The gold (GLD) market has been quite volatile lately, with prices moving erratically on little to no news. As it stands, gold prices are down over 25% from their peak in September 2011, yet the debate over the future for the yellow metal has never been more heated. While we did briefly believe that the initiation of QE3 would be a positive catalyst for gold back in September 2012, the fizzle out and complete lack of follow-through after this extremely bullish development caused us to question gold. Considering its performance since, we feel vindicated in our recent short gold call, and are now more confident than ever that the future for gold is bleak. Depending on the surrounding macro environment, we could see an environment where gold hits $1,000 or below within 2 years.
The Rise and Fall of Gold
To start with, let's view the price of gold in a historical context. A 10 year chart of gold is shown below.
As can be seen from the chart, gold rose in a fairly steady pattern (with 2008 being an extended correction), from the early 2000s until September 2011. Viewing this chart, it appears the perfect picture of an asset bubble and collapse. The early stage, 2002-2007, saw early adopters buy the asset with knowledge of future bullish fundamentals. By 2008, gold was a hot topic, but still shunned by the vast majority of market participants. After a plunge lower coinciding with undiscerning liquidation in all markets in October 2008, gold began to march higher again, eventually exceeding the $1000/oz barrier with force. From there, it did not look back until September 2011.
The easy question is, what changed between 2006, 2008 and 2011 for gold and why did the price rise so much? In our estimation, the answer is nothing. The same bullish fundamentals, interest rates that were too low, future monetary debasement, etc. were present the entire time. A good argument could be made that in the post-2008 period, these bullish fundamentals were much more pronounced, and the price rise was correspondingly more feverish in the 2008-2011 time period. Considering there is no "right" price for the price of gold, but rather only the price that the next buyer is willing to pay, more and more investors came around to the bullish gold thesis, and this gradual realization drove the price higher.
Buyer Exhaustion: Knowledge of Gold Became Widespread
However, by 2011, nearly every market participant knew or understood gold's appeal, and since gold could be easily purchased through an ETF or futures contract, everyone who believed in the thesis was in. The following chart shows the number of ounces of gold held by ETFs.
As can be seen, gold ETFs saw massive inflows after the QE1 announcement in early 2009, and during the 2009-2011 period, gold ETFs accumulated nearly 35 million ounces of gold.
We believe this massive accumulation of gold was the primary driver of the most recent leg of the bull market, punctuated by leveraged futures traders exacerbating the final spike. Moreover, ETF and futures demand for gold can be considered the marginal player, as central banks and other physical gold holders rarely trade in and out, so ETFs are setting the marginal price due to their relatively high turnover.
When Bubbles Burst: Prices Cannot Catch Up to Unrealistic Expectations
In our opinion, bull markets/bubbles do not end because the fundamentals surrounding them no longer exist, it is because the last marginal buyer has bought because everyone has now accepted the bullish thesis, and so new demand cannot be located. Such a situation leaves a plethora of sellers with no new buyers, causing prices to correct dramatically lower before buyers step back in. As an analogy, take tech stocks in 2000 or real estate in 2006. While we can all agree that both were overvalued, both were overvalued for months or even years before they started to collapse. The reason why they collapsed is because the market simply ran out of buyers at ever-higher prices after nearly every doubter/short-seller gave in, and prices tumbled under their own weight.
Turning back to gold, summer of 2011 saw a fever pitch in demand for gold. Nearly every financial media purveyor and market pundit was preaching the value of gold, especially with the global economic turmoil turning up due to the twin events of the U.S. debt downgrade and European economic collapse. The rallying cry was that QE3 was a certainty, and that buyers should buy gold now while it was "cheap," because once the Fed initiated QE3, $2,000/oz would be a distant memory. In response to such a chorus, gold ran up from $1500 in June 2011 to $1900/ounce in August 2011.
Once the Fed meeting in late September 2011 came around, the expectation of QE3 was so high that anything else would be a huge disappointment. Of course, the Fed did disappoint, and launched Operation Twist instead of QE3. That event kicked off a massive downward spiral in gold and silver prices, as all the leveraged players in the precious metals market who had been late to the rally ran for cover and liquidated. It was truly a classic case of a bubble bursting.
Fast forwarding one year, gold did recover a bit, and traded all the way up to $1700/oz, once again on the expectation of QE3. While QE3's announcement did cause prices to trade nearly to $1800/oz, the euphoria was short-lived and gold began to fall less than a month after the announcement.
