Gold’s powerful surge in 2016 has been driven by utterly massive investment buying. This is a marked sea change from recent years, where investors relentlessly pulled capital out of gold. But with that dire sentiment reversing, they are rushing back in with a vengeance. Major investment capital inflows into gold are an exceedingly-bullish omen, as they are what transform a mere gold rally into a new bull market.
Submitted by Adam Hamilton, Zeal:
With gold enthusiasm growing, it’s easy to forget how radically different things looked just a few months ago. Back in mid-December the day after the Fed hiked rates for the first time in 9.5 years, gold dropped to a miserable 6.1-year secular low of $1051. The popular level of antipathy towards this asset class by investing professionals was mind-boggling. They universally believed it was doomed to keep spiraling lower.
But with gold so epically out of favor and loathed, it was a dream buy for the rare contrarians. On the final trading day of 2015 as gold still languished at $1060, I published an essay titled “Fueling Gold’s 2016 Upleg”. In it I explained what was going to “fuel a mighty new gold upleg in 2016”, drawing much ridicule. And that usual pattern of early-upleg gold buying has indeed played out exactly like I forecast.
New gold uplegs emerging out of major lows are always driven by three distinct stages of buying. First futures speculators cover short positions, then futures speculators add new long positions, and finally investors follow the futures speculators in. The third stage is the biggest and most critical, and it only happens if the futures speculators’ early buying boosts gold high enough for long enough to win over investors.
When gold plunges to a major new secular low, the futures speculators who’ve shorted it are the main initial buyers. Gold-futures trading requires very little cash up front relative to position sizes, granting extreme leverage which makes these bets incredibly risky. Futures speculators selling short effectively have to borrow gold before selling it. So they are legally obligated to soon buy gold back to cover and close their shorts.
After speculator gold-futures short covering ignites the initial rally out of major gold lows, sharp upside momentum attracts in more speculators on the long side. Unlike short covering which is compulsory, gold-futures long buying is totally voluntary. Speculators need to have a high level of conviction that gold will keep rallying instead of soon revisiting its recent lows to make these risky leveraged upside bets.
The leverage inherent in gold futures is astonishing. Back in 2015’s final week when gold averaged $1065, a single 100-troy-ounce gold-futures contract controlled $106,500 worth of gold. Yet the futures exchanges only required speculators to keep $3750 cash per contract in their accounts as maintenance margins. That works out to 28.4x leverage, so a mere 3.5% adverse move in gold could wipe out traders.
Today after gold’s mighty early-2016 rally, the situation isn’t much less extreme. The CME has raised its gold-futures maintenance margins to $4500 per contract, but at this week’s $1240 gold levels each one is worth $124,000. That works out to similar 27.6x maximum leverage today in gold futures, which is so far beyond the legal limit of 2.0x in the stock markets imposed by the Fed in 1974 that it boggles the mind.
Since trading anything at 20x+ leverage is so insanely unforgiving and dangerous, the actual numbers of speculators willing to shoulder such instant-bankruptcy risks are small. So any gold rally only fueled by gold-futures speculators covering shorts and then adding new longs will soon fizzle out. Though this elite group of traders can really bull the gold price around, the pools of capital they control are small and finite.
Thus futures speculators are incapable of doing the heavy lifting necessary to grow a gold rally into a major new upleg or bull market. Gold rallies in recent years have stalled out when futures speculators either chose to stop buying or ran out of capital firepower. In order to transform into something much bigger, investors have to follow futures speculators into gold. They must take the gold-buying baton from speculators!
Of course investors control vastly larger pools of capital than speculators, so they have the means to buy gold for years on end while speculators can only sustain a few months of heavy buying. But essential differences between investors and speculators go far beyond that. Unlike speculators, investors use little or no leverage and buy for long time horizons instead of just day-to-day momentum. So they are strong hands.
Gold’s surge this year is so darned powerful because investors have indeed usurped the gold-buying leadership from futures speculators for the first time in some years! Unfortunately this is not yet widely understood because the gold world is so vexingly opaque. Gold trades in an enormous global market that has evolved over millennia, with fantastic complexity in terms of trading venues and numbers of participants.
