An increase in the amount of gold bullion held by GLD (the SPDR Gold Shares) and other bullion ETFs does not cause the gold price to rise. The cause-effect works the other way around and in any case the amount of gold that moves in/out of the ETFs is always trivial compared to the metal’s total trading volume. However, it is reasonable to view the change in GLD’s gold inventory as a sentiment indicator.

Ironically, an increase in the amount of physical gold held by GLD and the other gold ETFs is indicative of increasing speculative demand for “paper gold”, not physical gold. As I explained in previous blog posts (for example, HERE), physical gold only ever gets added to GLD’s inventory when the price of a GLD share (a form of “paper gold”) outperforms the price of gold bullion. It happens as a result of an arbitrage trade that has the effect of bringing GLD’s market price back into line with its net asset value (NAV). Furthermore, the greater the demand for paper claims to gold (in the form of ETF shares) relative to physical gold, the greater the quantity of physical gold that gets added to GLD’s inventory to keep the GLD price in line with its NAV.

Speculators in GLD shares and other forms of “paper gold” (most notably gold futures) tend to become increasingly optimistic as the price rises and increasingly pessimistic as the price declines. That’s the explanation for the positive correlation between the gold price and GLD’s physical gold inventory illustrated by the following chart. That’s also why intermediate-term trend reversals in the GLD gold inventory tend to follow reversals in the gold price. The thick vertical lines on the following chart mark the intermediate-term trend reversals in the US$ gold price.

Interestingly, the increase in the GLD inventory that occurred in parallel with the most recent upward trend in the gold price was relatively small. This suggests that the price rally was driven more by increasing demand for physical gold than by increasing demand for paper gold. Furthermore, the minor downward correction in the gold price since the February-2019 short-term peak has been accompanied by a disproportionately large decline in GLD’s physical inventory. In fact, at the end of last week GLD held about 30 tonnes less gold than it did when the gold price was bottoming in the $1170s last August. Again, this suggests that the gold price has been supported by demand for the physical metal.

In terms of influence on the gold price, speculative trading of gold futures is vastly more important than speculative trading of GLD shares. Therefore, assumptions about paper versus physical demand shouldn’t be based solely on the change in the GLD inventory. The situation in the gold futures market also must be taken into account.

I won’t get into the details in this post, but changes in futures-market positioning and open interest over the past few months are consistent with the idea that the demand for physical gold has been strong relative to the demand for paper gold.

The relatively strong demand for physical gold does not imply that a big gold-price rally is coming, but it does imply that the downside price risk is low.

If you look hard enough you will always be able to find reasons that the gold price is about to rocket upward, because such reasons always exist regardless of whether gold’s prospects are bullish or bearish. More generally, searching for reasons that something specific is about to happen is a bad way to speculate or invest because it will always be possible to find evidence to support any preconceived view. Rather than attempting to justify preconceived views, it is much better to approach the markets with an open mind and to base buy/sell decisions on objective indicators with good long-term track records.

One of the financial world’s most reliable indicators is the gold/commodity (g/c) ratio. The g/c ratio is more predictable than the US$ gold price, or to be more accurate the g/c ratio has a more consistent relationship with other markets than does the US$ gold price. This is possibly because removing the ever-changing dollar from the equation suppresses ‘noise’ and amplifies ‘signal’.

The following chart is an example of the g/c ratio’s consistent, and therefore predictable, relationship with another market. It shows that almost all of the time the g/c ratio (as represented by the US$ gold price divided by the GSCI Spot Commodity Index) trends in the same direction as credit spreads (represented here by the IEF/HYG ratio).

The relationship depicted below is sufficiently reliable that if you know, or at least have a good idea regarding, what will happen to credit spreads over a certain period, then you will be able to accurately forecast whether gold will strengthen or weaken relative to the average commodity over the period. By the same token, knowledge about whether gold is poised to strengthen or weaken relative to the average commodity leads to a high-probability forecast about credit spreads.

There are other inter-market relationships involving the g/c ratio that work just as well as the one mentioned above, and at the beginning of this year I used one of these to forecast that gold would be weak relative to commodities during the first half and strong relative to commodities during the second half of 2019. The first-half forecast has panned out to date. The second-half forecast still looks plausible but is subject to revision based on what happens to various indicators over the next couple of months.

Another of the financial world’s most reliable indicators is sentiment. An accurate reading of market sentiment doesn’t lead to specific conclusions about future price movements, and as discussed HERE there are pitfalls associated with using sentiment to guide buy/sell decisions. However, understanding how sentiment affects the markets can give an investor a decisive edge.

I’m not going to write about why or how sentiment can be used to good effect when attempting to time buys and sells in the financial markets. I’m also not going to mention the most useful indicators of market sentiment. The reason is that Bob Moriarty has covered this ground and more in his latest book: “Basic Investing in Resource Stocks: The Idiot’s Guide“. The Kindle version of the book is only US$6, or just a little more than the price of a large cappuccino at my local cafe.

Bob’s book is essential reading for anyone speculating in junior resource stocks, especially anyone who is inexperienced or hasn’t coped well with the huge swings in these stocks in the past.

