Oh boy… the crowd is about to get killed in resource stocks again.

And this time, the Grim Reaper comes in the form of “rare earth element” stocks…

As my editor Brian Hunt told you last week, “‘Rare earth elements’ is the name of an exotic group of metals, including strange-sounding members like lanthanum and cerium. These little-known metals are crucial components of electric car batteries, wind turbines, and advanced electronics (the kind in your iPod or cell phone).”

Rare earth elements are the hottest thing in the mining world right now. China holds a virtual monopoly on the rare earth industry. And in the past few months, the Chinese have reduced the amount of rare earths they’re willing to ship to other countries.

[ad#Google Adsense]This has created a frenzy for the handful of rare earth element plays in the stock market.

Take Molycorp (MCP) for instance…

Molycorp controls the Mountain Pass mine. In the 1970s and 1980s, before China got in the game, the U.S. was the world’s largest producer of rare earths. A big part of that production came from Mountain Pass. The mine is shuttered now, but it remains the largest developed rare earth deposit in North America.

Just a few months ago, Molycorp went public at $14 per share… It has ridden a hype wave to a 150% gain and a $3 billion market cap.

Here’s the thing: The demand for rare earth elements isn’t that large. According to the MIT Technology Review, it will be 125,000 tons this year. The entire market is worth less than $1 billion per year. In other words, Molycorp’s market cap is three times the size of the annual market of its proposed product (yes, that market is going to grow, but it will remain relatively small).

There is another huge problem with Molycorp… It isn’t owning up to the amount of work required to meet its promises to shareholders. Right now, the only place you can refine the rocks into pure metal is in China. Molycorp will need to spend over $511 million to build the infrastructure it needs to compete with the existing Chinese industry.

(The company estimates it can be in full production by 2012. In my experience, most mines develop hiccups along the way. Full production is likely to occur sometime in 2013.)

Finally, the potential for loss at this stock price is huge… I calculated the net present value for Molycorp. This is a rough estimate of the fair value for the stock right now. It takes into account assets, debt, and future cash flows. I also figured out the company’s the value by comparables (like valuing your house by looking at the recent deals in your neighborhood).

These two methods produced values between $570 million and $636 million.

Today, Molycorp trades for $2.94 billion. That’s between 4.6 times and 5.1 times larger than its current value.

Remember, this company must spend hundreds of millions of dollars over the next few years. It won’t be cash flow positive for at least three years. It won’t even know if it can get the loans for the construction before next summer. In other words, the downside risk here is enormous… yet the stock is priced for perfection. If bad news comes (and it comes often in mining), shares of Molycorp could fall a long, long way.

If you already own shares, congratulations. You’ve made a heck of a trade. Now, it’s time to tighten up your trailing stops. Don’t hesitate to sell. Aggressive traders can consider shorting the stock (although it might be hard to get shares to borrow).

If you’re on the sidelines watching the hype build and thinking about hopping in here, you’re crazy. It’s much too dangerous… the assets are much too expensive. You’ll find safer and comparably large returns in uranium miners right now.

Good investing,

— Matt Badiali

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Source:  Daily Wealth