Radical Gold Underinvestment
Adam Hamilton | Oct 18, 2015 03:52AM ET
Despite gold blasting higher this month, this metal remains deeply out of favor among investors. They have shunned it for years thanks to extreme central-bank money printing levitating stock markets. This slayed demand for alternative investments, led by gold. But the resulting radical underinvestment in gold today is super-bullish. Vast capital inflows will be necessary to return gold investment to normal levels.
It’s impossible to overstate just how much gold is hated these days. Investors’ opinions on it range from total apathy to fervently believing gold is the worst investment on Earth. You can easily test this out in your own social circles. The next time the markets or investing come up, ask if gold is now a good buy. Everyone will say no, usually emphatically. And if you advocate for gold, they’ll think you’re naive or stupid.
This extreme gold antipathy is the natural consequence of this metal’s terrible price action in recent years. Between August 2011 and August 2015, gold lost 42.8% in a brutal secular bear market. Over that same span, the flagship S&P 500 stock index soared 86.8% largely thanks to the Federal Reserve’s epic QE3 debt-monetization campaign. And this recent history of gold getting slaughtered is all most traders remember.
But like all markets, gold is forever cyclical and never moves in one direction forever. Bear markets are inevitably followed by bull markets. And those mighty bull markets are always born in the darkest depths of despair when gold looks hopeless. The last time gold suffered from universal disdain similar to today’s was in the early 2000s. And that very extreme bearishness sowed the seeds for an enormous bull.
Between April 2001 and August 2011, gold skyrocketed 638.2% higher! It was the best-performing asset class over that decade, obliterating the S&P 500’s dismal 1.9% loss over that span. It is utterly amazing that investors have forgotten in recent years how incredible gold bulls are for multiplying wealth. And the time to buy low is after a long bear when prices are low and everyone believes they will stay that way forever.
This latest gold bear was totally artificial, conjured by the Federal Reserve’s extreme market distortions. Back in early 2013, the Fed ramped up its wildly-unprecedented open-ended third quantitative-easing campaign. Since QE3 had no predetermined size or end date like QE1 and QE2, it had a vastly greater impact on stock-market psychology. Traders came to believe the Fed was effectively backstopping stock markets.
Every time the stock markets threatened to slide in a normal healthy selloff, the FOMC itself or top Fed officials would jawbone about their willingness to ramp the extreme QE3 money printing if necessary to arrest the selling. So traders aggressively bought on this incredible Fed dovishness, ignoring normal indicators of overextended, overbought, and overvalued stock markets. The Fed levitated the stock markets!
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Their massive Fed-fueled rally dwarfed everything else, with stocks’ performance sucking vast amounts of capital out of other assets including gold. Traders love to buy winners and chase rallying markets, so everything else withered. This ultimately led to today’s radical underinvestment in gold, with capital in this asset class far below normal levels. Like all market extremes, this one will inevitably mean revert too.
As gold is an opaque global market, there’s no way to directly measure total gold investment. Since gold enjoys inherent intrinsic value, and is physical and private, it can’t be tracked at the investor level. But gold investment can be inferred through a variety of metrics including national imports and exports. Of particular interest today is American investors’ level of gold investment, since they control such vast capital.
While American contrarian investors still prefer owning physical bullion coins in their own possession for a variety of excellent reasons, mainstream investors have gravitated towards a new vehicle. When they want gold exposure in their portfolios, they turn to the flagship GLD SPDR Gold Shares (N:GLD) gold ETF. It is the world’s largest gold ETF by far, and utterly dominates American stock investors’ gold holdings.
GLD offers many advantages that really appeal to mainstream investors. It is a super-cheap way to get gold exposure, with a trivial 0.4% annual expense ratio about an order of magnitude smaller than the commissions on traditional coin purchases. And investors can buy or sell gold instantly via GLD, which holds the underlying physical gold bullion in trust for its shareholders. GLD is the most efficient way to own gold.
This is especially true for large investors like pension funds, mutual funds, and hedge funds. It’s just too impractical and expensive for them to deploy large amounts of capital in physical bars or coins. Not only would they have to worry about high commissions, but transfer, storage, and ongoing security. So the birth of GLD in November 2004 effectively opened up large gold investment to the entire fund industry.
GLD is incredibly transparent, publishing a comprehensive list of every single gold bar it holds in trust for its shareholders every day. The latest list this week was a whopping 1102 pages long! By studying the value of GLD’s gold bullion over longer periods of time, we can gain priceless insights into the levels of gold investment by large American investors. And these days they remain radically underinvested in gold.
This first chart looks at the value of GLD’s holdings, a great proxy for gold investment among American stock traders, superimposed over gold. It is simply computed by multiplying GLD’s daily holdings by the price of gold. And thanks to the combination of recent years’ gold bear along with the epic mass exodus from GLD by stock traders spawned by the Fed’s stock-market levitation, GLD investment is now super-low.
As of the middle of this week, the total amount of capital American stock traders had deployed in gold via GLD was just $26.5b. Despite gold’s sharp October rally, that wasn’t far above the major secular 6.5-year low of stock-market gold investment of $23.3b in early August. The last time gold investment was that low was in January 2009 when gold was trading near $855. This is what radical gold underinvestment looks like.
