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The Death of Gold…….Or Not!

24 July 2015

Precious metal investors suffered yet another rude shock early this week, with the price of gold plunging below USD $1100oz, with a nearly USD $50oz sell off occurring in a matter of minutes in early Asian trading on Monday the 20th July.

In total, some 5 tonnes of gold was dumped on the Shanghai market in this two minute window, an extraordinary amount when one considers DAILY trading volume is typically in the vicinity of 25 tonnes.

At the same time, according to ANZ Bank, there was also 7,600 August 2015 gold contracts traded on the COMEX, equivalent to another 23 tonnes of metal.

The market has since bounced around, trading back above USD $1100oz at one point, though this morning we see that the metal has eased again, currently sitting at USD $1,091oz, whilst silver has fallen below USD $15oz, with the gold/silver ratio now sitting at 73.82

Australian dollar investors have not been spared this time around, with the AUD price falling back below AUD $1500 per oz. Year to date, this has reduced gains (yes, investors are still UP for the year in local terms, albeit mildly) to just 2%, though the recent sell off has also led to marked increase in trading volumes for bargain hunting physical buyers.

China Gold Announcement

Whilst the majority of the sell off in gold reflects extreme pessimism and aggressive short positioning in the markets (more on this below), perhaps some of the weakness in gold prices this week can be tied back to the Chinese announcement on Friday the 17th regarding their updated physical gold holdings.

To recap, on the 17th Juy 2015 the Chinese government announced that national gold holdings had increased to 1658 tonnes, up some 57% in the past 6 years. Based of these figures, the Chinese state has been buying roughly 100 tonnes of physical gold per year for the past 6 years.

This number disappointed many analysts and gold bulls who thought the number would be somewhere between 3,000 and 5,000 tonnes.

Despite the much lower than expected announcement, the updated figures still put China in fifth spot when it comes to the largest national gold reserves, behind the United States, Germany, Italy and France. Despite this, physical gold holdings still officially represent less than 2% of China’s massive foreign exchange reserves.

So what to make of it?

A few months ago, we wrote a piece for Livewire that specifically discussed Chinese national gold holdings. Titled “There are known knowns, known unknowns, and unknown unknowns”, we stated that whatever the number ended up being, “we think the number will offer plenty for both the bulls and bears to argue about, and we’re almost certain it won’t move markets as some expect”.

Whilst the sell off in the gold market this week might lead some to argue we were wrong regarding the impact of the announcement, we are happy to stand by our comments, for a few reasons.

Firstly, it is worth mentioning that China does not just hold physical gold through the People’s Bank of China (PBOC). They can also hold gold through the State Administration of Foreign Exchange (SAFE), and the China Investment Corporation (CIC).

When it comes to SAFE, one of their major functions is; “to undertake operations and management of foreign exchange reserves, gold reserves, and other foreign exchange assets of the state.”

The CIC on the other hand is a Chinese sovereign wealth fund. Founded in 2007 with roughly USD $200 billion of investment capital, it had grown to well over USD $550 billion by August of 2013. As at the end of December 2014, some 26% of this money was sitting in what the CIC describe as long-term investments, which include resources and commodities specifically.

As a result, we’re relatively certain that Chinese national gold holdings across all the entities it controls are higher than the official number, though it remains a known unknown as to what the true figure is.

It is also worth mentioning that if Chinese national gold holdings really only are in the vicinity of 1,600 tonnes, and that the Chinese state has been doing far less buying than many anticipated, then by default it means the Chinese citizenry have been doing more buying than might have originally been anticipated.

At the end of the day, we know that thousands of tonnes have been shipped into China in the past few years, and we also know that China is now the largest miner of gold.

We’re quite certain that the gold imported and mined hasn’t been thrown away, so if the state wasn’t buying it, someone or a group of someone’s, clearly has been.

Finally, it pays to remember the game that China is playing. At present, getting the yuan included as part of the SDR is a major priority, therefore announcing respectable but not threatening levels of national gold reserves, and not doing anything to potentially cause gold prices to rise makes plenty of sense from a Chinese perspective.

But don’t forget for a minute the long-term plan, which Song Xin of the China Gold Association has alluded to previously, that being the accumulation of at least 8,500 tonnes of gold over time to at least match/exceed the United States sovereign gold reserve.

Bottom line: China will be a net buyer, and a net importer of physical gold for years to come. In and of itself that won’t necessarily cause a sharp rally in gold prices anytime soon, but gold acquisition from the Chinese state and her citizens, as well as emerging market central banks the world over will continue to provide support for the physical gold market.

Those that have sold gold in the past few days (and there have been plenty in the ETF and futures markets) as a result of the “disappointing” number out of China may have just caused the capitulation event that typically marks the bottom of any bear market.

The Death of Gold

And so we come to the “Death of Gold”, a headline we saw earlier in the week accompanying a story about a particular ASX Stock that had soared 400%, alongside a sales pitch for investors imploring them to part with their hard earned cash for more stock tips. This headline capped off a week of unanimously bearish stories on the future prospects for gold, just some of which we’ve included below as images.

A

B

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Even in the depths of the GFC induced bear market in equities, the headlines, commentary and analysis that surrounded the stock market was not as pessimistic as the commentary that surrounds gold today.

The lack of inflation and a much anticipated interest rate hike by the Federal Reserve are the key reasons cited for the bearishness towards the precious metal market. Whilst this is understandable, it is also overly simplistic, with investors and analysts clearly forgetting the strong return of gold for the majority of the past 15 years, though inflation predominantly trended lower over this entire period, which has been interspersed with hugely deflationary events like the NASDAQ crash, the GFC, the European debt crisis and even lately, the flare ups in Greece and the Chinese stock market.

