One of our readers posted a very interesting comment that I thought deserved a bit more research and the results would be of benefit to gold investors, so I decided to include the comment in a little more detail.
Aricool posted the following:
"However, there is one area where I diverge, and that is on what is the cause. I've long expected gold price to drop back to pre QE levels when the fear hedge trade is over. Doesn't it only make sense that people's allocation to gold would just drop back to pre-QE levels when nearly all the financial risk metric return to pre crisis levels (e.g., consumer leverage, jobs, housing stability, corporate profits, consumer confidence, inflation rate, etc.) . And, indeed we see as the recovery metrics got better gold ETF holdings dropped in lockstep- see this graph:
So, holdings are at 2009/early '10 levels, but unlike Ag which price returned to that of back then, gold has held up amazingly well. Based on ETF holdings, it should have fallen to $900 by now, yet it has been very sticky to $1200. So, that may tell us that the cause is people believing in the recovery, and returning gold allocation to 0-3%, instead of 3-10%."
The essence of the argument (at least in my interpretation) is that investors are less interested in gold so they:
- Lower their allocations and sell their GLD shares
- GLD sells physical gold into the market
- This depresses the gold price.
Thus as gold ETF holdings decline to 2009 and 2010 levels, the gold price also should fall to those levels. The takeaway for investors (if you agree with this argument) is that gold will go down as the ETF holdings continue to decline and investors should wait for the holdings to rise before they start being bullish on the gold price.
It's an excellent and very logical argument, but we do disagree and think there is one major fault with the argument and correlation. That fault should make investors take the opposite approach and look at gold more bullishly when gold ETF holdings are FALLING.
The Problem We Have With This Argument
We're going to use GLD and SLV as examples since they are the largest trusts and hold a significantly greater amount of gold and silver than any of the other trusts.
Here are the same two charts with all transparent gold and silver holdings as of November 7th, 2014.
The first and most obvious thing to take away from here is that physical gold holdings across the ETF universe have fallen with the gold price, while physical silver ETF holdings have risen and WHILE the silver price has fallen. So basically we see the opposite relationship in silver that we see in gold.
If the argument above was true that gold ETF holdings have declined because of a loss of investor interest, we should see exactly the same thing happen in the silver ETFs as the vast majority of precious metals investors invest in both assets - it is probably very rare to find a gold investor that has absolutely no silver investments and vice versa.
This is further emphasized by the historical relationship between gold and silver, which we believe has a more than 90% correlation (if anybody has the exact number please post it below) - the vast majority of the time when the gold price goes up so does the silver price and vice versa.
What We Think Is Going On
So if we don't believe in this argument, then what is going on with this major discrepancy between the gold and silver ETFs on assets that are very highly correlated?
This is where understanding a bit more about GLD and SLV may offer investors a little insight into what's going on with the ETFs.
We don't have the time or space to go in detail into the exact mechanics of GLD and SLV ETFs, but investors can read a lot more details by going through this excellent post by Bron Suchecki of the Perth Mint (by the way, Mr. Suchecki is one of my favorite reads when it comes to gold, so I urge anyone interested to his excellent personal blog). But for our purposes, the following is a quick summary of what investors should know about how gold is added or withdrawn from GLD:
- Only Authorized Participants can add or withdraw gold from GLD
- They exchange gold or shares (in baskets of 100,000 shares) to add or remove gold from GLD
These are a list of the current Authorized Participants (APs) as of the end of 2013 from the GLD 10-K:
"As of the date of this annual report, Barclays Capital Inc., Citigroup Global Markets Inc., Credit Suisse Securities (NYSE:USA) LLC, Deutsche Bank Securities Inc., Goldman, Sachs & Co., Goldman Sachs Execution & Clearing, L.P., HSBC Securities Inc., J.P. Morgan Securities Inc., Merrill Lynch Professional Clearing Corp., Morgan Stanley & Co. Incorporated, Newedge USA LLC, RBC Capital Markets Corporation, Scotia Capital Inc., UBS Securities LLC, Virtu Financial Capital Markets, LLC (f/k/a EWT, LLC) and Virtu Financial BD LLC are the only Authorized Participants."
