Gold Investment Stalled

Gold has largely been drifting sideways for the better part of a couple months now, sapping enthusiasm. Gold investment demand has stalled due to extreme stock-market euphoria. Investors aren’t interested in alternative investments led by gold when stocks seemingly do nothing but rally indefinitely. But once stock-market volatility inevitably returns, so will gold investment demand which fuels major gold uplegs.

Like nearly everything else in the global markets, gold prices are heavily dependent on investment capital flows. When investors are buying gold in a meaningful way, demand exceeds supply which drives gold’s price higher. When they’re materially selling, supply trumps demand thus gold’s price naturally retreats. The past couple months have been stuck in the middle, with gold investment flows neutral on balance.

The World Gold Council is the leading authority on global gold supply and demand, publishing quarterly Gold Demand Trends reports that offer the best fundamental reads available on the gold markets. The latest Q3’17 GDT was just released early yesterday morning. While it doesn’t cover the ongoing Q4 where gold is drifting, it does offer great insights into what’s happening with gold investment demand.

Overall world gold demand was quite weak in Q3, dropping 8.6% YoY to 915.0 metric tons. That made for an 86.1t absolute drop. Investment demand, though it only accounted for just over a quarter of the total, was responsible for this entire demand decline. Gold investment demand plunged 27.9% YoY in Q3, or 93.4t! The WGC further breaks down that category into bar-and-coin demand and ETF demand.

The traditional physical-bar-and-coin gold demand was actually quite strong in Q3, surging 16.9% YoY to 222.3t. That’s up a healthy 32.1t YoY. But the stock-market gold demand via exchange-traded funds far more than offset this, plummeting an astounding 86.9% YoY or 125.4t! If ETF demand had been stable in Q3, overall global gold demand would’ve climbed a healthy 3.9% YoY. Gold has stalled because of ETFs.

Gold exchange-traded funds act as conduits enabling vast amounts of stock-market capital to slosh into and out of physical gold bullion. These big changes in collective buying or selling really move gold. Since the gold ETFs seek to mirror the underlying gold price, they have to shunt excess ETF-share supply or demand directly into actual gold bars. There’s no other way for gold ETFs to successfully track their metal.

The world’s leading and dominant gold ETF is the venerable American GLD SPDR Gold Shares. Every quarter the World Gold Council also ranks the world’s top-ten gold ETFs. At the end of Q3, GLD alone accounted for a whopping 36.9% of their total gold-bullion holdings! GLD was 3.8x larger than its next biggest competitor, which is the American IAU iShares Gold Trust. GLD is the behemoth of the gold-ETF world.

The supply and demand of GLD shares, and all gold ETFs, are totally independent from underlying gold’s own supply and demand. So when stock investors buy GLD shares faster than gold is being bought, the GLD share price starts decoupling from gold to the upside. That is unacceptable, as GLD would fail its mission to track gold. So GLD’s managers must vent this differential buying pressure directly into gold.

They do this by issuing sufficient new GLD shares to meet the excess demand. All the money raised by these GLD-share sales is then plowed into physical gold bars that very day. This mechanism enables stock-market capital to flow into physical gold. Of course this is a double-edged sword, as excess GLD-share selling pressure forces this ETF to sell real gold bars to raise the capital to buy back its share oversupply.

What American stock investors are doing with GLD shares is the primary driver of gold’s trends! GLD has grown massive since its launch 13 years ago this month, and acts as a direct pipeline into gold for the immense pools of stock-market capital. So nothing is more important for gold prices now than GLD inflows and outflows. These are very transparent, as GLD reports its physical-gold-bullion holdings daily in great detail.

I call stock-market capital inflows into GLD as evidenced by rising holdings builds, and outflows as seen by falling holdings draws. In recent years there have been plenty of quarters where GLD builds and draws accounted for the entire global change in gold demand! That wasn’t the case in Q3 though. While the world gold-ETF demand fell 125.4t YoY, GLD’s holdings were actually up 12.1t in Q3. So gold edged up 1.4%.

But if American stock investors had been buying or selling GLD shares aggressively, gold certainly would’ve risen or fallen accordingly. Gold has been drifting in recent months because GLD’s holdings are flat, with stock investors neither buying nor selling GLD shares at differential rates relative to gold. That’s why gold investment demand has stalled. GLD has grown into the tail that wags the global-gold-price dog!

Amazingly many if not most investors still don’t grasp GLD’s critical role in gold price trends. They attempt to understand today’s gold’s price action in historical pre-gold-ETF-era terms. But for better or for worse, the gold world is radically different now. GLD, and to a lesser extent the other large gold ETFs trading in foreign stock markets, changed everything. Gold investors ignoring GLD’s holdings are flying blind.

This chart drives home this critical point. It superimposes GLD’s daily physical-gold-bullion holdings in blue over the gold price in red. Carved into calendar quarters, gold’s performance in each one is noted above GLD’s quarterly holdings changes in both percentage and absolute terms. The correlation between GLD’s physical-gold-bullion holdings and gold prices is very strong. GLD capital flows explain much for gold.

