ETFs and the Fabled Gold Bubble

By Melissa Pistilli and Michael Montgomery—Exclusive to Gold Investing News

While it’s not what many gold investors want to hear, there is a growing chorus of consensus that gold is not trading off fundamentals and that in fact the recent price rally is merely momentum driven. Contrarians argue that higher prices are not sustainable because supply levels are not in anyway constrained and demand from jewelry and industrial production is down significantly. Some have even pointed out that higher gold prices are pushing production outputs higher, further adding to oversupply in the market.

In fact, the emotion-laden word “bubble” is being joined to “gold” in more and more analyst discussions, and not just in reference to George Soros’ recent comments. Investment strategists such as Barclays Wealth’s Manpreet Gill are warning investors to avoid gold as there is a possibility of a bubble forming. Online trading news wire DailyFX is also calling a bubble in the gold market and in a recent survey of global fund managers by Bank of America Merrill Lynch, 19 percent saw the precious metal as overvalued.

Commerzbank is also growing more cautious on gold, reports Kitco’s Allen Sykora: “In our view, gold’s latest price rally was more down to dollar weakness than gold strength, so the rally has a shaky footing.”

“We would liken buying gold now to buying technology in 1999,” said David Katz, chief investment officer of Matrix Asset Advisors, in a recent CNBC interview. “There’s a lot of uncertainty in the markets and people are moving toward gold, but gold has had its run.”

Although S&P’s chief technical analyst Mark Arbeter is long-term bullish on gold, his warnings that gold may be heading toward a bubble appeared in an International Business Times article over the summer. “We think because the gold market has been so strong, this bull market will end with a bang. Remember oil prices and oil stocks in 2008, Internet stocks in 1999, housing stocks in 2005. The bubble for gold is percolating and it should be interesting.”

But not everyone agrees with this prognosis. Most notably, the World Gold Council who recently published a report, entitled “The 10-year Gold Bull Market in Perspective,” arguing no such bubble exists. The report’s authors, Ashish Bhatia and Natalie Dempster, use statistical analysis to compare the characteristics of prior bubbles, which include the 1980s Japanese Economic Bubble, the 1999 Tech Bubble, and the 2008 Housing Bubble, to the current developments in the gold price.

Bhatia and Dempster counter that “comparing the evolution of gold price against asset price bubble experiences clearly illustrate that the pace and increase in the gold price does not reflect a bubble.”

Gold not trading on fundamentals?

No one can argue with the fact that investment demand, rather than industrial or jewelry demand, has been the main driver of gold prices since 2008 if not before. The argument lies in whether that demand is purely speculative and based on fear and greed, or whether investors are truly coming around to the intrinsic value of gold as a safe-haven store of wealth; and also, in whether or not physical supply is eclipsing physical demand.

Gold demand for the manufacture of jewelry, dental and industrial uses has been on the decline for several years now. While at the same time global gold coin demand declined 13 percent year-on-year for the period ending June 30, “despite the headline-making crisis that enveloped Europe in Q2,” pointed out precious metal’s analyst Jon Nadler during the Kitco eConference earlier this month.

DailyFx currency strategist Ilya Spivak says global gold supply is increasing as gold scrap levels are up (27 percent according to some reports) and gold mine production is on the rise for the first time in seven years. Statistics published by CPM Group show global mine supplies rose 7 percent year-on-year to 2,572 tons in 2009.

As highlighted by Nadler, recent statistics from ABN Amro Bank show that in 2009, the gold market was in a surplus of 387 metric tons with a 504 ton surplus forecasted for 2010.

However, George Milling-Stanley, Managing Director of Government Affairs at the World Gold Council, has a more price positive outlook for the supply side of gold’s fundamentals. Mr. Milling-Stanley foresees coming supply strains, rather than surplus, as gold producing firms struggle to find new deposits to keep up with rising demand.

“There is a constraint in the terms of the principle components of supply, which is new mine production,” said Milling-Stanley, in an exclusive interview with Gold Investing News on September 23.