The point here is that investors CANNOT withdraw gold from the GLD; it must be done by one of the above-mentioned APs. So when gold is removed or added to the GLD ETF, it means that one of these APs has decided to withdraw or add gold to the ETF.
So a good question comes up: "If the price of gold has dropped don't we have to remove gold from the ETF?"
This is a common misunderstanding and we understand where it comes from because logically if the price of an asset falls, you expect the underlying asset to be sold into the market. But the problem is that the price of gold/silver should have no effect on the actual physical holdings - all that needs to happen is for the share price to decline or increase to deal with the demand for the ETFs. Why does the actual amount of gold held at the GLD need to decrease when the price of gold falls? It doesn't.
Further evidence of this is what is happening with the holdings at the silver ETFs.
As investors can see, the silver price declined significantly but that seemed to have little to no effect on the silver price.
Further evidence can be seen in the Sprott Gold ETF PHYS as holdings have not declined significantly from their all-time highs.
Compared to GLD holdings below, we see a very LARGE difference.
Presenting Our Theory About What Is Really Going On
Let us get down to the meat of this - what we really think is going on is that the GLD ETF is being used as a convenient piggy-bank to source large amounts of physical gold to satisfy Eastern physical gold demand. It is by far the easiest way for the Authorized Participants (who also happen to be major participants in the London Gold market) to get significant amounts of gold that they can ship to Indian and Chinese buyers.
Let us take another look at total gold transparent holdings and the gold price.
Notice how the gold price (in blue) peaks almost one and half years BEFORE transparent gold holdings peak? The gold price had already been declining for 18 months or so even as ETF holdings continued to increase - that means there is another factor here that is driving ETF holdings lower.
Now, let us take a look at Chinese gold demand as represented by Hong Kong imports.
Notice how Chinese demand really didn't start getting to be off the charts until the end of 2012 and the start of 2013 - almost exactly when GLD holdings start to decline significantly. Investors should note that China actually increased the number of avenues for gold imports over the last six months, so the decline in net imports through Hong Kong towards the end of 2014 is not reflective of a decline in Chinese demand which we can see evidenced by Shanghai Gold Exchange withdrawals - Koos Jansen does an excellent job of detailing it further in his regular research. So our point is that we do not think it is coincidence that GLD holdings started to decline at around the same time Chinese gold imports surged.
Investors need to remember that we're talking really large amounts of gold here on a monthly level that China needed to import. For example, 100 tonnes of gold is equivalent to a little over 3.5 million ounces of gold. To put that into perspective, the total available gold (registered gold) held at the COMEX is currently around 800,000 ounces, or only 20% of what you would need on a MONTHLY basis to satisfy this demand. If we include every single ounce available at the COMEX, it is only a little more than 8 million ounces - simply not enough to meet surging Chinese demand on any kind of regular basis.
The GLD ETF provides enough gold to help meet this tremendous Chinese demand without driving the price of gold through the roof. Imagine that these bullion banks needed to go to the open gold market to purchase tens of tonnes of gold regularly from different non-ETF sources to ship to Asia - that would drive the gold price through the roof!
Thus the GLD ETF provides a convenient way to source large amounts of physical gold (by redeeming baskets of gold shares) without being forced to buy gold in the open market and drive the price up. Investors should also remember that the ONLY parties that can withdraw gold from the GLD are the Authorized Participants, who also happen to be bullion banks with significant worldwide gold operations.
This also explains why silver ETF holdings have not declined with the silver price - despite a larger decline in the silver price than in the gold price. There simply isn't the same demand from Asia for silver as for gold, and thus there is less need to source large amounts of physical silver than physical gold - thus no need to redeem SLV shares for physical silver to satisfy Eastern silver demand.
But Wouldn't Buying Up Large Amounts of GLD Shares Drive the Price of Gold Up?
Assuming many different players with small positions that would be true, but if you have a few players with extremely large financial resources then there are ways to drive the gold price and force GLD holders to sell their shares.
