Will the Mining Shares Plunge in a General Market Sell-Off?

|
 |  Includes: GDX, GDXJ, SIL
by: Erez Davidi

In the 2008 market selloff, PM mining shares got completely whacked. Some of the major silver producers [think Pan American Silver (NASDAQ:PAAS)] haven’t fully recovered yet. The question of how the mining shares will perform if a broad market selloff occurs again has bothered many precious metal investors ever since.

Below, you can see a chart of the S&P 500 from the year 2007 to 2010. From the top of approximately 1550, the S&P 500 has declined to 670, a 56 percent decline. During the same time period the HUI suffered a 70 percent decline.

In order to asses what are the probabilities of a similar major decline in the mining shares due to a broad market selloff, let’s first analyze the market selloff when the Nasdaq bubble burst together with the S&P. Below, you can see a chart of the HUI from the low at the end of 2000 to the year 2003. During that time period the HUI rose 400 percent. During the same time period, the S&P declined 33 percent. The broad selloff in the S&P didn’t drag the mining shares with it.

There are a few more fundamental differences between 2008 and today:

  1. Just before the 2008 market crash, oil was trading at a high of $148 and gold was trading at $1034 per ounce. As everybody knows, oil is a major factor in the cost of extracting precious metals out of the ground. Today, oil is trading at $108 per barrel, while gold is trading at $1428. In other words, in 2008, an ounce of gold would buy you 6.9 barrels of oil, while today, an ounce of gold buys you 13.2 barrels of oil. As long as the spread between oil and gold widens, the profit per ounce of the mining shares will increase.
  2. Without getting too much into it, the Fed and the U.S. Government have undermined the USD fundamentals by the various TARP’s and Quantitive Easing(s). Therefore, these actions decrease the possibility of a flight to the USD during a market panic. It’s more likely that people will buy precious metals for safety as people now know that the Fed’s reaction to a market collapse is just printing more money. During the 2008 panic, most people didn’t anticipate that Fed’s reaction thus they fled to the USD.
  3. Click to enlarge
    (Click to enlarge)

  4. Not much needs to be added to the chart below. The U.S. government debt has been increasing at an alarming rate.

    Click to enlarge
    (Click to enlarge)

  5. As was mentioned above, a lot of mining shares are trading way below their all-time highs. For example, the XAU index is currently trading slightly above its 2008 peak. Unlike the XAU, gold has risen from its 2008 top by 38 percent and, as the mining shares are so undervalued compared to the physical metal they are less poised for a severe correction.

In summary, the evidence is inconclusive as history shows that both outcomes can occur. With it, taking into account the better gold/oil ratio, the higher profitability of the mining companies against their undervalued market price, the Fed factor, and obviously the tightness of the physical PM market, there is a high probability that any selloff, if it does occur, will be short- lived after which, the PM bull market will assert itself.

Disclosure: I am long SLV, GLD.