The increases of volumes bought in China and India of 32% and 13% were only possible because of the selling by ETFs

The increases of volumes bought in China and India of 32% and 13% were only possible because of the selling by ETFs. Photo Originally epSos.de

The dollar gold price peaked at $1,894 per troy ounce on 7th September, 2011. By 21st December, 2013 it had fallen 37% to $1,196/oz. In less than three months it has jumped 15% to $1,344/oz at the time of writing. Is the gold bull market back on? And what’s driving it? Could the price fall again?

According to the World Gold Council, 2013 was a year when combined global physical gold demand – for jewellery, bars and coins – jumped sharply, up 21%. But investors in gold backed exchange traded funds (ETFs) were cutting their positions significantly, dumping 881 tonnes of the metal, versus purchases of 279 tonnes in the previous year.

ETF sales of 881 tonnes effectively added 20% to the 4,340 tonnes of global gold supply that came from mining and recycling. That’s a big deal, and goes a long way to explaining the 28% fall in the gold price during 2013.

Owners of physical gold tend to keep it for the long term. It’s a real, tangible store of wealth. Plus it’s relatively difficult to buy and sell. You have to go to a dealer to buy coins and bars, and negotiate a price. And just try persuading your wife or girlfriend to part with a piece of jewellery that you bought her. Not a good idea if you’re planning to keep her happy.

Transaction costs for physical gold are relatively high too. For example, even simple one ounce bullion coins – such as South African Krugerrands, American Eagles or Chinese Pandas – usually sell at 5-10% above the wholesale spot gold price. Most people will only pay that kind of premium for things they intend to keep.

…markets in the Middle East and India, simple jewellery with high gold content can be bought much closer to the spot gold price.

New jewellery often retails for twice or more the value of the gold content, once you take account of fabrication costs, distribution and retail profit margin. That said, in some markets in the Middle East and India, simple jewellery with high gold content can be bought much closer to the spot gold price.

But the upshot is that buyers of physical gold tend to be in it for the long run. They are the “strong hands”.

Whereas many ETF investors are in it for the short term. They want to speculate on price moves. Buy and sell orders are just a click away, through their online brokerage accounts. Also they may use “stop losses”. This means that if the price falls by a certain amount, say 20%, they automatically liquidate their positions. They are the “weak hands” of the gold market.

So 2013 was a year when gold flowed from weak hands to strong hands, from short term price speculators to long term wealth accumulators. Most notably mainland Chinese physical demand was up 32% to 1,066 tonnes. Chinese jewellery demand jumped 29% and bar and coin demand surged 38%. The Chinese took full advantage of the lower prices handed to them by Western ETF sellers.

Chinese physical demand for gold also overtook India for the first time in 2013. But Indian demand itself was no slouch, increasing 13% to 975 tonnes.

The big question is whether gold is now firmly back in the bull market that started in 1999. The market low of $256/oz was famously caused by the then British Prime Minister, Gordon Brown, pre-announcing plans to sell 400 tonnes of government gold reserves.

This immediately drove the price down to new lows and ensured that the British government received the worst possible price for its gold. British gold traders, in their usual sarcastic style, refer to this episode as the “Brown bottom”.

Starting at that low the gold price is up 5.2 times against the US dollar in the past 15 years, even after the price fall since late 2011. That’s a compound gain of just under 12% a year. Not bad for an asset that famously pays no income yield, and way ahead of the performance of most stock markets over the same period.

For comparison the MSCI USA index is up just 37% in total over the same period, or just 2.2% a year compound annual price gain. Add in 2-3% of annual dividend yield and US stock investors have made around 5% a year since July 1999, much less than holders of gold.

Further gold price increases depend on two questions, in the long run. Have ETF investors now stopped selling their holdings, or even started increasing them again? And will physical demand in China and India remain strong, driving the price to new highs?

We can get some insight into the ETF question by looking at the gold holdings of the SPDR Gold Shares ETF (NYSE:GLD). This is by far the largest gold backed ETF in the world.

On 7 December 2012 GLD’s gold holdings peaked at 1,353 tonnes. By 14 January 2014 they had fallen 42% to just 790 tonnes. That is a massive liquidation of 563 tonnes of gold from this one ETF alone.

As of 13 March 2014 GLD’s holdings have increased slightly to 813 tonnes. So far the signs are that gold ETF holders have stopped dumping their positions.

The increases of volumes bought in China and India of 32% and 13% were only possible because of the selling by ETFs. Gold supply from mining and recycling grew only 2% in 2013.

But what about physical demand? Well clearly it can’t keep growing at the pace of 2013. The increases of volumes bought in China and India of 32% and 13% were only possible because of the selling by ETFs. Gold supply from mining and recycling grew only 2% in 2013.

In fact mined supply jumped by an unusually high 8% last year and recycled gold volumes fell by 12%. If ETF selling has now stopped, then recycling volumes would have to jump substantially for the volume of physical demand to be able to grow sharply again in 2014.

So if physical gold demand stays strong, but volumes available for sale are constrained, this will be clearly bullish for the gold price.

But a word of caution here. Gold is already up 15% in the first two and a half months of 2014, against an average annual gain of 12% in the past 15 years. So has gold gone up by too much and too fast?

Most recently, at least part of that price jump has been caused by nervousness about the potential fallout from the crisis in the Ukraine. If things settle down then the price could fall in the short term.

It’s also worth nothing that there have been seven years in the last 15 when the gold price has risen more than 20% in the year. Of those, there were only two when it rose by more than 30% (2007 and 2010).

In the short term anything could happen to the gold price, most likely driven by speculators in paper futures markets. It could go up, or it could go down. But I continue to recommend that all OfWealthers own at least some physical gold for the long term.

We live in a world of strong ongoing physical demand in the large emerging markets, geopolitical uncertainty in places such as the Ukraine, money printing, and excessively large financial derivative markets. In my view that makes it essential to own some of this timeless, famously desirable and notoriously indestructible metal.

The future remains bright and shiny for gold.

Stay tuned OfWealthers,

Marco Polo

marcopolo@ofwealth.com