Silver-Mad Small Investors Fueled an Epic Rise and Fall

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.

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.

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.

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.

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