A seventy percent drop in exploration and development spending during the gold bear market, which lasted from 1980 to 2000, has translated into “the absence of a developed pipeline of projects.” Flat to declining mine production is expected for the next five to perhaps even ten years, he suggests.

Another factor hurting supply, says Milling-Stanley, is “the fact that central banks around the world, who for two decades have been sustainable sellers of substantial quantities of gold to the private sector markets, have became small net buyers around five quarters ago starting in the second quarter of 2009.”

Jewelry demand’s influence on the gold price

For investors watching the gold market for price indicators, it’s important to consider jewelry as well as investment demand. And the former is giving many analysts reason to question the stability and the longevity of the recent price rally. For 2009, world jewelry consumption fell 24.6 percent to a 21-year low.

The argument made by the gold bears (or the pragmatists) is that rising prices in the face of declining physical demand for bullion and jewelry from the world’s leading gold consumer, India, in the midst of the nation’s buying season, profoundly illustrates that gold’s current price levels are unsustainable. Some analysts are not confident gold can maintain a strong hold over $1300 an ounce, nor climb much higher, without strong jewelry demand.

Rising gold prices are locking many Indian buyers out of the gold market, further decreasing physical demand for the metal. It’s only a matter of time before falling demand in this extremely important market negatively impacts prices.

S.Ravi Kant, the executive vice president of India’s largest jewelry retailer, Titan Industries, recently said jewelry sales are expected to grow at the slowest pace in five years in the 12 months ending June 30, according to Bloomberg.

Last year, overall gold demand from the Asian nation reached a 12-year low.

Mr. Milling-Stanley strongly takes issue with those who say gold’s recent price rally is not based on fundamentals. It’s important to look at the demand picture as having three components, he says: Industrial, Jewelry and Investment.

In terms of decreasing jewelry demand and increasing investment demand, this is a natural phenomenon given the recent global downturn, not the makings of a price bubble, he argues. “We have seen in the past, whenever there were economic troubles around the world, jewelry demand would fall off because demand is all really based on people’s sense of their own prosperity,” notes Milling-Stanley.

However, investment demand works as a “compensating mechanism.” When jewelry and industrial demand go down during times of economic distress, investment demand tends to go up as people seek safe-haven assets. “Investment demand has always been a good part of the gold market. Sometimes it has been as low as 10 percent of each year’s consumption,” he said. “Over the last 20 to 30 years, it has probably been close to 15 percent. Last year, it was around 50 percent.”

However, some would argue that both jewelry demand and investment demand need to be in sync in order for prices to be sustainable, a goal that isn’t always attainable.

ETFs: Easy Come, Easy Go

“Reasonably enough, if real factors were the only forces driving the market, falling demand and rising supply suggest the price of gold ought to have declined over recent years,” said DailyFx’s Spivak.

But the nature of demand in the gold market has changed and now nearly half of all new demand is coming from financial investors, especially through exchange-traded funds.

While investment demand has marginally eclipsed jewelry demand in past downturns, this time it is really significant with demand from jewelry fabrication down 5 percent worldwide alongside of a 118 percent rise in investment demand that includes bullion and ETFs. Such a difference is by no means marginal, giving further support to the argument that current gold prices are based more on speculation than actual fundamentals.

Although many proponents of gold-backed ETFs, including the World Gold Council, defend the funds as having brought many previously locked-out investors into the gold market, others are now warning that they are a major factor in a momentum driven rally and the creation of a price bubble, much like sub-prime mortgages led to the housing bubble of 2008.

In hindsight, financial analysts point to the creation of “non-conforming” or “sub-prime” mortgages as being a critical factor in the creation of the housing bubble because they allowed people previously locked-out of the housing market to become home owners, creating more demand and higher prices.

In July, fretting about gold’s price gains becoming the “impetus for demand- the precise opposite of how an asset is normally expected to behave,” DailyFx’s Spivak showed that “linear regression studies suggest that a whopping 89% of the variance in the spot gold price is explained by variance in the holdings of the SPDR Goldshares ETF.”

Launched in November 2004, SPDR Gold Trust (NYSE: GLD), the world’s largest gold-backed ETF, also holds the prize for the world’s sixth-biggest holder of gold bullion with approximately 1,300 metric tons; an impressive figure which is substantially larger than many of the globe’s central banks, as the International Business Times’ Palash R. Ghosh has pointed out.

