Gold-ETF Inflows Return

Stock-market capital finally started flowing back into the flagship GLD gold ETF for the first time in 14 months in February!  Though this buying was small, this is truly a momentous event.  Extreme gold-ETF outflows were the dominant culprit behind last year’s epic gold selloff.  Without that massive influx of additional supply weighing on the global markets, gold is going to surge on strong physical demand.

The World Gold Council’s latest Gold Demand Trends report published just a couple weeks ago really drives home the importance of gold-ETF selling.  In 2013 they suffered their first net annual outflows ever seen since the first one was launched in 2003.  As today’s secular gold bull is the first time these gold ETFs ever even existed, the gold market has literally never experienced anything like last year.

The WGC’s comprehensive supply-and-demand data, which is the best in the world, showed that gold-ETF outflows added a staggering 880.8 metric tons of gold supply last year!  This was larger than the combined 678.5t physical demand increase from jewelry and bar-and-coin investment, so the gold price fell.  Jewelry and bar-and-coin demand actually surged 16.5% and 28.3% last year, very strong growth!

But thanks to that huge gold-ETF supply, overall global gold demand fell 14.9% last year or 659.7t.  Thus gold plummeted 27.9% to its worst annual performance in nearly a third of a century.  And GLD bears the brunt of the blame due to its dominant size among gold ETFs.  It saw a shocking 552.6t of outflows in 2013, a whopping 63% of total global gold-ETF outflows and 84% of the overall drop in global demand!

If American stock traders hadn’t fled GLD shares last year in a wildly unprecedented mass exodus on a colossal scale, global gold demand wouldn’t have slumped.  And if gold prices had behaved normally in 2013, the selling from the rest of the world’s gold ETFs wouldn’t have happened.  And neither would the resulting heavy selling in the global futures markets.  GLD dug gold’s hole, and GLD will claw it back out.

So February’s shift to capital flowing back into GLD is supremely important, likely the vanguard of a major reversal.  GLD is a tracking ETF, designed to mirror the gold price.  So when American stock traders buy or sell GLD shares faster than gold itself is being bought or sold, this ETF will decouple from the gold price and fail its mission.  The only solution to this problem is to equalize GLD-share supply and demand into gold.

So like all tracking ETFs, GLD acts as a conduit for stock-market capital to flow into and out of physical gold bullion.  When stock traders are bidding up GLD shares faster than gold, GLD threatens to break away to the upside.  So GLD’s custodians have to neutralize this differential GLD-share demand by adding more supply.  So they issue new GLD shares and sell them, absorbing the excess demand.

They use the resulting cash to buy more physical gold bullion, growing GLD’s hoard.  So whenever GLD’s holdings are growing, stock-market capital is literally flowing into gold through this ETF.  This naturally boosts the global gold price, since more demand is being shunted into the gold markets.  And its holdings relentlessly growing on balance was the story of this ETF before last year’s extreme anomaly.

ETF capital conduits between markets are a double-edged sword, amplifying the underlying asset’s downside as well as upside.  When stock traders sell GLD shares faster than gold, this ETF is going to decouple to the downside.  So its custodians quickly step in to sop up this excess share supply.  They buy back GLD shares to maintain tracking, and the cash to do this comes from selling some of the ETF’s gold bullion.

So when GLD’s holdings are falling, stock-market capital is actually moving out of physical gold bullion.  And as investors and speculators learned last year, this can happen on a massive-enough scale to overwhelm even large physical demand increases.  Differential GLD-share selling pressure crushing the gold price was almost the entire gold story of 2013, which makes February’s buying so significant.

This first chart looks at GLD’s holdings superimposed over the flagship American S&P 500 stock index (SPX) over the past year and a half or so.  Stock traders were dumping GLD at dizzying rates to chase the Fed-driven stock-market levitation.  GLD selling generally slowed dramatically during SPX pullbacks, and surged again when the SPX resumed melting up.  That precedent makes February even more impressive.

Last month, there was enough differential buying pressure on GLD shares to drive a 10.5 metric-ton build in this ETF’s gold-bullion holdings.  These capital flows from stock markets to gold are still small, worth just $441m at February’s $1301 average gold price.  And on this chart, the upturn is barely a blip.  But it was still enough to push gold 6.5% higher, which was this metal’s best month since July 2013.

February 2014 was GLD’s first holdings build in 14 months, since December 2012.  Its 10.5t was the largest absolute holdings build since November 2012, and its 1.3% gain was the best seen since way back in September 2012.  In each of those three months, the gold markets were still normal with prices averaging $1684, $1722, and $1749.  2013’s epic sentiment-cratering slaughter hadn’t happened yet.