Rising GLD holdings reveal stock-market capital is flowing into gold bullion via GLD, due to differential GLD-share demand. Conversely falling GLD holdings show stock-market capital coming back out of gold, thanks to differential GLD-share selling. When American stock investors are either buying or selling GLD shares at much-faster rates than gold is moving, their collective capital flows greatly impact its price.

This is readily evident in strategic and tactical terms. GLD’s holdings are highly correlated with gold price levels. American stock investors sold down GLD’s holdings in 2015, and gold fell in lockstep. But that all reversed sharply in early 2016, when stock investors flooded back into GLD which catapulted gold into a new bull. Gold kept surging as long as differential GLD-share demand persisted, then stalled when it abated.

After Trump’s surprise election win a year ago, stock investors dumped GLD shares at dizzying rates and gold plunged. Then since GLD’s holdings have largely drifted sideways on balance this year, so has gold. GLD capital flows and gold prices are joined at the hip. So what American stock investors are doing and likely to do with GLD shares collectively is absolutely critical for gaming where gold is likely heading next.

Thus the key question for gold investors is what motivates American stock investors to buy or sell GLD shares en masse? The answer is simple, stock-market fortunes. Gold is effectively the anti-stock trade since it tends to move counter to stock markets. So gold investment demand via GLD shares surges as stock markets suffer major selloffs, and withers when stock markets rally to lofty euphoria-generating highs.

The entire reason gold investment demand has stalled out in recent months, which has left gold drifting, is the extreme euphoria in US stock markets. Wall Street constantly claims there’s no euphoria, but that’s not true. The words “euphoria” and “mania” are often confused. Mania means “an excessively intense enthusiasm, interest, or desire”. In the stock markets, manias are associated with bubbles at bull-market tops.

Euphoria is a milder term meaning “a strong feeling of happiness, confidence, or well-being”. While the stock markets haven’t rocketed vertical in a mania, there’s no doubt euphoria is extreme. Investors feel happy and confident about stocks after this past year’s incredible Trumphoria rally. Polls now universally show investors are the most confident stocks will keep rallying over the next year since 2000, a bubble peak!

Following gold’s usual Summer Doldrums, gold investment demand as evidenced by rising GLD holdings was robust until late September. Differential GLD-share demand started petering out as the flagship S&P 500 stock index (SPX) started powering to seemingly-endless new record highs with no meaningful selloffs in between. Gold peaked at $1348 in early September right before the first SPX record close in 5 weeks.

The 43 trading days since then have seen a mind-boggling 23 record stock-market closes! The worst SPX down day in that entire surreal span was merely -0.5%, trivial. The SPX’s VIX-Implied Volatility fear gauge has averaged just 10.1 since then, exceedingly-low levels betraying extreme complacency. The stock investors as a herd don’t have a care in the world. They are totally convinced stocks can rally indefinitely.

So why bother with gold? Why prudently diversify stock-heavy portfolios with counter-moving gold if the perceived risk of a major stock-market selloff is nil? Investors have little interest in gold when the stock markets are trading near record highs after an exceedingly-long and exceptionally-massive bull. Gold investment demand has always had a strong negative correlation with stock-market fortunes, they are opposed.

That new Q3 GDT from the World Gold Council said overall global gold demand last quarter was actually the weakest since Q3’09. In Q3’17 the SPX powered 4.0% higher, seeing 15 new all-time record closes. Back in Q3’09, the stock markets were also exciting. Coming out of a once-in-a-century stock-panic low, the SPX rocketed 15.0% higher in that single quarter! Exciting stock markets really retard gold demand.

Conversely one of gold’s best global-demand quarters was Q1’16, when stock markets were weak. The SPX suffered two corrections in a row leading into early 2016, after going a near-record 3.6 years without a single one. The first 10 trading days of January that year ignited much fear. In that short span the SPX suffered serious down days of 1.5%, 1.3%, 2.4%, 1.1%, 2.5%, and 2.2%! So gold investment demand exploded.

Gold had been deeply out of favor before that, suffering a 6.1-year secular low in mid-December 2015 just after the Fed’s first rate hike of this cycle. GLD’s holdings slumped to a 7.3-year low of their own that same day. Yet once the stock markets started rolling over, investors were quick to remember gold’s role as the ultimate portfolio diversifier. Total global gold demand rocketed up 17.1% YoY or 185.8t in Q1’16!

American stock investors were overwhelmingly responsible, as GLD’s colossal 176.9t quarterly holdings build accounted for 95.2% of that total jump in world gold demand per the latest WGC data! Gold was catapulted into a new bull market on a mere couple of stock-market corrections. Q2’16 saw this major GLD-share buying momentum continue, with GLD’s 130.8t build alone driving gold’s entire 120.2t world demand growth.