Over the summer, Ghosh posed the question: “has the participation of an ETF like GLD inflated the metal’s demand and, thereby, accelerated its price? Just like a mass entry into a promising stock would send its share price through the roof?”

“I suppose you could make that argument, but it would be very difficult to quantify,” remarked Paul Justice, director of North American ETF Research at Morningstar. “If you open up access to any asset that was formerly restricted to most investors; a large rush of buyers could make some impact on its underlying price to some degree.”

In the World Gold Council’s “The 10-year Gold Bull Market in Perspective,” part of Bhatia and Dempster’s argument against the existence of a gold bubble involves comparing and contrasting the gold market with the housing bubble, and they note that “innovations” in mortgage finance helped create the housing bubble. However, the Council doesn’t hold the view that ETFs are providing a comparable mechanism for bubble creation in the gold market.

During Gold Investing News’ interview with Milling-Stanley and Ashish Bhatia, Reporter Michael Montgomery asked, “How do you respond to critics who charge that ETFs, as an innovation in gold investing, have negatively changed the demand side of the gold sector in a way that fosters the creation of a bubble market?”

Mr. Milling-Stanley, as a member of the team responsible for the creation of the SPDR Gold Trust, defended the introduction of ETFs into the gold market as “a big contribution to advancing the investment universe.”

“I haven’t actually heard that criticism before, but it’s an interesting attitude to take. I think that what we did by pioneering the gold-backed ETF was to open up investing in gold to a whole new universe of investors who had experienced insurmountable barriers to investing in gold for many years. When we surveyed the investment market and asked people who weren’t investing in gold, Why not? They all said it was cumbersome, costly and complicated. They wanted something transparent and easily accessible that was traded on a regulated stock exchange. A light bulb went off over people’s heads and we decided a gold ETF sounds like a really good idea.”

He also argues that investment in traditional small bars and coins is still larger “ounce for ounce” than that in ETF investment. “It’s not the case that the ETF tail is wagging the gold market dog right now.”

The question of whether or not gold ETFs are creating a bubble may not be answered until years to come; however, that’s not what has the gold bubble proponents spooked. Rather, it’s the very real possibility that a change in speculative sentiment toward gold could lead to a massive self-off in ETF positions that could in turn demolish prices, or in effect, burst the bubble.

“The truth is that the rally has become self-fulfilling, with its appeal to investors dependent almost entirely upon its continued gains,” cautions Spivak. “It leaves the door open for a sharp reversal at the first hint of a meaningful setback.”

And this sharp reversal could be amplified by investors pulling out of ETF-based positions, which are just as easy to liquidate as they are to acquire.

“So what happens if a wave of ETF-based redemptions hits the market, something to the tune of 200 to 300 tonnes out of the 1,200-plus tonnes that they have now?” asks Nadler in an interview with Hard Assets Investor earlier this year. “I don’t know. We’ve never seen these funds’ effect in a sideways or downward phase of the market, so we don’t know what would happen. To the gold price, of course, it would do significant damage because there’s physical gold behind these funds, and that physical gold would flow into the market in case of redemptions. And this market, at this time, given current fundamentals of supply/demand, is totally ill-prepared to absorb such sizable potential outflows.”

In fact, Barclays Wealth has been advising clients to short SPDR Gold Shares, says vice president and strategist Michael Crook. “At some point it will be evident that the crisis we should be worried about is not a credit crisis it’s not a financial crisis any longer,” The Street’s Alix Steel quoted Crook in an article on the topic earlier this month. “It is a crisis of high unemployment, low zero inflation and very low growth … all of those things are bad for gold.”

Crook, who is not alone, sees prices for the yellow metal crashing to $800 an ounce by 2012. GFMS, Nadler, and Societe Generale have also put out similar forecasts.

However, many of these same seemingly bearish analysts will tell you rather strongly that gold is still a wise choice for your investment portfolio as a hedge against uncertainty. But taking on new positions may not be your best move at these prices.