Bankrupt Tactics in a Deepening Debt Crisis

The European continent seemed to disappear from the financial map last week. There was no Greece, no Portugal, no Italy nor any other euro-anything that troubled investors. European equity markets rallied for four straight days, while the Dow Jones Industrial Average rallied five straight days — chocking up a 500-point gain in the process. Precious metals, on the other hand, retreated as investors seemed to forget what worthwhile purpose these elements serve.

Your Daily Reckoning editors dutifully reported these curiosities, while also urging their Dear Readers to distrust them. “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,” we remarked last week.

“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 last Wednesday’s edition of The Daily Reckoning‘Gold Stocks Are Cheap’, gold stocks, rather than gold itself, seem particularly compelling at the moment.”

This morning, the financial cartographers have re-discovered Europe…and its worsening debt crisis. The European equity markets are down about 3% — led to the downside by European bank stocks.

The falling share prices in the Old World are weighing on share prices here in the US. The Dow is down 230 points to 11,278.

Greece is the culprit…again.

The Greeks are probably not any more bankrupt than they were last week, but neither are they less bankrupt. Unfortunately, the leaders of the European Union seem to be tactically bankrupt. The more money they send to Greece, the more the debt crisis deepens.

The multi-billion-euro bailouts are not producing anything that resembles solvency. Instead, the Greeks merely cash the checks, spend the money and await more checks.

The Greeks are insolvent. Bailouts are not the remedy. Default is the time-honored remedy, and it works every time. A default eliminates debt and restores solvency in the twinkling of an eye. This remedy is not without pain, of course. But it is very effective.

To the modern financial mind, however, a default seems primitive and unnecessarily brutal — like amputating a gangrenous limb without anesthetic. So instead, the central bankers of the West have adopted a more humane approach to insolvency: Anesthetize the patient and hope the gangrene doesn’t spread.

Much less pain; much more humane; but ultimately disastrous.

The Greek debt crisis is worsening and spreading. Unless the surgeons in the European Union break out their saws and start hacking away the dead flesh, the euro is going to get a lot sicker…and perhaps perish.

No matter what tactic the EU pursues, economic conditions are likely to get worse before they get better. Stocks, in general, are likely to provide disappointing returns for a while. But precious metals are likely to provide a satisfactory (at least) hedge for a while. And as we pointed out last week, precious metals stocks might provide an even more satisfactory hedge than the precious metals themselves.

“Gold stocks are as cheap as they have been in a decade,” we observed. “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.”

Apparently, Mr. Market sometimes reads The Daily Reckoning. In today’s trading action on Wall Street, the stock market is down…a lot…and gold and silver are both down…a lot. Nevertheless, a wide variety of gold and silver mining stocks are trading higher on the day. Newmont Mining (NEM), Barrick Gold (ABX), Buenaventura (BVN), Silver Wheaton (SLW) and Silver Standard (SSRI) are among the many gold and silver mining stocks that are trading to the plus side.

One day does not make a trend, but it does make for a very interesting data point.

Eric Fry
for The Daily Reckoning