The past year has been especially good for owners of metals and mining companies. This has led to some highly unrealistic expectations for metals prices and the share prices of many of these companies. Whether it's outright fraudulent Chinese shell companies, speculative rare earth investments such as Molycorp (MCP) and Shen Zou (NYSEMKT:SHZ), or blue chip miners like Freeport McMoran (NYSE:FCX) and BHP Billiton (NYSE:BHP), the entire sector has reached excessive valuations. The metals themselves, whether gold, silver, copper, palladium, or other metals have also run far ahead of themselves. Bullishness in this sector, especially among momentum traders and retails investors, has never been higher.
Metals and mining are considered a can't miss investment theme. China and the rest of the developing world are growing. Inflation is rising. Shortages of physical metals are looming. Mine production can't keep pace with demand. Some of this is true, but all the good news is priced into this sector. Additionally, there is a lot of bad news out there that is not factored into the prices of these metals or mining shares.
First, China and other emerging economies are already overheating. They're raising interest rates to slow down their economies. China specifically may be facing a massive real estate and construction bubble that is in the process of collapsing. By some estimates, 66% of all the growth in China is construction oriented. Much of this construction is being built with loans that will never be repaid and there is nobody to buy the real estate or use the infrastructure that's being built. The looming slowdown and possible collapse of Chinese construction will hit the metals and mining hard. One of the most successful short sellers in the world, Jim Chanos, is heavily short mining companies for exactly this reason. Chanos has made money for his investors over the years by correctly predicting the collapse of Enron and other frauds.
Second, accelerating inflation is driving up the costs of mining operations. Although mining revenues are rising, their costs are also rising substantially. This will hinder profit growth and these companies even if metals prices stay elevated.
Third, most of the recent money flowing into metals and mining is short term, speculative, leveraged, uninformed, and not based on fundamentals. At the first sign of chart weakness, this money is likely to head for the exits in search of new momentum oriented investment theme in some other sector. As this money exits in a hurry, a cascade of selling could begin and drive prices down fast and hard even below fundamental value.
I do not recommend shorting this sector because the momentum could continue for a while longer, but investors should consider under weighting or even exiting entirely metals and mining shares. This is particularly true for long term investors, and for any of the more speculative investments in this sector, such as those focused on rare earth elements, junior gold miners, or silver miners. Several ETFs that I would avoid include SPDR Metals and Mining (NYSEARCA:XME), SPDR Basic Materials (NYSEARCA:XLB), SPDR Gold and Silver Trusts (NYSEARCA:GLD) and SLV, Physical Palladium Shares (NYSEARCA:PALL), Market Vectors Gold Miners and Juniors (NYSEARCA:GDX) and GDXJ, and Global Silver Miners (NYSEARCA:SIL).
If you must stay long the inflation theme, I think the energy sector is a better way to invest right now. Valuations and fundamentals of energy companies, especially the larger cap energy companies, are much better than those in the metals and mining sectors. If the inflation theme stays strong, these energy companies should continue to do well and offer a much lower risk way to bet on further inflation.
Some ETFs to consider in energy are SPDR Select Energy (NYSEARCA:XLE) and Oil Service Holders (NYSEARCA:OIH). I would avoid investing directly in oil or natural gas futures, especially via the ETFs, because of issues related to futures roll that will interfere with making a good return in the long run.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.