While $25b is a lot of money, it is vanishingly small in the grand scheme of investors’ capital. As of the end of September, fully 169 of the 500 companies in the S&P 500 had market capitalizations over $25b. The collective market capitalization of all 500 of those companies in that index was $17,581b. So $25b in gold via GLD is practically nothing, literally a rounding error. American investors really have shunned gold.
Stock traders’ incredibly-low levels of gold exposure today are best understood through the context of the history of GLD holdings’ value. The extreme weakness plaguing gold in recent years started in early 2013 as the Fed ramped up its unprecedented QE3 campaign. And 2008 of course saw that once-in-a-century stock panic that spooked the central banks into their current mode of extreme interventionism.
So the last normal years sandwiched between the stock panic and extreme central-bank distortions in the global markets ran from 2009 to 2012. During that span, the total value of the physical gold bullion GLD held in trust for its shareholders averaged $53.7b. That’s a little over double today’s levels of gold investment! So even a simple mean reversion would require massive stock-market-capital inflows into gold.
This will happen naturally as gold itself continues mean reverting higher out of this past summer’s totally-artificial lows driven by an extreme gold-futures shorting attack. The more gold rallies, the more investors will want to own it. Nothing begets buying throughout the entire markets like rising prices. So they will migrate capital back into GLD, which is already accelerating this week. Investors just love to buy a winner.
And GLD itself is actually a conduit for stock-market capital to flow directly into the global physical gold market. GLD’s mission is to track the gold price, and this is only achievable if this ETF can vent any excess buying or selling pressure on its shares directly into gold itself. If this flow-through mechanism didn’t work, GLD’s price would quickly decouple from gold’s due to their separate supplies and demands.
When investors buy GLD shares faster than gold itself is being bought, GLD’s price will accelerate away from gold to the upside. In order to stop GLD shares from failing to mirror gold, GLD’s managers have to sop up that excess demand. So they issue enough brand-new GLD shares to satisfy and offset it. Then they use the proceeds from these GLD-share sales to directly buy physical gold bars to add to GLD’s holdings.
So as gold rallies and investors return, the amount of capital invested in GLD will rise through both the gold price appreciation and the growth of GLD’s bullion held in trust for shareholders. Thus it’s not going to take $27b of capital inflows to return American stock traders’ gold investment to normal levels again. Let’s conservatively assume that half of the increase in GLD’s value will come from direct capital inflows.
We are still talking about $13b+ of new GLD investment, which is big money in the gold market! There’s no doubt that such huge collective GLD-share buying would force the gold price much higher. All this excess differential demand would have to be directly shunted into gold itself, so GLD’s gold-bar buying would directly bid up global gold prices. Today’s radical gold underinvestment guarantees big future buying!
But there’s a superior way to measure American stock investors’ gold exposure than just using the value of GLD’s holdings. It’s looking at GLD’s holdings relative to the collective market capitalization of the elite S&P 500 component companies’ stocks. I’ve been alluding to this measure for years, but finally got around to building the huge spreadsheets containing the staggering data necessary to build this chart.
Every month-end at Zeal, we gather data on all 500 S&P 500 companies to compute the general-stock-market valuations. We’ve long weighted individual price-to-earnings ratios of each company by their market capitalizations, so small companies with outsized P/Es don’t have undue influence in skewing the overall average. And part of this involved over 15 years of calculating the entire S&P 500’s market cap.
To get an idea of American stock investors’ total portfolio exposure to gold, we can divide the value of GLD’s holdings by the S&P 500 components’ aggregate market capitalization. This is an outstanding proxy of the percentage of their portfolios invested in gold. Here’s this chart I’ve been procrastinating on for years because it was so tedious to create. This ratio is superimposed over GLD’s actual holdings in metric tons.
It took about 100k pieces of data to build this chart, and the results are super-bullish for gold investment demand going forward. Per the proxy of looking at the value of GLD’s holdings compared to the total market cap of the S&P 500 companies, American stock investors’ portfolio exposure to gold right now is around just 0.14%! That’s not a typo, we are talking about 1/7th of a single percentage point here, nothing.
Thanks to that extreme gold-futures shorting attack back in July, this ratio of the values of GLD to the S&P 500 fell as low as 0.12% in early August. That happened to be a major secular 7.7-year low in this measure of gold investment. Once again like all extremes, this one isn’t sustainable. Gold can’t and won’t stay loathed forever, and as it mean reverts higher out of these lows investors will start returning.
And reasonable normal levels of GLD investment are far higher than today’s dismal lows. Once again in those last normal years between 2008’s stock panic and the early-2013 dawn of the Fed’s incredibly-manipulative QE3 campaign, 2009 to 2012, American stock investors’ portfolio exposure to gold via GLD averaged near 0.48%. That long 4-year secular span is a rock-solid baseline, not a fleeting gold-euphoria moment.
In order to merely mean revert back to that normal-year average, not even overshoot, this ratio would have to soar 3.4x from current levels! That means a lot of stock-trader capital flowing into GLD, a lot of gold-price appreciation, and probably plenty of general stock-market selling thrown in to boot. Again using that normal-year average span between 2009 to 2012, we can get a decent idea of how much of each.