The best global gold demand data comes from the venerable World Gold Council. This elite marketing organization is funded by the world’s biggest and best gold miners, and has excellent global resources at its disposal to gather gold investment data. The problem is this big effort takes lots of time. The WGC can’t collect, analyze, and publish quarterly gold-investment numbers until about 6 weeks after quarters end.
So gold’s most-comprehensive fundamental data is only current to Q4’15, before gold’s mighty new-year upleg began. But provocatively despite gold’s average Q4 price of $1105 making for its worst quarter since Q4’09, global gold investment demand still surged 14.9% YoY to 194.6 metric tons according to the WGC! Even late last year as gold was hated, investment demand was already picking up though few knew it.
While the WGC’s outstanding quarterly Gold Demand Trends reports are inarguably the gold standard of tracking gold investment demand, their once-per-quarter resolution delayed a half-quarter is insufficient to keep traders informed. But there is a fantastic proxy for gold investment demand that is updated every trading day, and interestingly it was birthed by the WGC. It is the world’s largest and dominant gold ETF.
This of course is the American GLD gold ETF, now known as SPDR Gold Shares. GLD was not only the first true gold ETF launched way back in November 2004, but it remains the juggernaut. As of the end of 2015, GLD’s physical gold bullion held in trust for its shareholders more than quadrupled its next biggest competitor’s. As 2016 dawned, GLD’s holdings accounted for 2/5ths of all the world’s gold ETFs’ holdings!
A creation of the world’s gold miners to boost American gold investment demand, GLD has always been exceptionally transparent about its holdings. So every single trading day it publishes not only how much gold bullion it holds, but a comprehensive list of every single individual gold bar in its inventory. As of the middle of this week, that included 62,214 gold bars with stats spread across 1245 separate pages!
As a lifelong student of the markets and speculator who has spent decades studying and trading the precious-metals realm, I’ve long been convinced that this daily tally of GLD’s physical-gold-bullion holdings is one of the single-most-important indicators for gold investment demand. Every speculator and investor interested in gold really needs to carefully watch GLD’s daily-holdings data like a hawk.
The reason why is simple. GLD’s mission is to track the gold price, which isn’t trivial. GLD’s shares have their own unique supply-and-demand profile totally independent from gold’s. The American stock investors who are GLD’s owners can and do buy and sell GLD shares at rates different from what gold is experiencing at any given moment. That makes GLD-share prices constantly prone to decouple from gold.
But if GLD disconnects from gold, this ETF fails. And there is only one way to keep GLD-share prices mirroring gold prices. Any excess supply or demand of GLD shares relative to gold must be directly shunted right into physical gold itself. This process equalizes GLD-share supply and demand into the far-larger underlying gold market. GLD is literally a conduit for stock-market capital to flow into and out of gold!
If GLD shares are experiencing excess supply (selling) compared to gold, they threaten to decouple to the downside. GLD’s managers have only one way to avert this failure. They need to buy back enough GLD shares to sop up that excess supply. They raise the capital necessary to do this by selling some of GLD’s physical gold bullion. So when GLD’s holdings are falling, stock-market capital is exiting gold.
Conversely if GLD shares see excess demand (buying) compared to gold, they will soon disconnect to the upside. The only way to keep GLD’s price tracking gold’s is to equalize this differential buying directly into gold itself. So GLD’s managers issue new shares to offset that excess demand, and then use the proceeds to buy physical gold bullion. Rising GLD holdings mean stock-market capital is flowing into gold.
This concept is very basic, and I’ve been writing about it for many years. Yet few traders seem to really understand it. The rise and fall of GLD’s holdings reveals American stock-market investors and their vast pools of capital either migrating into gold or exiting out of it. GLD’s holdings remain the best proxy for gold investment demand available at a daily resolution, and they prove it’s been astounding in 2016!
This first chart looks at GLD’s holdings in metric tons (blue) superimposed over the gold price. Also noted are each calendar quarter’s percentage change in the gold price, and percentage and absolute changes in GLD’s gold-bullion holdings. When this blue line is falling, capital is flowing out of gold. When it is rising, capital is flowing out of the stock markets and into gold. Check out 2016’s incredible surge.
