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June 20, 2008

SLV Silver ETF
by Adam Hamilton

On April 28th, 2006, Barclays launched the first silver exchange-traded fund in the US. Traded on the AMEX as SLV, the iShares Silver Trust was eagerly anticipated by silver investors ahead of its birth. It ushered in a new era where vast pools of stock-market capital gained an easy conduit into the physical silver market.

One of the reasons investors originally liked SLV so much is silver consumers aggressively lobbied the SEC to kill it. The Silver Users Association wrote some fascinating letters to the SEC bemoaning the birth of SLV as the end of cheap silver as we knew it. Established in 1947, the SUA is an organization of industrial users of silver in applications including photographic, electronic, silverware, jewelry, and other fabrication.

In a February 13th, 2006 letter to the SEC, the SUA's director claimed its members processed "80% of all silver used in the United States". In the conclusion of its plea to the SEC to not approve SLV it said, "The Silver Users Association opposes the creation of a silver ETF because of the concerns that doing so will require the holding of physical silver in allocated accounts, thus removing large amounts of silver from the market."

With SLV generating some controversy lately among a small subset of contrarian investors, remembering how aggressively the silver industrial consumers opposed it prior to its launch is illuminating. The SUA was terrified of stock investors gaining easy access to silver and driving a huge silver spike. It said "the proposed silver ETF could be a legal way for investors to squeeze the silver market." The SUA knew the silver ETF would take a huge pile of physical silver bullion off the markets, driving up prices.

Just over two years later, the SLV silver ETF has been a major success. It has given non-traditional silver investors in the stock markets an easy way to gain silver exposure in their usual stock-trading accounts. Stock-market capital shunted into the silver market via this ETF has pulled a vast amount of silver off the markets, as the SUA feared. And today with years of trading history under its belt, there is finally enough data to analyze SLV's impact.

I've been a big fan of commodities ETFs since 2002, two years before the launch of the GLD gold ETF and four years before SLV was born. Despite this, I will probably never invest in either GLD or SLV, although I will use them as short-term trading vehicles to speculate. Why? I am a physical guy. When I buy gold and silver to undergird my own investment portfolio, I want physical bullion coins held in my own immediate physical possession. To me, everything else is inferior paper.

A lot of hardcore contrarians feel this way, they wouldn't touch SLV with a ten-foot pole. And this is fine, as SLV is not designed for traditional buyers of silver bullion. The target market for SLV is stock traders who haven't owned physical silver yet. It is like a gateway drug for them. I've heard from many investors over the last four years who started out owning a little GLD or SLV and "graduated" into buying bullion.

SLV is also for institutional investors like mutual funds that can't buy physical silver bullion. Their charters restrict them to trades in the stock markets. As a physical-bullion owner, I am thrilled when institutions bid up SLV which ultimately shunts stock capital into silver. SLV is also for speculators. If you want to trade silver for a multi-month run, it is impractical and very inefficient to buy or sell physical bullion to do this.

So if you don't like SLV, don't buy it. I hate Chinese food with a passion (sorry), but that doesn't mean I would ever want it off the market. If others like it, more power to them. I'll eat my steak, they can eat their rice. The more avenues for silver investing, the easier it is to deploy capital in the silver sector, the better off all silver investors will be regardless of how they choose to hold their silver.

SLV is not designed as a physical-silver substitute, but as a silver tracking vehicle. It attempts to mirror the performance of the silver price. There is only one way this can be done. Any time supply/demand pressures in SLV threaten to veer away from those in silver itself, SLV has to adjust its own physical-silver holdings to equalize this pressure differential. If it doesn't, SLV will cease tracking silver and fail.

If stock traders bid up SLV faster than futures traders bid up silver itself, SLV will threaten to decouple to the upside. Its custodians must shunt this excess demand into silver to restore balance and maintain tracking. They do this by issuing more SLV shares. The additional supply of SLV sops up the excessive demand and raises cash. Then the custodians use these proceeds to actually buy more physical silver. This process effectively shunts stock capital directly into the silver market.

The conduit SLV opens for stock-market capital to flow to silver is a double-edged sword though. If SLV is being sold faster than silver, SLV will decouple to the downside. In this situation its custodians must buy back SLV shares to absorb the excessive supply. Where do they get the cash to do this? They sell some of their physical silver bullion, equalizing SLV selling into silver itself. Like GLD for gold, SLV increases both upside and downside volatility in silver.

