"Real" Price of Gold Trying to Break Out

I am deeply indebted to Mr. Bob Hoye of Institutional Advisors (see blog link list if you want read through his free archives) for the concept of the "real" price of Gold and what it means to unhedged Gold miners. Mr. Hoye has his own proprietary index, but I use the Gold price divided by the Reuters Continuous Commodity Index ($CCI) to determine a rough "real" price of Gold.

The "real" price of Gold (as opposed to its nominal price) is how producing Gold miners make (or lose) money. When the ratio of the price of Gold to the ratio of the price of other commodities (some of which, like energy, are heavily used in mining) is rising, Gold miner profitability is increasing. When this ratio is falling, profitability is decreasing. This gets rid of currency considerations and focuses on operating margins and profitability.

The cruel irony is that this ratio most consistently rises during "hard" times, particularly in deflationary secular credit contractions. Swift upward moves in this ratio do not bode well for the price of any stocks and are usually a sign of fear and economic contraction. For example, a big spike higher in the "real" price of Gold occured during the Great Fall Panic of 2008.

It looks like this ratio is trying to break out (much like the Volatility Index [$VIX]) to the upside. This is not necessarily short-term bullish for Gold miners if it occurs, but it is definitely long-term bullish because it means Gold miners will be increasing their profits. I remain wary of the current run-up in the Gold and silver price (at the risk of incurring wrath and ridicule, I'll mention that I actually sold a big chunk of my modest physical silver hoard today). I am not a great market timer if the last 6 months is a decent guide to my skills as a trader, but I still strongly believe the U.S. Dollar is bottoming on an intermediate-term basis and I still believe a wicked bear leg down in the general stock markets is dead ahead.

These two core underlying beliefs (Dollar intermediate-term bottoming and wicked stock bear leg coming) color my thinking and, if they turn out to be wrong, I'll be kicking myself due to missed opportunities. Oh, well, such is speculation. My physical Gold will be held until the Dow to Gold ratio reaches parity.

Anyway, I am not buying miners here, but am eagerly anticipating the expected upward breakout in the Gold:CCI ratio, as it will lay the fundamental groundwork for a massive bull leg higher in the Gold mining sector. When the next stock market puke fest occurs, I will again be buying Gold miners large and small. Because the Gold miners have not yet met my criteria for a solid bottom, I am mostly watching from the sidelines right now (bummer!).

Here is a weekly candlestick chart of the "real" price of Gold over the last 18 months:



Remember that I have some core thoughts that do not align with most Gold bulls and yet I am on the same side of the trade as they are. I think we are in for deflation and cash is king during deflation, with Gold the best form of cash. Deflation is much more consistently bullish for Gold miners than inflation is. I, too, fear a currency devaluation but do not think that this will necessarily spark significant inflation overall (but is the reason Gold is my preferred form of cash). I am also not interested in investing in commodities (for now) and think they are about to get killed (again).