This young new year has already seen utterly massive gold investment demand! Quarter-to-date as of the middle of this week, GLD’s holdings alone have already surged 22.8% higher. That’s a staggering level of gold demand from American stock investors. The 146.2 tonnes of gold they’ve purchased via GLD shares in 2016 alone is already the equivalent of 3/4ths of total global investment demand in Q4’15!
This epic trend change couldn’t be more pronounced. After GLD’s holdings fell on balance for years as American stock investors abandoned gold, they’ve suddenly taken off like a rocket following the Fed’s first rate hike in a decade. As I warned just the week before that rate hike when everyone thought that higher rates would slaughter gold, Fed-rate-hike cycles have actually proven very bullish for gold historically!
The unprecedented investor flight from gold in recent years leading to the 7.3-year secular low in GLD’s holdings the day after that rate hike in mid-December was a gross Fed-conjured anomaly. Gold didn’t plunge on collapsing investment demand because it was fundamentally impaired, but because stock markets were being levitated by record extreme Fed easing. Investors abandoned normal prudent diversification.
In 2012 before the Fed’s third quantitative-easing campaign ramped to full steam, gold’s price averaged $1669 per ounce while GLD’s holdings averaged 1294.2t. The Fed’s wild distortions that crushed gold began in early 2013 as full-strength QE3 came online. This newest bond-monetization campaign was radically different from QE1 and QE2 in that it was totally open-ended with no predetermined size or end date.
That seemingly-subtle difference changed everything. Each time the lofty overvalued stock markets started selling off, top Fed officials would rush to the microphones to declare they were ready to expand QE3 if necessary. Stock traders interpreted this exactly as the Fed intended, that the central bank would defend the stock markets. These perceptions of a Fed Put sucked capital out of everything else to chase stocks.
As the leading alternative asset that tends to move counter to stock markets, gold was a major casualty of their fake Fed-conjured levitation starting in early 2013. If this brazen central bank would ensure that stocks do nothing but rally indefinitely, then why bother diversifying portfolios anymore? So investors sold vast amounts of gold to move that capital into red-hot stock markets, as GLD’s plunging holdings revealed.
The worst of that mass exodus hit like a runaway freight train in Q2’13. Gold plummeted 22.8% on epic GLD selling, its worst quarterly performance in an astounding 93 years! This once-in-a-century storm was driven by an epic 1/5th holdings draw from GLD. American stock investors’ differential selling of GLD shares was so great this ETF had to spew 251.8t of gold bullion into the markets that quarter alone!
This wreaked such catastrophic sentiment damage that gold couldn’t recover for years, as long as the Fed’s record easing continued to levitate the stock markets. But with this central bank’s launch of a new rate-hike cycle in mid-December, the epic Fed tailwinds boosting stocks vanished. And as the extreme market distortions courtesy of the Fed started to unwind this year, stocks fell and investors remembered gold.
Because it moves contrary to stock markets, gold is the ultimate portfolio diversifier. As one of the very few assets that rally when stock markets suffer cyclical bears, a substantial gold allocation is utterly essential in every portfolio. With stock markets selling off sharply in early 2016, unlike anything seen in all those Fed-levitation years, investors are flocking back to gold. And odds are this major reversal is only beginning.
Despite these incredible GLD capital inflows so far in Q1’16, its holdings were merely back to a 17.7-month high as of the middle of this week. In order to mean revert back to 2012 average levels seen before the extreme QE3 distortions, GLD’s holdings still have to climb by another 2/3rds or 505.7t! That’s another 3.5x as much differential buying of GLD shares as the initial vanguard already witnessed in 2016.
And gold investment buying of the magnitude seen so far this year is exceedingly bullish! Nothing like it has been witnessed since early 2009, when hedge funds flooded back into gold after 2008’s once-in-a-century stock panic. And that last comparable surge of gold-investment buying was very early on in the massive 166.5% gold bull market between November 2008 and August 2011. Gold’s next bull has been born.
