Awaiting the Inevitable Correction in the Silver Price

The International Can-Kicking Team is busy again today, as the European Central Bank, US Federal Reserve and three other central banks linked arms to kick the European debt crisis down the road until the end of the year.

Specifically, the Can-Kickers announced that they would provide three-month US dollar loans to European banks to insure that the banks have enough liquidity to make it to the end of the year.

If past scams of this nature are any guide, the “short-term” assistance will somehow morph into long-term or permanent assistance, funded by taxpayers. The markets are rallying because this scam “sends a powerful message,” according to one financial news source.

Message received: When all else fails, launch a massive bailout.

The markets will probably continue rallying a while longer, and the gold price will probably continue to retreat (just as Bill Bonner has been predicating). But the longer these counter-trend moves proceed — i.e. stocks up, gold down — the better the opportunities for forward-looking investors to re-weight their portfolios.

The recent selloff in gold, for example, is providing a glittering opportunity to add a little more weight to the precious metal sector. And as we mentioned in yesterday’s edition of The Daily Reckoning, gold stocks, rather than gold itself, seem particularly compelling at the moment.

Following up on this theme, we present the nearby chart for your consideration. First, the conclusion: Gold stocks are as cheap as they have been in a decade. Now the details: The chart below shows the price-to-EBITDA ratio of the XAU Index of stocks, both in absolute terms and in comparison to the price-to-EBITDA ratio of the S&P 500 Index. This ratio is a measure of price-to-cash-flow and tends to illustrate valuation more accurately than the more familiar price-to-earnings (PE) ratio.

The Price-to-EBITDA of the XAU Index

In absolute terms the price-to-EBITDA of the XAU Index is currently around 7.5 times, which is only about 10% higher than the price-to-EBITDA of the S&P 500 Index. Both of these metrics are as low as they have been in a decade.

Obviously, however, “cheap” does not mean “buy.” Cheap stocks have a tendency to get cheaper, on the way to becoming way-too-cheap. Gold stocks are cheap, but they could still fall to way-too-cheap. Silver stocks, on the other hand, may already be way-too-cheap.

A Daily Reckoning reader named Kyle Sorgel makes the argument:

Within the precious metals sector, silver mining stocks may be the very best bet…

A consensus estimate of the total amount of silver mined from 3000 BC to now is about 44.4 billion ounces and for gold is about 4.25 billion ounces. This yields a gold-to-silver ratio of about 10.44, a far cry from the current gold-to-silver ratio of 45. In modern times, mines are pulling less silver out of the ground, relative to gold, than they did in ancient times. Total annual mine production of silver is only 8.6 times greater than total gold production. Furthermore, and most importantly, 53% of the total silver demand is used in industrial processes versus gold’s 11%. This means that every year 53% of the total supply of silver is USED UP, meaning it’s gone, vanished, disappeared.

Silver is an extremely versatile metal and as time has progressed science has found multiple uses in which silver provides a benefit that no other metal can provide (even gold). And since the silver is used in such trace amounts, most of it can’t be recovered.

Based on these facts, it seems inevitable that the large price disparity between gold and silver should narrow over time.

Mr. Sorgel’s argument is compelling. But please remember, dear reader, inevitable is not the same thing as imminent.

Eric Fry
for The Daily Reckoning