Gold-ETF Selling Waning

Gold’s worst year in memory was largely the result of extreme gold-ETF selling. A flood of gold supply hammered gold prices as stock investors around the world aggressively dumped gold ETFs. They were rotating out of gold to chase the Fed-driven stock-market levitations. But as toppy stock markets inevitably reverse, so will capital flows. Gold-ETF outflows are already waning, and will soon shift to accelerating inflows.

This is a very bullish omen for battered gold prices. They are determined by supply and demand, like everything else traded in financial markets. When supply exceeds demand, prices retreat until a new equilibrium level is reached that balances buying and selling. Fundamentally, this year’s extreme gold-ETF selling is responsible for literally all the world’s excess gold supply. That vanishes and gold soars.

The World Gold Council, which is funded by the large gold miners, is the premier authority on global gold supply and demand. According to its data, extreme gold-ETF selling is the entire story behind this year’s brutal gold-price anomaly. In the first three quarters of 2013, overall global gold demand fell 12.0% year-over-year. Gold’s average price perfectly mirrored this decline, falling 11.9% YoY in 2013’s first 9 months.

On balance during this period, buyers wanted 383 fewer metric tons of gold. This was entirely the result of a massive reversal of gold-ETF flows. They swung from inflows of 191t in 2012’s first three quarters to jaw-dropping record outflows of 698t in 2013’s! Obviously this dwarfs the decline in overall gold demand, which would have risen about 10% this year if ETF holdings had been flat. Gold ETFs are the sole culprit.

The world’s dominant ETF remains the American SPDR Gold Shares. Its outflows in the first 9 months of this year were a whopping 445t, or nearly 2/3rds of total global gold-ETF outflows! This alone is bigger than the total world decline in gold demand. So if American stock traders alone hadn’t aggressively dumped GLD, gold would have been higher this year. GLD’s gold sales were so overwhelming nothing else matters.

GLD’s mission is to track the gold price. But the supply and demand of GLD shares doesn’t always match the underlying supply and demand of gold itself. This requires stock-market capital to be shunted into and out of gold. This year GLD was plagued with extreme differential selling pressure, its shares being sold at a much faster pace than gold was being sold. This excess GLD-share supply had to be quickly absorbed.

GLD’s custodians raised the cash to buy back its excess shares being sold by selling some of this ETF’s gold bullion held in trust for its shareholders. That gold hit the global markets as supply, and hammered prices. It’s hard to believe, but exactly one year ago GLD’s holdings hit their all-time record high just over 1353t. This week they are down under 839t, revealing epic GLD liquidations nearing 515 metric tons!

The good news is GLD’s gold holdings, and indeed those of all the world’s gold ETFs, are finite. There is absolutely no way next year can see ETF liquidations even remotely close to this year’s. Down 512t year-to-date, this represents a massive 38% holdings correction. A similar amount next year would gut GLD’s holdings by nearly 2/3rds, which isn’t going to happen even if the gold price somehow spiraled far lower.

With every additional GLD shareholder that sells, this flagship gold ETF’s remaining shares become concentrated in stronger and stronger hands. Those investors understand gold’s bullish fundamentals, and generally still have large gains. The last time GLD’s holdings were at today’s levels was way back in January 2009 when gold was just $885! Even at this week’s dismal levels, this metal is still 40% higher.

And I suspect 2013’s trend of extreme gold-ETF selling is reversing. It is certainly dramatically slowing, with global gold-ETF outflows down 71% sequentially between this year’s second and third quarters. GLD’s alone plummeted by 3/4ths! The main reason is selling exhaustion and the number of remaining weak hands waning. But an additional important major reason is the incredibly-toppy US stock markets.

This first chart looks at GLD’s holdings during this past year superimposed on the flagship American S&P 500 stock index (SPX). The US stock markets have been levitating and melting-up all year long thanks to the notion that the Fed’s massive QE3 campaign is backstopping them. This seduced investors away from alternative investments including gold, leading to the capital rotation out of GLD into general stocks.

A year ago just before the Fed more than doubled QE3, the gold market was still normal. Even though gold was near $1700, it certainly wasn’t loved. It had spent the past 16 months consolidating after getting too overbought in a sharp rally during the summer of 2011. But gold was still at least respected for its essential role as an alternative asset not correlated with stock markets to help diversify stock portfolios.

But as this year dawned, the stock markets started surging higher on the fabled Fed put. Investors came to believe that the epic liquidity injections from the Fed’s unprecedented open-ended QE3 campaign would prevent the stock markets from correcting. So stock investors with gold exposure through GLD started to sell their shares faster than gold was being sold, forcing GLD’s custodians to liquidate bullion.