The current fundamental problem in the gold market is that every bullish fundamental has already been revealed, with QE3 standing squarely in the center. As we often see in financial markets, the expectation of a bullish event is much more powerful than the event itself. Since QE3 was actually more like QE-infinity due to the open-ended and indefinite time span nature of the easing, the Fed has already placed all of their easing cards on the table and there is no more bullish surprise to be expected. In this manner, there is no upside surprise left for gold investors, but there remains plenty of downside surprise.
Gold Can Be Hurt in Both a Bullish or Bearish Macro Environment
The main reason we believe gold to be such a good short at this point in time is its susceptibility to nearly every conceivable economic scenario going forward, bullish or bearish.
While we already know that the Fed will print with reckless abandon until they reach their pie in the sky economic goals, what happens if events force their hand and they are forced to go the other way, cutting the size of QE3 or ending the program altogether?
Since the time that the QE program was initiated, the Fed has been basking in paradise, causing asset price inflation in only the right assets, without causing true consumer price inflation or blowing any obvious bubbles. While the stock market advanced a great deal since the bottom in 2009, investors could always argue that valuations were below historical norms, corporate earnings were at all-time highs, and consumer price inflation was very low. Whether by luck or by design, the Fed has been able to achieve massive equity, fixed-income, and, more recently, real estate price inflation while the price of crude oil, wheat, corn, natural gas and other necessities has stagnated.
However, we are starting to see signs that the end may be near. The S&P 500 is currently on a maniacal run, with the stock market already up 14% in just the first 4 months of the year, with valuations at 4-year highs. Junk bonds are trading at ridiculously low yields, with questionable issuers being able to issue debt at very low yields. Commercial real estate prices have made a new peak, along with private equity issuing debt to any and all comers, backed by less than stellar companies. Even crude oil prices, with U.S. crude inventories at 82-year highs, are well above fundamental supply/demand equilibrium. If the S&P 500 hits 1700 this summer, can the Fed really stand by and watch the stock market blow itself into a bubble?
Our thinking is that further asset price appreciation by the Fed would force the Fed's hand into tapering off the QE program. Of course, such a move would be disastrous for gold and bullish for the dollar, given that it will stop increasing the size of the Fed balance sheet, leaving it constant while every other major central bank's balance sheet expands. However, the reverse scenario is not so bullish for gold, either.
Even if economic data disappoints and stocks fall, it is not clear that gold would be a beneficiary. As we saw during the gold liquidation rout, the fall in gold prices fed a fall in broader risk asset prices. The problem for gold holders in the bearish economic scenario is that the Fed's increase in money printing has already been telegraphed, while the cross-ownership of gold and stocks leaves gold vulnerable to liquidation.
Because of how widespread the bullish gold reasoning has been sown, the very same investors who own gold own stocks. Even if Bernanke increases the size and pace of QE3, the fact that leveraged equity holders need to liquidate will hurt gold all the same. With margin debt on the NYSE at all-time highs, equity holders are leveraged at this point in time, and would need to liquidate if a true correction were to develop. Additionally, bullish U.S. dollar positions would also do fairly well in a negative economic scenario. In such a manner, gold could and should fall in both a bullish or bearish macreconomic scenario.
Future for Gold
What is interesting about the chart of gold ETF holdings is the coincident downturn in gold ETF holdings and the plunge in prices so far in 2013. This year, the amount of gold held by ETFs has dropped nearly 12 million ounces already. During the same time span, gold price is down 13.5%.
The fact that gold's price is falling due to ETF liquidation is a flashing red warning sign. During the gold collapse of 2011, gold ETFs actually added gold, indicating that more passive players such as individuals, endowments, pensions, and hedge funds were adding to holdings as the price dropped. The price drop during this period was most likely due to leveraged futures traders liquidating after running prices up too far too fast during the summer of 2011.
As a result of the liquidation of weak hand futures traders and the continued accumulation of gold by passive allocators, gold climbed again in 2012 as ETF holders continued to add, and the macro environment became conducive to risk assets once again. The rise in gold continued until the QE3 announcement in September 2012, at which point gold peaked just below $1800/oz.
However, once the expectation of QE3 was turned into reality, ETF holders have been liquidating, driving the price lower. The fact that ETF holders are the primary driver in sending prices lower is an especially bad omen because of just how much more they could liquidate if they continue to be unimpressed with precious metals. The following chart shows the amount of gold held by ETFs in dollar terms.