Investors have also clearly overlooked the fact that three of the fastest period of gold price appreciation in history, 1971 to 1974, 1976 to 1980 and 2001 to 2007 occurred during periods of Fed tightening, indicating that higher rates alone are clearly not enough to sink the gold market. That fact often shocks people who buy into the simple narrative regarding gold and interest rates, which is why the following slide typically raises a few eyebrows when presented at investment conferences and the like.

Rates

But be that as it may, the market is a voting machine, in the short term at least, and right now the votes are clearly going against the gold market, with ETF outflows picking up pace, and speculative positioning at record levels, with well over 100,000 money manager contracts short gold , as you can see on the chart below.

MM

We are not in Kansas anymore.

Gross short positions in total, across all market participants, were also at a record 180,000 contracts, with net positioning at the lowest level since November 2014. Speculators using the futures market to express a position in gold have never been this bearish!

On the ETF front, last Friday saw 11 tonnes of gold divestment out of the SPDR Gold Trust, the largest single day outflow since 2014. For an understanding of highly correlated gold price moves are to the flows in and out of ETFs, consider this excellent chart from ANZ, which plots the two side by side over the past year.  

ANZ

As you can see, investors in gold ETFs tend to follow the momentum of the gold market, and the price action itself, and are no doubt heavily influenced by some of the commentary they’re seeing regarding gold right now, with Societe Generale’s Robin Bhar recently stating; “If anyone can show me the bullish case for gold, I’d like to see it. I doubt this is the final nail in gold’s coffin. I think we can add a few more.”

The precious metal miners were also buried in the latest sell off, with GDX falling by over 12% at its lowest point this week. This was a true capitulation panic out of gold, with some 169 million shares in GDX changing hands this Monday, a volume that dwarfs turnover in previous periods of turmoil in the gold market.

As to how decimated the precious metal mining complex now is, consider the following excerpt from a July 21st update from Pater Tenebrarum from Acting Man, who commented that; “the HUI Index produced an RSI of slightly above 11 on its daily chart, after declining for a record 10th day in a row. This RSI reading is the lowest in the history of the index (the previous record low was produced in 1998 at about 16). Moreover, gold stocks have now broken every historical bear market record in the sector. Not only is this by now the biggest decline on record, the sector (as measured by the BGMI) is also trading at a record low relative to the gold price – undercutting the previous record low established in 1942 in the mini-crash following the Pearl Harbor attack.”

That is some sell off.

As for when the selling ends, no one can be 100% certain, and perhaps analysts like Bhar who I mentioned above will be correct, with severe price declines to come in a short period of time, and a bottoming out process closer to USD $800-900oz.

But a headline like “The Death of Gold” can’t help remind us of arguably the most famous Business Week headline of all time, released two months before I was born, back in August of 1979.

Titled “THE DEATH OF EQUITIES: How inflation is destroying the stock market” – it is the most frequently cited example of why investors should do the exact opposite of what the headlines in the financial media are telling them to do, for the very simple reason that this headline almost marked to the day the beginning of one of if not the greatest stock bull markets of all time.

Many investors have heard of this article and magazine cover, though we are certain not as many have read the article, nor picked up the fact that the same magazine specifically mentioned oil and gold, discussing the merits of indexing bonds to the two commodities. We have included the article as a link here, for those of you who wish to take a step back in time. We've also included a screen shot of the infamous cover.

DOEQ

The article is a truly extraordinary read, commenting on the disappointing performance of the Dow Jones over the preceding decade; nothing that “since 1968, according to a study by Salomon of Salomon Bros., stocks have appreciated by a disappointing compound annual rate of 3.1%, while the consumer price index has surged by 6.5%. By contrast, gold grew by an incredible 19.4%,”

The high inflation of the period, and gold’s outperformance throughout it was no doubt the reason why the concept of indexing bonds to gold would have held such appeal. By doing so, investors in fixed income products theoretically would have had their coupon and eventual principal repayments protected from the reduction in real purchasing such inflation causes. Of course the end of the 1970s would have been an unfortunate time to implement such a strategy, as gold was soon to peak, but that is what an era of high inflation leads too.

Today, some 35 years after this infamous article was released, the situation is completely reversed, with optimism towards financial markets at all time highs, and gold so universally loathed as an investment choice that the Wall Street Journal is calling it a ‘pet-rock’, whilst others call for the death of an asset that has survived for six millennia, protecting wealth along the way.

I’m fairly confident the headlines will be as wrong today as they were back in August of 1979, and have topped up my precious metal holdings accordingly. I might be a little early on that trade, but dollar cost averaging into the market will work over time, whilst the universal distaste towards the precious metal market that we see today can’t help but whet a contrarian’s appetite.

Until Next Week

Disclaimer

This publication is for education purposes only and should not be considered either general of personal advice. It does not consider any particular person’s investment objectives, financial situation or needs. Accordingly, no recommendation (expressed or implied) or other information contained in this report should be acted upon without the appropriateness of that information having regard to those factors. You should assess whether or not the information contained herein is appropriate to your individual financial circumstances and goals before making an investment decision, or seek the help the of a licensed financial adviser. Performance is historical, performance may vary, past performance is not necessarily indicative of future performance. Any prices, quotes or statistics included have been obtained from sources deemed to be reliable, but we do not guarantee their accuracy or completeness.

JE