Silver ETF Divergence
Launched 4 years ago this week, the SLV silver ETF has proven very successful. With $5.1b in net assets, it already ranks among the top 20 largest ETFs in the US. And the 287m ounces of physical silver bullion it holds in trust for its stock investors is impressive. For comparison, elite market-darling silver streamer Silver Wheaton only produced 17m ounces last year (equivalent to 6% of SLV’s holdings).
SLV has truly become a force to be reckoned with in the silver world, fulfilling the worst fears of silver’s industrial users who actively lobbied the SEC against approving this ETF before it was born. They feared the massive pools of stock-market capital that would flood into physical silver via this new ETF conduit would drive up prices. They were right, silver was trading around $12 when SLV came online.
But SLV has proven a boon for silver investors on multiple fronts. Most importantly, more capital chasing the small silver market ultimately means a longer secular bull powering to a higher climax. SLV created a first-ever conduit for stock investors, which aren’t traditionally physical-silver investors, to easily migrate capital into silver. Billions of dollars of stock-market capital have already flooded into this metal that probably wouldn’t have otherwise.
SLV also offers a crucial glimpse into silver-investor psychology that we have never had before. Its custodians are completely transparent, publishing its physical-silver-bullion holdings on a daily basis. Watching these holdings change over time, especially when considered alongside silver price action, offers countless insights into how stock investors are feeling about silver at any given time.
This is due to the innate mechanics all ETFs share. Any ETF intending to track an underlying asset must actively shunt capital to and from the actual underlying asset to equalize supply-and-demand differentials between the ETF itself and the underlying asset. In SLV’s case, its share price is determined by the real-time supply and demand of its shares. If stock investors as a whole are buying more SLV than they’re selling, its price rises. If they are selling more than they’re buying, its price falls.
But SLV is explicitly designed to track the silver price, to give stock investors the functional equivalent of silver exposure in their portfolios. And silver has its own unique supply-and-demand profile totally independent of SLV’s. At any given moment if there is more silver demanded than supplied, its price will rise. And if there is more silver offered than wanted, its price will fall. The only way to synchronize the independent supply-and-demand profiles of SLV and silver is through active ETF management.
SLV’s custodians equalize these different profiles by shunting any differential ETF supply or demand directly into physical silver bullion itself. This is the only way tracking ETFs can function, and SLV’s efficiency in tracking silver is perfect. When SLV demand is running higher than silver demand, SLV shares threaten to decouple to the upside. To prevent this, SLV’s custodians issue new SLV shares to meet the marginal demand and use the cash raised to buy more physical silver bullion.
Conversely when SLV supply is greater than silver supply, SLV shares will decouple to the downside. Of course any decoupling will destroy this ETF’s tracking and scuttle its mission. To prevent this scenario, SLV’s custodians buy back this ETF’s shares to sop up the excess supply. They get the cash to do this by selling some of the physical silver bullion they are holding in trust for stock investors. The net impact is excess stock-market demand or supply is shunted directly into physical silver itself.
This mechanism means changing SLV holdings effectively reflect stock investors’ views on silver at any given time. If SLV’s holdings are rising, it means stock investors are buying SLV shares at a faster rate than silver is being bought. They are not only bullish on silver, but actively buying more exposure to it via SLV. And when SLV’s holdings are falling, there is less demand for silver exposure among stock investors than for silver itself. They are relatively bearish, either selling faster than silver is being sold or buying slower than silver is being bought.
And of course understanding stock-investor psychology on silver offers excellent insights into where silver is likely heading in the near-term. When stock investors get too bullish on silver, driving SLV’s holdings up too fast, it probably means an interim top is near in silver. And when they get too bearish, forcing SLV to liquidate silver too rapidly, it probably portends an imminent interim bottom. Thus it is important for silver traders to monitor SLV’s holdings on an ongoing basis as a key sentiment indicator.