Make no mistake, gold investment demand will explode again and drive gold sharply higher when today’s lofty hyper-complacent bubble-valued stock markets inevitably roll over again. Leading into Q1’16 the SPX corrections were only 12.4% and 13.3%, not serious. Corrections can grow as big as 20% before they become new bear markets. Imagine what an SPX selloff around 20% would do for gold investment demand.

And that’s coming far sooner than most think. Investors as a herd are always wrong at major market turning points. Major bull-market toppings are always marked with extreme euphoria just like today’s. Countless sentiment indicators are showing investors are now the most complacent or most bullish since late 2007 or early 2000. Those were the last bull-market toppings before brutal 49.1% and 56.8% SPX bears!

Stock-market bulls fail once valuations grow excessive. Over the past century and a quarter, the stock markets have averaged a 14x trailing-twelve-month price-to-earnings ratio which is fair value. Twice that at 28x is formally bubble territory, exceedingly dangerous. As October ended, the simple-average TTM P/E of all 500 SPX companies was a terrifying 30.1x! Stock markets can’t trade at bubble valuations for long.

But these super-bearish sentiment and fundamentals pale in comparison to what’s coming from the Fed and European Central Bank in 2018 and 2019. This stock bull grew so monstrous because major central banks were injecting hundreds of billions of dollars a year into markets via quantitative easing, which is a euphemism for money printing. Next year this QE stock-market rocket fuel will slam to a screeching halt.

A couple weeks ago I explained what’s coming in depth in an essay on the Fed and ECB strangle this stock bull. Because of the Fed’s new quantitative tightening reversing its QE, and the ECB just starting to taper its own QE bond buying, 2018 will see these dominant central banks effectively tighten by $950b compared to 2017! Then again in 2019 that will expand to another $1450b of tightening compared to this year.

The QE era that helped levitate stock markets is over, with $2.4t of central-bank liquidity that exists this year vanishing over the next couple years. There’s nothing more ominous for QE-inflated stock markets than the Fed starting to reverse QE through QT and the ECB greatly slowing its own QE. There’s simply no way possible that won’t eventually fuel a major stock-market selloff, a large correction or more likely a new bear.

When these stock markets roll over materially, when investors face a couple weeks of big down days like in January 2016, gold investment demand will explode again. Investors will stampede back to counter-moving gold to stabilize their bleeding stock-heavy portfolios. GLD’s holdings will soar again like they did in the first half of 2016, which catapulted gold 29.9% higher igniting a major new bull. Gold stocks fared far better.

The leading HUI gold-stock index skyrocketed 182.2% higher in essentially the first half of 2016 on that gold rally! When American stock investors aggressively buy GLD shares in response to stock-market selloffs reintroducing fear, gold surges and gold stocks soar. This well-worn pattern will play out again in the next major stock-market selloff. Once differential GLD-share buying resumes, gold is off to the races.

So if you want to understand why gold is doing what it’s doing and where it’s likely heading next, it’s imperative to follow GLD’s holdings. Stock investors’ capital flows into and out of gold via that key ETF conduit have utterly dominated recent years’ gold trends. Quite literally, gold is hostage to stocks! The higher the stock markets, the less gold investment demand. The more they sell off, the more gold demand surges.

With stock euphoria so extreme today after this past year’s incredible Trumphoria rally, gold investors need to focus on the stock markets. As long as stocks remain high which stalls gold investment demand, gold will likely continue to drift on balance. But once stocks sell off long and deep enough to rekindle sufficient fear, gold investment demand will explode again. Big GLD-share buying will catapult gold sharply higher.

Gold and especially its miners’ stocks remain deeply undervalued today due to the extreme stock-market euphoria. But that never lasts. Gold’s bull market will resume with a vengeance once American stock investors get interested in GLD shares again. That should coincide with the coming months’ major winter rally, the strongest seasonal span for gold and its miners’ stocks. Gold miners have enormous upside potential.

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At Zeal our core mission has always been profitable real-world trading, so we doggedly focus on what’s actually moving the markets and why. And really since 2013, the dominant driver of gold’s fortunes has been American stock investors’ capital flows via GLD. Following GLD’s holdings and the stock-market trends driving them is crucial for all gold and gold-stock investors and speculators, enabling better trading decisions.

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The bottom line is gold investment demand has stalled out in recent months, condemning gold to drift sideways. American stock investors in particular aren’t doing any differential GLD-share buying, which is essential to fuel gold uplegs. Mesmerized by the extreme stock-market euphoria, they no longer fear any material stock-market selloff. Thus they feel no need to diversify their portfolios with counter-moving gold.

But this anomaly can’t and won’t last for long. Sooner or later the hard bearish realities of bubble-valued stock markets and looming epic central-bank tightening will shatter today’s hyper-complacency. Then once again vast amounts of stock-market capital will migrate back into gold, catapulting it dramatically higher. As always the prudent contrarians who invest before the herd arrives will reap massive gains.

Adam Hamilton, CPA

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