Radical Gold Under Investment / Commodities / Gold and Silver Stocks 2018

Global investors areradically underinvested in gold today. Years of relentless stock-market rallying to endless new record highshave left this classic alternative investment deeply out of favor.  But this gold-demand ebb is ending.  The same central banks that fueled theseextreme stock markets through epic easing are reversing to massive andunprecedented tightening.  As stocks rollover, gold investment will return.

Gold is a unique assetclass established over millennia that should play a critical role in everyinvestment portfolio.  Unlike virtuallyeverything else, gold generally rallies when stock markets inevitably suffertheir periodic major selloffs.  That effectivelymakes gold the anti-stock trade.  A substantial gold allocation is essentialand necessary to diversify and protect stock-heavy portfolios, moderating theiroverall volatility.

But late in major stockbulls after years of rallying on balance, complacent investors mostly forgetabout gold.  If stocks apparently donothing but rally indefinitely, then why bother with counter-moving gold?  Thus their collective gold allocationsgradually slump to unsustainable lows as stock euphoria mounts.  The lack of gold investment demand leaves itlanguishing at relatively-low prices, deeply out of favor like today.

Like nearly everythingelse in the global markets, gold prices are heavily dependent on investment capital flows.  When investors are buying gold in ameaningful way, demand exceeds supply which drives gold’s price higher.  When they’re materially selling, supplytrumps demand thus gold’s price naturally retreats.  This past year or so has been stuck in themiddle, with gold investment flows generally neutral on balance.

The definitive arbiterof global gold supply and demand is the World Gold Council.  It publishes quarterly Gold Demand Trendsreports with the best gold fundamental data available.  As these typically come out 5 to 6 weeksafter quarter-ends, the Q4’17 GDT hasn’t been released as of this writing.  But 2017’s world gold investment demandcurrent to the end of Q3 still reveals the radical underinvestment in goldthese days.

During the first threequarters 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 morethan responsible for the entire 388.1t drop in overall total gold demand inthat span.  Investment demand is furthersplit out into traditional bars and coins and new ETFs.

Physical-bar-and-coindemand actually proved strong in the first 3/4ths of 2017, rising 13.0% or87.1t to 755.3t.  But ETF demand cratered a catastrophic 75.0% or 538.5tYoY!  Due to their ease of trading and trivialcommissions compared to physical gold, ETFs have become the gold vehicle ofchoice for stock investors.  And withstock markets surging extraordinarily on taxphoria last year, gold was largelyshunned.

Gold exchange-tradedfunds act as conduits enabling vast amounts of stock-market capital to sloshinto and out of physical gold bullion.  These big changes in collective buying orselling really move gold.  Since the goldETFs seek to mirror the underlying gold price, they have to shunt excessETF-share supply or demand directly into actual gold bars.  There’s no other way for gold ETFs tosuccessfully track their metal.

The world’s leading anddominant gold ETF is the venerable American GLD SPDR Gold Shares.  Every quarter the World Gold Council also ranksthe world’s top-ten gold ETFs.  At theend of Q3, GLD alone accounted for a whopping 36.9% of their total gold-bullionholdings!  GLD was 3.8x larger than its next biggest competitor, which is the AmericanIAU iShares Gold Trust.  GLD is thebehemoth of the gold-ETF world.

The supply and demandof GLD shares, and all gold ETFs, are totallyindependent from underlying gold’s own supply and demand.  So when stock investors buy GLD shares fasterthan gold is being bought, the GLD share price starts decoupling from gold tothe upside.  That is unacceptable, as GLDwould fail its mission to track gold.  SoGLD’s managers must vent this differential buying pressure directly into gold.

They do this by issuingsufficient new GLD shares to meet the excess demand.  All the money raised by these GLD-share salesis then plowed into physical gold bars that very day.  This mechanism enables stock-market capitalto flow into physical gold.  Of coursethis is a double-edged sword, as excess GLD-share selling pressure forces thisETF to sell real gold bars to raise the capital to buy back its shareoversupply.

What American stockinvestors are doing with GLD shares isthe primary driver of gold’s trends! GLD has grown massive since its launch back in November 2004, and actsas a direct pipeline into gold for the vast pools of stock-market capital.  Nothing is more important for gold prices nowthan GLD inflows and outflows.  These arevery transparent, as GLD reports its physical-gold-bullion holdings daily ingreat detail.

I call stock-marketcapital 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 anddraws alone accounted for the entire global change in gold demand!  Rather incredibly, GLD has grown into themonster tail that wags the global-gold-price dog.  American stock investors dominate gold’sfortunes.