All this brings me to the topic of this essay. A strange divergence has developed in SLV’s holdings since early March. Over a span of time where silver has rallied nicely, SLV’s holdings have plunged rather sharply. I’ve been watching this with increasing interest. It is readily apparent in this chart, where SLV’s holdings are plotted in red along with the silver price in blue. This divergence is the largest ever.
On March 1st, SLV’s holdings ran nearly 305m ounces of physical silver bullion. At the time, silver was trading around $16.50 and had rallied nicely (9.6%) since its interim low a few weeks earlier in February. But despite silver continuing to rally on balance, SLV’s holdings started falling rather sharply. Almost 7 weeks later, SLV had shed 6.0% of its silver over a span where silver actually rallied 7.7%.
This is quite literally unprecedented. Prior to this past month, SLV’s largest decline in holdings over the same span of time was merely 3.5%. And that was near the heart of the stock panic in December 2008, an exceedingly-rare event that wreaked unbelievable havoc on the silver price. Today’s psychological environment is obviously vastly different from the one driven by plunging silver during the panic. At one point this metal’s price had plummeted 33% in just 4 weeks!
Put in quantity terms, SLV has shed over 18m ounces of silver since early March. This physical silver bullion has hit the marketplace, retarding the advance of silver’s new upleg. This is a staggering amount of silver to hit in a short period of time, more than the 17m ounces elite market-darling Silver Wheaton produced in all of last year. I’ve really been trying to understand the psychology behind this odd divergence.
Silver, and its primary driver gold, have both done well since their latest corrections bottomed and bounced in early February. At best since then, silver and gold have rallied 22.9% and 9.3% respectively. These are sizable rallies over a relatively short 10-week timespan. And silver has even easily outperformed the flagship S&P 500, which rallied 14.7% since its own interim low of early February.
With gold and especially silver looking strong heading into their usual spring rallies, you’d think stock investors would be getting more bullish on silver. Nothing grows interest in an asset faster than relentlessly rising prices. Yet as is clear from the sharp reduction in SLV’s bullion holdings, SLV demand from stock investors has waned considerably. They aren’t the least-bit excited about this new silver upleg yet.
One possibility is that stock investors are actually selling SLV, reducing their silver exposure. It is hard to rationalize the psychology behind this possibility though, especially given silver’s strong performance lately and its current high levels relative to most of today’s bull. A second possibility is stock investors are just buying SLV at a slower rate than silver itself is being bought. In order to prevent SLV from falling behind silver and decoupling, its custodians have sold bullion and used the cash to buy back shares.
While we can’t know for sure what is going on in the hearts and minds of all SLV investors, this second possibility seems far more likely. As I discussed last week in a Silver/Gold Ratio analysis, gold is the primary driver of silver psychology. Silver traders endlessly watch it for trading cues. And though gold has rallied respectably since early February, its rally hasn’t been exciting. There have been few fast surges and no new highs, gold has kind of been melting up slowly much like the general stock markets.
And without fast-moving gold to spark some excitement in silver, the stock traders haven’t had much incentive to add to their SLV holdings. The net result is SLV exposure has been drifting and lagging silver’s advance, necessitating this ETF’s bullion selling to buy shares to maintain tight silver tracking. As soon as gold’s upleg accelerates and gets silver traders excited, SLV’s waning holdings should reverse.
But at the moment, SLV’s custodians have had to dump over 18m ounces of silver onto the markets in less than 7 weeks. Roughly equivalent to the annual production of some of the world’s biggest and best primary silver producers, this had to weigh on silver’s young upleg. If relatively-low SLV demand hadn’t forced this ETF to dump so much physical silver, I suspect silver’s gains since early March would have been considerably larger.
This SLV divergence also highlights the double-edged nature of precious-metals ETFs. When demand for their shares is high so they have to expand their metals holdings, they are very bullish for prices. But when stock investors start selling or not buying as fast as the underlying metals are rising, the ETFs must contract their holdings to buy back shares and maintain tracking. These ETFs add capital, along with its intrinsic volatility and risks, to the gold and silver markets. This can amplify or retard underlying moves.
