"People are looking at the stock market, and they're stunned, and there's no inflation. So people are saying, 'What do we need gold for?'" - Donald Selkin, National Securities Corp
It would be an understatement to say that the gold market has struggled as of late. Not only is the price of the yellow metal down roughly 30% from its intraday high set back in September of 2011, but Friday and Monday's two-day decline of -13.7% represented the worst two-day drop since 1980. We have a meaningful allocation to gold (GLD, IAU) in our portfolios, so watching the recent price action has been stressful for us to say the least.
Macro investors and financial media outlets have been in a frenzy trying to explain what exactly is going on in the gold market. As is often the case, it can be difficult to sift through the "noise" to find the "signal". The talking heads (who always have to be saying something) are offering up a variety of potential explanations, some viable and some not. For our part, we have spent hours thinking, discussing and reading in search of logical explanations for Friday and Monday's events. Our goal is not simply to be able to explain the declines, but more importantly to understand what exactly is shifting in the market and be willing to adjust accordingly.
Our take is that six months ago we reached a bullish extreme in gold sentiment based on expectations of more QE. The tide in sentiment then reversed leading to a 6 month slide in gold prices. The slide was punctuated by a dramatic two day sell-off last Friday and this Monday in a wave of technical-related trading by hedge funds and speculators. The green vertical bars in the chart below plot the results of Morgan Stanley's monthly buy-side sentiment survey showing the % of survey respondents who are bullish on gold. As you can see, the reading of 72% last October was the highest it's been in years, and it has since collapsed to 36%, its lowest reading on the chart. Measures of sentiment are classic contrarian indicators as they identify when a particular trade or investment thesis becomes "crowded" in one direction or the other. In other words, when 72% of the market is bullish on gold there is more potential for moods to shift and become negative than there is for even more bullishness. So in hindsight it appears that gold was due for a pullback by virtue of the fact that optimism had reached excessive levels and by the same token looks poised today for a rebound with sentiment at historically low levels.
So what caused this massive sentiment reversal? There is always a catalyst around major shifts in the market's mood towards a particular investment, and in this case the main culprit was clearly the green shoots in the US economy. Despite a weak Q4 GDP print, housing, autos, manufacturing and labor have all been showing signs of improvement on the margin over the past six months. Against the backdrop of low headline inflation this has created a "goldilocks" expectation of steady and accelerating growth leading to a smooth withdrawal of loose Fed monetary policy beginning as early as this year. Gold has simply lost its luster as a hedge against excessive monetary policy and future inflation. Add to the mix a stock market making new highs and it's not that surprising to see gold's "safe haven" status beginning to get traded in by investors for more stock market exposure (SPY, ACWI) which has been the only game in town lately as Donald Selkin pointed out in the opening quote.
While this explains the broader six-month trend, it does not necessarily lead us to any conclusions about the nearer term. After all, the past couple weeks have done nothing but confirm the continuing presence of aggressive global monetary easing. Not only did the Bank of Japan announce its intention to double the size of its balance sheet by the end of next year, but several disappointing data points in the US have defrayed expectations of any near-term withdrawal of Fed stimulus. What weighed on gold prices last week was a combination of investment banks cutting year-end forecasts for the metal (Goldman cut to $1,545 and Deutsche Bank cut to $1,637) and the announcement on Friday that Cyprus's central bank may sell up to $523 million of its excess gold reserves in order to cover losses incurred during the recent banking crisis. We believe these headlines caused the initial dip in prices but were not enough to be game changers. Rather, the bulk of the losses were driven by a wave of automated trading that was set off when key technical support levels around $1,540 were violated.
Gary Kaltbaum, president of Kaltbaum Capital Management, explained it this way:
"Gold was a very over-owned and a very big bull market and when it broke support, the masses got out. When the big money guys own a boatload of stuff, and are all watching the same number, when support breaks, I call it the 'give up, we are done' response."
In other words, when enough large investors are watching the same technical level of price support, a break below that level can become a self-fulfilling prophecy that spirals into the type of violent selloff we saw Friday and Monday. Sell orders are placed in an effort to stem near term losses regardless of the long-term view, and exacerbating this dynamic is the fact that large speculators in gold futures use leverage and are thus subject to margin calls when the value of their assets fall below an acceptable level relative to the collateral in their account. Steep declines can lead to margin calls which in turn trigger more selling, and on-and-on it goes. Given the absence of an adequate fundamental explanation, we believe this is the most likely explanation for the -13.7% two-day drop, but some analysts have even gone a step further and suggested that the technical selloff was triggered by Wall Street banks manipulating markets to make a quick buck.
It's more than a little frustrating to see dynamics like these have such a dramatic impact on the short-term P&L of certain holdings inside our portfolios. One response would be to throw up our hands in disgust concluding that long-term macro fundamentals have no bearing on the success of our investment decisions. But a more rational response would be to seek to understand what exactly we got wrong in our analysis (in this case it was not adjusting for the sentiment extremes and underappreciating the marginal improvement in the US economy), and to what extent this short-term aberration might actually be creating a great buying opportunity. The financial media has made it abundantly clear that gold has now entered official "bear market" status, effectively sounding the death knell on gold's amazing bull run of the past decade. But has that much really changed in the past week?
John Reade, a partner and gold strategist at Paulson & Co., released an email statement yesterday in which he defended the company's heavy bias towards the yellow metal:
"Federal governments have been printing money at an unprecedented rate creating demand for gold as an alternative currency for individual and institutional savers and central banks alike. While gold can be volatile in the short term and is going through one of its periodic adjustments, we believe the long-term trend of increasing demand for gold in lieu of paper is intact."
We would tend to align ourselves with this thinking, as we expect central banks around the world to continue on their current path of monetary easing. Indeed, as Kyle Bass of Hayman Capital recently said in a Bloomberg interview, "I'd much rather own gold than paper." Money supply growth in and of itself does not necessitate an increase in the price of gold, but as the chart below shows, long-term periods in which money supply growth outpaces real economic growth have tended to be good times to own the yellow metal.
High money supply growth and low real GDP growth is exactly what we have right now, and we see no reason to expect a material healing of the global economy or any sort of pullback from central bank stimulus at any point in the near term. As such, we view the current decline as a cyclical bear market within a longer-term uptrend that will resume again at some point in the future. The primary risk to this thesis is that the recent decline has done permanent damage to the broad market's willingness to hold gold as a diversifier or inflation hedge. If this is the case it might be much longer than we're anticipating for the fundamental tailwinds to once again take hold and translate into price appreciation.
We are holding tight with our allocation to gold and have shifted more of our allocation from the iShares Gold Trust to the Central GoldTrust (GTU), which is a closed-end fund we wrote about in our previous post on gold. GTU was trading at roughly a 6% discount to its net asset value intraday on Monday, a level it has only reach one time previously back in 2007. We shifted our allocations into this fund in anticipation of that discount closing and the share price once again trading in line with the fund's underlying asset value (a stock of gold bullion). In theory, this represents a 6% "margin of safety" in the shares we purchased yesterday. Premiums and discounts in closed-end funds are primarily driven from shifts in sentiment. With the sentiment in gold at very bearish levels, our expectation is for this sentiment wave to reverse at some point in the future to the benefit of gold prices and GTU in particular.
Additional disclosure: Transparency is one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.