Amazingly many if notmost investors still don’t grasp GLD’s critical role in gold price trends.  They attempt to understand today’s gold’sprice action in historical pre-gold-ETF-era terms.  But for better or for worse, the gold worldis radically different now.  GLD, and toa lesser extent the other large gold ETFs trading in foreign stock markets,changed everything.  Gold investorsignoring GLD’s holdings are flying blind.

This chart drives homethis critical point.  It superimposesGLD’s daily physical-gold-bullion holdings in blue over the gold price inred.  Carved into calendar quarters,gold’s performance in each one is noted above GLD’s quarterly holdings changesin both percentage and absolute terms. The correlation between GLD’s physical-gold-bullion holdings and goldprices is very strong.  GLD capital flows explain much for gold.

Rising GLD holdingsreveal stock-market capital is flowing into gold bullion via GLD, due todifferential GLD-share demand. Conversely falling GLD holdings show stock-market capital coming backout of gold, thanks to differential GLD-share selling.  When American stock investors are eitherbuying or selling GLD shares at much-faster rates than gold is moving, theircollective capital flows greatly impactits price.

This is readily evidentin strategic and tactical terms.  GLD’sholdings are highly correlated with gold price levels.  American stock investors sold down GLD’sholdings in 2015, and gold fell in lockstep. But that all reversed sharply in early 2016, when stock investorsflooded back into GLD which catapulted gold intoa new bull.  Gold kept surging aslong as differential GLD-share demand persisted, then stalled when it abated.

After Trump’s surpriseelection win in November 2016, stock investors dumped GLD shares at dizzyingrates and gold plunged.  Then GLD’sholdings stabilized and largely drifted sideways on balance in 2017, so golddid too.  GLD capital flows and goldprices are joined at the hip.  WhatAmerican stock investors are collectively doing and likely to do with GLDshares is critical for gaming where gold is likely heading next.

Thus the key questionfor gold investors today is what motivates stock investors to buy or sell GLDshares en masse?  The answer is simple, stock-market fortunes.  Gold is effectively the anti-stock tradesince it tends to move counter to stock markets.  So gold investment demand via GLD sharessurges as stock markets suffer major selloffs, and withers when stock marketsrally to lofty euphoria-generating heights.

The entire reason goldinvestment demand has stalled out over the past year, which left gold drifting,is the extreme euphoria in US stockmarkets.  Wall Street constantly claimsthere’s no euphoria, but that’s not true. The words “euphoria” and “mania” are often confused.  Mania means “an excessively intenseenthusiasm, interest, or desire”.  In thestock markets, manias are associated with bubbles at bull-market tops.

Euphoria is a milderterm meaning “a strong feeling of happiness, confidence, or well-being”.  There’s no doubt investors have been euphoricon hopes for big tax cuts soon since Trump won the election.  And since those Republican corporate tax cutsactually 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&P500 broad-market stock index is starting 2018 with its elite component stockstrading literally at bubble valuations.  The simple-average trailing-twelve-monthprice-to-earnings ratio of these 500 stocks was running 31.8x at the end of January!  That’s above the 28x historical bubblethreshold, or double the 14x fair value over the past century and aquarter.  These stock markets aredangerously expensive.

Despite that fear of missing out fueled extremecapital inflows in the opening weeks of 2018 as investors rushed to buy stockshigh.  In this year’s first 18 tradingdays, the S&P 500 rocketed 7.5% higher which annualizes to an absurd 104%pace of gains!  That stretched thisleading stock index as much as 14.0% above its 200-day moving average, makingfor some of the most-overbought conditions ever witnessed.

Sentiment indicatorswere universally crazy in January too, revealing the most-extreme herdbullishness, optimism, and greed seen since soonbefore huge past selloffs.  Thoseincluded late 2007 leading into a 56.8% S&P 500 bear market, early 2000ahead of the previous 49.1% S&P 500 bear, and even 1987 prior to October’sinfamous Black Monday crash where the S&P 500 plummeted 20.5% in a singletrading day!

With virtually everyonetotally convinced these euphoric, bubble stock markets can keep surgingforever, it’s no surprise gold has fallen out of favor.  Investors are so caught up in thisirrationally-exuberant late-bull psychology that they don’t perceive anymeaningful downside risk.  So there’slittle motivation to prudently diversify stock-heavy portfolios at all, letalone with gold.  That’s driven radical underinvestment in it.

