Radical Gold Underinvestment 3

Gold was again blasted to new post-election lows this week, further trashing contrarian sentiment.  The Fed proved more hawkish than expected in its rate-hike-trajectory forecast, unleashing heavy selling in gold futures.  This catapulted gold bearishness back up to extremes not seen in a year.  Investors are once again convinced gold is doomed, and thus radically underinvested.  That’s actually super-bullish for gold.

It certainly wasn’t the Fed’s second rate hike in 10.5 years this week that hammered gold.  Actually that was universally expected.  Federal-funds-futures traders had assigned it an average 96% probability in the two weeks leading up to that rate hike.  If the Fed had simply raised its federal-funds rate by 25 basis points to a 0.50%-to-0.75% range, gold-futures speculators would’ve likely yawned.  They knew it was coming.

The unexpected hawkishness came in the FOMC’s Summary of Economic Projections that is published quarterly at every other policy meeting.  Also called the “dot plot”, it shows where each FOMC member and regional Fed president expects the FFR to be in the next several years and beyond.  The collective expectations of these top officials who actually set monetary policy grew from two rate hikes in 2017 to three.

Seeing the timid Yellen Fed do this was a surprise.  Just a couple weeks earlier in the Fed’s Beige Book economic report that supports FOMC meetings, one of the major reasons cited for regional US economic weakness was the strong US dollar.  Something like half the revenues of the elite S&P 500 component stocks come from abroad, making the US dollar already near 13.7-year secular highs a big threat to stock markets.

The red-hot dollar makes the products and services American companies are selling in foreign countries more expensive, naturally retarding sales.  And any profits earned have to be translated back into US dollars.  So extreme US-dollar highs are very damaging for corporate profits, a serious problem for lofty US stock markets currently trading at bubble valuations.  It wasn’t rational for the Fed to further goose the US dollar.

Yet it did, with the US Dollar Index rocketing 1.0% higher after that FOMC decision to a new 14.0-year secular high!  That epic dollar strength after the Fed was more hawkish than expected on rate hikes in 2017 is what triggered that heavy gold-futures selling.  But that really didn’t make any sense on a couple key fronts.  The dot-plot rate-hike projections are notoriously fickle, and gold actually thrives in rate-hike cycles.

Exactly a year ago, the FOMC staked its zero-interest-rate policy with its first rate hike in 9.5 years.  Gold-futures speculators panicked, blasting it to a dismal 6.1-year secular low the next day.  The dot plot the Fed released at that initial hike forecast four rate hikes in 2016.  How many did we actually see?  One!  The FOMC is bold and hawkish when stock markets are high, but quickly capitulates when stocks sell off.

Since futures speculators were so terrified of Fed rate hikes a year ago, I researched the entire modern history of gold’s performances in the exact spans of Fed-rate-hike cycles.  Gold actually thrives during rate-hike cycles.  Before this current one there had been 11 since 1971.  Gold’s average gain through all of them was 26.9%, nearly an order of magnitude greater than the S&P 500’s 2.8% average gain in all of them!

In the majority 6 of these 11 where gold actually rallied, its average gain was a staggering 61.0%!  In the other 5 in which it lost ground, gold’s average loss was an asymmetrically-small 13.9%.  Gold fared best when it entered Fed-rate-hike cycles low in secular terms and they were gradual.  Today’s started with gold at major secular lows, and there’s never been a more-gradual rate-hike cycle at one hike per year.

So it’s dumbfounding that gold-futures speculators so fear Fed rate hikes.  Have they no history books?  You’d think they could at least look to the last cycle.  Between June 2004 to June 2006, the FOMC more than quintupled the federal-funds rate to 5.25% through 17 consecutive rate hikes totaling 425 basis points.  Did that slay gold?  Not so you’d notice.  This metal powered 49.6% higher over that exact span!

Even if the Fed does hike three times next year, historically Fed-rate-hike cycles have been very bullish for gold.  But just like this year, the Fed won’t hike so aggressively.  As these euphoric wildly-overvalued stock markets roll over into an inevitable major selloff, the Fed will again scale back its future federal-funds-rate forecasts so aggressively traders’ heads will spin.  This pattern has been recurring for years now.

