Why are the values of gold and silver mining stocks going so low?

With the price of gold taking over a 30% drop from its most recent peak in October of 2012 and nearly a 35% drop from its all time high in September of 2011, the precious metal mining sector has been absolutely crushed.

Specifically the large cap Market Vectors Gold Miners Index ETF fund (GDX) has dropped 58% and the small cap Market Vectors Junior Gold Miners ETF (GDXJ) has dropped 65% from their most recent peaks in September of 2012.  They are down substantially more from their all time peaks (65% and 80% respectively).

So why have the miners taken so much more drastic of a plunge than gold itself?  The following is a simplified analysis to help you get started understanding the answer.

Over the last hundred years (or so) we’ve removed all the easier to find gold from the near surface of the earth, and now miners have to do a lot more work, in more remote locations, while using bigger and more powerful equipment to get at harder to access deposits in the earth.  And that work and equipment costs more and more money.

If you add up all the expenses it takes for a company to pull as much gold as they can out of the ground in a year, then divide it by the total weight of that gold they extracted in that year, you get an average cost per weight that it takes for the company mine gold.

If that average price to mine gold is below the current price of gold, the miner obviously loses money when they sell their extracted gold.  If the price they can sell the gold for is greater than their average cost to pull it out of the ground, they obviously make money.

The kicker is that when the price of gold is bigger than than the cost to mine it, every extra amount that the selling price of gold goes up is pure extra profit.

Lets take an example.  Say it costs the mining company $1300/oz to extract the gold and get it ready to sell.  And, say the current price of gold is $1400/oz.  The miner profits $100/oz.

Now say that the cost to mine remains the same at $1300/oz, but the price of gold rises to $1500/oz.   Now the miner profits $200/oz.  So the miner’s profits doubled without them doing anything different.

A company who’s profits double, is (in simple terms) worth twice as much, or will have a 100% increase in value above its price before the profit change.  Whereas in the scenario above, gold only increased in value 7%.  So a 7% increase in gold price, caused a 100% increase in the value of the average company mining it.

From the example above, you should be able to see that relatively small changes in the price of gold can have significant impacts on the profits, and therefore, the trading prices of gold mining companies.

Currently, depending on what source you find and decide to believe, the price of gold is near or below what it costs for for an average mining company to mine it.  So the mining companies are, on average, losing money.

If a company loses money for more than a short period of time, it is likely to go out of business.  A company that is likely going to go out of business is worth very little and nobody wants to buy it.

So with the price of gold going down, and the miners seemingly losing money, it appears as though miner stocks are not worth purchasing, and their trading prices have plummeted to those apparent levels.

Beyond the basic examples above, it is also helpful to know that pricing gets taken to extremes as the sum of people trading in the market make up a virtual mob that is actually quite emotional. When things are going in a certain direction, the mob becomes increasingly focused in that unilateral direction and pays less and less attention to the extremeness of the trend.

It starts with the basic economics of supply and demand. Because just about everyone is doing the same thing, there is usually not enough of whatever the mob is buying (supply) for the amount of people in the mob trying to buy it (demand).  Therefore the price of that thing goes up to balance the limited supply and growing demand.

In the opposite direction, as is happening with the miners, there is too much supply because everyone is selling, creating an oversupply, and the price therefore goes down.

On top of this, add in the effect that people psychologically see that a trend is happening and expect that it will go on forever and you get an extreme overall sentiment in the mob.  People see that everyone is doing something, and expect that because everyone is doing it that same thing it will go on forever.  So it becomes seemingly obvious that one should join the crowd.

We saw this with the housing bubble.  People bought houses because they prices were going up so drastically.  If you didn’t by a house “now”, you’d never be able to own one, because the prices just kept going up and up.  Loans were easy and cheap so people bought as much house as they could afford the payments on, expecting that if anything went wrong, they could just sell the house for a profit as everyone had heard about “those people” that bought a house and sold it a few months later for a 50% profit.  This caused prices to surge.

Of course the reverse also turned out to be true.  When the short term interest rates on those easy loans started adjusting up, people could no longer afford the payments on their homes and suddenly everyone started having to sell their houses.  With virtually everyone selling and nobody buying, the prices plummeted.  Many homeowners, even though they could afford their payments, walked away from their houses, because there was “no way it would ever get its value back”.

Bringing this thought pattern back to gold and the gold miners, we currently have a situation where the price of gold and the miners are going down.  So we have a trend that is snowballing downward.  The mob is becoming unilaterally focused on the downward trend.  People believe that because the price of gold is going down, it is going to continue going down forever, and therefore the miners are never going to be profitable again.  So more and more investors are joining in on selling and “cutting their losses”.  So the miners seem to have virtually no value and their stocks are trading at such a value.

Now… there’s one more effect I need to mention that adds to exponentially increase the already exponential effect of the mob mentality.  And that is the wonderful and exciting ability for market participants in the mob to “short” sell a stock.  This means that a company (stock) can be sold by a person that doesn’t even own it!

What?!!

Yes, that’s right! And you can even short sell gold!  Yes, there are ways to sell gold that you don’t even yet own!

As this article is already getting long, we can get into the details of “short” selling stock and gold in another article, but for now you just need to know that people try to profit on the downtrend of a stock or commodities price.  They “sell” a stock they don’t yet own, and if the price goes down, they can make money.

This (somewhat virtual) selling makes it look like the mob is more focused on selling than it really is. This amplification effect causes the a fore mentioned psychological reasons to sell to be exponentially stronger, as the situation looks like even more of the mob is aligned in one selling direction, causing the trend to look even more negative.  A trend develops and the psychological effect to join in and sell before the value becomes worthless sets in.

So the miners are currently really getting hit hard by all these effects and their prices have plummeted.

So is it time to invest in the mining sector?

I have been buying and I believe it is a great time to start purchasing down in a proprietary pyramid fashion that I’ve developed over my years of successful investing, and I’ll discuss what that means and give deeper reasoning why I believe its time to purchase the mining sector in another article.

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UPDATE:  See my article on ETFs creating shares for short positions for yet another reason why miner ETF prices get overly extended on the down (and up) side.