This standard ETF methodology of normalizing supply/demand imbalances between an ETF and the asset it tracks helps explain this first chart. It shows SLV's silver-bullion holdings along with the silver price. When SLV's holdings grow, SLV ETF demand exceeds that of silver itself. When SLV's holdings contract, SLV supply exceeds that of silver itself. As this chart shows, so far SLV's demand growth has far outstripped silver's.

When SLV was born in late April 2006, it had 21m ounces of silver stored in trust. But this highly-anticipated ETF proved hugely popular and SLV demand growth far exceeded that of silver itself. So SLV's custodians issued more shares and used this cash to buy more silver to equalize this imbalance. Just two weeks after launch, SLV's holdings had more than tripled to 65m ounces!

Unfortunately, silver itself was topping on May 11th, 2006 after a massive 124% upleg. Some revisionist analysts today want to attribute that silver crash to SLV's influence, but this theory is just plain silly in light of history. In early May 2006 gold itself was overbought and due to correct, and silver follows gold. In our April 2006 Zeal Intelligence newsletter, published weeks before SLV launched and silver topped, I wrote...

"...silver exploded up in a way that only speculators can drive. While exciting, such a surge demands extreme caution. Silver has stretched nearly as far over its key 200dma support now as it did back in April 2004 before a wickedly vicious crash. If you have leveraged silver longs do not forget that silver tends to fall faster than it rises and such corrections happen blisteringly fast with virtually zero warning. While I remain incredibly long-term bullish on silver, the short-term probabilities overwhelmingly favor a correction now."

Silver's May 2006 correction was anticipated well before SLV launched. And SLV's holdings also show that the thesis it drove the May 2006 silver crash is pure nonsense. In the two weeks following its May 2006 top, silver plunged 15.9%. Yet SLV's silver-bullion holdings actually grew by 13.7% over this same span of time. SLV was actually buying silver bullion, retarding the silver crash, not selling and exacerbating it!

On May 12th, 2006, the day this crash started, silver fell 4.9%. Yet SLV's holdings simultaneously soared by 4.8% in a single day. Silver crashed because it was technically overbought and greed reigned, SLV had nothing at all to do with it. Ultimately silver shed 35.1% in May/June 2006 in just over four weeks. Over this very same span of time, SLV's holdings grew by 10.4%. So realize SLV-spawning-silver-crash theories are total nonsense.

After being stable through this silver crash, SLV's popularity resumed and its silver holdings surged again. This growth was all the more impressive considering silver was merely grinding sideways in a high consolidation after that May 2006 crash. Yet SLV demand growth far outstripped silver demand growth so SLV's custodians had to keep buying bullion. By August 2006, four months after birth, SLV's holdings had already nearly quintupled to 100m ounces!

When silver weakened further in 2007, especially during its usual dull summer months, SLV still continued growing slightly on balance. This is very impressive. SLV holders were not scared by the silver weakness in Q3 2007, which implies they were strong hands with a long-term perspective. Since SLV still had to slowly add to its holdings, stock-market demand for SLV continued to exceed that for silver itself.

By late 2007, SLV's holdings surged again on renewed popularity sparked by silver's latest major upleg. Since SLV had to buy bullion so fast, demand growth for SLV from the stock guys was once again running at a much higher rate than demand growth in silver itself from the futures guys. Provocatively, SLV's holdings even grew during the latest silver crash in March so SLV buying actually moderated silver's downside!

Over four trading days in March 2008 surrounding the Fed's "restrained" 75 basis-point cut that hammered commodities speculators, silver plunged 19.0%. Yet SLV's silver-bullion holdings, over this same span of time, grew by 2.0%! Thus SLV sellers were selling slower and less frantically than silver sellers which created a supply/demand imbalance that forced SLV's custodians to buy silver bullion during this panic.

So in light of its soaring silver holdings, SLV has been a dazzling success. The Silver Users Association was right to fear it. Today SLV holds about 195m ounces of silver bullion on behalf of American stock traders! This is stellar 828% growth in just over two years. To put this number into perspective, the top three primary silver miners in the world will only produce 19.5m, 16.0m, and 15.0m ounces respectively this year.

