Silver-Mad Small Investors Fueled an Epic Rise and Fall

Silver-Mad Small Investors Fueled an Epic Rise and Fall

By GREGORY ZUCKERMAN And CAROLYN CUI

When silver prices hit a three-decade high last week, David Zornetsky decided to do some buying. Searching for a job, the 31-year old in Beacon, N.Y., hoped to use gains from silver to finance a move to New York City and to pay down student loans. "I had been hearing that silver could go up to $150 an ounce this year," says Mr. Zornetsky.

Instead, silver has suffered its worst one-week drubbing since 1980, when an infamous alleged attempt by Texas's Hunt brothers to corner the silver market came undone. This week's brutal tumble sent silver-futures prices down to $35.28 an ounce from nearly $50 in just five trading days, and has left Wall Street pros and individual investors dazed, some dealing with sudden losses.

"I don't understand," says Mr. Zornetsky, whose silver investment fell about 25%. "Silver is supposed to do very well this year."

Behind silver's historic collapse is a market that came loose of its moorings, fueled by speculative traders, many of them small investors who may have jumped in at just the wrong moment.

"If gold is a Monte Carlo casino, silver is a slot machine in Las Vegas," says Andy Smith, a senior metals strategist at Bache Commodities.

Even the most sophisticated investors are divided about precious metals. For many of Wall Street's most-respected names, such as hedge-fund manager John Paulson, silver and gold represent protection from central banks that continue to spray money into the world's financial system, threatening to push inflation higher. But others, like George Soros, view those fears as overstated, arguing that the Federal Reserve is unlikely to let inflation get out of hand. Mr. Soros's funds have sold silver and gold positions in recent weeks.

All kinds of commodities have run up this year, but few markets surged liked silver. That's because silver is different than most others, making it more susceptible to quick peaks, as well as plunges.

For one thing, silver is smaller than many other markets, which means it scares off some larger investors who might otherwise step in to temper big moves. Gold has nearly four times the amount of tradeable futures contracts as silver. The value of new gold supply last year was $217 billion, with 17% of the total supply held by the world's central banks and multinational financial institutions. By comparison, the new supply of silver amounted to $49 billion in 2010, according to GFMS Ltd., a London-based metals consultancy. And less than 5% of silver is held by central banks and institutions, analysts estimate.

A big chunk of the world's silver is instead held by individuals in the form of coins, medals and bars, though it's hard to get accurate estimates of this figure.

Such investors are attracted to the relatively low price of silver, but they can also be prone to panic. Long-time fans of precious metals often are mavericks who can be suspicious of mainstream securities firms, wary of financial catastrophe and reluctant to keep their money in the bank. They often rely on the advice of newsletter writers, obscure websites and coin-shop proprietors or their own research.

Once considered a haven for those with bleak economic outlooks or dystopian views of society, gold and silver began to rise early in the last decade, as investors searched for ways to protect against the falling dollar.

Silver tumbled to $9 an ounce during the financial crisis of 2008, as investors dumped all kinds of holdings, but buying resumed in early 2009. The bull market accelerated last August, when the Federal Reserve and other central banks announced aggressive measures to buy bonds and pump money into the global financial system, steps that raised concerns about the value of the dollar and other leading currencies.

Silver buying moved into high gear over the past eight months, suggesting that prices had begun to reflect a speculative frenzy, rather than currency or inflationary fears. Silver climbed 165% between late August and last week, well above the 26% rise in gold.

In recent months, trading volume of silver-futures contracts, which allow investors to purchase or sell a certain amount of silver, soared.

So far this year, those contracts' daily volume has more than doubled compared with the same period last year, another sign of the rabid interest in silver.

Day traders, or individuals who quickly buy and sell stocks, began to focus on silver, much as they did with Internet stocks in the late 1990s. A majority of the 350 individual traders hosted by T3 Trading Group in New York began buying and selling silver, rather than stocks.

"It's been 1999 all over again," says Evan Lazarus, a 35-year old trader who manages T3 Trading. In April, Mr. Lazarus shifted his own trading to leveraged exchange-traded funds, or those that rise or fall in price twice or three times the move of silver. "Silver is the new stock market."

Many individuals piled into such funds. Over a three-week period last month, assets at a half-dozen silver ETFs soared about $4 billion, or more than 20%.

Newsletter writers helped fuel the market's surge. "It is obvious to anyone with any ability to think, that precious metals are a must investment!" said longtime silver backer David Morgan, whose newsletter has 1,000 subscribers and thousands more who read email alerts. The note came after Standard & Poor's warned of a possible downgrade of the U.S.'s credit rating. "Where else can anyone invest for capital preservation outside of precious metals?"