At one point during the book I thought that Bob was making successful speculation in the stocks of small mining and oil companies seem too easy, because the hard reality is that even when you understand the most effective way to trade these stocks you still will stumble into traps from time to time. However, later in the book Bob warns the reader that large losses can happen even when all the ducks appear to be in a row. He does this by recounting some amusing stories about his own failed speculations and the management teams that helped to create these failures.

Even if you already know how to use sentiment and how to operate profitably at the speculative end of the stock market, you will get something out of the Bob Moriarty book linked above. It’s well worth the 6 bucks for the electronic version or the 12 bucks for the paper version.

A popular view is that the Fed has given up on monetary tightening and as a result the stock market should continue to trend upward over the months ahead. This view is based on flawed reasoning.

The reality is that the Fed possibly will give up on monetary tightening later this year, but currently the Fed is pulling quite firmly on the monetary reins via its on-going balance-sheet normalisation (that is, balance-sheet reduction) program. Moreover, the Fed’s on-going withdrawal of money from the economy is not being fully offset by the actions of the commercial banks, so the overall US money-supply situation is becoming increasingly restrictive. This is evidenced by the following chart of the year-over-year (YOY) change in US True Money Supply (TMS). The chart shows that in March-2019 the US monetary inflation rate made a 12-year low.

However, the unusually slow pace of US money-supply growth is not a good reason to be short-term bearish on the US stock market. This is partly because changes in the financial markets lag changes in the monetary backdrop by long and variable amounts of time. It is also because of a point that was covered in a TSI blog post about three weeks ago.

The point I’m referring to is that whether the overall monetary situation is ‘tightening’ or ‘loosening’ is not solely determined by the change in money supply. Instead, over periods of up to a few years the change in the demand for money (meaning: the change in the desire to hold/obtain cash as an asset) often will dominate the change in the supply of money.

In general terms, the change in overall liquidity is determined by the change in the supply of money relative to the change in the demand to hold cash or cash-like securities. As a consequence, it’s possible for the liquidity situation to be tight even if the monetary inflation rate is very high and/or rapidly increasing. A great example is the period from September-2008 to March-2009, when a large and fast increase in the US money supply was more than offset by a surge in the demand for money. Also, it’s possible for there to be abundant liquidity even if the monetary inflation rate is very low. A good example occurred over the past 3-4 months.

Although the supply side of the monetary equation tends to be dominated by the demand side of the equation over the short-to-intermediate-term, today’s unusually low monetary inflation rate is still significant. It means that only a small increase in the demand to hold cash could bring about another plunge in the stock market. To put it another way, due to the low monetary inflation rate the US stock market is far more vulnerable than usual to a short-term increase in risk aversion.

Taking a wider-angle view, the money-supply situation also leads to the conclusion that if a bear market did not begin last year (it most likely didn’t) then it will begin by the second half of next year at the latest. Other indicators will be required to narrow-down the timing.

[In a blog post last October I mentioned that a recent divergence between the gold/commodity ratio and the T-Bond price had bullish implications for the T-Bond. A strong rebound in the T-Bond soon got underway. Another divergence between the gold/commodity ratio and the T-Bond price has since developed, this time with bearish implications for the T-Bond. A discussion of the most recent divergence was included in a TSI commentary published on 28th March and is reprinted below.]

The gold/commodity (g/c) ratio and the T-Bond price tend to move in the same direction. As previously explained, this tendency is associated with what Keynesian economists call a paradox (“Gibson’s Paradox”) and Austrian economists call a natural and perfectly understandable consequence of the relationship between time preference and prices. The reason for revisiting the gold-bond relationship today is that a significant divergence developed over the past three months and such divergences are usually important.

The following chart illustrates our point that the gold/commodity ratio (the US$ gold price divided by the GSCI Spot Commodity Index) and the T-Bond price move in the same direction most of the time. It also shows that over the past three months the two quantities have diverged, with the g/c ratio trending downward while the T-Bond price extended its upward trend and moved to a marginal new 12-month high.

Given that the relationship between the g/c ratio and the T-Bond has a solid fundamental basis, that is, given that it’s not a case of random correlation, it should continue to apply. Therefore, we expect that the divergence will close over the months ahead — via either a rise in the g/c ratio to above its December-2018 high or a decline in the T-Bond price to well below its February-2019 low.

The divergence probably will close via a decline in the T-Bond price, because if there is a leader in this relationship it is the g/c ratio. For example, in each of the three biggest divergences of the past five years (the areas inside the blue boxes drawn on the above chart), the g/c ratio reversed course months in advance of the T-Bond. The g/c ratio also led the T-Bond by 2-3 months at the Q3-2017 top and by a couple of weeks at the Q4-2018 bottom. In other words, the recent performance of the g/c ratio is a reason to be intermediate-term bearish on the T-Bond.

One realistic possibility is that the T-Bond is now topping similarly to how it bottomed between December-2016 and March-2017. Back then, both the g/c ratio and the T-Bond turned up at around the same time (in late December of 2016), but whereas the g/c ratio trended upward throughout the first quarter of 2017 the T-Bond made a marginal new low in March before commencing an upward trend of its own. This time around the g/c ratio and the T-Bond turned down at around the same time (in late December of 2018), but whereas the g/c ratio has continued along a downward path the T-Bond has risen to a marginal new multi-month high.