The crash in silver and some other commodities highlights the dilemma of every investor in a potential bubble. Do you see the market heading for the cliff and sit out?  Or, do you believe the growth forecasts and stay on board?

Momentum is a prime ingredient of any investment decision, but how do you know when it is time to get off the train before it goes off a cliff? Many silver traders received a harsh lesson when they ran out of greater fools. Recently we have seen run-ups in a number of other commodities and markets. Have these markets run out of momentum? Is this the beginning of a global meltdown or is this the pause that refreshes?

The main point about silver was that its run and fall, despite the commentators, had little to do with economics. The 26% (and counting) decline was not triggered by any major change in supply, demand for the commodity or change in the global political or economic situation. It was triggered by a rise in the Chicago Mercantile Exchange (Comex) margin requirements on silver futures four times in two weeks. But this is not that unusual. Silver can swing 2% in a day and margin requirements must go up when prices go up. So the Comex damping volatility was simply doing its job.

Other reasons given for the fall have to do with the failure of the market to breach the psychologically important $50, or simple profit-taking. The apologists have plenty of reasons why the collapse should not have happened, such as increased industrial demand and tight supply, although both of these things existed before the current run-up. If you are really desperate, you can always cite the declining dollar and Chinese growth. Although both assumptions are considered religious dogma among financial analysts and economists, they are still assumptions open to question.

The reality is that it was a bubble and it was time. Silver had risen 57% in 2011 alone and the turnover of the leading vehicle for US retail speculation, the iShares Silver Trust, was up over 10 times in April. Certainly these are extremes, and financial historians will no doubt tell us that all the signals were there, but the speculators simply didn’t read them. But is there something more here, and what does silver’s collapse tells us about potential bubbles in other frothy markets?

Two famous stars of investing have radically different views on the subject. One, John Paulson, the head of hedge-fund giant Paulson & Co, has kept his portfolio of gold investments. The other, the legendary George Soros, is head of Soros Fund Management, one of the biggest hedge-fund firms in the world that has sold much of its gold and silver investments over the past month. The reasons for this diametrically opposed strategy represents the Apollonian (rational) versus Dionysian (emotional) view of investing.

Mr Paulson appears to be the more rational investor. Paulson has most of his personal wealth in gold-denominated funds and believes that gold could climb as high as $4,000 an ounce over the next three to five years, a courageous view after this week’s sell-off. Mr Paulson’s view is very logical and rational. He sees gold as a hedge against currency devaluation. With various central banks in developing countries printing money as never before, any good economist, and Mr Paulson uses the best, would assume that paper money would depreciate against hard assets such as gold. It would also be rational to assume that such depreciation would be reflected in the market. In other words, the markets accurately reflect economic reality and gold would appreciate substantially against the dollar.

Mr Soros also has access to the best economists. But Mr Soros does not necessarily believe that markets reflect economic truth. He believes in what he calls ‘reflexivity’. Reflexivity is a special condition that can arise due to excess leverage and the trend-following tendency of traders. In these circumstances, which may have occurred with metals and other commodities, the investor bias grows and creates a bubble. So according to Mr Soros, the market is often irrational and completely wrong.

What is interesting is that both investors followed the trend, using momentum to make money. This is despite Mr Soros’s prediction last September that gold was the “ultimate bubble.” Mr Soros could have followed his reason and not invested in what he knew was a bubble. He could have stayed out or shorted the market, but he still followed the herd to his profit as did Mr Paulson.
 
All of which leads to a dilemma for investors. Assume it is April 1999. The dot.com fury is beginning to escalate. Do you see that the market is heading for a cliff and sit it out? Do you believe the forecasts of an ever-growing internet and stay on board. After all, the market did recover 20% by August 2000 after its first bottom in May. Or do you realize that the market is irrational and get on board, but feel confident you can leave before the cliff? Or be a contrarian and short the market? Perhaps the lesson is that there is nothing more rational than understanding the irrational.

(The writer is president of Emerging Market Strategies and can be contacted at [email protected]  or [email protected].)