Adam Hamilton: Radical Gold Underinvestment
Global investors are radically underinvested in gold today. Years of relentless stock-market rallying to endless new record highs have left this classic alternative investment deeply out of favor. But this gold-demand ebb is ending. The same central banks that fueled these extreme stock markets through epic easing are reversing to massive and unprecedented tightening. As stocks roll over, gold investment will return.
Gold is a unique asset class established over millennia that should play a critical role in every investment portfolio. Unlike virtually everything else, gold generally rallies when stock markets inevitably suffer their periodic major selloffs. That effectively makes gold the anti-stock trade. A substantial gold allocation is essential and necessary to diversify and protect stock-heavy portfolios, moderating their overall volatility.
But late in major stock bulls after years of rallying on balance, complacent investors mostly forget about gold. If stocks apparently do nothing but rally indefinitely, then why bother with counter-moving gold? Thus their collective gold allocations gradually slump to unsustainable lows as stock euphoria mounts. The lack of gold investment demand leaves it languishing at relatively-low prices, deeply out of favor like today.
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. This past year or so has been stuck in the middle, with gold investment flows generally neutral on balance.
The definitive arbiter of global gold supply and demand is the World Gold Council. It publishes quarterly Gold Demand Trends reports with the best gold fundamental data available. As these typically come out 5 to 6 weeks after quarter-ends, the Q4'17 GDT hasn't been released as of this writing. But 2017's world gold investment demand current to the end of Q3 still reveals the radical underinvestment in gold these days.
During the first three quarters of 2017, global gold investment demand ran 935.0 metric tons. That was down sharply year-over-year, collapsing 32.6% or 451.4t from the comparable 9 months of 2016! This plunging gold investment demand was more than responsible for the entire 388.1t drop in overall total gold demand in that span. Investment demand is further split out into traditional bars and coins and new ETFs.
Physical-bar-and-coin demand actually proved strong in the first 3/4ths of 2017, rising 13.0% or 87.1t to 755.3t. But ETF demand cratered a catastrophic 75.0% or 538.5t YoY! Due to their ease of trading and trivial commissions compared to physical gold, ETFs have become the gold vehicle of choice for stock investors. And with stock markets surging extraordinarily on taxphoria last year, gold was largely shunned.
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 back in November 2004, and acts as a direct pipeline into gold for the vast pools of stock-market capital. 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 alone accounted for the entire global change in gold demand! Rather incredibly, GLD has grown into the monster tail that wags the global-gold-price dog. American stock investors dominate gold's fortunes.
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 in November 2016, stock investors dumped GLD shares at dizzying rates and gold plunged. Then GLD's holdings stabilized and largely drifted sideways on balance in 2017, so gold did too. GLD capital flows and gold prices are joined at the hip. What American stock investors are collectively doing and likely to do with GLD shares is critical for gaming where gold is likely heading next.
Thus the key question for gold investors today is what motivates 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 heights.
The entire reason gold investment demand has stalled out over the past year, which 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". There's no doubt investors have been euphoric on hopes for big tax cuts soon since Trump won the election. And since those Republican corporate tax cuts actually became law in late December, stock markets have arguably entered the mania phase. This is readily evident on fundamental, technical, and sentimental fronts.
The flagship S&P 500 broad-market stock index is starting 2018 with its elite component stocks trading literally at bubble valuations. The simple-average trailing-twelve-month price-to-earnings ratio of these 500 stocks was running 31.8x at the end of January! That's above the 28x historical bubble threshold, or double the 14x fair value over the past century and a quarter. These stock markets are dangerously expensive.
Despite that fear of missing out fueled extreme capital inflows in the opening weeks of 2018 as investors rushed to buy stocks high. In this year's first 18 trading days, the S&P 500 rocketed 7.5% higher which annualizes to an absurd 104% pace of gains! That stretched this leading stock index as much as 14.0% above its 200-day moving average, making for some of the most-overbought conditions ever witnessed.
Sentiment indicators were universally crazy in January too, revealing the most-extreme herd bullishness, optimism, and greed seen since soon before huge past selloffs. Those included late 2007 leading into a 56.8% S&P 500 bear market, early 2000 ahead of the previous 49.1% S&P 500 bear, and even 1987 prior to October's infamous Black Monday crash where the S&P 500 plummeted 20.5% in a single trading day!