While the gold focus this week is the more-hawkish-than-expected Fed, the real issue is the stunning post-election stock-market rally.  Gold was faring well right up to election night, surging as high as $1337 as Trump’s odds of winning mounted!  But when stock traders’ sentiment turned on a dime and decided that Trump was bullish instead of bearish for stocks, gold selling snowballed as stocks surged higher.

Gold has always been the anti-stock trade, as it is a rare asset that moves counter to stock markets.  Thus gold investment demand for prudent portfolio diversification surges when stock markets suffer material selloffs, and wanes when stock-market highs breed great complacency.  This has led the two dominant groups of gold traders, gold-futures speculators and gold-ETF investors, to dump gold with a vengeance.

Last week I dug into the extreme gold-futures selling seen since the election, which is slowly exhausting itself despite this week’s hawkish-Fed flare-up.  So this week I’m going to focus on the extreme selling in gold-ETF shares seen since the election.  The world-leading and globally-dominant gold ETF remains the venerable American GLD SPDR Gold Shares.  GLD capital flows are absolutely essential for gold’s outlook.

This first chart superimposes GLD’s physical gold-bullion holdings held in trust for its shareholders on the gold price.  GLD reports its holdings daily, in extensive detail down to individual gold-bar weights and serial numbers.  GLD acts as a direct conduit for the vast pools of stock-market capital to flow into and out of physical gold bullion.  Nothing was more important for gold in 2016 than capital flowing through GLD!

Leading into last December’s first Fed rate hike in nearly a decade, stock investors liquidated their gold exposure via GLD shares as evidenced by falling holdings.  GLD is a tracking ETF, designed to mirror the gold price.  Since GLD-share supply and demand is totally independent from gold’s own, the only way GLD can accomplish its mission is if excess GLD-share supply or demand can be shunted into gold itself.

When stock investors are selling GLD shares faster than gold is being sold, this ETF’s price threatens to decouple to the downside.  This happened in Q4’15 leading into that initial hike, and at a much-larger scale in Q4’16 on that stunning post-election stock-market surge.  In order to keep GLD’s share price tracking gold in this differential-selling scenario, this ETF’s managers have to quickly absorb the excess supply.

So they buy back enough GLD shares to keep GLD’s price mirroring gold’s.  The capital that’s necessary to fund these purchases is raised each day by liquidating some of GLD’s gold-bullion holdings.  That is real physical gold that hits the global markets, pushing gold lower.  So stock-market capital flowing out of gold as evidenced by GLD-holdings draws spews bullion into world markets, exacerbating gold selloffs.

As of this week’s Fed Day, gold has plunged 13.3% so far in Q4.  That’s definitely among gold’s worst quarterly performances ever, though far short of Q2’13’s devastating all-time-record 22.8% plummet.  This post-election drop is the result of a combination of extreme gold-futures selling and extreme GLD-share differential selling.  GLD shares have been dumped so aggressively that it’s vomiting vast amounts of gold.

Quarter-to-date, the total GLD draws necessary to buy back all these excess shares are running way up at a staggering 98.5 metric tons!  That’s an enormous amount of gold, far too much for markets to absorb in such a short span of time.  Rather interestingly, this massive GLD draw is running 2.2x that seen a year ago in Q4’15.  Gold’s quarter-to-date drop is running a roughly-proportional 2.7x greater than Q4’15’s.

For two years now, and especially in 2016, gold’s price has closely tracked GLD’s holdings.  For nearly all of 2015, GLD suffered ongoing draws as stock investors forsook gold diversification to chase levitating stock markets.  Gold’s major 6.1-year secular low the day after last December’s Fed rate hike happened on the very day GLD’s holdings finally bottomed at a 7.3-year secular low of their own.  That’s no coincidence!

From those deep lows where gold was universally despised, just like today, this metal would soon rocket 29.9% higher in essentially the first half of 2016.  Why?  The stock markets finally started to roll over on the Fed’s hawkishness, leading investors to once again seek some prudent portfolio diversification with gold.  But most of that stock-market selling after the Fed’s first rate hike was delayed until the new year.

