The ins and outs of ‘silver selloff’ explained

It sounds so harsh. The rich get richer and the poor get poorer.

Almost makes you want to go out and register as a Democrat. That way we can redistribute some of this wealth as our current president would like.

But the current silver market is a classic case of irrational individual investors driving up the price of the market, only to have sophisticated institutions leave them holding the bag.

Well how did this happen and what happens to the silver markets from here?

The silver rally goes back to the bailouts of late 2008. After $700 billion of TARP, billions more to save the auto industry, and the election of Barack Obama, it became very clear that the U.S. was in the mood to print cheap money.

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After reaching a low of $8.79, silver began to slowly rally. First it rallied due to Ben Bernanke almost tripling the monetary base. Then it rallied due to the $860 billion Obama stimulus. Then it continued to rally after Obama became the first president in United States history to rack up a yearly deficit in excess of $1 trillion.

Before we knew it silver was trading in excess of $30 per ounce.

Wow. What a move.

After going up some 400 percent individual investors started to take notice. Then as the U.S. markets started to sputter, Ben Bernanke and the Federal Reserve instituted something called Quantitative Easing 2 or simply QE2.

QE2 has the net effect of placing more U.S. dollars into the financial system and ultimately into circulation.

When more dollars are placed into the market without the necessary demand, inflation happens.

BINGO.

This was the impetus that individual investors needed to get in the game. Silver again started to skyrocket.

Then came news that Bernanke didn’t plan to stop QE2 by this June and planned to take it further.

Blastoff.

We now saw silver hit intraday highs in excess of $49, a sign of major speculation and irrational exuberance.

You see in silver markets, many individual investors are leveraged buyers of the metal. What that means is they take a loan out to buy more silver than the money they have in deposit.

While some individual investors use a smart amount of leverage, many times they are tricked into borrowing anywhere between 4-8 times their money.

Case in point, if you had $10,000 cash in your account, you could buy let’s say $50,000 worth of silver borrowing at 5:1 or five times the amount of money you have in the account, for a total borrowed amount of $40,000.

Utilizing margin is supposed to maximize your profit, but when used unwisely, it maximizes your risk.

If you bought silver between $47-49 with this type of margin, your overall account value would be in the area of $37,000-$39,000 (depending on fees, costs, etc.).

That means that you have lost all of your original $10,000 and you are now liable for the difference between your account value, in this case $37,000-$39,000, and your loan value, which in this example is $40,000.

Had you just bought $10,000 worth of silver, your account would be down to about $7,500-8,000 but you would still have positive equity. With unsafe leverage in our example above, you end up owing between $1,000-$3,000. This is known as a margin call.

From $8k to owing up to $3k. That’s a very big swing.

Now getting back to overall markets. Realizing that leverage and speculation were driving prices higher, the CME Group (which is the owner of the Chicago Mercantile Exchange) hiked margin requirements three times since the beginning of last week.

This caused firms to tighten up their leverage and some firms even made stricter requirements than the CME Group.

The reduction in the amount of leverage that can be used caused selling pressure to increase last week which brought silver down to $45 an ounce after trading higher than $49 per ounce just days before.

Then add on top of this a once in a lifetime event (literally), with the death of Osama bin Laden. This sent silver prices, which rallied back to $48.22, down to $42 per ounce.

However, once the market absorbed the Osama factor, silver prices rose in excess of $47 off its Osama lows.

Institutions know the game. They knew that with margin requirements tightened that if they started selling they could trigger a significant selloff in silver. So they did.

As institutions were selling, individuals who were overleveraged in silver began what the term “margin call” means. As the price went down, it triggered individual investors to sell their positions in order to cover their investment amounts. This drove down the price of silver even further.

Add on top of this hedge fund gurus like George Soros indicating that he will start to liquidate his long gold and silver positions, and the down market can take on a life of its own.

As the market continues to go down further, shaking out most individual investors, we will start to see institutions re-enter the game, buying back in the $30s the same metals that they sold in the $40s.

You see even the institutions that are just getting out now (in the low $40s to high $30s range) aren’t concerned because they’ve been buying silver since it was trading in the $15-20 range.

So to them all they lost was just a couple bucks of profit.

But the opportunity to take silver from $49 to let’s say $36 just to buy it back again and ride it all the way to $50, that’s a score.

For silver buyers out there, key adages provide the proper insight into these markets.

The first adage to follow is to remember history. Historically, gold trades at a 16 times premium to silver. These days that ratio is at 38 (meaning the price of gold is 38 times the price of silver.

Although margin requirements on silver are now more onerous than those on gold, the underlying fundamentals and price ratios for silver make it very attractive.

Secondly, individual investors in silver should be long-term players, not short-term flippers.

Silver is a dangerous metal. It can go up and down as much as 20 percent in just a couple of days. We’ve seen that before. We’ve seen it now. And we will certainly see it again.

If you are a long-term player you can afford to sit out these short-term hiccups and just focus on the long term fundamentals. The U.S. dollar is heading down, emerging markets are consuming more, and the demand for silver (industrial, inflation-hedge, and luxury) is increasing.

Just look at U.S. debt. We have $14 trillion in unfunded Social Security liabilities, $77 trillion in unfunded Medicare liabilities, and $19 trillion in unfunded prescription drug liabilities.

That’s $110 trillion new dollars that we have to print just to cover our existing liabilities. God forbid that President Obama figures out a new way to start spending even more money.

So when you want to know where the price of silver is going, I’m going to give you the same answer that Steve Forbes gave me today while we talked at Starbucks, “Just follow Ben Bernanke.”

Because as Bernanke gets the orders to print the dollars to pay the bills, silver will go up and up and up.

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