I'll Take A Crack At Explaining The Performance Of The Mining Shares

There's been reams of discussion recently about the performance of the mining shares relative to the price of gold/silver. I believe a lot of the disappointment in the performance of the shares is because the metals have been hitting new highs almost every day now. But there are a lot of "levers," or variables, that drive mining share valuation - not just metal in the ground multiplied out by the price of gold/silver. And make no mistake about it, the HUI and XAU have been hitting new all-time highs during this period, so anyone not making money in the mining shares should reassess their strategies and anyone not happy with their bounty will probably always be a malcontent.

But rather than let our views get overwhelmed by conpiracy theories and childish whining, let's cut to the chase and just look at some numbers and market theory. I'm going to keep this simple for illustrative purposes. To begin with, the price of a stock at any given time largely reflects the current fundamental value, or instrinsic value, of the company plus some expection of the company's future prospects. So if a mining stock is priced at $50, that value reflects everything that is currently known about the company and its industry fundamentals PLUS it contains some value that reflects what the market thinks will happen in the future. So for a solid mining stock at $50, that price contains the public knowledge that gold is at $1500 PLUS some "discounted value" for the expectation/probability that the price of gold will be higher in the future. So just because gold goes from $1400 to $1500, if the market thinks that $1500 is all we'll see, the price of the stock won't move.  This is "rational expectations" theory in a nutshell and is good for explaining a large part of stock market valuations, everything else being equal.

Now, what I believe, and what has been the case for the duration of this 10+ year bull market, is that MOST of the market players do not understand gold or why it's moving higher AND they believe gold has topped out every time it hits a new high. This is GREAT news for the minority contingency who DO understand the dynamics, because at some point the size of the market that does come to understand the market will grow larger and the cash pools flowing into the sector will grow at a geometric rate, accelerating the push higher in these mining stocks. I personally believe that we will see at least $5000 gold.  But think about the small percentage of market players that actually believe $2000 is even possible. Probably less than 5%. The price of mining stocks reflects this huge imbalance between the "knowers" - gold bulls - and the skeptics - the 95% who think I'm nuts.  This dynamic is part of what is known as the "efficient markets" hypothesis and I believe that the market is being very "inefficient" in its understanding of the precious metals.  Because of this, and this view of the market has been proved correct for the past 10 years because the metals sector has substantially outperformed ALL other asset classes, I believe that there are still huge profits to be made in this sector up until the entire market has knowledge and understanding.  THAT is when we will be in the bubble phase.  Until then I believe there is still a lot of easy "information arbitrage" profits to be had.

There's a lot of other factors at play as well. As my good friend and colleague "Jesse" has pointed out, there is a 50% correlation between the SPX and gold and a very high correlation between the SPX and the mining stocks. The SPX is about 3% below the high it hit in mid February. So if the mining stocks are lagging the performance of gold, a meaningful part of this lag can be attributed to the overall weakness in the stock market.  You are doing yourself a disservice if you do not read his work on this:  LINK

From a technical perspective, Dan Norcini wrote an excellent description of a "ratio" trade that is being played en masse in the hedge fund community, in which they go long a gold ETF and short the mining shares. This is an excellent piece that I believe explains a lot about what is going on:  LINK   Because I know from experience that big NYC hedge funds all travel in herds, I know that there is a "herd" of cash playing this trade and that most of the players do NOT know about, and could care less about, what gold is doing and why. Suffice it to say that there is a large pool of capital that is long gold/silver and short the mining stocks. Because the universe of mining stock shares is very illiquid compared to the broad stock market, the effect of a lot of cash shorting the shares will "exaggerate" the price pressure put on them. But of course, as Norcini points out, the reversal of this trade en masse will send the mining shares higher very quickly in violent fashion. So get ready for that ride because it will come.

Finally, there's some other important "levers" that go into valuing mining stocks besides the price of gold and the amount of metal in the ground. The two biggest factors are cost and risk. Energy represents about 50% of the cost of actual mining. So a high production mining company's expenses increase rapidly when the dollar declines rapidly and the price of oil appreciates rapidly. This fact is not lost on the market and is reflected in a lesser valuation multiple assigned to stocks in this industry. In addition, the cost of labor increases AND so do regulatory costs. Regulatory costs include taxes and environmental legislation.

And finally, and especially relative to 10 years ago, the political risk and costs associated with that factor have escalated substantially over the last 10 years. Just ask any mining company with operations in Venezuela or Bolivia. Although you can't quantify this risk on paper, I guarantee anyone reading this that the market collectively will assign a discount factor to the sector based on political risk expectations. So, for example, the price of gold can move from $1000 to $1500, but if the market thinks a couple of countries in South America and Africa will either massively increase mining tariffs OR outright nationalize operations, this expectation will be reflected with relatively lower valuations in relation to a big move higher in gold. And trust me, as the price of gold continues to escalate, the risk that "have not" Governments seize the bounty increases. I promise you this is a factor in the performance of the shares.

Now having said all that - and please make no mistake about it - I am NOT saying that manipulation is not a sizable factor in the mining shares, it is my view that the price of gold/silver will continue to appreciate a LOT more rapidly than the true cost of energy, labor, regulation and geopolitical risk. AND if you have a carefully selected portfolio of large cap and small cap mining shares, you will make a fortune.

I will say that our fund has been weighted about 60/40 metal/miners since the beginning of the year because we felt that the price of the metal would outperform the shares on a risk/return basis. I will also say that if you have a VERY carefully picked selection of junior exploration mining stocks that you might get wealthy off of them. Most people, even those heavily involved in this sector, are not at all aware of the degree to which penny mining stocks shot up during the 1970's. Many of the today's junior mining stocks will have breath-taking moves over the next five years.  Because junior miners do not have the cost of mining attached to their operations, the hope of the next massive discovery will eventually capture the imagination of the investing public and speculative money will eventually flood into the juniors.  This is a wave that I know is coming and that I want to ride, especially since I believe we have picked some companies that have a good shot at actually finding some big discoveries (you learn a lot about selection and whom to talk to and whom to trust after doing this sector exclusively for 10 years).

We have the stock side of our fund weighted about 50/50 between juniors and large caps. The percentage in juniors will likely increase when we decide that the risks mentioned above have been overly discounted by the stock market and the miners are ready for another big move. In other words, we hope to get a little lucky with market timing but if we don't we still will make a lot of money for our investors because of our junior mining stock exposure.

I hope this helps clarify what I believe is going on right now.