Why Has Gold Stalled?

Gold’s young bull market has totally stalled out in the past couple months.  This major loss of momentum following gold’s powerful surges in 2016’s first half is really souring sentiment and vexing traders.  They are trying to figure out if gold’s recent consolidation drift is the dawn of a new bearish trend or a healthy pause within an ongoing bull.  The likely answer comes from understanding what’s causing gold’s high consolidation.

Back in mid-December right after the Fed’s first rate hike in 9.5 years, gold slumped to a miserable new 6.1-year secular low.  That was driven by heavy gold-futures selling from speculators, who were utterly convinced higher rates are gold’s mortal nemesis.  But with bearishness so extraordinary and investors’ gold allocations so low, a mighty mean reversion higher for gold was very likely in 2016 as I wrote in late December.

Indeed that soon came to pass.  As the grossly-distorted stock markets artificially levitated by the Fed’s extreme easings rolled over in January, investors started remembering the wisdom of diversifying some of their portfolios into gold.  As a unique asset tending to move counter to stock markets, gold remains the leading diversifier to mitigate downside risks in stock-heavy portfolios.  Gold was finally off to the races.

By early March gold formally entered bull-market territory for the first time since mid-2011, surging 20%+ off its deep secular lows.  Gold’s enormous 16.1% gain in Q1’16 made for its best quarter in 30 years, since Q3’86!  Such a blistering pace of ascent wasn’t sustainable, and gold started faltering in Q2’16.  But heavy investment buying was soon rekindled, starting with a colossal US-monthly-jobs miss in early June.

Then in late June, gold rocketed higher again after the surprise success of the British people voting to overthrow the tyranny of those unelected, unaccountable EU bureaucrats.  But gold’s newfound post-Brexit strength was short-lived, as it topped at $1365 in early July.  In just 6.7 months, gold had blasted an astounding 29.9% higher!  So a breather was certainly overdue, especially inside gold’s summer doldrums.

Summer has always been the weakest time of the year seasonally for gold, as it’s devoid of the outsized demand spikes driven by income-cycle and cultural factors that gold enjoys much of the rest of the year.  And indeed between that early-July peak and the end of August, gold pulled back 4.1% to $1308.  This metal has been drifting in the mid-to-low $1300s for over 9 weeks now, breeding mounting bearishness.

Until last Friday, this summer’s unbelievable stock-market levitation to new record highs offered some cover for gold’s lethargy.  As recent years proved in spades, gold investment demand wanes when the stock markets apparently do nothing but rise indefinitely thanks to endless central-bank easing.  Why diversify into gold if stocks seemingly never sell off materially?  But that levitation finally started to fracture.

A week ago the flagship S&P 500 plummeted in a massive 2.5% single-day loss!  That was a stunning wake-up call to the legions of hyper-complacent stock bulls.  Yet there was no accompanying surge in gold investment demand for prudent portfolio diversification.  The world’s dominant leading gold ETF, the American GLD SPDR Gold Shares, actually suffered a major 1.1% draw that day stock markets rolled over!

So what the heck is going on with gold here?  If not even the biggest stock-market down day by far since that late-June Friday when the Brexit-vote results became known could spark some life in gold, what will?  The longer gold remains stalled, the more investors’ and speculators’ concerns mount about the health of its young bull.  Understanding what’s been holding gold back is critical to gaming its next major move.

Gold’s young bull has stalled due to an interplay between investors’ gold demand, speculators’ gold-futures trading, this summer’s lofty US stock markets, and typical weak mid-year seasonals.  Since this year’s powerful gold bull has been driven almost exclusively by investment buying, that’s the place to start.  This chart looks at GLD’s gold-bullion holdings overlaid on the gold price during the past couple years.

As gold slumped to last year’s major secular lows, its investment demand as evidenced by builds and draws in GLD’s physical gold bullion held in trust for its shareholders waned dramatically.  The very day that gold bottomed in mid-December immediately after the Fed’s first rate hike in nearly a decade, GLD’s holdings hit their lowest level in 7.3 years!  American stock investors had abandoned gold, leaving it for dead.

But this dire trend soon reversed right out of the gates in early 2016.  Thanks to a sharp stock-market selloff, which would snowball to the biggest in 4.4 years for the benchmark S&P 500, investors finally started returning to gold.  They began aggressively adding gold exposure via GLD shares, which is the quickest, easiest, and cheapest way by far for mutual funds and hedge funds to buy gold.  GLD demand just skyrocketed.

GLD is a tracking ETF, it’s designed to mirror the price of gold.  But GLD-share supply and demand is totally independent from gold’s own supply and demand.  Thus GLD-share prices always threaten to decouple from gold prices.  There’s only one way to neutralize this inherent conflict.  Excess GLD-share supply or demand has to be directly shunted into underlying physical gold bullion itself, to equalize any pressures.

So when American stock investors buy GLD shares faster than gold itself is being bought, their prices will soon break away from gold’s to the upside.  GLD’s managers have to intervene to maintain tracking.  So they issue enough new GLD shares to supply and offset the excess demand, keeping GLD’s price in line with gold’s.  Then they immediately deploy the capital raised from these share sales by buying gold bars.