10.5t looks trivial on this chart because American stock traders’ gigantic mass exodus from GLD shares sucked an astounding 563.8t of gold out between December 2012 and January 2014.  From its holdings’ all-time record high in December 2012, they plummeted by 41.7% in just over 13 months!  Before that, the biggest draws GLD had ever suffered maxed out at merely 129.1t and 13.0% in two separate events.

So 563.8t and 41.7% is an outlying draw so extreme it defies superlatives.  American stock traders chose to abandon gold (via their GLD positions) because of the amazing stock-market levitation.  Through both its enormous QE3 bond-monetization campaign and parallel jawboning, our central bank worked to convince stock traders that they had nothing to fear.  The Fed would step in to head off any major selloff.

This so-called Fed Put made stocks the only game in town.  Alternative investments like gold lost their luster, and the essential and prudent concept of portfolio diversification was tossed out the window.  The professional money managers no longer worried about losing their customers’ money thanks to the Fed’s effective backstop, they instead started intensely fearing falling behind their peers’ performance.

So they aggressively bought what was rising, general stocks, and dumped what was falling, gold.  This quickly became a vicious circle for gold.  The more it was sold, the farther its price dropped.  And naturally the lower its price went, the more GLD shareholders were scared out of their positions.  So month after month after month, stock capital flowed out of GLD at staggering rates as this chart reveals.

This inverse correlation between the stock markets’ performance and GLD’s holdings is readily apparent.  While there are occasional exceptions driven by specific gold events I’ve discussed in much depth in past essays, for the most part GLD differential selling accelerated when the SPX was melting up.  This is especially true in the second half of 2013, after April’s panic-like gold plunge had passed.

When the stock markets were levitating, GLD-share selling intensified.  The stock traders who held GLD shares were tempted enough by the general-stock gains to rotate capital out of gold into stocks.  And then when the SPX pulled back in one of its periodic minor selloffs, GLD’s holdings would stabilize or even start rising like in August.  The light-red shading above highlights these SPX pullbacks visually.

GLD’s holdings first appeared to be bottoming and reversing in August, thanks to a sharp SPX pullback.  And then after getting dragged even lower by the greedy stock psychology brazenly nurtured by the reckless Fed, they look to have bottomed and reversed again in January as another sharp SPX pullback was getting underway.  Interest in and demand for alternative investments grows when general stocks droop.

Understanding this past year’s strong inverse relationship between SPX performance and GLD-share demand is essential to grasping the significance of February’s GLD build.  Last month’s GLD capital inflows weren’t only the first and biggest since late 2012, they happened in a month where the SPX was exceedingly strong!  It rocketed 4.3% higher, its best month since October when the partial government shutdown ended.

Now after last year’s precedent, you’d think that any differential buying pressure on GLD shares would require a significant stock-market selloff.  Yet stock capital still flowed back into gold bullion via the conduit of this flagship gold ETF despite a big SPX surge to new nominal record highs.  This strongly suggests that the GLD selling is exhausted, that all stock traders who wanted out of gold have already exited.

So what will happen to demand for GLD when the overbought, overextended, overvalued, and euphoric stock markets inevitably roll over?  Odds are it will soar!  Not only has gold always been a safe haven in times of market weakness, it is probably the world’s cheapest asset class after last year’s epic selloff.  So investors and speculators won’t only gain diversification through gold, but large gains as it mean reverts higher.

The World Gold Council’s comprehensive global supply-and-demand data proves that gold would not have plummeted in 2013 without the extreme American selling of GLD.  Depending on how much of that worldwide surge in physical demand the low prices resulting from that GLD mass exodus drove, gold may have even rallied.  But without the enormous and relentless GLD outflows, it certainly would have been far higher.

GLD holding gold down has been quite apparent for the better part of a year now, as the WGC releases its excellent fundamental gold reports quarterly.  I’ve contended since the middle of last year that if the excessive GLD selling merely slows, gold is going to surge.  And as this next chart superimposing gold over GLD’s holdings shows, that is exactly what is happening now.  This is very bullish harbinger.

Back in July and August as GLD’s holdings stabilized, the gold price surged dramatically.  Though American futures short covering played a big role in August’s surge, early July’s gains were from physical demand growth outpacing gold-ETF liquidations.  Gold didn’t resume retreating until American stock traders again aggressively dumped their GLD positions as the SPX yet again resumed levitating.