By last week, the price of 32 ounces of silver equaled one ounce of gold. In contrast, over the past three decades, it took an average of 63 ounces of silver to buy an ounce of gold. The last time silver was as pricey relative to gold was in 1983.

When Chairman Ben Bernanke reaffirmed the Fed's low-interest rate policies on April 27, silver soared close to $50 an ounce, a 31-year nominal high.

That week, a team of risk-management specialists at the CME Group, which operates the Comex, the biggest silver trading exchange, picked up on a sudden spike in volatility, according to Kim Taylor, a CME executive. The team decided to hike margin requirements, forcing traders to come up with more cash or other collateral to ensure there was sufficient capital in their accounts to cover losses if the volatility continued.

On Tuesday and Thursday of this week, CME raised requirements again. Those moves increased trading costs by about 80% and a number of investors cashed out.

"What all members need to think about now is protecting your gains," Mr. Morgan urged his newsletter readers. "REDUCE YOUR RISK."

Lou Forte found himself both a winner and loser in silver's wild ride. On Monday morning, when the dollar briefly strengthened on news of Osama Bin Laden's death and silver showed immediate weakness, Mr. Forte, a 35-year-old day trader from Westchester County, N.Y., bought a silver ETF. It soon rallied. He sold at a profit. Next, he correctly bet prices would fall. On a roll, he tried to call the bottom again, buying early on Thursday. But this time silver kept plunging and he suffered losses.

"I traded through the Internet bubble and traded through a lot of crazy days, and this has been one of the most gut-wrenching times in my 13 years of doing this," said Mr. Forte. "The volatility is enough to make you vomit."

Silver ETFs, favored by many individuals, have suffered among the most pain, and there are signs investors are getting out. More than 36 million ounces of silver has been dumped into the market between April 26 through this past Thursday, more silver than all the American Eagle silver coins that investors bought from the U.S. Mint last year.

After this week's bloodbath, "some of these people probably would never touch silver again," says Mr. Smith of Bache Commodities.

Though silver is a playground of smaller investors, it has also attracted growing interest by hedge funds and other pros. They've formed two sides of an intellectual debate, pitting those who fear severe economic disruption against those who think the Federal Reserve can steer the economy to calmer territory.

Mr. Soros's fund, now run by Keith Anderson, spent the last two years accumulating silver and gold holdings in the expectation that deflation, or a sustained fall in prices, would boost interest on precious metals by skittish investors. Their holdings in that case would soar.

But Mr. Soros's firm recently exited its gold and silver positions, according to people close to the matter, because the firm is convinced the Fed's aggressive actions have eliminated the possibility of deflation. They have faith the Fed will succeed in keeping a lid on inflation by signaling its intention to raise interest rates, perhaps over the next six months.

Others dumping precious metals lately doubt the Fed will take much more aggressive action to help the economy, at least for now. That could potentially reduce appetite for a range of investments, including silver.

John Burbank, who runs hedge fund Passport Capital in San Francisco, became a fan of precious metals in 2002. Earlier this year, however, he sold his entire $150 million stash of gold, convinced the Fed won't extend its so-called quantitative easing measures beyond June.

"Silver prices have been parabolic, but the time to buy again will be months away," he says.

Bulls on precious metals, like John Paulson, who has focused his buying on gold, say the Fed won't be able to rein in inflation once it begins in earnest. Silver is more attractive than gold, some of these investors say, partly because its inflation-adjusted all-time high is about $140 an ounce, about four times where it trades today. Gold, which traded Friday at $1491.20 an ounce, is actually closer to its adjusted all-time high.

Silver remains up 14% in 2011, one of the best investments, despite the recent plunge. Indeed, some hedge funds, such as Kyle Bass's Hayman Capital, bought silver early Friday, sensing the white metal had reached bargain levels and was due for a bounce, says a person close to the trader.

Some smaller investors are holding on, too. Donna Badach, a 55-year-old retiree, started buying silver in 2003 at an average cost of $25 an ounce. She now has a cache of silver coins and bullion, which she says are stored in a "private depositary" and account for 60% of her net worth. She buys silver "for insurance purpose," because "it's so shaky to see what's going on all over the world."

"I don't believe the correction will last long. Silver will hit $100 before the end of this year," says Ms. Badach, who had worked in the mortgage-banking industry in Hillsboro, Fla. "I have never felt so sure in my life about something."

—Tom Lauricella
contributed to this article.