From the start of the year until the end of April, silver had risen an incredible 53% (from Rs. 46,257 to Rs. 70,837). In the last week, silver fell by 24% (from Rs. 70,837 to Rs. 53,737). This brings the total annual gain of silver to just 16% (which is still fairly high nonetheless). (Note that these figures are based on MCX spot prices)
A fall of 24% in a single week is quite unheard of. Especially given that silver is a large and liquid international commodity. The last time such a fall occurred was in 1980 - when silver prices reached an all time high due to market manipulation. Whether manipulation was present in today's market is not clear. One thing that is clear is that silver prices exhibit the characteristics of a classic bubble.
First, let us consider the price rise of 53% in the first four months of the year. How much of this was fundamentally driven? The primary fundamental factor identified for silver's increase has been the US Federal Reserve's quantitative easing policies. Other factors include safe haven demand due to the Eurozone debt crisis.
While both these factors are important, it certainly does not explain the rise fully. After all, the market has been aware of quantitative easing for some time now. In the second half of last year, gold had a strong run as quantitative easing began to take place, as investors feared high inflation and currency debasement. However, in the first four months of this year, there has not been a significant change in the Fed's policy. No major news events appeared to drive the price.
Moving on to the European debt crisis, it is much the same story. The market has known about the debt crisis even longer than quantitative easing. While there were some new news events about the debt crisis during this year, most of the major news took place in the previous year.
What we can conclude is that fundamental factors cannot fully explain silver's rise. There have not been any major changes in the last four months that would have caused the price to go up. Thus, the fact that we have had this correction in the last week should not be such a surprise given the fast pace at which silver rose earlier.
The timing of corrections is notoriously difficult to predict. Silver managed to fall 24% this week, although there were no major news events or drivers that led to this. It was just a bubble bursting, and bursting very fast. In the near term, silver will probably remain very volatile. It may easily rebound or fall quite quickly.
One of the problems with silver is that it is difficult to place a fundamental value on the commodity. When demand is driven by fear of future inflation, or fear about sovereign debt crises, we would need a way to quantify this fear in order to put a fair price on silver. This partially explains why prices are so volatile. No one really knows the true value of silver. As a result, there are plenty of investors who are willing to hold silver at any price - and this can explain why we have such large up and down moves in prices.
Disclosure: I do not hold the commodity/currency discussed in this article.
Asad is an Economics Graduate from The London School of Economics who has also been a part of the currency derivatives team of Deutsche Bank in London. Currently pursuing his PhD at the University of California San Diego where he's researching on Algorithmic Trading Strategies, Asad will be your direct line for answers to all the questions you might have on short-term investing. A part of the Equitymaster Team since 2010, Asad has been sharing his knowledge on short term trading strategies with our valued readers, like you, through our various services. In fact, at the last count, his weekly newsletter, Profit Hunter, was being delivered to more than 100,000 smart traders across the world!