And once again since mid-December, the gold price has surged as the stock-capital outflows from GLD stopped as evidenced by its stabilizing holdings.  The strong worldwide physical demand has been forcing the gold price higher without the supplies from big gold-ETF selling to offset it.  The stage for this reversal in both gold’s price and GLD’s capital flows was stealthily set in the second half of last year.

Between gold’s January 2013 high before last year’s anomalous selling and its late-June low after the Fed laid out its best-case QE3-tapering timeline, gold plunged 29.1%.  This was mostly driven by the huge 27.4% or 366.4t drop in GLD’s holdings over that same span.  I say mostly because American futures speculators were also selling gold longs and adding gold shorts at incredible rates, augmenting the pressure.

Despite its mid-year rally, gold ended up slumping back down to those lows over the next 6 months or so.  In mid-December when the Fed actually surprised and started its QE3 taper earlier than expected, gold slumped to a new low.  But that was only 0.8% under late June’s, despite the mere threat of the QE3 taper being the catalyst that whipped gold-futures traders into a hysterical bearish frenzy during 2013.

Considering that psychology, a sub-1% gold loss in 6 months was trivial.  Gold effectively held steady at strong support despite continued big GLD selling.  Its holdings dropped another 16.6% or 160.8t over that span.  Remember that before 2013, that would have easily been the biggest GLD draw ever witnessed!  Yet gold still held strong, which means physical demand growth was absorbing these GLD supplies.

If gold could hold its own in last year’s second half despite heavy capital outflows from GLD, how much will it thrive this year if GLD’s holdings don’t slide lower?  We already have the answer in January and February, gold is surging without gold-ETF differential selling.  And what if GLD’s holdings actually continue growing?  Then its custodians would be forced to buy bullion back, amplifying gold’s upside.

GLD experiencing differential buying pressure in 2014, and thus shunting stock capital into gold, is all but a certainty for multiple reasons.  Once the stock markets inevitably roll over, alternative investments and prudent portfolio diversification will gradually return to favor.  Gold will no longer be spurned, but increasingly bought.  And as the SPX melt-up perfectly illustrated, nothing begets buying like higher prices.

The more gold recovers, the higher its price gets, the more attractive it will become to stock investors and speculators.  As they return to gold via GLD, and buy GLD shares faster than gold is being bought, the gold rally will accelerate.  GLD’s custodians will of course need to supply additional shares to meet this excess demand, and they will then plow the resulting capital raised back into underlying gold bullion.

But provocatively, GLD might not have an easy time buying back gold bullion!  This massive ETF can’t buy just any gold, it can only own the world-standard London Good Delivery bars.  These LGD bars averaging 400 ounces are essential for a large-scale gold-tracking ETF because they can be easily and quickly bought and sold.  ETF custodians have to act fast to equalize differential pressure on GLD shares.

The World Gold Council just reported that most of the LGD bars spewed out by gold ETFs last year no longer exist!  They were actually melted down and transformed into tiny bars and jewelry that was purchased by Asian consumers.  So we may actually experience an LGD-bar shortage this year if enough differential buying pressure is placed on GLD shares by Americans!  That will really ramp up gold prices.

February’s modest GLD build and apparent reversal of its unbelievably extreme 2013 liquidation is truly a watershed event for the gold market.  Even if GLD’s holdings merely stabilized, gold would head much higher on strong global physical demand.  But if American stock capital actually continues flowing back into GLD, and likely accelerates due to the seductive psychology of rising prices, gold is going to be off to the races.

While gold’s upside performance this year is likely to be excellent to outstanding, it will be dwarfed by the beaten-down gold and silver stocks.  Even the best of these miners’ and explorers’ stocks fell so low in late 2013 that they were trading as if the gold price was a small fraction of current levels.  As gold continues to run higher on stable or growing GLD holdings, these stocks will have to skyrocket to catch up.

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The bottom line is stock capital has started flowing back into gold ETFs for the first time in over a year.  Since global gold-ETF outflows were responsible for much more than the total drop in worldwide gold demand last year, this new reversal is a momentous event.  Without the massive additional gold supplies added by differential gold-ETF selling, gold will power higher on very strong global physical demand.

This is true even if gold-ETF holdings merely stabilize around current decimated levels.  But if stock traders start migrating back into gold in a meaningful way via these tracking vehicles, the gold price is going to soar.  The more differential buying pressure they put on gold-ETF shares, the more physical gold bullion these ETFs’ custodians will have to buy.  This self-feeding process will amplify gold’s recovery upleg.

Adam Hamilton, CPA

March 7, 2014

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