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GLD Cannibalizing the HUI?
With gold stocks languishing near lows in a desolate sentiment wasteland, investors are wondering why this sector has fallen so deeply out of favor. One theory is capital that would have traditionally flowed into major gold producers has been diverted into the GLD gold ETF instead. Taken to extremes, this logically leads to the conclusion gold stocks will never thrive as long as GLD exists. Is it cannibalizing the miners?
Undoubtedly it is, so the real question is to what degree. Since GLD's birth in November 2004, it has grown into a wildly successful behemoth holding a staggering $71.5b worth of physical gold bullion in trust for its shareholders. I suspect the majority of GLD purchases have been for diversifying large portfolios, for obtaining that necessary fractional exposure to the gold price. GLD is fantastic for that.
In a parallel universe where GLD had never been conceived, some fraction of the massive capital it has attracted inarguably would have flowed into traditional "gold exposure" for portfolio diversification. And that was buying shares in the world's biggest and best gold miners, the ones that dominate the leading gold-stock index (HUI). Thus the thesis that GLD is cannibalizing the HUI is correct to some extent.
But traders have to be careful, as conspiracy theorists tend to extrapolate this theory way too far. Despite GLD's phenomenal success, there has always been a vocal minority that hate it with a passion bordering on religious fervor. Rather than seeing GLD as a bullish conduit for vast pools of stock-market capital to flow into gold and amplify its bull, they believe it is a cunningly-devised fraud undermining gold's advance.
While discussing these conspiracy theories is beyond the scope of today's essay, several years ago I investigated and debunked GLD conspiracy theories in another comprehensive essay. I've also written extensively about GLD's impact in years past. So if you need to get up to speed on the controversy that surrounds GLD in some circles, read those earlier essays. They will put everything in proper perspective.
Though GLD has to be cannibalizing the HUI, it can't be to the extent its detractors fear. The numbers don't add up. In early December 2012, GLD's physical-gold holdings hit all-time record highs of 1353.3 metric tons. That day they were worth $74.1b. Now if all the elite gold stocks that comprise the HUI had a collective market capitalization less than that, you could make the argument GLD's cannibalization was major.
But just a week earlier at the end of November, the total market cap of all HUI component companies was $190.4b. So there was still on the order of 2.6x as much capital invested in HUI gold stocks alone as the flagship gold ETF. If you could magically transfer that $74.1b in GLD over to the HUI, its market cap would only have risen 39%. While that isn't trivial, it is far from being as apocalyptic as conspiracy theorists believe.
Consider this comparison from the HUI's perspective. That index's bull-to-date high of 635 was achieved in early September 2011. Just a week earlier at the end of August, the HUI's total market cap was $246.7b. GLD's holdings were worth $73.9b the day the HUI peaked. So if all GLD's capital would have been deployed in gold stocks instead, the HUI would have only been trading around 30% higher.
Thus even if we make the indefensible assumption that every dollar ever invested in GLD would have gone into gold stocks if that ETF had never existed, it would only have added about a third to the HUI's levels. That is nowhere near enough to account for their underperformance. The HUI has been trading at panic levels relative to gold in recent weeks, and would have to more than double to hit its secular pre-panic average.
The raw market-cap numbers simply don't support GLD overpowering gold-stock investment. Gold stocks as a group remain far larger than the capital this ETF has attracted. But some would argue that GLD has had an adverse psychological impact, and that may be true. Where big fund managers used to have to buy gold stocks, to actually think about this sector, now they can simply buy some GLD and call it good.
And since investing in gold stocks is far riskier than owning gold itself, the ease with which GLD enables instant portfolio exposure to the gold price may have short-circuited gold stocks' traditional role. But I've always subscribed to an alternative theory. Rather than shrinking interest in gold-sector investment, I suspect GLD has expanded it dramatically. This ETF is the ultimate gateway drug, growing the pool of capital chasing gold.
The more investment capital that flows into physical gold, regardless of the vehicle, the higher its price is driven. And the higher gold's price goes, the more investor interest it generates. Everyone loves a winner, and gold's performance has been incredible over the past 8 years since GLD opened up a direct conduit for stock-market capital to flow into physical bullion. And of course higher gold prices help gold stocks.
Not only do they draw investors' interest to the entire precious-metals realm, they multiply the profits to be made wresting this scarce resource from the bowels of the Earth. Last summer, the HUI gold stocks were actually trading at their lowest price-to-earnings ratios of their entire secular bull. The HUI was cheaper than it was during the stock panic's depths, and considerably cheaper than the general stock markets!
