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1 Thing Investors Are Missing About Gold and Silver

By Jordan Wathen – Dec 26, 2013 at 9:51AM

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Here's what investors are missing about gold and silver, and why they can still trade lower.

There's no sugar-coating it: Gold and silver were terrible investments in 2013. The SPDR Gold Trust (GLD 0.09%) is down 28%, and iShares' Silver Trust (SLV -0.49%) 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. 

Fool contributor Jordan Wathen has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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