When stock markets rally considerably in any given year, investors with big capital gains often delay any selling until January of the subsequent year.  That pushes their capital-gains tax liabilities another full year into the future.  And the incentives to hold until January are far greater this year than most, since 2017 may see lower tax rates thanks to Trump.  So there’s a big risk of pent-up stock selling exploding next month.

Last January as stock markets fell into their worst correction since mid-2011, a 13.3% S&P 500 selloff, gold investment demand via GLD shares soared.  In Q1’16, GLD’s holdings rocketed 176.9t higher.  Later the World Gold Council, the definitive arbiter of global gold supply-and-demand fundamentals, declared total world gold demand grew by 219.4t year-over-year.  GLD’s holdings build alone accounted for 80.6% of that!

So without American stock investors flooding into GLD shares to modestly diversify their portfolios as the stock markets sold off, gold’s young new bull this year never would’ve happened.  Unbelievably GLD’s dominance grew even greater in Q2’16.  GLD’s holdings jumped massively again, soaring by 130.8t that quarter.  The WGC reported that total global gold demand grew 139.8t YoY, pegging GLD’s contribution at 93.6%!

The dominant reason gold’s bull stalled in Q3’16 is because the shocking new stock-market highs in the wake of late June’s Brexit-vote surprise killed gold investment demand from American stock investors.  So GLD’s enormous holdings builds in the first half of 2016 withered to a trivial 2.1t draw.  Without that key differential GLD-share buying that had overwhelmingly driven gold’s bull, this metal couldn’t keep climbing.

In Q1, Q2, and Q3 this year, gold’s performances ran +16.1%, +7.4%, and -0.4%.  These are remarkably proportional to GLD’s quarterly builds of 176.9t, 130.8t, and -2.1t.  Given that precedent, it shouldn’t be surprising that Q4’s massive 98.5t GLD draw so far has resulted in a 13.3% gold plunge.  The pain that spawned for contrarian investors and speculators has been immense, fueling extreme gold bearishness.

Every indication before the election was that a surprise Trump win would trigger a major stock-market selloff and thus a major gold rally.  So the resulting carnage has been brutal, hammering gold, silver, and their miners’ stocks down through stop losses.  The psychological damage suffered by contrarians in one of gold’s worst quarters ever is huge.  I’m not cavalier about it after drinking from this bitter cup too.

But speculation and investing aren’t about the past, which can’t be undone.  The greatest mistake made by most traders is to extrapolate current trends out into the future indefinitely.  This is especially true when markets trade at extremes, like the stock markets and gold today.  If you’d been 100% in cash through all of Q4, and thus had no emotional attachment, would it make more sense today to buy stocks high or buy gold low?

The horrendous gold psychology this December feels exactly like it did a year ago.  The euphoric stock traders had just shrugged off the first Fed rate hike in nearly a decade, while gold traders panicked on it.  Yet from the very week of that rate hike, gold would surge nearly 30% higher in the next half-year while the S&P 500 merely climbed 4.3%.  The leading gold-mining stocks would nearly triple over that same span!

The entire trader community is making the same foolish linear assumptions today that it made a year ago.  Traders again expect stock markets to miraculously keep surging from wildly-overvalued levels without any material selloffs, and for gold to keep spiraling lower.  This universal belief has led to radical gold underinvestment.  With stock markets far riskier, this is even more bullish for gold today than a year ago.

This last chart looks at a proxy for gold investment by American stock investors, the guys responsible for the lion’s share of 2016’s gold bull.  It compares the total value of GLD’s gold-bullion holdings with the collective market capitalization of all 500 elite S&P 500 stocks.  Dividing these numbers and charting the results over time reveals when gold is really in favor or out of favor, great times to sell high or buy low respectively.

As of the end of November, the value of GLD’s holdings was just 0.166% the market capitalization of the S&P 500.  We only calculate the latter number monthly, but can estimate where this GLD/SPX ratio sat as of Fed Day this week.  It likely dropped near 0.152%!  That conservatively implies that American stock investors have allocated well less than 0.2% of their portfolios to gold.  That may as well be zero it’s so low.