In 2007, these same three elite companies produced 41.7m ounces collectively. Thus SLV, merely two years into its existence, has already taken the equivalent of nearly five years' worth of silver production from the three largest primary silver miners off the market. No wonder silver has gone from trading around $11 to trading around $17 during SLV's life. 195m ounces is a lot of silver buying!

And I suspect much of this SLV buying wouldn't have existed if there wasn't a silver ETF. Traditional physical-silver buyers who hate SLV would have kept on buying coins and bullion as always whether or not an ETF existed. But non-traditional investors, stock traders who wanted some silver exposure in their portfolios, would almost certainly not have gone through the trouble of buying that much physical. Some would have, but the great majority of SLV buying is probably brand-new non-traditional demand.

In my studies of the immensely popular GLD gold ETF, which is already the sixth-biggest ETF in the US, I always look at trading volume in the ETF itself. SLV's trading volume should also offer insights into how its popularity is growing and how silver-price movements affect the psychology of stock traders owning SLV. Not surprisingly, the volume trends in SLV are very similar to GLD's in its own first couple years.

Visually, SLV trading volume had a fairly flat trend for most of 2006 and 2007. This could be interpreted as traders failing to grow more interested in it. I doubt this though for a variety of reasons. First, silver was grinding sideways in a high consolidation during that time. Prices drifting lower tend to repel speculators since excitement ceases to exist. So SLV maintaining its volume despite a long consolidation is impressive.

Second, with flat share volume and a silver price rising on balance ($13s in mid-2007 compared to $10s in mid-2006), capital volume was rising nicely. Capital volume is the share price multiplied by the number of shares traded. In a rising-price environment, the capital involved grows even if share volume trends sideways. More capital was getting interested in SLV all the time, as its silver holdings certainly reflected.

Finally, the solid red line labeled "Gradually Ramping Up" is actually a mathematical best-fit line. So SLV volume was growing over this entire span statistically. Provocatively SLV volume utterly soared earlier this year as silver surged from $17 to $21. This is great news too, as it means more stock traders are watching the silver market and flooding into SLV when silver starts getting interesting. Capital volume was huge.

Just like GLD, SLV's biggest volume spikes generally occurred during selloffs. This is pretty typical in all financial markets. While the greed driving buyers to bid up a price gradually builds over months, fear can flare up intensely in a matter of hours. Fear and greed are very asymmetrical in their urgency, making sharp fear-driven plunges much more probable than sharp greed-driven rallies.

But despite these big SLV volume spikes reflecting heavy selling on silver's declines, it is not disproportionate to the supply/demand pressures in silver itself. Since SLV's holdings rarely ever decline by much, it is not being forced to liquidate much, if any, bullion during these selling episodes. This means SLV selling pressure is staying pretty proportional to actual silver selling pressure when the metal swoons. I'm glad to see this because SLV would really amplify silver's downside if SLV traders got too frightened.

This final chart examines SLV's success in achieving its core mission, tracking the silver price. The yellow line is the SLV share price divided by 10 (since each SLV share represents 10 ounces of silver). It is superimposed over the actual silver price which is rendered in blue. The red and white lines represent the 5-day moving averages of variances between spot silver and the SLV and the London silver fix and the SLV. The latter is included because SLV's custodians use London silver as their tracking benchmark.

SLV's custodians should be commended, because they have done an outstanding job of keeping SLV tracking silver. Since its birth SLV and silver have had a stellar daily correlation r-square of 99.9%! This means that for tracking purposes SLV effectively is silver. Considering how hyper-volatile silver tends to be in history, this achievement is really impressive. I can't imagine a harder commodity to tightly track.

Now if you follow the yellow SLV/10 line, early on it totally obscures the blue silver line. Its tracking was incredibly tight. But lately, more blue is showing which means SLV's tracking is loosening a bit. This development is also reflected in the downtrend of the red silver/SLV variance line. While slightly looser tracking may concern some, it is totally normal and expected over the life of any ETF.

Like everyone else providing a valuable service, the ETF custodians deserve to earn a living. It is hard work launching and managing an ETF to keep it tracking its underlying commodity. To provide this service, they charge SLV owners 0.5% of this ETF's assets annually. They sell a little silver each year to pay expenses and earn a reasonable profit. So after the first year, SLV is only 99.5% backed by silver, after the second 99.0%, etc. All ETFs, including the pure stock ones, work this same way.

