A Word About Fundamentals Part II: Silver

• Posted by Robert Sinn
• on September 27th, 2011

What is an ounce of silver worth? What is it worth to you? What is it worth to your neighbor? What is it worth to the guy in the futures pit in Chicago? Does it matter?………The answer to the “does it matter?” question depends upon who you are; if you are a trader then it most certainly does NOT matter what you, your neighbor, or some talking head on CNBC thinks silver is worth.

Case in point: The recent insane volatility which we have witnessed in silver – silver($SI_F, $SLV) traded above $40/ounce just one week ago, early Monday morning it traded as low as $26.15, this morning silver traded as high as $33.58. Did any of this wild price movement have to do with the fundamental value of silver? No, the 30+% drop in less than one week had to do with the herd mentality of large institutions as they all ran for the exits simultaneously. Moreover, the widespread use of leverage in futures markets causes a vicious positive/negative feedback cycle when markets make outsized movements in the short term.

Another situation where short term market moves can wildly disconnect from perceived fundamental valuations occurs during a short squeeze. Some recent examples of this phenomenon are $JVA and $NFLX among many others. During a short squeeze a stock with fundamental momentum can garner technical momentum as shorts cover their positions at higher and higher prices. This can cause the stock to trade at unsustainable valuation levels, often for much longer than one might think possible.

Simply stated, short term market movements are usually much more tactical in nature and have much more to do with temporary market dynamics than fundamentals. Fundamentals will take hold of a commodity such as silver over the long run, however, as the famous quote from John Maynard Keynes goes “in the long run we are all dead”. More importantly, the fundamentals are always changing; therefore, strong industrial and speculative investment demand for silver right now is often transitory and already discounted by market prices.

Finally, the best way to think about price volatility during market “panics” is to think in terms of “what is the price of liquidity?” In other words, how much are those who are in pain willing to pay to close out their positions and alleviate the pain? In silver we recently learned that the price of liquidity was very high indeed – in a matter of hours stuck longs were willing to sell their positions at 10+% notional losses in order to exit the market and alleviate their pain.

Side note: I personally know of a prop futures trader who tried to be a “liquidity provider” in $SI_F at $29 on Sunday night, he was “bagged and tagged” (stopped out) near the lows only a few hours later. Another market participant became his liquidity provider as my friend paid a hefty price to alleviate his pain – as they say, timing is everything.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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