Gold and Silver Mining Stocks, Why So Much Risk for that Pittance of a Reward?

By: Dr_Jeff_Lewis

The “smart money” says if you want to rev up returns, then you must run to producers.  Gold and silver, on their own, just match inflation, and they don't beat it. If only that were true!

Laughing All the Way to the Bank

Throughout gold and silver's record decade romp to $1400 and $31, respectively, we heard a number of people cringe as the silly “gold and silver bugs” took flight for physicals rather than gold and silver mining stocks.  “Why would you want gold when you can own the producer?” analysts and commentators would ask.  “Why wouldn't you want the natural leverage?”  But really, the question gold and silver bugs should have asked back is: “What leverage?”

The leverage, analysts thought, was in exchange-traded funds like GDX, a gold miner fund that encompasses a number of producer stocks.  As gold rises, analysts believed, miner profits would increase at a faster pace than the change in gold, and as such, gold miners would rise faster than gold itself.  From 2006 to the end of 2010, however, this wasn't the case.  In fact, exchange-traded fund “derivatives” essentially broke the idea of rational expectations.

Systemic Dangers of Sector Investing

To the average investor, sector swapping is an excellent investment strategy.  You can buy one whole sector when it's hot, dump it when it's cool, and have exposure to a myriad of companies that produce the same product.  It's brilliant, really, but only for the individual - not for the market.

Since 2006 and the creation of a gold miners ETF, gold and gold miners became interchangeable to investors.  A short term investor might buy either gold or a gold miner intra-day to play a rising gold price, and the idea was that he or she would match the rise in gold.  That was true - until 2008.

Everything changed after the onset of the financial crisis and the “Great Recession.”  Investors sold off gold stocks in mass on temporary deflation fears, sending the GDX exchange-traded fund from a high of $56 to $17 in a matter of months.  Gold, however, fell from $1000 to the low $700s.  It was only at that giant trough that gold stock investors would've beaten physicals, and any purchase outside the last quarter of 2008 should have been in physical, not stocks.

These funds and funds of funds predicate additional risk taking and ruin sound markets.  In bull markets, investors expect the very best of corporate profits, and in bear markets, investors expect the very worst.  This is why, in less than one year, gold mining stocks took a nosedive of 70%.  Expectations went from the top of the chart to the bottom of the chart in a complete binary reversal of forecast prices.

Miners Are for Data Diggers

Mining companies are in large part a fool's game.  Dilution is routine, and sometimes extreme; many “junior miners” have devalued their stock by half or more in a matter of days.  Mining companies are known to take extreme financing measures or engage in contracts that dilute their upside. 

Silver Wheaton, one of the fastest growing “silver mining” companies, is one such financier.  The company has made a proverbial mint giving other miners cash in exchange for silver purchase agreements at less than half silver's current value.  For Wheaton, it's big bucks, but for the actual miners, it's accepted slavery.  Now you know how this company makes so much money by operating few mines of its own.

Physical investors need only very simple analysis: gold and silver are being depleted, currencies are falling, and global inflation is exploding.  That simple analysis, if you can believe it, beat the companies that produce gold and silver over the past five years.  And that analysis will exceed expectations for the next five, as well.

By Dr. Jeff Lewis

Dr. Jeffrey Lewis, in addition to running a busy medical practice, is the editor of Silver-Coin-Investor.com and Hard-Money-Newsletter-Review.com

Copyright © 2010 Dr. Jeff Lewis- All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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