Gold: Thinking about how far we fall

The sentiment has dramatically shifted on precious metals. The gold bugs have gone silent or are desperately trying to reframe their pitches, the bears have gotten loud, and people previously claiming neutrality—in no small part out of fear of the wrath of the gold bug crew—now feel free to pile on. With sentiment having shifted so far, is the slide in precious metals over?

Short answer: no. Here are a few points from the longer answer.

Gold is a bubble. The selloff is not recent. It has been going on for two years. What has changed is that we’ve entered the acceleration phase of the decline.

If you have resisted this idea up until now, you’re still in time to come clean with yourself. The legs on which the post-QE phase of the gold ramp was built have cracked. No hyperinflation, no systemic collapse, no fiat debasement. The biggest misconception of all—that ‘printing money’ causes inflation—has been thoroughly discredited by anyone who followed the debate closely. In fact, collective fears seemed to have tipped in the direction of deflation.

This shift in thinking has been mirrored in the precious metal markets. They reacted to QE1 and QE2, but by the time QE3 rolled around monetary stimulus lost its juice, as investors increasingly got past the arm waving and came up to speed on how monetary policy actually works.

You can see this on this chart:

The leftmost yellow line shows the sharp upward turnaround in the price of gold when the Fed first went nuclear in November 2008. Similarly, when Fed Chairman Bernanke dropped heavy hints at Jackson Hole in August 2010 that more monetary easing would follow, the precious markets responded strongly and positively (2nd yellow line).

However, as time marched forth and the inflation/debasing that motivated much of the rush into gold didn’t materialize, the economy continued to heal below the surface, and the positioning in gold became heavy, the shiny metal rallied progressively less to every accommodative twitch out of the Federal Reserve. Those of us watching this market closely also noticed the gold’s correlations to other assets were also changing. Gold’s positive correlation to the equity market was all but gone, and it’s negative correlation to the US dollar had declined considerably. In fact, things had changed to such a degree that by the time QE3 was trotted out, there was a brief bump in the gold price, followed by a sharp reversal. Gold has been on a one-way slide ever since (3rd yellow line).

So, how far do we fall?

It is important to note that the peak in precious metals coincided with the peak in emerging markets equities (silver and EEM peaked, in fact, the same week). This is not random. The commodity boom had two phases (both, BTW, turbo-charged by the arrival of ETFs). The pre-QE phase was driven in large part by the paradigm shift in emerging markets and the extrapolation of their appetite for ‘scarce’ commodities. Both asset classes are now well into their unwind. (More on that here, for those interested.)

The post-QE phase of the commodity boom was more narrow. In fact, it may surprise many readers that the price of oil is roughly unchanged since QE started. The big run up in the price of oil came in the pre-QE phase, driven by the EM story, as you can see here:

The gist is that the post-QE commodity rally was heavily concentrated in precious metals. This matters a lot if you want to make an educated guess as to how far gold can fall. The chart is pretty ominous:

Why does this mater a lot? The implication is that if you believe—as markets increasingly do—that the Fed will let it’s book of QE roll off and their much discussed exit strategy will transpire without systemic collapse or rapid inflation, we are likely to revert roughly to pre-QE levels for precious metals. (NB: You may still believe catastrophe awaits, but by now you should at least concede that the scope for saying “no, no, not yet; I was just early” is unambiguously contracting.)

What does that reversion look like? Here:

I am not a huge fan of targets. But I am a big fan of concepts. And if you think the market got its monetary gloom and doom QE analysis wrong, it does make sense that pre-QE levels is where cruel reversion is likely to take us. That range you see on the chart above is $700-$900 for gold. (If you think any of the emerging market/pre-QE phase of the gold rally should unwind, then gold would have to fall of course further.)

There is another reason to think there is much more selling to come. The chart below shows Total Known ETF Gold Holdings.

You can see that gold holdings have fallen less than the gold price. As an economist would say, this means the price elasticity of gold demand is very low.  In other words, the price of gold fell disproportionately to the quantity of gold the sellers were able to unload.

Many like to say “for every seller there is a buyer, so what’s the big deal?” This misses the important point of elasticity.  It is not symmetrical. And elasticities are extremely sensitive to animal spirits. Buying $300mm of gold can move the market up by less than a percent in a normal market. But when sentiment for gold turns adverse, selling $300mm can drive it down, say, 2-3%.

The upshot is this often leads others who have decided to sell but have not executed to freeze. Just like when it comes to selling your house and you don’t “like” the market price. This leaves a backlog of trapped longs and results in many praying for an uptick. I think we all know how this story ends.

The trapped long chart for silver is even worse:

There are ways to manage your position and (importantly) your mental capital if you are a trapped long. If you haven’t been involved and are looking to go short, there are also ways to get into a short position that mitigate the risk of ‘chasing’.  I intend to write a post later today on how to go about these strategies. Until then, good luck.