An ETF that Foreshadows Gold Price Movements

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An ETF that Foreshadows Gold Price Movements

Interested in trading gold? Then you’ll probably want to know about this ETF that usually turns just ahead of gold prices. That means if you are thinking about going short in gold, you can wait for the ETF to turn lower, which means gold prices should follow shortly after. If you want to go long gold, wait for the ETF to turn higher and gold should move higher shortly after.

The ETF

An ETF is an exchange traded fund. It is like a mutual fund but trades on a stock exchange like a regular stock. The Market Vectors Gold Miners ETF (ARCA:GDX) is an ETF that owns stocks in a bunch of different gold miners. The stocks of gold miners have a tendency to react a bit before gold.

The phenomenon is most noticeable on a daily chart, and helps pick turning points in gold. On intra-day charts this also occurs, but the signal isn’t as reliable because sometimes gold will lead GDX and other times GDX will lead gold.

Figure 1 shows several instances where GDX peaked or bottomed before gold. The chart is a daily chart of The SPDR Gold Trust (ARCA:GLD), another ETF (actually a “trust” in this case) which tracks the price of gold because it holds gold in trust.

GDX is overlain on the chart in yellow so gold (or a proxy for it) and GDX can be seen side-by-side.

The chart shows that GDX has a tendency to peak or bottom out a few days before gold.

This is only useful though when some other form of analysis involved. This is because it is only in hindsight that we see when major bottoms and peaks occurred. In real-time we don’t know if a bottom or top in GDX is going to result a just a small reversal or a big reversal.

Trading the Relationship

Trend analysis can aid in this regard. Assume the trend is down in gold, as it was during 2020. The trend gives us the direction to trade in and therefore the GDX “indicator” is more useful.

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During a downtrend in gold, wait for a pullback to the upside. Once GDX stops rising, and begins to fall again, you can look to initiate the short position. “Begins to fall again” needs to be defined though. In the chart below I have drawn small trendlines to mark points that if GDX drops below, GDX (and gold) is likely to continue dropping.

In figure 2 above we see several pullbacks higher within an overall downtrend. During those pullbacks we let the price pause so we get very small support areas. When the price breaks through those support areas in GDX it indicates GDX is going to continue dropping. This would also be the time to take a short position in gold, because gold is likely to follow suit and move lower a couple days after GDX.

Final Word

Using a gold miner ETF such as GDX to help trade gold is a method that can be used when there is a strong directional bias in both the ETF and gold. While GDX may provide a slight foreshadowing of what is likely to happen with gold prices, traders need to remain adaptable. In real-time we don’t know if a peak or bottom will be a major one or not; this is why we use a trend and trade in the trending direction. GDX simply helps with timing trades in the gold market.

Like any method, being able to perform this type of analysis, and ultimately being able to trade off of it, takes practice. Try your hand at it in a demo account before utilizing real money.

What Moves Gold Prices?

The price of gold is moved by a combination of supply, demand, and investor behavior. That seems simple enough, yet the way those factors work together is sometimes counterintuitive. For instance, many investors think of gold as an inflation hedge. That has some common-sense plausibility, as paper money loses value as more is printed, while the supply of gold is relatively constant. As it happens, gold mining doesn’t add much to supply from year to year. So, what is the true mover of gold prices?

Key Takeaways

  • Supply, demand, and investor behavior are key drivers of gold prices.
  • Gold is often used to hedge inflation because, unlike paper money, since its supply doesn’t change much year to year.
  • Studies show that gold prices have positive price elasticity, meaning the value increases along with demand.
  • However, the investment growth rate of gold over the past 2,000 years has not been meaningful, even as demand has outpaced supply.
  • Since gold often moves higher when economic conditions worsen, it is viewed as an efficient tool for diversifying a portfolio.

Correlation to Inflation

Economists Claude B. Erb, of the National Bureau of Economic Research, and Campbell Harvey, a professor at Duke University’s Fuqua School of Business, have studied the price of gold in relation to several factors. It turns out that gold doesn’t correlate well to inflation. That is, when inflation rises, it doesn’t mean that gold is necessarily a good bet.

So, if inflation isn’t driving the price, is fear? Certainly, during times of economic crisis, investors flock to gold. When the Great Recession hit, for example, gold prices rose. But gold was already rising until the beginning of 2008, nearing $1,000 an ounce before falling under $800 and then bouncing back and rising as the stock market bottomed out. That said, gold prices rose further, even as the economy recovered. The price of gold peaked in 2020 at $1,921 and has seen ups and downs since that time. In early 2020, prices fetched $1,575.

