Physical gold ‘flowing’ into GLD and the other gold ETFs does not cause the gold price to rise and physical gold flowing out of gold ETFs does not cause the gold price to fall. The cause and effect actually works the other way around, with the price change being the cause and the flow of gold into or out of the ETFs being the effect. I’ve covered the reasons before (for example, HERE and HERE), but cause and effect are regularly still being mixed up in gold-related articles so I’m revisiting the topic.

The Net Asset Value (NAV) of a gold ETF such as GLD naturally moves up and down by the same percentage amount as the gold price, so a change in the gold price will not necessarily require any change in the size of GLD’s bullion inventory. It’s only when GLD’s market price deviates from its own NAV that a change in bullion inventory occurs. For example, assume that the gold price gains 10%. In this case, GLD’s NAV will gain 10% and there will be no increase or decrease in GLD’s inventory as long as GLD’s market price also rises by 10%. However, if GLD’s market price rises by 11% then gold will be added to the ETF’s inventory to bring its market price and NAV back into line, and if GLD’s market price rises by only 9% then gold will be removed from the ETF’s inventory to bring its market price and NAV back into line.

Note that the manager of the ETF doesn’t have to initiate anything in the above-described process. The ETF’s Authorised Participants (APs) initiate the process in order to generate arbitrage profits. More specifically, a deviation between market price and NAV creates an opportunity for the ETF’s APs to pocket risk-free profits by selling or buying gold bullion and simultaneously buying or selling ETF shares.

All ETFs work the same way. That is, there’s nothing special about the way GLD works. The modus operandi ensures that the market prices of ETFs usually track their NAVs very closely.

Why, then, does the following chart show a long-term positive correlation between the gold price and GLD’s bullion inventory?

Because traders of GLD shares tend to get more optimistic about gold’s prospects and buy more aggressively AFTER the gold price has risen, causing GLD’s market price to rise relative to its NAV and prompting arbitrage that results in the addition of bullion to the ETF’s inventory. And because traders of GLD shares tend to become more pessimistic about gold’s prospects and sell more aggressively AFTER the gold price has fallen, causing GLD’s market price to fall relative to its NAV and prompting arbitrage that results in the removal of bullion from the ETF’s inventory. The correlation is far from perfect, because GLD traders won’t always become increasingly optimistic in reaction to a price rise or increasingly pessimistic in reaction to a price decline.

A final point worth making is that the annual change in GLD’s bullion inventory has always been very small relative to the total size of the gold market. Given the size of the total aboveground gold supply, there is very little chance that a few hundred tonnes per year moving into or out of GLD’s coffers could have a significant effect on the price.

So, the answer to the question “What do changes in GLD’s bullion inventory tell us about the future gold price?” is: nothing.

In a recent blog post, Martin Armstrong wrote: “This constant attack on central banks is really hiding what the problem truly is — government. When the Fed was created, it “stimulated” the economy by purchasing corporate paper. The Fed was NEVER intended to buy government bonds. The politicians did that for World War I and never returned it to its purpose.” That’s not entirely true. Also, it’s naive to believe that the Fed would benefit the overall economy if it were restricted to its originally-intended purpose.

Contrary to Mr. Armstrong’s assertion, the Federal Reserve Act of 1913 actually does enable the Fed to buy government paper. Specifically, Section 14 of the Act states:

“Every Federal reserve bank shall have power … [to] buy and sell, at home or abroad, bonds and notes of the United States, and bills, notes, revenue bonds, and warrants with a maturity from date of purchase of not exceeding six months, issued in anticipation of the collection of taxes or in anticipation of the receipt of assured revenues by any State, county, district, political subdivision, or municipality…”

More generally, the Federal Reserve Act gave Federal Reserve banks the power to purchase short-term commercial paper (bills of exchange) and short-term government paper, and to set the discount rates associated with these purchases.

Secondly, the whole concept of economic stimulation by central banks in general and the Fed in particular is one of world history’s greatest-ever cases of mission creep. A central bank cannot possibly stimulate an economy by lowering interest rates and creating money; all it can do is distort an economy and exacerbate the boom-bust cycle. Although the theoretical framework had not yet been fully developed by the likes of Ludwig von Mises, this was generally known by economists at the time of the Fed’s establishment in 1913 and explains why there was no mention in the Federal Reserve Act of the Fed taking actions in an effort to modulate the pace of economic growth. Unfortunately, economics is the one science that has taken a giant step backwards over the past 100 years. Whereas there was originally no intention of having the Fed interfere with market rates of interest and react in a counter-cyclical manner to shifts in economic activity, most economists can no longer even envisage an economy that is free from central-bank manipulation.