Remember the price of GLD is highly dependent on the gold price, thus if the gold price drops, the GLD will also drop at a similar rate. So if you can drive the gold price, you can force the price of GLD to increase or decrease - the key here is to spend less money doing that than the amount of GLD shares you want to buy. This goes beyond the scope of this article, and there are probably readers with a much better understanding than us on the best ways to do this, but this is really not a far-fetched concept and it's come up repeatedly in the financial press (here is an article from the Financial Times that discusses it) regarding gold and other assets.
One tell-tale sign of this is large sales of gold during less active trading hours, which we have seen very frequently over the last few years - last week is an excellent example. The only reason to sell large amounts of gold futures at these times is to drive the price down - it is certainly not the best way to unload large amounts of gold if you wish to get the best price for your gold.
What Does This Mean For Investors?
The real conclusion for investors here is the opposite of what the correlation we mentioned earlier, where GLD holdings are correlated to the gold price.
In fact, if our theory is correct, then the lower GLD holdings get the LESS "convenient" gold remains to be sourced by bullion banks to meet Eastern demand. Thus investors should be very interested to see GLD holdings continue to fall as there gets to be a point where large amounts of gold will need to be sourced from outside of the ETFs to meet Asian demand.
It is a bit like a game of chicken between the bullion banks and investors seeking physical gold (mostly in Asia). If demand drops to levels that don't require large amounts of ETF gold to meet, then bullion banks can accumulate gold again and put it back into the ETF to save to meet later demand. If demand continues to remain at current levels and the GLD gold holdings are driven down further and further, bullion banks will need to source gold from other source and will have no choice but to drive the physical price up.
That's what investors need to understand and deploy their gold investments accordingly.
We believe that eventually this source of "convenient" gold will be pushed too far by physical demand from investors, and thus bullion banks will be pressured to buy large amounts of gold from the open market. That will not be easy and probably cannot be done without pushing the price of gold significantly higher.
Even if Asian demand subsides a bit in the near term, the large providers of gold outside of the ETFs, the gold miners, are struggling to maintain gold production at current prices. Many of them are barely keeping their head afloat below $1300 an ounce (let alone the silly predictions for $1000 or $800 gold), and they certainly aren't able to invest to maintain future production as gold discoveries have plummeted. Even a fairly small 10% decline in gold production means around 250 tonnes of gold that will need to be sourced from elsewhere simply to meet annual demand.
Thus the declining gold held in GLD and the other gold ETFs are actually a very bullish thing for gold investors as "convenient" gold is becoming scarcer and scarcer. Therefore we maintain our position, boring as it may seem, that investors continue to accumulate physical gold and the gold ETFs (SPDR Gold Shares, PHYS, CEF). For those looking for more leverage they may want to consider evaluating gold miners such as Goldcorp (NYSE:GG), Agnico-Eagle (NYSE:AEM), Newmont (NYSE:NEM), or even some of the explorers and silver miners such as First Majestic (NYSE:AG) or Pan American Silver (NASDAQ:PAAS). We're not suggesting these companies specifically - only suggesting them for further investor research. Investors interested in the miners may be interested in taking a look at some of our investment thesis detailing some of the rules we're currently looking for in a gold miner.
But we think the real opportunities right now are in the explorers, as their valuations are much lower than the miners and the fact of the matter is that these gold miners will be looking to expand reserves and buying out the quality explorers, so we'd suggest investors be aggressively investing in these quality explorers. For those interested in explorers, we'll be issuing research on the companies we like soon, so join our free email list, or find a high-quality newsletter writer or analyst that tracks and follows explorers - it's very important that investors follow the news flows out of the explorers they own as it is not a "buy-and-hold" type investment.
We think there is plenty of evidence that the disparity between the gold and silver ETFs, and the continuing losses of physical gold from GLD signal that Asian demand for physical gold remains very strong. In fact the lower they go, the closer we are to a bottom in the gold price - or as Rick Rule says, the shorts in the gold market may soon have "a religious experience."
Disclosure: The author is long SGOL, PAAS, AG, SIVR.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.