Massive Gold Investment Buying (Part 2)

Gold’s strong gains so far this year have been overwhelmingly fueled by one dominant driver, massive investment buying.  After shunning prudent portfolio diversification with gold for years, investors are finally starting to reestablish those essential positions.  And since their collective gold holdings were so incredibly low heading into 2016, reflecting hyper-bearish sentiment, gold’s investment buying has only begun.

Nothing is more important for driving prevailing gold price levels than investment demand.  This isn’t as intuitive as it sounds, as gold’s global supply-and-demand fundamentals imply otherwise.  The best data available on this front comes from the venerable World Gold Council, which publishes outstanding Gold Demand Trends reports quarterly.  They offer a valuable fundamental perspective which is unparalleled.

Per the WGC’s data, in 2015 and 2014 jewelry accounted for 57.2% and 58.6% of gold’s world demand.  That’s about 4/7ths, a typical proportion throughout most of modern history.  Meanwhile in those same recent years, investment demand was only responsible for 21.4% and 19.4% of total demand.  Running at about 1/5th, far less than jewelry, it’s hard to imagine investment demand dominating gold price levels.

Yet it does, and always has.  The reason is investment demand is wildly variable, while jewelry demand is relatively stable.  When investors flock to gold like we’ve seen in 2016, gold prices surge dramatically no matter what’s going on in jewelry.  Q1’16 again proved this, with gold rocketing 16.1% higher for its best quarterly performance since Q3’86!  So jewelry demand at 4/7ths of the total had to be robust, right?

Rather shockingly, just the opposite was true.  Q1’16’s total gold jewelry demand per the WGC plunged by 19.3% year-over-year and 27.3% sequentially from Q4’15!  That collapse was due to political turmoil in India, gold’s second-largest jewelry market after China, after government proposals to raise taxes on the gold trade including jewelry manufacturing.  But the point here is gold investment demand trumps all.

The best read on world gold investment demand absolutely comes from those quarterly GDT reports.  As a long-time gold investor and speculator, they are my most-highly-anticipated gold data by far.  But the quarterly resolution is far too sparse to support buying and selling decisions.  Also these quarterly GDTs aren’t released until about 6 weeks after quarter-ends, because of the intensive efforts getting this data.

But thankfully there’s an excellent daily proxy available on investment capital flows into and out of gold.  Every morning when I sit down at my desk, it’s the first thing I check.  It’s the total gold bullion held in trust for the world’s leading GLD SPDR Gold Shares gold ETF.  Every trading day, GLD’s managers publish comprehensive data on this ETF’s entire gold holdings down to the individual-gold-bar level!

As of the middle of this week, this list of every bar’s serial number, refiner, gross weight, fine weight, and assay purity was 1413 pages long.  But it’s the aggregate total gold held that is of supreme interest to anyone trying to game gold trends.  The reason GLD’s holdings are so important is this ETF effectively acts as a conduit for the vast pools of American stock-market capital to migrate into and out of physical gold.

GLD’s mission is to track the gold price.  But GLD’s shares have their own separate supply and demand that is totally independent from gold’s.  Thus the GLD share price is always threatening to decouple from gold’s.  If the pace of GLD share demand exceeds gold’s, GLD’s price will break away to the upside and fail its mirroring mission.  If GLD share supply exceeds gold’s, this ETF will drift away from gold to the downside.

The only solution is to shunt excess GLD-share supply and demand directly into underlying physical gold bullion itself, equalizing those forces between the ETF and metal.  GLD’s managers accomplish this by issuing and redeeming shares.  When GLD demand is outpacing gold’s, they issue enough new GLD shares to offset that differential excess demand.  The cash raised is then used to buy more gold bullion.

When GLD supply exceeds gold’s, they buy back enough existing GLD shares to absorb that differential excess supply.  These buybacks are paid for by selling a portion of GLD’s gold-bullion holdings.  Thus the fluctuations in GLD’s daily holdings levels literally reveal stock-market capital flowing into or out of physical gold.  GLD’s bullion holdings rise on inflows from investment buying, and fall on outflows from selling.