Once investors start migrating back into gold again in a big way, their buying tends to run for years. The more capital they move into gold, the higher gold’s price rallies. And since investors love momentum and winners, the higher gold rallies the more capital investors will allocate to it. Nothing begets buying like buying. This powerful virtuous circle unleashed by major investor buying is just getting underway again.
As I warned late last year, investors were radically underinvested in gold after the Fed’s stock-market levitation. Interestingly, GLD’s daily holdings can also be used as a proxy for American stock investors’ level of gold diversification in their portfolios. This final chart divides the total value of GLD’s physical-bullion holdings by the collective market capitalization of all the companies in the benchmark S&P 500 stock index.
For many centuries if not thousands of years, the world’s smartest and most successful investors have advocated having at least 5% of every portfolio invested in gold. As the ultimate diversifier, owning gold is an outstanding form of portfolio insurance. When some unforeseen event hammers the rest of one’s portfolio, even if it is just an overdue cyclical stock bear, gold shines and offsets some of those broader losses.
By looking at the ratio between the total value of GLD’s holdings and the collective S&P 500 market cap, we can get a great idea of what percent of American stock investors’ portfolios are in gold. And back in mid-December, that was incredibly low. GLD was valued at just 0.111% of the elite S&P 500 stocks, so American stock investors’ allocation to gold was only just over 0.1%. That’s 1/45th of that classic 5% target!
While technically an 8.0-year low in the ratio of the value of GLD to the S&P 500 (SPX), it was effectively an all-time low. Remember GLD was the world’s first true gold ETF introduced in November 2004, so those initial several years of its existence were a ramping to normal levels by early adopters. The only years of GLD’s existence that were normal were sandwiched between 2008’s stock panic and 2013’s dawn of QE3.
And during that last secular normal-years span between 2009 to 2012, GLD’s value averaged 0.475% of the collective market cap of all SPX stocks. Those years encompassed a mighty gold bull as well as the subsequent sharp correction and long consolidation, so they should be representative. Since this 0.5% GLD allocation persisted for years, it is far more likely again soon than that historical ideal of a 5.0%+ gold allocation.
In order for American stock investors to mean revert their collective portfolio gold allocation from its mid-December secular low to normal levels, it had to multiply 4.3x. And from the latest read of a 0.171% allocation thanks to gold’s spectacular early 2016, their allocation still has to balloon by another 2.8x. So the recent massive gold investment buying by American stock investors has only started the mean reversion.
Once investors seize the gold-investment-buying lead from futures speculators, history shows that their buying tends to run for years. And coming from such record-low levels of gold investment in late 2015 thanks to years of artificial Fed-driven gold weakness, it’s almost certainly going to take years for world investors’ gold holdings to return to some semblance of normal levels. Naturally this is fantastic news for gold.
Since investors have so aggressively taken the gold-buying baton from speculators, the odds are stellar a new bull market in gold has been born! Investors can ride this in physical gold itself or GLD shares, which each offer their own advantages and drawbacks. Physical gold in your own immediate control is safer, but more expensive to acquire. GLD offers instant paper exposure to gold prices, but at a 0.4% annual fee.
And as always the gold miners’ stocks offer big upside leverage to gold. They were hammered down to fundamentally-absurd 13.5-year secular lows in mid-January, and have rocketed radically higher since. Yet even with their immense recent gains, the fundamentally-derived gold-stock upside targets remain vastly higher from today’s levels. Great wealth will be won in the coming years as gold stocks mean revert higher.
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The bottom line is gold’s amazing rally in 2016 has been driven by utterly massive investment buying. Investors have seized the buying baton from futures speculators at a magnitude not seen since early 2009, early in the last mighty gold bull. And once investors start aggressively buying gold again, their capital inflows ignite a virtuous circle that tends to run for years. Their buying has created gold’s next bull market.
American stock investors are leading the way with enormous differential demand for GLD shares. The end of the Fed’s record easing is plunging the US stock markets into a long-overdue new cyclical bear. And as stock markets weaken, gold investment demand for prudent portfolio-diversification purposes soars. And coming out of record gold underinvestment, years of strong buying will be necessary to normalize.
Adam Hamilton, CPA
March 4, 2016
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