In their paper titled The Golden Dilemma, Erb and Harvey note that gold has positive price elasticity. That essentially means that, as more people buy gold, the price goes up, in line with demand. It also means there aren’t any underlying “fundamentals” to the price of gold.   If investors start flocking to gold, the price rises no matter what shape the economy is or what monetary policy might be.

That doesn’t mean that gold prices are completely random or the result of herd behavior. Some forces affect the supply of gold in the wider market, and gold is a worldwide commodity market, like oil or coffee.

Supply Factors

Unlike oil or coffee, however, gold isn’t consumed. Almost all the gold ever mined is still around and more gold is being mined each day. If so, one would expect the price of gold to drop over time, since there is more and more of it around. So, why doesn’t it?

Aside from the fact that the number of people who might want to buy it is constantly on the rise, jewelry and investment demand offer some clues. As Peter Hug, director of global trading at Kitco, said, “It ends up in a drawer someplace.” The gold in jewelry is effectively taken off the market for years at a time.

Even though countries like India and China treat gold as a store of value, the people who buy it there don’t regularly trade it (few pay for a washing machine by handing over a gold bracelet). Instead, jewelry demand tends to rise and fall with the price of gold. When prices are high, the demand for jewelry falls relative to investor demand.

Central Banks

Hug says the big market movers of gold prices are often central banks. In times when foreign exchange reserves are large, and the economy is humming along, a central bank will want to reduce the amount of gold it holds. That’s because the gold is a dead asset—unlike bonds or even money in a deposit account, it generates no return.

The problem for central banks is that this is precisely when the other investors out there aren’t that interested in gold. Thus, a central bank is always on the wrong side of the trade, even though selling that gold is precisely what the bank is supposed to do. As a result, the price of gold falls.

Central banks have tried to manage their gold sales in a cartel-like fashion, to avoid disrupting the market too much. Something called the Washington Agreement essentially states that the banks won’t sell more than 400 metric tons in a year. It’s not binding, as it’s not a treaty; rather, it’s more of a gentleman’s agreement—but one that is in the interests of central banks, since unloading too much gold on the market at once would negatively affect their portfolios.

The Washington Agreement was signed on Sept. 26, 1999, by 13 nations and limits the sale of gold for each country to 400 metric tons per year. A second version of the agreement was signed in 2004, then extended in 2009.

Besides central banks, exchange-traded funds (ETFs)—such as the SPDR Gold Shares (GLD) and iShares Gold Trust (IAU), which allow investors to buy into gold without buying mining stocks—are now major gold buyers and sellers. Both ETFs trade on the exchanges like stock and measure their holdings in ounces of gold. Still, these ETFs are designed to reflect the price of gold, not move it.

Portfolio Considerations

Speaking of portfolios, Hug said a good question for investors is what the rationale for buying gold is. As a hedge against inflation, it doesn’t work well. However, seen as one piece of a larger portfolio, gold is a reasonable diversifier. It’s simply important to recognize what it can and cannot do.

In real terms, gold prices topped out in 1980, when the price of the metal hit nearly $2,000 per ounce (in 2020 dollars). Anyone who bought gold then has been losing money since. On the other hand, the investors who bought it in 1983 or 2005 would be happy selling now. It’s also worth noting that the ‘rules’ of portfolio management apply to gold as well. The total number of gold ounces one holds should fluctuate with the price. If, for example, one wants 2% of the portfolio in gold, then it’s necessary to sell when the price goes up and buy when it falls.

Retaining Value

One good thing about gold: it does retain value. Erb and Harvey compared the salary of Roman soldiers 2,000 years ago to what a modern soldier would get, based on how much those salaries would be in gold. Roman soldiers were paid 2.31 ounces of gold per year, while centurions got 38.58 ounces. 

Assuming $1,600 per ounce, a Roman soldier got the equivalent of $3,704 per year, while a U.S. Army private receives $17,611. So a U.S. Army private gets about 11 ounces of gold (at current prices). That’s an annual investment growth rate of about 0.08% over approximately 2,000 years. 

A centurion (roughly equivalent to a captain) got $61,730 per year, while a U.S. Army captain gets $44,543—27.84 ounces at the $1,600 price, or 37.11 ounces at $1,200. The rate of return of 0.02% per year is essentially zero. 