As can be seen, even with the value of gold ETF holdings falling by over $35 billion this year, there remains over $105 billion of gold in ETFs. Clearly, there is plenty of gold left to be liquidated from these funds.
While leveraged futures traders could kick prices around in a volatile range, ETF holders of gold have been steadfast in their selling even as prices have recovered in the short term. Despite gold recovering from $1320 to today's $1450 from April 16th to today, gold ETFs liquidated 4 million ounces of gold in that time span. While prices have recovered 10%, longer-term ETF holders of gold are unequivocally sending the message that they are using temporarily higher prices to get out.
At this point in time, with interest rates around the world staying low indefinitely, investors are grabbing for yield anywhere they can find it. Nearly every other asset, between stocks, fixed-income, alternative, and real estate, produces a higher current yield than gold's 0%. Given the fact that gold has not made a new high in 19 months, traders can no longer rely on price appreciation to make up for gold's lack of yield and utility. Therefore, they are selling the metal, and they have quite a bit more to get rid of before all is said and done.
How Low Could Gold Fall?
Given that gold is a commodity, most commodities eventually trade to their cost of production. Those of you that have taken a basic economics class will remember that marginal cost = marginal revenue. However, if we apply this analysis to the gold market, we get a scary picture.
For most senior gold miners, the cost of production is not more than $800/oz, if that. See Barrick Gold's most recent presentation. Note that there has been a recent shift in the industry to display "all-in sustaining cost" next to cash costs. This new metric is much higher because it incorporates many items that should not be included in mining cash costs, including general corporate expenses and "sustaining" capital expenditures, which could include new mine exploration. These new metrics are an attempt for gold miners to show why they don't make as much money as they should, but even using those, we see that the cost of production is worlds lower than the current price of gold. Whatever the case may be, the cost of production is absolutely below $1,000/oz.
If gold were to return to $1,000/oz, that would constitute a 31% loss from present levels. Of course, bulls will argue that such a fall is unlikely given that investor demand got it up here in the first place. However, we should all take note that investor demand is extremely fickle and changes on a dime. Just ask anyone who bought Apple (AAPL) shares in the past 9 months.
If investment demand continues to decline and gold ETF holders continue to sell, we believe a gold price below $1,000/oz is a near certainty. Gold will eventually return to its true cost of production, squeezing miners' profit margins.
Debunking the Myth: Gold is Not a Currency
The final bullish argument heard around precious metals is that "gold is a currency, not a commodity." While it is cute to think of gold as something that it is not, even a cursory analysis will tell us that gold is clearly not a currency.
A currency is a medium of exchange that can be readily exchanged for nearly any other good. For example, when you walk into a Subway, you pay $5 for a foot-long. Alternatively, you could take that $5 to a clothing store and buy a pair of socks. A currency allows the holder to purchase a variety of different items directly using the currency.
Gold, while being a "store of value," is not a currency. No matter how valuable, gold cannot be exchanged for food, energy, stocks, or bonds. It is simply another asset, no different than Apple stock or your home. It has been fairly good at "storing value," but it still must be converted into a currency before being used to exchange for goods.
As we have seen recently, the rate at which gold is exchanged into actual currency can be quite volatile. As gold recently did, no true currency goes down 10% in one day. If it did, we would all think ourselves fools for holding such a volatile and fickle currency. However, the price of Apple stock, real estate or other financial assets frequently move with great volatility for no apparent reason. In this manner, gold is true to its behavior as a "store of value" but not as a currency.
We believe those who continue to hold gold because it is a currency are simply fooling themselves into believing that the bull market in gold will resume as soon as "the market realizes...." The problem with gold is that the market sets the price and there is no fundamental value. We must always be cognizant of this when investing in a psychological asset.
In our belief, the psychology of gold has undergone a sea-shift, and while monetary policy, sociopolitical events and other factors are squarely bullish for gold, the market clearly has ceased to interpret them as such. With only negative surprise left for the metal over the coming months, we believe a resumption in price decline is all but inevitable.
Despite gold's recent collapse, long-dated volatility on gold remains cheap. We recommend purchasing the January 2015 $100 put on the GLD for $1.90 or better. Such an option would become profitable if gold were to fall to ~$1034/oz at some point over the next 20 months. Furthermore, the implied volatility of the option is only 22%, indicating a low level of fear about gold's possible decline in this period.