Now GLD’s holdings aren’t just important because they are reported daily.  As of the end of 2015, GLD’s 642.4 metric tons of gold held in trust for its shareholders represented a dominant 40.0% of the total for all the world’s gold ETFs!  The second-place competitor merely held 9.5%, GLD’s reign is unchallenged.  Much to the chagrin of GLD conspiracy theorists, this WGC-created ETF has become the dominant gold force.

While nothing is more important for driving prevailing gold prices than investment demand, there is no more important source of investment demand than American stock investors buying GLD shares.  It is these capital inflows into this single leading ETF that are responsible for much of the massive gold investment demand seen so far in 2016.  GLD buying is the primary story behind this year’s mighty new gold bull!

This first chart looks at GLD’s daily gold-bullion holdings in tonnes superimposed over the gold price during the past several years or so.  Each calendar quarter’s GLD-holdings build or draw is noted in both percentage and tonnage terms, and compared to gold’s same-quarter price action.  GLD shares have been aggressively bought at a torrid pace by American stock investors prudently seeking portfolio gold exposure.

Gold’s reversal of fortune over the past half-year has been epic.  In mid-December, gold slumped to a major 6.1-year secular low after the Fed’s first rate hike in 9.5 years.  But that reaction was sentimental, it had no fundamental justification.  Gold has actually thrived in past Fed-rate-hike cycles, with impressive average gains of 26.9% during the exact spans of all 11 since 1971!  Rising rates boost investment demand.

Gold’s late-2015 psychological woes proved to be the end game in a long mass exodus of stock-market capital from GLD shares, forcing huge gold-bullion sales.  Between GLD’s record gold-bullion-holdings peak of 1353.3t in early December 2012 and their 630.2t trough in mid-December 2015, huge differential selling forced this ETF to liquidate 53.4% of its holdings or a whopping 723.2t!  This blasted gold 38.3% lower.

The catalyst for this extreme GLD liquidation far beyond anything ever witnessed before was the Fed launching and expanding its third quantitative-easing campaign in late 2012.  QE3 was unprecedented in that it was open-ended.  Unlike QE1 or QE2, there was no predetermined size or end date for these enormous new bond monetizations by the Fed.  This fueled recent years’ radically-distorted financial markets.

Fed officials deftly used QE3’s ambiguity to their advantage to actively manipulate psychology among stock traders.  Whenever the already-lofty stock markets threatened to roll over into a healthy pullback or correction, top Fed officials rushed to reassure that QE3 could be expanded if necessary.  This led to a crazy stock-market levitation, stock markets that did nothing but rise on balance thanks to the implied Fed Put.

These artificial one-way stock markets led investors to forget the wisdom of keeping their portfolios well-diversified with gold, which rather uniquely tends to move counter to stock markets.  So they started to exit gold en masse, and GLD selling was the sharp end.  All gold’s endless sentimental woes of recent years originally sprung from an epic GLD liquidation in Q2’13, the most extreme GLD differential selling ever.

Understanding what happened in Q2’13 is necessary to understand what’s happening in 2016.  That fateful quarter investors sold so many GLD shares that they forced a mind-boggling 251.8t holdings draw!  That single quarter was responsible for 34.8% of GLD’s total draw over recent years.  And with GLD being forced to spew out 20.6% of its holdings to keep tracking gold, the gold price plummeted 22.8%.

That proved gold’s worst quarter in an astounding 93 years!  Fully 55.7% of gold’s total loss between late 2012 and late 2015 came in that one awful quarter.  And GLD was solely responsible.  The WGC’s Q2’13 GDT reported that total global gold demand plunged by 12.1% YoY or 118.3t.  GLD’s crazy-big 251.8t draw was more than double the overall global demand drop!  Jewelry demand actually soared 36.8% YoY.

So there is powerful precedent of American GLD-share trading utterly dominating gold price action in past extreme quarters.  This same phenomenon in reverse just happened in Q1’16, igniting gold’s first new bull market since 2011.  American stock investors flocked back to GLD to regain some critical gold portfolio exposure after the US stock markets suffered their worst selloff in 4.4 years.  Their levitation was failing.