These GLD draws, effectively stock-market capital flowing back out of gold, accelerated. The more gold that GLD was forced to sell, the more these ETF sales weighed on global gold prices. And that capital being redeployed into stock markets certainly aided their melt-ups. As the performance gap between the levitating stock markets and retreating gold prices grew, more and more gold-ETF shareholders decided to sell.

There were other factors that played into this too, such as gold plummeting in April when long futures speculators were trapped in a rare forced liquidation. And no matter how many times the Fed tries to convince traders that QE3 won’t last forever, gold keeps suffering from a tapering hysteria. So on big gold down days driven by Fed fears, stock investors definitely put more differential selling pressure on GLD.

But filter out this occasional noise, and the dominant force in GLD’s massive bullion liquidation this year was the capital rotation out of alternative investments into general stock markets. All year long there has been a strong negative correlation between GLD holdings and the benchmark SPX. GLD differential selling pressure surges when the SPX climbs, but then slows dramatically when the SPX later retreats.

This critical relationship for gold is readily evident in this chart, where periods of SPX pullbacks are shaded in red. Let’s start in late April, right after gold’s most extreme selloff in three decades. Even though gold prices soared nearly 10% in the final half of that month after the panic lows, the differential selling pressure on GLD shares continued to be massive as evidenced by its sharp holdings plunge.

While much of this was residual fear since gold had just plummeted, the levitating stock markets certainly played a major role. Even as the extreme gold fears abated, GLD’s holdings kept right on plunging in May until the SPX peaked. Then when it started to retreat in late May and June, GLD’s holdings stabilized as its draws slowed dramatically. They didn’t start accelerating again until late June on a Fed QE3-tapering scare.

But that was short-lived, and GLD’s holdings were flat again in late June until the SPX starting surging in another levitation. Like clockwork, the differential GLD selling pressure resumed. It didn’t slow again until the SPX started to get top-heavy in early August. For a variety of reasons I explained at the time, that looked like the long-awaited reversal of 2013’s mass exodus from GLD shares. Alas though, it wasn’t to be.

GLD’s holdings indeed gained ground in much of August, that month’s outflows of just 6.3t slowing to a trickle by this year’s standards. But as the stock markets rallied sharply again in September, the vexing differential selling pressure on GLD reignited. Stock traders seemed comfortable holding their GLD shares if the stock markets were weak, but were quick to resume rotating out of gold when they strengthened.

When the SPX’s late-September pullback hit, the differential selling pressure on GLD shares again slowed dramatically. But when the stock markets soon started soaring again, the GLD draws accelerated. Carefully examine this relationship in the chart above, GLD draws accelerating when the stock markets are rising and slowing or even stopping when the stock markets are falling. It is very important to understand.

Remember that gold prices fell this year because demand was lower. And this year’s extreme gold-ETF selling was responsible for far more than the entire drop in global gold demand. And nearly 2/3rds of the wildly unprecedented worldwide gold-ETF bullion outflows in 2013 came from GLD alone. Now layer the critical inverse relationship between GLD’s holdings and the SPX on top of these indisputable facts.

American stock traders fled GLD, resulting in all the gold carnage we’ve seen this year, to chase the outsized gains in the euphoric levitating stock markets. So when these toppy stock markets inevitably reverse, so will the heavy differential selling pressure plaguing GLD. Falling stock markets lack the allure to suck capital away from other investments, and they will rekindle the attractiveness of portfolio diversification.

Even in the stock bulls’ best-case scenario, the lofty US stock markets are way overdue for a serious correction approaching 20%. While healthy bull markets tend to get one 10%+ correction per year, the last one seen in today’s overextended cyclical bull ended nearly 26 months ago. And the worst-case scenario for stocks is them rolling over into a new cyclical bear, which will cut their prices in half over a couple years.

Either way, the global capital rotation out of gold by stock traders via gold-ETF shares will quickly die as stock markets enter selling mode. And without that huge differential selling pressure spewing hundreds of tonnes of gold bullion into the market, gold prices will soar. Remember that global gold demand would have risen 10% in the first three quarters of this year without the gold-ETF selling, a wildly bullish omen.

The whole story behind 2013’s crazy gold anomaly was the extreme gold-ETF selling. Nothing else is relevant, even the recurring QE3-tapering scares and periodic extreme futures selling. Man, I so wish today’s embattled and despairing gold investors understood this! The fundamental facts of global gold supply and demand are so simple and crystal-clear. This year’s gold prices are truly an unsustainable anomaly.