With virtually everyone totally convinced these euphoric, bubble stock markets can keep surging forever, it's no surprise gold has fallen out of favor. Investors are so caught up in this irrationally-exuberant late-bull psychology that they don't perceive any meaningful downside risk. So there's little motivation to prudently diversify stock-heavy portfolios at all, let alone with gold. That's driven radical underinvestment in it.
This is actually measurable to some extent using GLD's physical-gold-bullion holdings held in trust for its shareholders. Since American stock investors' gold capital flows via GLD shares often dominate gold's fortunes, the value of its holdings approximates overall gold investment. Looking at the ratio of that to the total market capitalization of all the S&P 500 companies reveals rough gold investment levels over time.
This ratio between the amount of capital invested in GLD and the total value of the S&P 500 is rendered below in red. That's superimposed over GLD's total gold holdings in metric tons in blue. Once this ETF ramped up past its initial early-adoption years, this metric revealed relative baseline gold investment levels for American stock investors. And gold investment has been very low during the recent taxphoria surge.
American stock investors' gold portfolio allocations as measured by this GLD/SPX value ratio have been extremely low throughout the entire taxphoria rally since Trump's victory. The amount of capital invested in GLD shares has been running around just 0.14% the amount invested in S&P 500 companies! Gold really can't get much more out of favor than an implied portfolio allocation of a trivial 1/7th of one percent.
The last quasi-normal years in the markets came between 2009 to 2012. That was sandwiched between the first stock panic in a century and the Fed's extreme open-ended money printing in QE3 that wildly distorted the markets ever since. During that span, gold investment was much higher. The capital invested in GLD shares averaged 0.475% of the collective market cap of the S&P 500, nearly half of one percent.
That implies American stock investors' gold portfolio allocations are well under a third of normal levels by recent standards! They would have to soar 3.4x merely to mean revert, not even overshoot which is very likely after such anomalous lows. While getting back near a 0.5% gold allocation would require massive capital inflows into GLD for years catapulting gold prices far higher, that level of gold investment remains conservative.
For centuries most of the world's smartest and most-successful investors have recommended portfolio gold allocations of at least 5% to 10% for every investor. One recent example came from Ray Dalio, the universally-respected founder of the world's largest hedge fund Bridgewater Associates. With his $17b net worth, when Dalio talks Wall Street listens. Back in August he wrote an essay echoing this classic advice today.
Dalio was warning about the serious downside risks in these lofty stock markets. On gold he said, "We can also say that if the above things go badly, it would seem that gold (more than other safe haven assets like the dollar, yen and treasuries) would benefit, so if you don't have 5-10% of your assets in gold as a hedge, we'd suggest you relook at this." That wasn't just idle talk, as Bridgewater's Q3'17 investing proved.
Funds have to report their holdings to the SEC in quarterly 13F reports. Bridgewater was buying GLD shares hand over fist as Ray Dalio advised building 5%-to-10% portfolio gold allocations. In Q3 alone its GLD holdings skyrocketed a staggering 575% quarter-on-quarter to 3.9m shares! Bridgewater's $474m in GLD shares was its fourth-largest position, making this hedge fund the eighth-largest GLD shareholder.
As these insane mania stock markets inevitably roll over into their long-overdue bear, other investors will follow Dalio's lead. The last time the stock markets corrected, fell more than 10%, was early 2016. That followed an extraordinary 3.6-year correction-less span thanks to extreme Fed quantitative easing, one of the longest on record. So gold was languishing near a deep 6.1-year secular low before stock markets fell.
The S&P 500 merely dropped 13.3% over 3.3 months leading into early 2016, relatively minor as far as major corrections go. Yet gold investment demand turned on a dime as volatility returning awoke stock investors from their complacent slumber. As the first chart showed, in Q4'15 gold fell 4.9% on a 6.6% or 45.1t GLD draw. With stock markets very high and euphoric, investors wanted nothing to do with gold.
Yet in Q1'16 after that modest stock-market correction, gold surged 16.1% higher on a gigantic 27.5% or 176.9t GLD build! Once investors realized stock markets could fall too, they rushed to diversify a little of their capital into gold. Provocatively that GLD build alone accounted for 95.2% of the total jump in world gold demand per the latest WGC data! Gold was catapulted into a new bull market on a mere stock correction.