GLD necessarily acts as a direct conduit between the vast pools of stock-market capital and the global physical gold market.  So daily builds in GLD’s holdings showing this ETF is buying gold bullion reveal stock-market capital flowing into gold.  Heading into February, differential GLD-share demand from big American stock investors, overwhelmingly funds, exploded higher as the stock markets kept tanking.

Take careful note of the timing.  In January, GLD’s holdings grew by 4.2% or 26.9 metric tons.  But in February they rocketed 16.1% higher in a gigantic 108.0t build!  This is a critical lesson for today.  Last Friday’s sharp S&P 500 selloff was merely the beginning of stock markets rolling over.  Selling pressure has to be sustained, becoming a trend, before stock investors’ complacency crumbles so they once again seek gold.

So far in this latest stock-levitation rollover, we’ve only seen 2 major S&P 500 down days.  Last Friday’s 2.5% and this past Tuesday’s 1.5%.  While no doubt steep in light of recent months’ record-low volatility, that’s not enough selling to convince stock investors the prevailing trend has decayed to down.  We will probably need a couple weeks of selling before they get worried enough to start re-diversifying into gold again.

Back in the first 10 trading days of January, the S&P 500 saw no fewer than 6 major down days!  They included daily drops of 1.5%, 1.3%, 2.4%, 1.1%, 2.5%, and 2.2%.  Gold investment demand didn’t pick up dramatically until stock investors were really getting spooked by an ongoing hammering.  The differential demand for GLD shares forcing holdings builds that drive up global gold prices didn’t come until after that.

So a couple days of material stock-market selling so far in September probably hasn’t been enough yet to shift stock-investor psychology away from this summer’s hyper-complacency.  If the stock markets keep grinding lower on balance as they certainly ought to after such an extreme Fed-conjured levitation to new record highs, gold will inevitably catch another major investment bid sooner or later here.  Be patient.

And the importance of GLD-share buying by American funds for this gold bull cannot be overstated, it is staggering.  In Q1’16, gold surged 16.1% higher on a 27.5% or 176.9t build in GLD’s holdings.  The best research available on gold’s actual underlying physical supply and demand comes from the venerable World Gold Council, in its indispensable Gold Demand Trends reports that are published once a quarter.

Back in May the WGC released its Q1’16 GDT.  It reported that global gold demand climbed 20.5% year-over-year, or a 219.4t gain.  Incredibly, that first-quarter 176.9t build in GLD’s holdings alone accounted for a staggering 80.6% of the total worldwide growth in gold demand!  That compares to traditional bar-and-coin demand only rising a trivial 1.7t YoY.  GLD gold-bullion buying was the whole story of Q1’16.

2016’s new gold bull exists solely because large American stock investors decided to flood back into gold via GLD shares after neglecting reasonable portfolio allocations to it for years.  Gold rocketed up in the first quarter not because small investors were buying bars and coins, but because big ones were buying ETF shares.  This gold bull’s incredible dominance by GLD-share buying actually intensified in Q2’16!

In August the WGC released its Q2’16 GDT report, revealing worldwide gold demand surged up another 15.4% or 139.8t YoY.  GLD’s Q2’16 holdings build alone of 130.8t accounts for a whopping 93.6% of this total global increase in gold demand!  Again world bar-and-coin demand was dead flat, up a trivial 2.5t in the second quarter.  Gold’s entire new bull market has been overwhelmingly driven by differential GLD buying!

Now odds are this anomalous GLD-dominating trend won’t persist.  As this gold bull lasts longer and marches higher, traditional demand for jewelry in Asia and bars and coins in the West will start growing and flourishing again.  ETF buying commandingly led by GLD will hand off the gold-buying baton to other investors.  But for now, this entire gold bull is built on the back of GLD.  And that’s why gold has stalled.

Differential GLD-share demand has totally evaporated in this almost-over third quarter.  As of the data cutoff for this essay on Wednesday, GLD’s holdings had actually fallen 1.5% or 14.6t so far in Q3’16!  This modest GLD draw, or more accurately the lack of big ongoing GLD builds, is why gold is dead flat quarter-to-date.  Without large American stock investors buying GLD, the entire impetus of gold’s bull has vanished.

There are a few reasons.  Differential GLD-share demand was extremely strong after that Brexit vote in late June into early July.  Early in quarters is when hedge funds often position capital for those entire quarters.  That big fund buying wasn’t sustainable, and soon petered out.  That was exacerbated by both the market summer and the shocking resumption of the stock-market levitation back up to new record highs.

All throughout the markets there is a big summer lull as traders’ attention naturally shifts to vacations and leisure.  Kids are out of school, the sun is warm and welcoming, so the majority of traders including big fund managers leisurely drift through summer.  They loosely watch the markets, but don’t often make major allocation decisions unless forced to.  That’s one reason gold has always languished in summer doldrums.

On top of that, the US stock markets surged to new record highs again soon after that pro-Brexit vote that was long-prophesied to spell doom.  Gold topped on July 8th, and the very next trading day the S&P 500 edged up to its first new record high in 13.7 months.  The failing stock bull was suddenly alive and well again despite the feared Brexit coming to pass.  The day after that GLD suffered a major 1.6% draw.

