3 Lessons from the Biggest Silver Bust in History

The remarkable run in gold and silver prices this year has had me thinking lately — particularly silver’s run. Recently, gold’s poorer cousin reached 30 year highs, with prices reaching $30 per ounce on the futures market. It reminded me of a story often told by old-school commodity pros on Wall Street. And I think there are three lessons today’s investors can learn from it.

The year was 1971 and inflation was on the rise. In the past, investors had long turned to gold coins and bullion as a store of wealth and protection against inflation. There was one little problem this time: the United States had abandoned the gold standard, and it was illegal to own gold bullion.

But millionaire brothers Nelson Bunker Hunt and William Hunt, sons of the legendary oilman H.L. Hunt, had a plan.

In 1973, the Hunt brothers began purchasing silver futures contracts. Not satisfied to stop there, the brothers decided to hold many of the contracts to maturity and actually take delivery of the metal, an unusual tactic in a market in which virtually all positions are offset before the contracts expire.

The strategy seemed to work: between 1973 and 1979, prices had gone from $1.95 to $5 — a gain of more than 156%.

The brothers figured if they bought enough silver, they could corner the market and make that 156% gain seem like chump change. By 1979, they had nearly succeeded. That year, prices rose to more than $50 an ounce, and the Hunt brothers were rumored to hold about one-third of the world’s silver supply in storage.

But the story doesn’t end there.

With prices so high, people began selling all the silver they could get their hands on. Prices plummeted 50% in four days. And the Hunt brothers had overleveraged themselves to the point that when margin calls came in, they were left holding the bag.

Later, the Commodity Futures Trading Commission changed the rules regarding margin trading and charged the Hunt brothers with manipulating the silver market. Lawsuits ensued, and the Hunt brothers were forced to pay millions in fines, back taxes and interest as a result. All told, it’s estimated the brothers lost more than $1 billion in the endeavor.

I bring up this story not for your entertainment, but for an important lesson — three to be exact. And I think it bears particular importance with regard to gold and silver’s recent runs.

  • Lesson #1: Leverage can break you. It’s regrettable, but 30 years later it seems much of Wall Street still hasn’t figured this out. When used by experienced investors, a little leverage can juice returns. Just don’t get too greedy.
  • Lesson #2: Uncle Sam can change the rules. Investors: plan accordingly.
  • Lesson #3: Know when to sell. Sounds simple — but it’s easier said then done. If you’re sitting on a position and aren’t sure if there’s more upside, there’s no shame in booking a nice profit and moving on.

Action to Take –> When it comes to precious metals, these lessons are even more important. The gold and silver markets are notoriously volatile and can turn on a dime. And as our own David Sterman recently mentioned, a market rally is often simply the result of investors following other investors.

Having said that, experts like Nathan Slaughter, editor of StreetAuthority’s Market Advisor newsletter, think silver could still have more room to run. And instead of buying an exchange-traded fund (ETF) like the Gold SPDR ETF (NYSE: GLD) or the iShares Silver Trust ETF (NYSE: SLV), Nathan holds Silver Wheaton (NYSE: SLW), a silver streaming company that acquires silver production from counterparty miners. This means the company has virtually no overhead (it costs very little if you’re just buying the silver production from a mining company). This gives you the upside of silver bullion without any storage or insurance costs. The company doesn’t mess around with futures contracts and doesn’t use any leverage, either. If you think silver has more upside, it’s a good option.

P.S. — Using the same principles that helped trounce the S&P 500 for seven years, one of our top investing gurus, Nathan Slaughter, hand-picked all 10 of the stocks featured in his latest exclusive report, The Top 10 Stocks for 2011. These 10 stocks are not only poised to deliver above-average returns throughout the 2011 calendar year, but also in the years that follow…