After GLD’s holdings grew rapidly in its early years as stock traders warmed to the concept of a gold ETF, and then experienced explosive growth just after 2008’s stock panic as hedge-fund managers flooded into cheap gold, GLD’s holdings hit a mature stage in early 2009. They had finally reached an equilibrium where they could keep gradually growing on balance, but were too large for more fast growth.
During that 4-normal-year span before QE3’s gross distortions, GLD’s gold bullion held in trust for its shareholders averaged 1208.5t. As of this week, its holdings languished way down at 694.9t which wasn’t far above their major 6.9-year secular low of early August. So a normalization in GLD’s holdings to pre-QE3 levels would require enough differential buying pressure on GLD’s shares to necessitate 513.6t of gold buying!
That’s an incredible amount of gold that would catapult GLD’s holdings nearly 75% above today’s low levels. I don’t know how long this full mean reversion would take, but let’s conservatively assume a couple years. That would equate to GLD bullion buying of 21.4t a month over that span. That would be a big boost to global gold investment demand, which ran at 75.7t per month in the first half of 2015 per the WGC.
So we are talking about a 28% boost in worldwide gold investment demand for a couple years as American stock investors reallocate capital to GLD to reverse their radical gold underinvestment. The amount of capital necessary to fuel this is vast by gold standards, but still small by stock-market ones. Between 2009 and 2012, the gold price averaged $1361. The midpoint between here and there is near $1275.
Buying the 513.6t of gold bullion necessary to mean revert GLD’s holdings back to normal would cost about $21b at $1275 gold. And $21b in differential new inflows to GLD from American stock investors would work wonders for gold’s price, bidding it much higher. The sheer capital shift necessary to fully unwind today’s radical gold underinvestment is super-bullish for gold price levels in the coming years.
And stepping back, seeing a 0.5% portfolio allocation in gold again by American stock investors certainly isn’t a stretch at all. Remember the average ratio of GLD holdings’ value to the S&P 500 collective market capitalization was 0.48% for 4 years between 2009 to 2012. At its height in August 2011 as gold soared to a euphoric, overbought peak, this ratio challenged 0.69%. And 0.5% still remains very low historically too.
For centuries it not millennia, prudent investors have advocated having at least 5% of total portfolios invested in gold. That’s 10x the conservative target for this coming mean reversion! Gold is a unique portfolio diversifier that generally moves contrary to stock markets. It acts as essential portfolio insurance against some massive selloff hammering the other 95% of portfolios. Literally every investor should own gold!
And there’s no doubt many more will in the coming years. Everything that’s happened since 2013 in the markets is a central-bank-conjured fiction, a fantastic illusion from zero interest rates and extreme QE money printing. The vast resulting distortions artificially boosted stocks while sucking great amounts of capital out of other investments including gold. Neither extreme of high stocks or low gold is sustainable.
As the Fed’s extraordinary stock-market levitation inevitably rolls over into a new cyclical bear, investors will seek out alternatives again. Since gold tends to thrive in weak stock markets and rallies during bear markets, it will again become a prime destination for countless investors. So not only is that very conservative 0.5% stock-investor portfolio allocation to gold easily doable, that metric will probably go much higher.
And don’t make the mistake American futures speculators are of fearing the Fed’s coming rate hikes. Historically gold has actually thrived on balance in Fed-rate-hike cycles, primarily because they wreak so much havoc on general stocks and bonds. Gold actually rallied through 6 of the 11 Fed-rate-hike cycles since 1971, with average gains of a staggering 61.0% within those exact rate-hike-cycle spans!
During the Fed’s last rate-hike cycle between June 2004 to June 2006 where it more than quintupled its federal-funds rate from 1.00% to 5.25%, gold soared 49.6% higher! That was despite 425 basis points of hikes across 17 consecutive FOMC meetings. Gold only fell in Fed-rate-hike cycles when they began when gold was near secular highs, for an average of just 13.9%. That obviously certainly isn’t the case today.
So don’t hesitate to heavily invest in gold now before the legions of American stock investors figure out they are radically underinvested. Their vast buying will catapult gold much higher. Either physical gold bullion or GLD shares are fine, but I far prefer the beaten-down stocks of the gold miners. They’ve been forced to fundamentally-absurd lows in recent years, and have big potential to at least quadruple in the next few!
The bottom line is American investors remain radically underinvested in gold. This is readily evident in the ratio of the value of GLD’s gold-bullion holdings to the collective market capitalization of the elite S&P 500 stocks. Portfolio allocations to gold were recently at their lowest levels in nearly 8 years, and remain at well under a third of recent years’ average levels before the Fed’s wild distortions from QE3.
That means American investors are going to soon plow tens of billions of dollars back into gold in an attempt to regain some modicum of prudent portfolio diversification. While these capital flows will be small compared to the stock markets, they are massive relative to gold investment demand. All that buying is going to catapult gold prices far higher, leading to gargantuan gains in the left-for-dead gold miners’ stocks.
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