Thursday, May 19, 2011

Silver Prices Plunged Over 28% In The Week To 5 May 2011

Silver Market Safe Haven Asset Plunged 28.4% In One Week!

Silver prices plunged 28.4% over the week to 5 May 2011, highlighting the immense volatility inherent in an asset many are calling a “safe haven”.

Key Points:
# Silver prices plunged over 28% in the week to 5 May 2011.
# While the recent margin increases by the CME have been cited as a reason for the pullback, the volatility highlights the huge influence of speculative forces in the silver market.
# Silver demand does not appear to justify the meteoric rise in silver prices.
# Other commodities have plunged over the same period; While the media has cited concerns over US economic growth as well as China tightening policy as factors, the extent of declines serves to highlight the influence of investment demand in driving commodity prices.
# Investors may thus wish to reassess the investment merits of precious metals and commodities in a portfolio, especially when one seeks “safe haven” assets.

Massive plunge in silver after strong YTD gains
Over the week ending 5 May 2011, silver prices plunged by a massive 28.4% in USD terms, falling from a 31-year closing high of US$48.44 a troy ounce on 28 April 2011 to just $34.70 a week later. This sharp drop comes after a huge 56.7% year-to-date increase (as of 28 April 2011), following an 83.2% gain over the course of 2010 (See Chart 1).

Chart 1
Silver(USD per Oz)

Speculative Forces at work?
The plunge in silver prices coincided with the raising of margin requirements by Comex (a division of the Chicago Mercantile Exchange), which after 9 May, would require an investor to deposit $21,600 per silver contract (which represents 5000 troy ounces of silver), up almost 84% from two weeks earlier. While many media reports attribute the sharp declines in silver to the latest move by the Chicago Mercantile Exchange, a better interpretation of the situation would be that speculative demand has been the main driver of silver’s returns in recent years.

Chart 2
Silver Demand

According to data from The Silver Institute, total worldwide demand for silver (see Chart 2) has grown by an annualised rate of just 2.1% since 2001, in stark contrast to the 23.5% annualised return for the price of silver, an increase of more than 6.5 times over the same period! More importantly, total fabrication, which includes industrial, decorative, photography and jewellery demand, has barely increased from 2001 to 2010 (a cumulative rise of just 0.6%), while investment demand appears to be the main driver for growth in silver demand. On the supply side, mine production has gained 21.4% from 2001 to 2010, suggesting that supply constraints are not a key issue in driving silver prices. Given the tepid industrial demand growth coupled with rising mining production, one may come to the conclusion that growth in investment demand (whether speculative or otherwise) has been the main overriding factor in driving up the price of silver in recent years.

Declines in other commodities over the same period
In addition to silver, other commodities also declined in recent weeks, with oil being one of the notable under-performers. WTI Crude Oil prices plunged 14.7% (in USD terms) from 29 April to 6 May 2011, a relatively hefty decline within the space of a week, while broader commodity indices also posted sharp declines (see Chart 3). While investment experts point to various fundamental factors like an apparent slowing of growth in the US, as well as monetary tightening in China potentially impacting commodity demand, the substantial movements (both to the upside as well as the downside) in global commodity markets serve to highlight the influence of speculative investments on commodity prices.

Chart 3
Silver Indices

Reassessing Investment Merits
On the back of the strong volatility and sharp correction in commodity prices, investors may wish to step back from the frenzy and reassess the notion of holding silver or other commodities as an investment. The basic requirement for any investment is to be able to achieve a positive return for the investor. The value of a stock is based on the present value of future profits (and corresponding cashflows), both of which have the potential to grow alongside the economy over time, while bonds are structured to provide a positive yield to investors.

On the other hand, commodities have no positive cashflows (with the exception of the convenience yield, which is not applicable for non-physical holdings of commodities), and futures prices usually incorporate the cost of storage, which can eat away at an investment even if the price of the commodity does not change. In addition, commodity prices are notoriously difficult to forecast or justify, with our analysis of silver demand indicating a clear mismatch between demand growth and price growth. This clearly suggests that speculative or “investment” demand is likely the key driver for many commodities, and makes an investment in commodities a speculative bet at best. Given the lack of foreseeable cashflows and profit from such instruments along with the many difficulties in forecasting price movements, it is difficult to find many investment merits for commodities (whether in physical or derivative form).

Safe haven assets not that safe
Also, precious metals like gold and silver have been termed “safe haven” assets in recent years, but their historical performance has done little to cement that status. Investors who bought gold at the 1980 peak lost 70.3% on their investment over the subsequent 20 years, and then waited another 9 years to break even. Investors who bought silver at the 1980 peak have fared worse; despite the rapid run-up in silver prices over the past few years, they have yet to break even. As the latest price movements in silver will attest to, a 28% price decline over a week is not what one should expect from a “safe haven” investment. Investors who are seeking safe haven assets are likely to fare better with a well-diversified portfolio of traditional assets like bonds and equities, with bonds providing a stable base for the portfolio and equities capturing economic growth upside and keeping pace with inflation.

Lastly, Investors are recommended to construct a diversified portfolio consisting of fixed income and equity funds because an investment portfolio with proper asset allocations can help investors reduce investment risks.


Source: FundSuperMart
Author : iFAST Research Team

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