That big gold investment buying continued in Q2'16, where gold rallied another 7.4% on another 16.0% or 130.8t GLD build. The only reason this trend stalled in Q3'16 was the S&P 500 surged back to its first new record highs in 13.7 months. The catalyst was hopes for more central-bank easing following that UK vote where the British people decided to leave the European Union. Record stock markets kill gold demand.
It's going to explode again like in early 2016 the next time these euphoric bubble-valued stock markets sell off materially. Given the extreme fundamentals, technicals, and sentiment rampant today, it's hard to imagine the overdue and coming major selloff not at least testing the upper limits of corrections. That's a selloff approaching 20%, probably the best-case scenario for the bulls. Anything beyond 20% is a new bear.
Unfortunately that new-bear scenario is far more likely. As of late January this S&P 500 bull has soared an extreme 324.6% in 8.9 years, making for the third-largest and second-longest stock bull in all of US history! Much of those gains were fueled by epic central-bank easing far beyond anything ever before seen in world history. This year both the Federal Reserve and European Central Bank are slamming on the brakes.
The Fed just started its first-ever quantitative-tightening campaign in Q4'17 to unwind years and trillions of dollars of quantitative easing. QT is going to gradually ramp up in 2018 to a powerful $50b-per-month pace starting in Q4 this year. Per the Fed's schedule, it will effectively destroy $420b of capital in 2018 by letting QE-purchased bonds roll off its balance sheet. Nothing remotely close has ever happened before!
On top of that the ECB just slashed in half its own QE campaign in January to a ?,?30b monthly pace, with a targeted QE end date of September. That means ECB QE will collapse from ?,?720b in 2017 to just ?,?270b in 2018, a radical 5/8ths plunge. Between the Fed's QT and ECB's QE tapering, there will be the equivalent of $950b more tightening and less easing in 2018 compared to 2017! That's going to leave a mark.
The Fed and ECB will literally strangle this stock bull by unwinding and slowing the QE that grew it. And this isn't just a 2018 thing. In 2019 the Fed and ECB are on track to have another $1450b of tightening compared to 2017. So these stock markets are in real trouble with central-bank liquidity being pulled regardless of their extreme overvaluations and overboughtness. 2018 sure ain't gonna look like 2017 at all!
Bear markets ultimately tend to cut stock prices in half, literal 50% losses in the SPX. The last couple bears that started in March 2000 and October 2007 saw the SPX drop 49.1% in 2.6 years and 56.8% in 1.4 years! Bear markets are exceedingly dangerous and not to be trifled with. They also tend to grow in size in proportion to their preceding bulls, so the next bear should be bigger than usual after such a massive bull.
When stock markets start materially weakening, investors return to gold. Gold is the ultimate portfolio diversifier because it tends to move counter to stock markets. Gold is forgotten when stock markets are high and euphoria and complacency abound. But once major selloffs inevitably follow major rallies, gold demand explodes as investors rush to diversify their stock-heavy portfolios. Gold is effectively the anti-stock trade.
Given the radical gold underinvestment following this extreme stock bull, investors will likely have to do big gold buying for years to reestablish normal portfolio allocations. That will continue to fuel this young gold bull born in late 2015 in the last stock-market correction. At best gold was only up 29.9% so far as of mid-2016, nothing yet. The last gold bull powered 638.2% higher over 10.4 years ending August 2011!
While investors can ride the coming gold bull in GLD shares, far better gains will be won in the stocks of its leading miners. They tend to amplify underlying gold gains by 2x to 3x due to their profits leverage to gold. With gold so out of favor, the gold stocks are deeply undervalued today. That gives them huge upside as gold mean reverts higher, dwarfing everything else in all the stock markets. Fortunes will be won.
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The bottom line is global investors are radically underinvested in gold today. Years of relentless stock-market rallying to endless new record highs has left prudent portfolio diversification with counter-moving gold deeply out of favor. But the same central banks that fueled this extraordinary stock bull are now reversing to massive and unprecedented tightening this year, which will inevitably force stock markets to roll over.
As stocks sell off in what is almost certain to become the long-overdue next major bear, gold investment demand will make a glorious renaissance. Investors will flock back to gold to stabilize their bleeding stock-heavy portfolios, catapulting its price much higher. It will likely take years of gold investment buying to restore overall gold portfolio allocations to reasonable historic norms. That's super-bullish for gold!
Adam Hamilton, CPA
February 2, 2018
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