Speaking of gold, the mighty parallel GLD gold ETF (third largest ETF on the planet) has not mirrored SLV’s recent behavior. This makes SLV’s divergence all the more curious. While SLV achieved its all-time record high of silver bullion held in trust back in early December (almost 306m ounces), GLD edged up to a new all-time record high of its own less than 2 weeks ago. And it has held this record, keeping its holdings steady, right as SLV has been forced to continue to sell down its own.
GLD’s enormous holdings have essentially remained stable since major hedge-fund buying drove them up fast to new records in the first quarter of 2009. That record surge was extremely important as it proved the fringe conspiracy theorists claiming these ETFs don’t really buy and sell physical bullion are dead wrong. As usual, hard evidence fails to support these highly-emotional flights of fancy that mislead countless investors.
A single large hedge fund aggressively buying GLD drove its holdings 30% higher in just 5 weeks in early 2009! GLD had to buy 238 metric tons of gold over this short span which catapulted gold prices almost 23% higher. If GLD wasn’t shunting differential buying pressure directly into physical gold bullion, this would have been impossible. There are other episodes where GLD and SLV bullion buying and selling have clearly and directly impacted the gold and silver prices. These ETFs truly are buying and selling physical bullion as advertised.
But I digress. For our purposes today, GLD has definitely not experienced the same waning demand among stock investors that SLV has. This makes SLV’s divergence look even more anomalous. For whatever reasons, stock investors’ enthusiasm for silver exposure via SLV has been ebbing. The resulting fast bullion liquidation by SLV to maintain tracking definitely affects all silver investors.
While silver’s run since its latest interim low in early February has been nice, it has had to weather a huge 18m-ounce headwind. There is no doubt that silver prices would be considerably higher today if SLV hadn’t been forced to sell so much silver so fast. So if you are disappointed with silver’s recent run, realize that stock investors are not only not supporting it but effectively retarding it. This could reverse anytime though, as a fast gold surge would probably ramp up general silver enthusiasm quickly.
And while this magnitude of SLV selling is odd, it does play into a long-known tendency of silver. In any given upleg, the majority of silver’s gains tend to accrue very rapidly near its climax. Silver will gradually grind higher early on, but once it rallies far enough to reach a critical mass of bullish sentiment then buying floods in and it rockets higher in short order. It is not uncommon to see around half of the total gains of an entire silver upleg (which might last 6 months) suddenly flare up in its final few weeks!
Thus this apathetic sentiment flowing into silver via SLV from the stock markets could turn around on a dime. As gold’s young new upleg accelerates, silver will almost certainly catch a bid and surge sooner or later here. And when the stock investors see that, I suspect they will once again be quick to collectively add more SLV exposure. It was psychology that created this SLV divergence, and psychology that will eventually reverse it.
At Zeal, we have been actively investing and speculating in silver and silver stocks since this metal traded near $4 in late 2001. Our subscribers have earned fortunes riding this secular silver bull in elite silver stocks. And whether you love or loathe SLV, there is no arguing that it has grown into a major force in the silver market. So all silver investors must watch its fluctuating holdings and integrate them into their silver analyses. Unfortunately many silver advisors choose to ignore SLV, hobbling their effectiveness.
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The bottom line is the SLV silver ETF has grown so large that it is increasingly affecting silver prices. And lately waning stock-investor interest in silver exposure has forced this behemoth to dump a great deal of physical silver bullion into the marketplace. This marginal supply has certainly retarded silver’s young upleg, not to mention revealed the silver apathy bordering on bearishness plaguing stock investors.
Nevertheless, this SLV divergence is unlikely to persist. As gold’s new upleg continues higher, it will spark renewed enthusiasm for silver as usual. Existing SLV investors, with their $5b deployed in silver through this ETF, will certainly take notice and start buying again. And the vast pools of stock-market capital will once again shift back to flowing into silver through SLV, expanding silver’s secular bull.
Apr 23, 2010
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