This is actuallymeasurable to some extent using GLD’s physical-gold-bullion holdings held intrust for its shareholders.  SinceAmerican stock investors’ gold capital flows via GLD shares often dominategold’s fortunes, the value of its holdings approximatesoverall gold investment.  Looking atthe ratio of that to the total market capitalization of all the S&P 500companies reveals rough gold investment levels over time.

This ratio between theamount of capital invested in GLD and the total value of the S&P 500 isrendered below in red.  That’ssuperimposed over GLD’s total gold holdings in metric tons in blue.  Once this ETF ramped up past its initialearly-adoption years, this metric revealed relative baseline gold investmentlevels for American stock investors.  Andgold 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 beenextremely low throughout the entire taxphoria rally since Trump’s victory.  The amount of capital invested in GLD shareshas 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 portfolioallocation of a trivial 1/7th of one percent.

The last quasi-normalyears in the markets came between 2009 to 2012. That was sandwiched between the first stock panic in a century and theFed’s extreme open-ended money printing in QE3 that wildly distorted themarkets ever since.  During that span,gold investment was much higher.  Thecapital invested in GLD shares averaged 0.475% of the collective market cap ofthe S&P 500, nearly half of one percent.

That implies Americanstock investors’ gold portfolio allocations are well under a third of normal levels by recent standards!  They would have to soar 3.4x merely to meanrevert, not even overshoot which is very likely after such anomalous lows.  While getting back near a 0.5% goldallocation would require massive capital inflows into GLD for years catapultinggold prices far higher, that level of gold investment remains conservative.

For centuries most ofthe world’s smartest and most-successful investors have recommended portfoliogold allocations of at least 5% to 10%for every investor.  One recentexample came from Ray Dalio, the universally-respected founder of the world’slargest hedge fund Bridgewater Associates. With his $17b net worth, when Dalio talks Wall Street listens.  Back in August he wrote an essay echoing thisclassic advice today.

Dalio was warning aboutthe serious downside risks in these lofty stock markets.  On gold he said, “We can also say that if theabove things go badly, it would seem that gold (more than other safe havenassets like the dollar, yen and treasuries) would benefit, so if you don’t have5-10% of your assets in gold as a hedge, we’d suggest you relook at this.”  That wasn’t just idle talk, as Bridgewater’s Q3’17investing proved.

Funds have to reporttheir holdings to the SEC in quarterly 13F reports.  Bridgewater was buying GLD shares hand overfist as Ray Dalio advised building 5%-to-10% portfolio gold allocations.  In Q3 alone its GLD holdings skyrocketed astaggering 575% quarter-on-quarter to 3.9m shares!  Bridgewater’s $474m in GLD shares was itsfourth-largest position, making this hedge fund the eighth-largest GLDshareholder.

As these insane maniastock markets inevitably roll over into their long-overdue bear, otherinvestors will follow Dalio’s lead.  Thelast time the stock markets corrected, fell more than 10%, was early 2016.  Thatfollowed an extraordinary 3.6-year correction-less span thanks to extreme Fedquantitative easing, one of the longest on record.  So gold was languishing near a deep 6.1-yearsecular low before stock markets fell.

The S&P 500 merelydropped 13.3% over 3.3 months leading into early 2016, relatively minor as faras major corrections go.  Yet goldinvestment demand turned on a dime as volatility returning awoke stockinvestors from their complacent slumber. As the first chart showed, in Q4’15 gold fell 4.9% on a 6.6% or 45.1t GLDdraw.  With stock markets very high andeuphoric, investors wanted nothing to do with gold.

Yet in Q1’16 after thatmodest stock-market correction, gold surged 16.1% higher on a gigantic 27.5% or176.9t GLD build!  Once investorsrealized stock markets could fall too, they rushed to diversify a little oftheir capital into gold.  Provocativelythat GLD build alone accounted for 95.2% of the total jump in world gold demandper the latest WGC data!  Gold wascatapulted into a new bull market on amere stock correction.

That big goldinvestment buying continued in Q2’16, where gold rallied another 7.4% onanother 16.0% or 130.8t GLD build.  Theonly reason this trend stalled in Q3’16 was the S&P 500 surged back to itsfirst new record highs in 13.7 months. The catalyst was hopes for morecentral-bank easing following that UK vote where the British people decidedto leave the European Union.  Recordstock markets kill gold demand.

It’s going to explodeagain like in early 2016 the next time these euphoric bubble-valued stockmarkets sell off materially.  Given theextreme fundamentals, technicals, and sentiment rampant today, it’s hard toimagine the overdue and coming major selloff not at least testing the upperlimits of corrections.  That’s a selloffapproaching 20%, probably the best-case scenario for the bulls.  Anything beyond 20% is a new bear.