This last chart highlights how extreme 2013’s gold-ETF selling was in terms of GLD alone, the world’s dominant gold ETF. It shows GLD’s holdings on a zeroed axis superimposed over the gold price. Every major correction in GLD’s holdings is noted, with both percentage and tonnage declines. Not only are the gold ETFs’ holdings finite, but so are their corrections. What we’ve suffered this year is radically overdone.

Before the madness of 2013, GLD had suffered 9 major bouts of differential selling pressure resulting in major holdings corrections. Even including the big stock-panic ones in 2008, they averaged GLD draws of 7.4% of its holdings or 67 metric tons. Their average duration was 3.4 months. What we’ve seen in the past year just dwarfs those averages, it is extreme beyond belief. But this correction won’t last forever either.

As of the middle of this week, over the past 11.9 months GLD’s holdings have plummeted by a ridiculous 38.0%! This is 5.1x bigger than the average correction. And in terms of total gold liquidated, this monster correction’s 515t is an astounding 7.7x bigger than average! Since gold ETFs never existed before this secular gold bull, nothing like this has ever been witnessed. It’s no wonder gold has had such a tough year.

But just like extreme futures shorting, extreme gold-ETF selling is self-limiting. GLD’s bullion holdings, along with every other gold ETF’s in the world, are finite. There is only so much gold they can sell, and only so many shareholders susceptible to being scared into selling low. And the lower these holdings are forced, the fewer shareholders are left to sell and the less likely the remaining ones are to exit.

The mighty GLD offers a perfect example of this. As mentioned earlier, the first time GLD’s holdings hit today’s levels in January 2009 gold was merely trading at $885. So theoretically (depending on the turnover) the vast majority of today’s remaining GLD shareholders are still sitting on nice gains. The lower GLD’s holdings are pushed, the stronger these remaining positions get. These investors aren’t likely to flee.

And with only 839t of holdings left, there is absolutely no way GLD is going to hemorrhage another 500t+ in 2014. That would take its holdings down under 350t, levels first seen way back in March 2006 when gold was merely trading around $550. There is some point coming, probably soon, where every gold-ETF shareholder with any likelihood of selling anytime soon will have already sold. Then ETF holdings won’t go any lower.

Gold has proved an essential asset class for investors all over the world for millennia, and it isn’t going away due to one anomalous year. There will always be demand for gold globally to diversify portfolios, preserve wealth, protect purchasing power from inflation, and to seek capital gains. This is even evident in this terrible year, with global physical bar-and-coin demand surging 36% YoY in 2013’s first 9 months!

The extreme gold-ETF selling responsible for all of 2013’s gold woes is already petering out. The world’s gold ETFs are running out of gold bullion to sell and running out of shareholders willing to sell low. This is evidenced by the dramatically-slowing decline in GLD’s holdings since mid-year. And as overextended and euphoric stock markets start sliding, the remaining gold-ETF selling will first stop and then reverse.

And at that point, gold is off to the races. With gold-ETF outflows merely zeroed, all the rest of global gold demand continues to grow strongly. Growing demand means higher gold prices. And as gold recovers, there is no doubt at all that stock-market capital will increasingly flow back into the gold ETFs to chase gold’s accelerating gains. Such inflows will greatly amplify gold’s next upleg, supercharging demand growth.

Investors always forget that the financial markets are forever cyclical, one extreme is always followed by the opposite one. Stock markets are not always loved, and gold is not always hated. The popularity of investment classes flows and ebbs, and after its extreme 2013 selloff gold is due for an epic mean-reversion upleg. The same gold ETFs that drove this year’s plunge will play a big role in gold’s recovery.

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The bottom line is this year’s anomalous gold selloff was driven solely by extreme gold-ETF selling. But this is not sustainable and is already petering out. Not only are gold ETFs’ holdings finite and dwindling, fewer and fewer remaining shareholders are likely to sell. And the global gold-ETF liquidation has been led by the dominant American GLD, which was largely a capital-rotation trade to chase euphoric stock markets.

As those stock markets top and reverse, so too will the differential selling pressure on gold ETFs. The sell-gold-low-to-buy-stocks-high bet crumbles when stocks start decisively retreating. When the gold-ETF outflows merely stop, gold prices will surge on strong global gold demand. And when they inevitably reverse into inflows, gold is going to soar. This loathed metal is destined for a huge mean-reversion upleg in 2014.

 

Adam Hamilton, CPA

December 6, 2013

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