsized influence of futures shorting on silver's price is primarily a function of two things. First, as silver has fallen deeply out of favor in recent years investing interest has dramatically waned. So the influence of futures speculation on silver prices rose proportionally. Second, futures trading is a hyper-risky zero-sum game played with extreme leverage. That gives futures speculators outsized silver-price impact.
Each silver futures contract controls 5000 ounces of silver, which is worth $85,000 even at this week's still-terribly-depressed silver prices. Yet speculators only need to keep $7700 in their accounts for each silver contract they own, the current minimum maintenance margin. That means they can run leverage of up to 11x, which is extreme. In the US stock markets, leverage has been legally limited to 2x since 1974.
At 11x leverage, a mere 9% move by silver against speculators' positions will wipe out 100% of the capital they risked. And they could lose even more than originally bet if they face margin calls! Silver has always had a well-deserved reputation as an exceedingly-volatile metal, so 9% moves are nothing. This past Tuesday and Wednesday, silver surged 5.4% and that was modest by silver's wild standards.
Speculators shorting silver, betting on its price falling, effectively have to borrow that silver before they sell it. This saddles them with the legal contractual obligation to buy that silver back to repay their silver debt. So high silver-futures short positions by this group of traders are very bullish for this white metal since they represent guaranteed near-future buying. As this chart shows, silver soon rallies after major shorting.
While speculators' silver-futures short positions today aren't extreme by recent years' epic levels, they are still very high. As of last Tuesday's CoT data, the latest available when this essay was published, American speculators held 49.6k short-side contracts. That is a huge bearish bet on silver prices. Between 2009 to 2012, the last normal years for the precious-metals markets, their short-side bets averaged just 21.5k.
The reason silver collapsed in early 2013 was because gold suffered its worst quarterly loss in 93 years thanks to the Federal Reserve's radically-unprecedented QE3 manipulations in the financial markets. As the Fed levitated the general stock markets, demand for alternative investments led by gold withered. And silver is ultimately a leveraged play on gold, amplifying the yellow metal's price action in both directions.
But even since then in the Fed's epically-distorted markets, speculators' total silver short contracts have rapidly contracted to or near 27k four separate times. This is support for speculator shorting in recent years. So it's highly likely this group of traders' downside silver bets will once again sharply fall back to these levels in the coming months. And that represents incredible levels of buying to catapult silver higher.
As of that latest CoT report, American speculators would have to buy to cover 22.6k contracts merely to return to that 27k short-side support level. And in the futures markets, the price impact of buying a long contract to offset and cover an existing short and buying a new long contract is identical. With each short contract representing 5000 ounces, this support approach would require an amazing 113m ounces of buying!
Now remember annual global silver investment demand averages around 200m ounces, so this short covering alone is equivalent to about 7 months of normal demand. And as the chart above shows, once these short-covering episodes get underway they unfold fast. The more speculators who buy to cover, the faster the silver price rallies. And the sharper silver's climb, the more pressure on remaining traders to cover.
It's only taken two or three months in recent years for speculators to buy back enough of their shorts to drive them back down to that 27k-contract support line. And that was from even higher total-short levels. So let's assume a couple months for this next support approach. Run the numbers on that, and this coming short covering equates to staggering buying of over 56m ounces per month. That's incredible!
During that short-covering frenzy, silver demand from this mandatory futures buying would run 3.4x the normal monthly average just under 17m ounces! If investors are migrating back into silver at the same time, both in physical and ETF terms, silver is going to power dramatically higher during that brief span. And investors returning becomes more and more likely with each passing day of silver rallying on balance.
So looking at SLV holdings and American speculators' silver-futures shorts alone, silver buying is only starting. Both groups of traders are likely to shift large amounts of capital into silver in a short period of time, on the order of a couple months. And they will soon be joined by investors from around the world, in a surge of new buying that will almost certainly ignite silver's next major upleg. Its upside potential is great.
Investors can certainly play this in traditional physical silver coins and bars or through the ETFs led by SLV. Since silver is so universally loathed these days, investors have forgotten that its price averaged over $31 in 2012 before the Fed's extreme stock-market distortions. And as those are gradually unwound, starting with the coming rate hikes, precious metals should mean revert back up to pre-QE3 normal levels.
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The bottom line is the recent silver buying is likely only just starting. American stock investors remain woefully underinvested in silver, while American futures speculators remain heavily short it. Even in the anomalous recent years, it's only taken a couple of months or so for both extremes to normalize. And that buying alone would run multiples of normal global silver investment demand over that span.
The resulting silver rally will probably be quite big and strong emerging from such bearish sentiment extremes. And it will motivate legions of investors around the world to redeploy in silver again. The more they buy, the faster silver will rally. And that will attract in even more investors, once again forming that very powerful bullish virtuous circle that silver is so famous for. Silver has real potential to surprise on the upside.
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May 15, 2015
Adam Hamilton, CPA |