Unfortunately thatnew-bear scenario is far more likely.  As of late January this S&P 500 bull hassoared an extreme 324.6% in 8.9 years, making for the third-largest andsecond-longest stock bull in all of US history! Much of those gains were fueled by epic central-bank easing far beyondanything ever before seen in world history. This year both the Federal Reserve and European Central Bank areslamming on the brakes.

The Fed just startedits first-ever quantitative-tighteningcampaign in Q4’17 to unwind years and trillions of dollars of quantitativeeasing.  QT is going to gradually ramp upin 2018 to a powerful $50b-per-month pacestarting in Q4 this year.  Per the Fed’sschedule, it will effectively destroy $420b of capital in 2018 by lettingQE-purchased bonds roll off its balance sheet. Nothing remotely close has ever happened before!

On top of that the ECBjust slashed in half its own QEcampaign in January to a €30b monthly pace, with a targeted QE end date ofSeptember.  That means ECB QE willcollapse from €720b in 2017 to just €270b in 2018, a radical 5/8thsplunge.  Between the Fed’s QT and ECB’sQE tapering, there will be the equivalent of $950b more tightening and lesseasing in 2018 compared to 2017!  That’sgoing to leave a mark.

The Fed and ECB willliterally strangle this stockbull 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 to2017.  So these stock markets are in realtrouble with central-bank liquidity being pulled regardless of their extremeovervaluations and overboughtness.  2018sure ain’t gonna look like 2017 at all!

Bear markets ultimatelytend to cut stock prices in half, literal 50% losses in the SPX.  The last couple bears thatstarted in March 2000 and October 2007 saw the SPX drop 49.1% in 2.6 years and56.8% in 1.4 years!  Bear markets areexceedingly dangerous and not to be trifled with.  They also tend to grow in size in proportionto their preceding bulls, so the next bear should be bigger than usual aftersuch a massive bull.

When stock marketsstart materially weakening, investors return to gold.  Gold is theultimate portfolio diversifier because it tends to move counter to stockmarkets.  Gold is forgotten when stockmarkets are high and euphoria and complacency abound.  But once major selloffs inevitably followmajor rallies, gold demand explodes as investors rush to diversify theirstock-heavy portfolios.  Gold iseffectively the anti-stock trade.

Given the radical goldunderinvestment following this extreme stock bull, investors will likely haveto do big gold buying for years to reestablish normal portfolioallocations.  That will continue to fuelthis young gold bull born in late 2015 in the last stock-market correction.  At best gold was only up 29.9% so far as ofmid-2016, nothing yet.  The last goldbull powered 638.2% higher over 10.4 years ending August 2011!

While investors canride 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 by2x 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 asgold mean reverts higher, dwarfing everything else in all the stockmarkets.  Fortunes will be won.

At Zeal we’ve literally spent tens of thousands of hours researchingindividual gold stocks and markets, so we can better decide what to trade andwhen.  As of the end of Q4, this hasresulted in 983 stock trades recommended in real-time to our newslettersubscribers since 2001.  Fighting thecrowd to buy low and sell high is very profitable, as all these trades averagedstellar annualized realized gains of +20.2%!

The key to this success is staying informed and beingcontrarian.  That means buying low beforeothers figure it out, before undervalued gold stocks soar much higher.  An easy way to keep abreast is through ouracclaimed weekly and monthly newsletters.  They draw on my vast experience, knowledge,wisdom, and ongoing research to explain what’s going on in the markets, why,and how to trade them with specific stocks. For only $12 per issue, you can learn to think, trade, and thrive likecontrarians.  Subscribe today, and getdeployed in the great gold and silver stocks in our full trading books!

The bottom line isglobal investors are radically underinvested in gold today.  Years of relentless stock-market rallying toendless new record highs has left prudent portfolio diversification withcounter-moving gold deeply out of favor. But the same central banks that fueled this extraordinary stock bull arenow reversing to massive and unprecedented tightening this year, which willinevitably force stock markets to roll over.

As stocks sell off inwhat is almost certain to become the long-overdue next major bear, goldinvestment demand will make a glorious renaissance.  Investors will flock back to gold tostabilize their bleeding stock-heavy portfolios, catapulting its price muchhigher.  It will likely take years ofgold investment buying to restore overall gold portfolio allocations to reasonablehistoric norms.  That’s super-bullish forgold!

Adam Hamilton, CPA

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