So a decade after it went live, SLV will only be 95% silver-backed. Understandably this bothers some people, and if you are one of them SLV is not for you. This is one minor reason why I only use physical silver bullion, under my own immediate physical control, for my own personal long-term silver investments. But regardless, ETFs cost money to run so taking a small cut out of assets annually is the only way they can exist. Think of it as a convenience fee.

For speculators, this is a stellar deal. Rather than paying huge commissions on physical silver, and dealing with the hassles of physical trading, they can buy SLV for trivial stock commissions. If they are gaming silver moves running less than a year or so, the custodians' cut is immaterial anyway. Yet they can effectively trade silver, in a stock account no less, for stock commissions. And just as options on GLD were just introduced this month, sooner or later stock options on SLV will hit the market too. SLV is a speculator's dream.

Anyway, the red variance downtrend above reflects SLV's expense ratio. It will keep dropping, by about 0.5% a year, until SLV is wound up and retired at some undefined point in the future. Since secular commodities bulls tend to run for about 17 years historically, eventually silver will get too overbought like in January 1980 and enter a multi-decade secular bear. So there is no need to hold SLV forever, just until the end of today's bull. After that it will be retired I'm sure.

So just after its second birthday, SLV has far exceeded my own expectations. It has indirectly put a vast quantity of silver in non-traditional silver investors' hands, expanding both the silver market and general interest in silver. It has fulfilled its mission of tracking silver closely, granting cheap and easy silver exposure to all stock traders. Like GLD, it is a huge success story for investors and precious metals.

If you are a hardcore physical-silver guy, and you hate SLV, then don't buy it. If you'd rather own coins or bars, buy them. If you'd rather own silver stocks, buy them. But realize just because you prefer one way to invest doesn't mean alternative ways shouldn't exist. The more capital that floods into silver, regardless of where it comes from or how it enters the market, the higher the silver price will ultimately go for all of us. We want other investors to follow us in! SLV is a gateway drug leading to more serious silver investment.

And if you are a stock trader, and you want to buy some SLV to add silver exposure to your portfolio, go for it! Ignore the fearmongers. Like every other publically-traded entity, SLV has all kinds of regulations and reporting requirements so there is no reason to believe it is not storing physical silver bullion as it says it is unless proven otherwise. Paranoia surrounding alternative investment vehicles always exists, I have had to deal with it constantly for the six years I've been writing about commodities ETFs.

At Zeal, we like all forms of silver investing and speculating. We first started recommending physical silver bullion to our newsletter subscribers in November 2001 when it traded at $4.20. We have traded in and out of countless silver stocks over the years for excellent realized profits. And we are eagerly looking forward to silver's next big upleg which will probably start with gold's after we sail through the usual lackluster summer doldrums.

We just published an awesome new report detailing the fundamentals underlying our favorite silver stocks. We started researching nearly 80 silver stocks and gradually whittled this field down to our favorite 12. Buy our report today and learn about the high-potential silver stocks we are looking to buy early in silver's next upleg. We also publish an acclaimed monthly newsletter that analyzes the markets and trades commodities stocks accordingly. Subscribe now!

The bottom line is SLV has been a great boon for all silver investors. It has created a conduit for stock-market capital to chase silver directly. Through this vehicle, non-traditional silver investors who probably would never have or could never have bought coins or bullion now own hundreds of millions of ounces of physical silver held in trust. On top of this SLV has tracked silver beautifully, realizing its core mission.

While SLV isn't for everyone, particularly hardcore traditional physical guys, it is really expanding the silver fold. Mainstream investors who are new to precious metals can buy a little SLV, which not only adds silver-price exposure but gets them watching silver regularly. SLV helps spread the silver gospel. And the more investors and capital that grow interested in silver, the bigger its secular bull will ultimately be.

Adam Hamilton, CPA
Zeal LLC.com

Do you enjoy these essays? Please help support Zeal Research by subscribing to Zeal Intelligence today! &www.zealllc.com/subscribe.htm

If you have questions I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/financial.htm for more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I WILL read all messages though, and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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