Thirdly, while it would be a great improvement if the Fed were limited by the rules that originally governed its actions, it is important to understand that the problems (the periodic bank runs and financial crises) that the Fed was set up to address are the result of fractional reserve banking. Rather than eliminate fractional reserve banking, which would have been the correct solution, a central bank was established as a work-around. This is mainly because some of the most powerful and influential people in the country were bankers. Not surprisingly, most bankers like having the legal power to create money out of nothing.

My final point is that the Federal Reserve Act of 1913 was a foot in the economic door. Once the foot was in the door it was always going to be just a matter of time before the entire body had wormed its way in. The reason is that the powers of central banks grow in the same way as the powers of governments, with each intervention leading to problems that create the justifications for more interventions and with the occasional crisis providing the justification for a quantum leap in power. To put it succinctly, the mission creep was inevitable.

(This post is an excerpt from a recent TSI commentary.)

Intermediate-term rallies in the gold-mining sector can happen during general equity bull markets and general equity bear markets, but on a long-term basis the gold-mining sector trends in the opposite direction to the broad stock market. An implication is that to get a new bull market in gold-mining stocks there will probably have to be a new broad-based equity bear market.

A good argument could be made that an equity bear market got underway last July, but at this stage the vast majority of market participants still believe that the bull market is intact. In general, people are very nervous about the short-term while remaining optimistic about the stock market’s long-term prospects. What would shake the long-term optimism of a critical mass of investors?

Based on what happened in 2000, an SPX break below the August-2015 low that was not quickly reversed would probably do it. This is the point we are trying to make with the following chart comparison. The chart compares the HUI and the SPX during the 12-month period beginning March-2000, or the 12-month period commencing just prior to the start of a cyclical stock-market decline.

Notice that the SPX bear market began with a sharp decline from a March high to an April low, after which there was a 4-5 month period of choppy trading that resulted in a test of the March high. At the time the March high was being tested hardly anyone believed that a bear market was underway. The market then began to trend downward and in October the SPX traded below its April low, but the downside breakout was quickly negated and there was a collective sigh of relief. It was still apparent to almost all market participants that they were dealing with a bull-market correction. Then, in November, the SPX again breached its April low and the breakout was not quickly negated. This was the point of recognition — the point when a critical mass of investors came to suspect that an equity bear market was in progress. This was also the point when the gold-mining sector commenced a bull market.

One of the reasons that the bear market in the gold-mining sector has been unusually long is that the general equity bull market has been unusually long. The general equity bull market is probably over, but very few people know it yet. Enough people to provoke a major trend change in the gold-mining sector will probably know it after the SPX makes a sustained break below the August-2015 low.

Anyone who closely follows the mining industry would be well aware that gold producers operating in Australia and Canada were given a large bottom-line boost over the past 18 months by large declines in the Australian Dollar (A$) and the Canadian Dollar (C$). In some cases, the favourable exchange-rate movements are hiding poor cost control.

Looking at the situation from one angle, the financial boost stems from a relatively high selling price for gold in local currency terms. Looking at it from a different angle, the financial boost stems from a lower reported cost when costs are converted to US dollars. For example, if a Canada-based gold producer has a stable cost per ounce in C$ terms during a year when the average C$/US$ rate falls by 10%, then in US$ terms its costs have declined by 10%. In such cases the decline in the US$ cost/ounce shouldn’t be portrayed as if it were due to smart management, but, perhaps not surprisingly, some management teams have given themselves public ‘pats on the back’ for cost improvements that were solely the result of the change in the exchange rate.

The example I’ll highlight is Lakeshore Gold (LSG), a junior gold producer operating in Canada. I’m picking on LSG because it’s a stock that almost everyone loves at the moment. I quite like it too, although I currently don’t own it and wouldn’t buy it at the current price.

All the information needed to figure out LSG’s cost performance in local currency (C$) terms is available in the financial statements issued by the company, but in its press releases LSG usually reports cost/ounce figures in US dollars only. For example, for 2014 it reported an AISC (all-in sustaining cost) of US$872/oz and for 2015 it reported an AISC of US$870/oz, which superficially looks like, and is certainly portrayed by the company as, evidence of good cost control. However, almost all of LSG’s costs are C$-denominated and the average C$/US$ exchange rate was about 13% lower in 2015 than it was in 2014. This means that LSG’s cost/ounce in US$ terms got a 13% benefit from 2014 to 2015, or, to put it another way, a stable cost/ounce performance in US$ terms masks a double-digit cost/ounce increase in C$ terms.

A similar conclusion (a double-digit deterioration in LSG’s mining efficiency from 2014 to 2015) is reached if the operating cost/ounce is determined by dividing the total C$-denominated production cost by the number of ounces produced.

The stock market often doesn’t care about declining efficiency as long as the bottom-line is improving or is expected to improve, but it’s something that investors should be aware of.