The Gold Miner's Trap

Grim doesn't even begin to describe it...

I spent last week at the Sprott Natural Resource Symposium in Vancouver. The annual conference covers just about anything you can dig out of the ground. But the main focus is gold.

The speakers made some attempts at optimism. But just about all of them had to mention the reality...

Gold miners are getting pummeled.

The speakers at the conference gave plenty of different reasons why that's happening. But after hearing dozens of explanations, I put together the real issue. It's deceptively simple, yet powerful.

It's the gold miner's trap.

Let me explain...

It's no surprise the mood in Vancouver was dark.

Since peaking in 2011, the major gold stock exchange-traded fund ("ETF") – the VanEck Vectors Gold Miners Fund (GDX) – has fallen roughly 66%. The S&P 500 Index soared 173% over the same period, including dividends.

You might think that miners are cheap after that major fall... that now is a great time to buy. Not so fast.

You see, gold miners are stuck. They've fallen into the miner's trap.

It's basic economics. But to understand it, we need to step back in time...

From 2009 to 2011, the price of gold soared. We'd just had a major economic crisis. Investors were looking for safety outside of stocks... And the "fear trade" helped push gold up, up, up.

Miners rushed to take advantage of it. They got as much production on line as possible to profit from higher prices.

Global gold production bottomed in 2008 at 2,280 metric tons. By 2013, that number had soared to 2,800 metric tons. But it didn't stop there.

Global gold production has continued to soar despite lower prices. Last year set a record in global gold production. Miners produced 3,150 metric tons of the stuff.

So we have an odd situation... Gold prices have been falling for years. But miners are producing more than ever.

It sounds crazy. But it makes sense when you think about the nature of mining.

Opening a gold mine takes lots of time and money. You've got to find the deposit... plan the mine... raise the capital... and then build the darn thing.

Under this business model, reacting to short-term price movements doesn't make sense. You don't fire employees and spend millions of dollars shutting down production just because gold prices fell $50 an ounce last week.

That's the option of last resort. Miners choose to tighten their belts instead. They continue operating in the lower-margin environment.

The more efficient the mine is, the less it needs to worry about short-term price movements. If margins fall, mines produce more to increase cash flow.

This is important. Boosting production works for larger and more efficient mines... but smaller projects get hammered.

As the downturn continues, the less efficient operations get squeezed out of the market. And by the time you get to where we are today, everyone feels the squeeze.

This is the gold miner's trap. Lower prices encourage high production... And high production keeps prices low.

It's counterintuitive. But it's true.

Now, this cycle can't continue forever. Eventually, only the mines with the deepest pockets will remain. And at that point, the market will turn over.

Production will decrease. And prices will rise.

That hasn't happened yet. And buying today – without the uptrend – means falling into the gold miner's trap.

The thing is, the biggest gains in assets happen when things go from "bad" to "less bad." If we get a little help from an increasing price of gold, then gold-mining stocks could take off.

We are not there... yet.

Wait for a solid uptrend before getting back into gold stocks.

Good investing,

Vic Lederman

Further Reading

Steve looks for investments that are cheap and hated. And despite some recent volatility, he's seeing huge opportunity right now in one set of stocks. Learn more here: The Safest Recipe for Massive Investment Gains.

Gold and precious metals are a great way to protect your investments with portfolio "insurance." Recently, Austin Root discussed this idea, how it works, and why you should hedge your bullish bets... Read more here: What One of the Scariest Days of My Career Taught Me.

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Like gold, this metal has struggled in recent years. That's pushed investors to their most hated levels ever. And as a result, triple-digit gains are possible once the uptrend returns...

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