Myriad of Factors Fueled Silver's Downward Spiral

The scary selloff that has wiped about one-third of silver’s value was triggered by a concoction of factors and drives home the point that ultra-volatile silver is not safe-haven gold.

A trifecta of factors have combined to put silver on track for its worst month since its historic rout in 1980: a mass exit from red-hot commodities, fear about central banks taking away the easy-money punch bowl and supply-and-demand metrics that got seriously out of whack.

“We’re learning once again it does respect the laws of gravity,” said Jon Nadler, senior analyst at Kitco Bullion Dealers Montreal.

While silver has been in a freefall (it’s taken just nine trading days to erase almost three months of gains), it was also on a rocket ship higher since the end of the summer.

Investors fearful about the previously-tumbling U.S. dollar swarmed to silver, sending the metal surging 165% between late August and the end of April to nearly $50 an ounce. The fantastic returns widely outpaced stocks, bonds and even gold, which gained about 26% over that span.

“The world of commodities was one where everything was just going to keep going up,” said Darin Newsom, senior commodities analyst at Telvent DTN.

Retail investors also got into the act, lured by easy-to-trade silver ETFs and silver’s relatively cheap price tag compared with $1,500 gold.

“Unemployed youngsters were trading it on their computers and Uncle Harry’s buying it and making a killing,” said Nadler, adding there were “all the signs” the buying was overdone.

Higher Rates, Stronger Dollar Slam Silver

Sentiment began to shift in the commodity world late last month as the Federal Reserve cemented its plans to end its $600 billion bond buying program, dubbed QE2, at the end of June as scheduled. The program had helped keep the dollar under pressure, leading to a buying binge in commodities like gold, silver and cotton.

“Under QE2, the black boxes were given the easy and simple order to ‘buy the dips, it does not matter, the Fed will give us more money to trade tomorrow and next week,’” Olivier Jakob, managing director at Petromatrix, wrote in a note. During his historic press conference last month, Fed chief Ben Bernanke showed many he was committed to keeping commodities from getting completely out of control.

“The Fed is cognizant the longer they stay in this no-interest paradigm, the commodities bubble could go on and endanger the recovery they’ve tried to bring about,” said Nadler.

Other central banks, such as India, Malaysia, the Philippines and Vietnam were actually tightening rates, not just talking about removing stimulus.

On top of the concerns about the end of QE2, the U.S. dollar has been helped by the continuing debt mess in Europe. Those jitters resurfaced last week in the wake of a report Greece was mulling an exit from the euro.

The greenback leaped 1.38% against the euro on Wednesday, leaving the currency at its best level since the end of March and up 4% in May alone.

“If you have a higher stronger dollar you are going to have some sellers in silver who are no longer in need of that hedge,” said George Gero, vice president of global futures at RBC Capital Markets.

Supplies Return to Focus

Meanwhile, silver, much more so than gold, can be moved by supply and demand, which had been largely ignored in favor of concerns about the dollar until recently.

Supplies of silver appear to be rather healthy and have actually been on the rise. According to the 2011 CPM Silver Yearbook, mine production, which accounts for the largest portion of total supply, increased 2.2% in 2010 to 667 million ounces.

Mine output was also projected to rise 3.4% in 2011 to 689.5 million ounces, CPM projected. Secondary supply of silver rose rapidly last year amid higher prices and demand for electronic items.

Silver prices “had become wholly divorced from the fundamentals of supply and demand,” said Nadler.

As the dollar rebounded and fundamentals came back into focus, silver prices began to take a hit at the beginning of May. The selling gained momentum when the CME Group (NYSE:CME) raised margin requirements, squeezing out many short-term investors.

Silver's 'Dual Personality'

At the same time, high-profile investors, including billionaire hedge fund manager George Soros, were announcing their exits from the silver market.

Some silver investors may have forgotten that the metal can be rapidly moved by supply and demand. The industrial demand side of silver is a key reason why silver isn’t a true safe haven play like gold is.

“Silver kind of has a dual personality of being a precious metal and an industrial metal,” said Newsom.

Gero goes a step further, saying, investors “should realize silver is a commodity. It’s not another currency like gold.”

So where does silver go from here?

Analysts forecast more turbulence in the short term and look for silver to perhaps stabilize around key levels of $34 or $29, the latter price marking a 50% retracement from its recent surge.

Silver was on another rollercoaster on Thursday, tumbling as much as 7% to $32.595 before making a comeback to trade off just 1% in midafternoon action.

Nadler said, “I think volatility will continue undoubtedly.”