Over two weeks in mid-July, the S&P 500 climbed to new all-time highs in 7 out of 10 trading days!  That kind of thing breeds epic complacency, rekindling the stocks-can-rally-forever myth of recent years fed by extreme central-bank easings and jawboning.  So with stocks back in vogue in a major way, the allure of counter-moving gold for portfolio diversification evaporated.  Just like it had during the past couple years.

Now I fully expect this love-stocks-hate-gold trend to reverse again just like it did back in January.  But we first need to see the stock markets sell off for long enough to worry investors that their trend is once again lower.  The sharp S&P 500 drops over this past week are a great start, but odds are we’ll need to see a couple weeks of lower stock markets before investors start actively diversifying portfolios into gold again.

They remain radically underinvested.  GLD is the best proxy by far for stock-market capital invested in gold.  Back in late August, its total physical gold-bullion holdings held in trust for its shareholders were worth $40.3b.  Meanwhile the collective market capitalization of all 500 elite S&P 500 stocks was way up at $20,063.4b.  So gold investment represented just 0.2% of stock investors’ portfolios by this particular metric!

That’s absurdly low, practically nonexistent.  For millennia, the world’s smartest and most-successful investors have advocated having at least 5% of every portfolio invested in gold.  And while that bare-minimum goal is likely far too lofty for American stock investors brainwashed into believing gold has no use in the modern world economy, their gold holdings are still very low even by their own recent standards.

The last normal years before this latest artificial stock-market levitation driven by the Fed’s open-ended QE3 campaign ran from 2009 to 2012.  During that span, the ratio of the value of GLD’s holdings relative to the total market cap of all S&P 500 components averaged 0.475%.  So American stock investors are woefully underinvested in gold today even by their own pathetic precedent, running at just 3/7ths normal levels.

This ongoing radical gold underinvestment despite this year’s huge GLD holdings build is glaringly obvious in this chart.  It divides the total value of GLD’s holdings by the collective market capitalization of the S&P 500, or SPX.  American stock investors’ investment-capital inflows into gold are only beginning, with the lion’s share yet to come when this artificially-extended stock bull inevitably rolls over into a new bear.

In late August, American stock investors had only 0.198% of their portfolios allocated to gold per this GLD/SPX ratio!  That’s really low relative to their own precedent after GLD’s early-adoption years, which averaged 2.4x higher in that post-panic pre-QE3 normal-year span between 2009 to 2012.  So they have vast GLD buying still left to do even from here merely to mean revert and normalize their gold exposure. 

This young gold bull’s overwhelmingly-dominant driver, heavy differential GLD-share demand from large American stock investors, is far from over.  Once normal stock-market cycles driven by valuations again overpower central banks’ false assertion that they’ve been eradicated, gold investment demand will come roaring back.  And that will ignite and fuel gold’s next major upleg, likely again led by GLD inflows.

While GLD isn’t the whole story of gold’s young new bull, it’s certainly the vast majority.  The remainder has been driven by gold-futures trading by American speculators.  As I warned back in mid-July, these guys added new long-side bets so aggressively last summer that they soared to all-time records.  That made for a record gold-futures selling overhang that has really dogged gold in recent months, truncating any rallies.

With speculators’ hyper-leveraged gold-futures longs remaining at near-record levels ever since then, this elite group of traders hasn’t had sufficient dry powder to bid gold higher.  This too has contributed to the stalling gold prices in recent months.  But digging into what’s going on in gold futures in depth would require another whole essay.  While important, the gold-futures developments take a back seat to GLD buying.

Gold stalled out in this third quarter because large American stock investors halted their diversification into gold via GLD shares.  The miraculous resurgence of the long-in-the-tooth stock bull to a streak of new records this summer despite the Brexit vote’s success rekindled recent years’ love affair with stocks.  But when these lofty overvalued stock markets unavoidably roll over, gold investment demand will soar again.

Investors can certainly play gold’s coming next upleg with GLD shares or physical gold coins.  Gold is essential for all portfolios, as its tendency to move counter to stock markets provides a critical hedge for the rest of portfolios.  But once that foundation is in place, gold’s gains will be dwarfed by those of the elite gold miners’ stocks.  Their profits greatly leverage rising gold prices, yielding stock-price gains many times gold’s own.

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The bottom line is gold’s young new bull market has stalled because American stock investors ceased aggressively buying GLD shares in the third quarter.  The stunning new stock-market record highs soon after the long-feared Brexit vote this summer shifted attention away from gold back to stocks.  Investment demand for gold wanes when stocks apparently do nothing but rally indefinitely, as recent years proved in spades.

But as these lofty, overvalued, central-bank-goosed stock markets inevitably roll over, American stock investors will once again look to counter-trending gold for prudent portfolio diversification.  It was their heavy differential buying of GLD shares that catapulted gold sharply higher in the first half of 2016, so their return to gold buying will also ignite and fuel gold’s next major upleg.  Get deployed now, before it arrives.

Adam Hamilton, CPA

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