1 Thing Investors Are Missing About Gold and Silver

There's no sugar-coating it: Gold and silver were terrible investments in 2013. The SPDR Gold Trust  (NYSEMKT: GLD  ) is down 28%, and iShares' Silver Trust (NYSEMKT: SLV  ) is off by 36% year to date.

SLV Chart

SLV data by YCharts.

It just wasn't their year. But persistent bulls won't give up.

There are plenty of explanations why gold and silver should be priced higher. Many focus on the high cost of production. If gold costs $1,500 per ounce to produce and silver costs $30, for instance, then gold and silver shouldn't trade lower than those prices. Miners will simply stop mining. 

That's a good way to think about gold and silver prices, since valuing gold or silver is vastly different than valuing a company. A company can be valued based on its future cash flows. Neither gold nor silver produce anything, so what they're worth is strictly what someone is willing to pay. And how much it costs to "make" a new ounce of gold or silver is a generally good starting point.

But production cost isn't the end of valuation. Sometimes it's as irrelevant as the price of tea in China.

Why production cost doesn't matter now
The majority of gold is never used. It's just stored as an investment or in a piece of jewelry. Silver, however, does have industrial uses, but just like gold, there are millions of ounces in the hands of investors and consumers.

And in recent years, the amount of gold and silver sitting in the hands of investors has only grown. The Silver Institute reports that in 2012 alone, investment demand made up roughly 15% of all silver demand. For gold, more than a third of all demand comes from investors.

Now, knowing that investors and consumers hold gold and silver above ground, you know why production cost is irrelevant. There's no need to mine gold and silver, at any price, if millions of ounces exist above ground in easy-to-sell quantities and qualities, and the current owners are willing to sell.

And that's the reason you shouldn't rely on production cost as a measuring stick for valuing gold or silver.

In the last few years, investors have stocked up millions of ounces of precious metals. If they sell, as they have been recently, the price can drop precipitously, regardless of how much money it takes to find a new ounce of metal.

So, while the price of gold and silver may be nearing their cost of production, so long as investors have ample gold and silver to sell, prices can still go lower, regardless of what the Fed's doing, whether or not the money supply is growing, or whether you fear hyperinflation is right around the corner. 

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  • Report this Comment On December 26, 2013, at 10:27 AM, preskeelpundit wrote:

    "A company can be valued based on its future cash flows. Neither gold nor silver produce anything, so what they're worth is strictly what someone is willing to pay."

    And yet PE ratios for non-mining companies have ranged from 1 to infinity in the past, and T-Bills and money markets pay a negative return after inflation. How is that any different?

  • Report this Comment On December 26, 2013, at 11:16 AM, AssetDesignCente wrote:

    While what you say may be true, i.e., sellers will sell when the price is right; you assume that holders of gold and silver are currently selling.

    Many believe that the prices of precious metals are being suppressed through "paper" markets such as futures contacts and ETFs. The reality of the futures markets is that few contracts are ever actually delivered. I've seen numbers that show something like if all of the gold that is currently sold was asked for through delivery, there are approximately 70 ounces of gold "sold" than there are available for delivery.

    Entities have been doing with precious metals what they have been doing with the banking system - fractional ownership. This could lead to a "run on the banks" in the gold and silver markets.

    And it wouldn't be the first time. Pres. Nixon closed the gold window when there was a "run on the gold bank". And even recently, A European nation asked that their gold be returned but was told that it would take seven years for the U.S. to deliver. This foreign entity was not even allowed to audit their holdings. Could this be still another JP Morgan gold situation?

    The need for the US to accumulate large amounts of gold for delivery could be a reason to manipulate gold prices lower, causing "weak hand" investors to liquidate and allowing the US to accumulate at low prices.

    I think that it's a great time to be accumulating the metals. They will probably go lower, perhaps silver trading down to 15. But once this market turns higher, prices may explode to the upside.

  • Report this Comment On December 26, 2013, at 3:18 PM, rhealth wrote:

    ^like

  • Report this Comment On December 27, 2013, at 9:45 AM, abcpanther wrote:

    Let's just address silver, silver is used in many different ways besides jewelry and money. It's used in medicine, electronics, highly reflective, very conductive, and also used in clothing and photography.

    As far as usage, over 800 million ounces are "consumed" each year(never recovered each year, purely used up). So if the mines aren't producing, then there IS a shortage. His thought is that millions of silver is already in the hands of investors and they are willing to part with it and the price wouldn't move. Hmmm, really?! If I'm an investor and Apple needs silver and I have thousands of silver, I'm not selling at $20 an ounce. I know I can get much higher. In fact, as an investor, you take that a step further ... if computer companies, car manufacturers, photography companies, and pharmaceutical companies, solar panel companies can't get silver I know they will be willing to pay much more and the cost to have me part with it will go much higher. They might have to pay me $50 or $75 an ounce.

    Let's take this a step further, if silver mines are not producing silver and they've been shuttered, then as an investor, I know it can take months maybe a years to get the mines back up to speed. So the shortage will be world wide and felt in multiple manufacturing sectors. With a global shortage of the metal, just by being patient, the price will be driven up, not down as Jordan thinks. This is when other investors realized that much of the SLV ETF (SLV - Electronically Traded Funds) can't or won't deliver "Actual" silver. They have a clause which allows them to deliver in the "Dollar" equivalent. This is when investors around the world will realize that their "Paper Silver" isn't worth anything because it's NOT really back with silver. Why can I say this? Because this is when they will refuse to settle any settlement with "Real" silver. They won't deliver and will have to shut down. Once this hits the financial markets, "Real silver" will go through the roof!

    Let's ask another question, if gold and silver is such a bad investment, why is China buying gold in record numbers? Why was India buying gold in record numbers? Why is Russia buying in record numbers? Why did Germany want there Gold back? Why when India made it difficult to purchase gold did the population switch to silver? Why do these countries value the purchase and ownership of these metals?

    On the other side, I think many investors know there is a problem with the DOW. We are sitting on a completely managed market. This is the only reason that people pay such close attention to what the Fed is doing. If they keep printing, then it will be reflected in the market. If they stop, then the market will crash. I think most true investors and economist believe that our market is very fragile. The big question is how long can this go on. We know the Fed can continue to print ... how long will other countries accept our dollar? When they stop, this is when we will see our dollars come rushing back to the united states.

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