Gold stocks are not suffering today because GLD is cannibalizing their capital inflows, but simply because sentiment is at an unsustainable ebb. Endless cycles of greed and fear echo through the markets. Prices soar to overbought heights when greed gets excessive, and then correct sharply. Eventually prices plunge to oversold lows and fear grows extreme. And then this cycle begins anew.
When investors start regaining interest in the precious metals, they pour capital into everything. It flows into the GLD ETF and gold stocks simultaneously. If GLD was really diverting a major fraction of the capital away from gold stocks, then the HUI wouldn't perform well when GLD's holdings were growing. But as this chart shows, that is certainly not the case. GLD's holdings and the HUI generally rise and drift together.
The red line is the HUI, the flagship gold-stock index. The blue one shows GLD's gold holdings in metric tons. When they are rising, it means stock traders are deploying new capital in that ETF. When they are stable, no capital is flowing into or out of GLD on balance. Buying demand and selling supply are roughly matched. And when these holdings are falling, capital is flowing back out of gold via GLD redemptions.
It is absolutely crucial to understand this dynamic. Remember the mission of GLD is to track the gold price. This can only be achieved in one way. Excess demand for GLD shares, or supply of them, has to be directly shunted into physical gold or else this ETF will decouple from the metal and fail. Its holdings only grow when it faces differential buying pressure from stock investors, and only fall under differential selling pressure.
If stock traders are buying GLD shares faster than the gold price is rising, then it will decouple to the upside. To equalize this excess demand and keep GLD's price in line with gold's, the ETF's custodians issue new shares in large baskets. These are sold into the market to sop up the differential buying pressure. The resulting proceeds are then immediately invested in new physical gold bullion, GLD's holdings grow.
The opposite is true when stock traders are selling GLD shares faster than the gold price is falling, it will decouple to the downside. GLD's custodians have to quickly absorb that excess supply. To raise the cash to buy back their shares, they sell gold bullion. The result is differential selling pressure through the ETF is shunted back into physical gold as well. GLD is simply a two-way conduit for stock-market capital to flow into and out of gold.
So realize when GLD's holdings are rising, new capital is flowing into the gold market through this ETF. When its holdings are falling, capital is flowing out. Once again if GLD was diverting a major fraction of the capital that would have flowed into gold stocks, the HUI would have the best chances of rallying when GLD's holdings weren't growing. But for nearly all of GLD's existence, the opposite has proved true.
Gold stocks tend to thrive the most when GLD faces big differential buying pressure and has to rapidly grow its holdings to keep tracking the gold price. This supports my psychology thesis, that capital seeks all precious-metals investments when gold is returning to favor. While the HUI may have advanced more if GLD didn't exist as an alternative, big GLD holdings growth certainly didn't eliminate massive HUI uplegs.
The chart above highlights them since the birth of GLD. Between May 2005 and May 2006, the HUI rocketed 136.9% higher in an awesomely profitable upleg. If GLD had been cannibalizing gold stocks to the extreme degree conspiracy theorists argue, such a major gold-stock surge couldn't have happened if GLD's holdings grew rapidly. Yet they nearly doubled over that exact span, soaring 97.8% higher!
The next time gold stocks returned to favor in a major way led to a 71.5% HUI upleg between August 2007 and March 2008. Yet it wasn't an either-or scenario, as interest reignited in gold capital flowed in all over this sector's landscape. GLD's holdings climbed another 28.8% over this span, from a much higher starting base. Soon after 2008's crazy stock panic hit, crushing gold stocks radically disproportionately.
Once it passed, GLD's holdings grew dramatically in their biggest absolute surge of this ETF's entire lifespan by far. A handful of major hedge funds were taking on massive positions in GLD, betting on the secular gold bull continuing after the panic. GLD had never seen such intense differential buying pressure before or since. Yet from October 2008 to December 2009 when its holdings surged 51.0%, the HUI still blasted an amazing 236.9% higher!
Gold stocks' next major upleg began soon after the subsequent correction in February 2010. By September 2011, the HUI had climbed 71.7%. Yet GLD's holdings still grew by 11.5% over this span. It is interesting that their growth rate slowed dramatically after the early-2009 hedge-fund buying frenzy had catapulted them well ahead of their secular uptrend. And soon after GLD's holdings stalled, so did the HUI's advance.
Sometime in late 2010 or early 2011, investors' enthusiasm for the entire gold sector began to wane. So both the gold stocks and the GLD holdings started to consolidate high. New capital inflows had dried up universally for this entire sector, which makes sense in psychological terms. It wasn't like the HUI stalled because all the new capital was diverted into GLD. There simply wasn't any new capital for this entire sector!