Q1’16’s GLD-share buying was so extremely intense that this ETF’s managers were forced to boost its physical-gold-bullion holdings by a staggering 176.9t or 27.5%!  The gold investment buying via GLD was so massive that it had to shunt incredible amounts of excess demand into gold to keep GLD from decoupling sharply to the upside.  Investors returning to gold after years of neglect is driving this new bull.

And much like Q2’13, GLD’s role in Q1’16 was dominant.  Remember jewelry demand dropped by 19.3% YoY in Q1 as the major Indian jewelry industry went on strike to protest proposed tax hikes on it.  Yet overall gold demand still soared 20.5% YoY to 1289.8t.  And traditional bar-and-coin investment didn’t help at all, as it was only up 0.7% YoY to 253.9t.  Q1’16’s entire gold demand surge was driven by ETF buying.

The World Gold Council’s elite researchers reported that global gold-ETF demand skyrocketed an epic 1320.7% higher YoY to 363.7t in Q1’16!  That was the only significant gold-demand category that jumped.  And of those 363.7t of gold purchased by ETFs on behalf of their shareholders, a dominant 48.6% came from GLD alone!  This year’s massive gold investment buying is from American stock investors returning to GLD.

And GLD’s role in this year’s new gold bull is even more dominant than that suggests.  Total global gold demand climbed 219.4t in the first quarter, so the GLD holdings build alone was a whopping 80.6% of that!  Without that huge GLD-share differential buying, world gold demand would’ve barely risen after that big jewelry plunge.  So three cheers for American stock investors remembering portfolio diversification.

And bullishly for gold, that massive Q1’16 investment buying wasn’t just a flash in the pan and remains far from over.  So far in the second quarter, GLD’s holdings are up another 61.9t or 7.6%.  That’s a huge build, easily the second biggest in recent years.  This continuing strong differential GLD-share demand from investors is pretty impressive considering the lackluster gold price action that has plagued much of Q2.

In its new bull run, gold first hit this week’s low-$1260s levels in early March.  So other than surging to new highs near $1294 briefly in late April, gold has essentially been consolidating in a sideways grind for 3.2 months.  That’s hardly likely to inspire confidence in an asset class that was universally despised just a few months before that.  Yet after an April lull, stock investors resumed strongly buying GLD in May.

May’s GLD holdings build of 64.5t wasn’t far behind February’s massive 108.0t, which was the biggest monthly build GLD had witnessed in exactly 7 years.  So even though gold was really overbought on a short-term basis, even though American speculators were ramping their gold-futures long positions to record levels which is an ominous contrarian indicator, investors continued to aggressively add gold exposure.

And if gold investment demand remained so strong in recent months despite lackluster gold price action, it’s almost certain to explode as gold’s young bull market resumes.  Nothing begets investment buying like rallying prices, investors love chasing winners!  The fact gold investment demand remains massive as evidenced by GLD shares’ differential buying proves that gold’s new bull market has a long ways to run.

There are many reasons.  Gold was hammered to secular lows late last year on epic bearish sentiment that was wildly unjustified fundamentally, so it needs to mean revert radically higher.  Before the Fed’s extreme QE3 distortions slammed gold in early 2013, it averaged $1669 in 2012.  And with the Fed’s printing presses puking out freshly-conjured money like there’s no tomorrow, gold thrives in inflationary times.

But perhaps most importantly of all, these artificial Fed-levitated stock markets remain way overdue to roll over into a major new cyclical bear that will at least cut stock prices in half.  So investors desperately need to diversify their stock-heavy portfolios to prepare for the return of normal market cycles.  And even now they remain radically underinvested in gold by recent standards, so their migration back is far from over.

This final chart expands on GLD’s role as the dominant gold-investment proxy, looking at the ratio of the total capital invested in GLD to the total market capitalization of the flagship S&P 500 stock index.  This metric effectively shows how much portfolio exposure American stock investors have to gold.  Despite all their massive buying so far in 2016, their gold diversification still remains not far above major secular lows.