The last normal years for gold and the stock markets before the Fed’s extreme QE3 campaign levitated stocks and thus killed gold investment demand ran between 2009 to 2012.  This GLD/SPX-ratio proxy of gold portfolio exposure averaged 0.475% over that span, over 3.1x higher than today’s meager levels!  That means stock investors have vast room to buy gold again when stock markets inevitably roll over from here.

For centuries the world’s smartest investors have recommended gold allocations in portfolios of at least 5% to 10% for every investor.  As the anti-stock trade, gold is the ultimate diversifier that acts as a hedge and form of insurance against significant weakness in stocks and bonds.  It’s hard to imagine anyone with some understanding of stock-market cycles and market history totally neglecting to maintain a gold allocation.

A massive new gold bull doesn’t require American investors’ collective gold allocation to soar way up to 5%.  Returning to merely one-tenth of that, 0.5%, would likely drive gold higher for years as stock-market capital poured into gold.  And just like a year ago, all it will take to get investors interested in gold again is a major stock-market selloff.  One is certainly overdue again no matter what wonders Trump works next year.

Stock markets perpetually move in great valuation-driven cycles, with bull markets always followed by bears.  Stock valuations get too stretched in bulls as traders bid up stock prices far faster than the critical underlying corporate profits are actually growing.  That leads to euphoric toppings that soon give way to major bears, which force stock prices lower for long enough for profits to catch up with lofty stock prices.

At the end of November even before this month’s incredible stock-market surge, the simple average of the trailing-twelve-month price-to-earnings ratios of all 500 S&P 500 companies was already 28.1x.  That is double historical fair value of 14x, and literally in bubble territory!  A major bear at least cutting stock prices in half is long overdue, but even a major correction approaching 20% is all but certain in 2017.

Remember all it took to rekindle gold investment demand in early 2016 was a 13% S&P 500 correction, fairly small as far as corrections go.  They range from 10% to 20%, with anything beyond that qualifying as a new bear market.  Sooner or later all the euphoria about what Trump and the Republicans could do will give way to the hard realities of what they actually can and will do.  It won’t be as extensive as traders hope.

Republican Congressional leaders are already blunting the tax-cut and infrastructure-spending hopes, declaring they need to be revenue-neutral so they don’t balloon the already-staggering federal debt.  And it is unlikely any major tax cuts will come before 2018 at the earliest, leaving the bubble-valued stock prices heavily exposed to falling profits thanks to the Fed-goosed US dollar.  Stock markets are in serious trouble.

And even if Trump comes through with gargantuan tax cuts and huge new spending, this vast deluge of new money will lead to rampant inflation.  This week the Fed already hinted at inflation rising, but what’s been seen so far is trivial compared to what’s coming if even half of Trump’s campaign proposals make it to reality.  Inflation is very damaging to stock markets, and thus very bullish for gold investment demand.

So it’s imperative smart investors and speculators fight the herd groupthink today.  The stock markets will not keep rallying indefinitely as everyone expects, and gold isn’t doomed to spiral lower forever.  Once these euphoric stock markets inevitably reverse decisively, investment capital is going to come roaring back into gold for portfolio diversification.  Gold’s upside potential in 2017 is much greater than it was in early 2016.

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The bottom line is gold is suffering from radical underinvestment today.  American stock investors have fled gold since the election, liquidating vast quantities of GLD shares.  The red-hot stock markets way up at all-time record highs have convinced them diversified portfolios are no longer necessary.  Every time such euphoria, complacency, and even hubris have happened in the past, major stock selloffs soon followed.

With American stock investors owning essentially-zero gold exposure, they have vast room to buy again when these wildly-overvalued stock markets inevitably roll over.  The same thing happened a year ago, and it led to gold powering dramatically higher in the first half of 2016.  That investment demand was triggered by post-Fed-rate-hike stock selling delayed until January for tax reasons.  It’s deja vu all over again!

Adam Hamilton, CPA

December 16, 2016

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