After a brutal gold-stock capitulation last spring, the great sentiment pendulum was pegged too far at the fear end of its arc so greed had to return. The only way that could happen is through rising prices, and the HUI indeed surged sharply between July and September 2012. Gold stocks blasted 35.6% higher over a short period of time where GLD's holdings also happened to edge up 4.0% to a new all-time record.
See the pattern here? GLD's holdings only grow when investor enthusiasm is returning for the entire precious-metals sector. This same psychological phenomenon also ignited the biggest uplegs in the gold stocks. HUI strength and stock-trader capital inflows into GLD had a high positive correlation. They both thrive when gold is returning to favor, and both slump later on when gold subsequently falls out of favor.
Rather than being mortal competitors gleefully spilling each other's lifeblood so they can drink it, GLD and the gold stocks are in the same boat. They thrive or wither together, battered about by the great greed and fear cycles that cascade through gold. When a rising gold price starts winning traders back and generating some excitement, there is more than enough capital flowing in to lift all this sector's vehicles.
The key to gold stocks' performance has always been gold, and GLD functions similarly. This next chart looks at GLD's holdings superimposed over the gold price. In general, this ETF experiences the greatest differential buying pressure from stock investors when gold is rallying smartly and returning to favor. Similarly when gold starts consolidating or correcting, growth in GLD's holdings stalls as new capital inflows dry up.
Other than the marginal new record GLD-holdings highs in recent months, not much has changed on this chart since I last discussed this relationship in depth a year ago. For our purposes today, just realize that GLD's holdings grow the most when gold's psychology is morphing from fear to greed in major uplegs. This same sentiment shift drives big HUI uplegs at the same times. GLD and gold-stock demand are both driven by gold's fortunes!
I started writing about a gold ETF a couple years before GLD launched, and have always been very bullish on the idea. The more capital that flows into any bull, the bigger it ultimately grows. So a gold ETF opening up a new conduit for the vast pools of stock-market capital to easily flow into gold would be a great boon for everything gold-related. It would help ease new investors into this secular-bull sector.
In addition to being a gateway drug, a gold ETF provides a quick and easy way for all investors to diversify into gold. Depending on how much capital you run, buying gold coins isn't a cost-effective way to own gold. If you have a $100k portfolio, putting 5% to 10% of your capital in gold coins is relatively easy. But if you are a hedge fund or pension fund managing tens of billions, the coin market is too small, illiquid, and expensive (high premiums over spot).
GLD fills that gap, allowing vast amounts of capital to be quickly and cheaply deployed into physical gold bullion held in trust. That portfolio-diversification mission has always been the primary market for GLD. Because of the necessary management fees to operate this massive ETF, GLD's performance will always lag gold's by 0.4% per year. This is acceptable to most money managers since owning large amounts of gold themselves is prohibitively expensive.
Gold stocks have an entirely different mission and constituency than GLD. Their profits leverage advances in the gold price, leading to gains in gold stocks that multiply gold's own when this sector is back in favor with investors. Instead of lagging gold's gains like GLD has to, gold stocks can amplify them by two times or even more in the right sentiment environment. I never thought GLD and gold stocks directly competed.
Large money managers who want low-risk diversification are not interested in the big additional operational risks gold stocks bear, and investors and speculators who want big gold-sector returns aren't interested in not even matching gold's gains. GLD is great for portfolio diversification, while gold stocks are great for investing in a secular gold bull. They each attract in very different groups of traders controlling separate pools of capital.
With such great differences in their risk-and-return profiles, odds are GLD has cannibalized gold stocks considerably less than most traders assume. While I am a big fan of GLD since it facilitates more capital pouring into gold to amplify its secular bull, I've never owned it nor recommended it. But I have owned and recommended hundreds of gold stocks over the 8 years since GLD was born. They are very different vehicles for very different traders.
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The bottom line is the gold ETF is not cannibalizing the HUI to any major degree. GLD remains much smaller than the HUI components' market cap, and its holdings grow the most when gold stocks are also enjoying major uplegs. Capital flows into GLD and gold stocks simultaneously when traders are feeling bullish and greedy on gold, and dries up for both when psychology decays to worry and fear.
Both GLD holdings and gold stocks have been consolidating for a couple years now, weathering the fear end of the great sentiment pendulum's arc. But after such a long time being out of favor, greed is due up next in the emotional cycles. And as gold returns to favor itself, gold stocks will rally and new capital will drive up GLD's holdings in parallel. There will be more than enough new investment to float all gold boats higher.