As of the end of May, the total value of GLD’s physical gold bullion held in trust for its shareholders was just 0.175% of the S&P 500’s total market cap.  That actually wasn’t much of an improvement from this ratio’s 8.0-year secular low of 0.111% in mid-December.  American stock investors’ portfolio exposure to gold has merely climbed from just over 0.1% to well under 0.2% so far this year!  That’s still utterly trivial.

For many centuries if not millennia, 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 one of the best forms of portfolio insurance.  When some major selling event hammers the rest of a portfolio, like an overdue cyclical stock bear artificially delayed by the Fed, gold surges to offset some of those losses.

While it’s a big stretch to see American stock investors collectively put 5% of their capital into gold, there is plenty of precedent for them having much-higher portfolio exposure.  Between 2009 and 2012, which were the last normal years before the Fed’s QE3 greatly distorted everything, the ratio between the value of GLD to the S&P 500’s market cap averaged 0.475%.  There’s no doubt it will mean revert back up there.

Those pre-QE3 levels of American stock investors’ portfolio gold exposure per GLD still remain 2.7x higher than today’s levels after that massive 2016 gold buying!  Investors have much more gold buying left to do than they’ve already done merely to restore recent years’ levels of normality in their portfolio gold exposure.  And during a major stock bear, there’s a good chance their gold exposure will dramatically overshoot.

The last bear market in stocks ran from October 2007 to March 2009, in which the flagship S&P 500 full of the biggest and best American companies plunged 56.8%.  Over that exact span, GLD’s holdings soared 75.7% higher which helped drive gold up 24.8%.  Assuming a new stock bear started back at May 2015’s all-time-record S&P 500 peak, a similar move today would catapult GLD’s holdings to 1257.0t.

That’s another 375.8t higher from this week’s levels, and dwarfs GLD’s massive 238.8t year-to-date build.  Interestingly such GLD levels are close to its 1208.5t average holdings seen between those last normal years of 2009 to 2012.  But I suspect that level of GLD holdings will be far exceeded during this next cyclical stock bear.  GLD was only born in November 2004, so its reputation wasn’t established in that last bear.

Since then, GLD has grown into a gold juggernaut that overwhelmingly drives this metal’s biggest price moves seen in many decades.  Most serious investors now know about GLD’s ability to instantly and cheaply add portfolio gold exposure.  So the number of investors and amount of capital likely to flood into GLD during this next stock bear is far greater than the relatively-modest inflows seen in the last one.

In addition, investors lulled into extreme complacency by the Fed’s blatant manipulations of recent years are going to be totally shocked when normal market conditions inevitably resume.  Artificially-levitated stock markets are almost certain to fall faster than non-inflated ones.  And the quicker the stock markets drop, the more investors will be motivated to lighten their stock-dominated portfolios and diversify into gold.

I’ve spent over 16 years now intensely studying and actively trading gold, silver, and the stocks of their miners.  And there’s no doubt that GLD’s rise to gold dominance has made it impossible to understand and game the gold market without closely following this leading ETF’s bullion holdings.  Investors who aren’t paying attention to stock-market capital flowing into and out of gold via GLD are foolishly flying blind.

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At Zeal we’ve long specialized in holistic analysis considering everything important to a given market.  We dig up and crunch the raw data until we understand exactly what’s moving markets.  And in gold’s case these days, it is stock-market capital flows via GLD and American futures speculators’ collective bets.  If you’re not closely following these dominant gold drivers, your efforts to buy low and sell high will fail.

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The bottom line is gold’s young new bull market was driven by massive investment buying.  Nearly all of that came from stock investors flooding into gold-ETF shares, led by the dominant American GLD.  And investors’ migration back into gold remains far from over.  Heavy GLD buying continued in May despite gold’s high consolidation of recent months.  Investors still remain radically under-deployed in gold even today.

The American stock investors scrambling to diversify their stock-dominated portfolios with gold via GLD shares ahead of the coming bear have barely started.  They have vast buying left to do merely to return their portfolio gold exposure to pre-QE3 normal-year levels.  Thus the massive gold investment buying has only begun.  It will likely take years to complete, driving gold’s new bull higher on balance the entire time.

Adam Hamilton, CPA

June 10, 2016

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