The conclusion Erb and Harvey have arrived at is that the purchasing power of gold has stayed quite constant and largely unrelated to its current price. 

The Bottom Line

If you’re looking at gold prices, it’s probably a good idea to look at how well the economies of certain countries are doing. As economic conditions worsen, the price will (usually) rise. Gold is a commodity that isn’t tied to anything else; in small doses, it makes a good diversifying element for a portfolio.

Physical Gold vs. GLD, Other ETFs, and ETNs

Gold ETFs

Exchange-traded funds (ETFs) give traders access to the price movements of gold without having to buy physical gold. Instead, the ETF does this for the investor.

Gold ETFs are typically structured as trusts. Under this structure, the ETF holds a certain amount of gold for each share of the ETF issued. Buying a share means owning a portion of the gold held by the trust.

These types of funds hold physical gold, so their prices move with the price of gold over the short term and the long term. There are only minor tracking errors when the ETF price deviates from the gold price. When tracking errors occur, arbitrageurs quickly correct them.

There are many gold ETFs, but we will only consider two of the most popular choices here.

GLD Gold ETF

The SPDR Gold Trust (GLD) is the most popular gold ETF, with $44 billion in assets under management as of November 2020. The GLD ETF averaged more than $1.4 billion a day in volume. According to SPDR, each share was worth 0.094214 gold ounces in net asset value (NAV). As the price of actual gold moves up or down, so does the price of GLD. Investors may push the price above or below the NAV, meaning that the shares may be worth slightly more or less than 0.094214 ounces of gold.

The GLD ETF began trading at approximately 1/10 the price of gold. However, the amount of gold held by each share is eroded slightly over time as the ETF charges investors a 0.4% annual fee. These fees slowly lower the NAV of the ETF, thus slightly reducing the amount of gold that a share is worth each year. This fee is relatively modest in the context of gold’s long-term gains. Remember that gold returned about 7.65% per year between 1971 and 2020, according to World Gold Council data. Physical gold storage and insurance fees for small investors are usually higher than 0.4% per year. Therefore, gold ETFs are an efficient vehicle for investing in gold.

Remember that gold returned about 7.65% per year between 1971 and 2020, according to World Gold Council data.

IAU Gold ETF

Another popular gold ETF is the iShares Gold Trust (IAU), with about $17 billion in assets under management in November 2020. The ETF averaged more than $300 million a day in volume. IAU has a 0.25% expense ratio, and it began trading at approximately 1/100 the price of gold. IAU also holds gold in trust and has a structure similar to GLD.

Leveraged and Inverse Gold ETNs

Leveraged and inverse gold funds are also available. These funds are more complex than plain-vanilla gold ETFs because they do not hold physical gold in trust. Rather than exchange-traded funds, leveraged and inverse funds often trade as exchange-traded notes (ETNs). ETNs are debt obligations of the underwriter of the ETN. The price of the ETN tracks a commodity index. However, an ETN depends on the creditworthiness of the underwriter and does not give investors ownership of gold.

Leveraged and inverse gold ETNs are only intended for short-term trades. They accurately track the daily movements in the price of gold, not the long-term changes. The use of leverage over time can magnify losses from volatility. Inverse gold funds have negative expected returns in the long run because the price of gold generally rises in a fiat money system.

Leveraged and inverse gold ETNs are only intended for short-term trades.

UGLD Leveraged Gold ETN

The Velocity Shares 3x Long Gold ETN (UGLD) provides exposure to three times the daily movement of gold futures contracts. Its expense ratio was 1.35%, with an average daily volume of about $20 million in November 2020.

DZZ Inverse Leveraged Gold ETN

The DB Gold Double Short ETN (DZZ) moves inversely to gold prices. If gold moves up 1% today, DZZ should drop by 2% because it moves twice as much in the opposite direction. The average daily volume was only around $80,000 as of November 2020. It had a 0.75% expense ratio at that time.

The Bottom Line

Gold ETFs operating as trusts are straightforward. The trust holds physical gold and issues shares. The shareholder has fractional ownership of that gold. The shares reflect the price movement of actual gold, but typically at about 1/10 or 1/100 of the metal’s price. The expense ratio slowly erodes the amount of gold for each share. However, ETFs are still typically more efficient than buying physical gold and storing it. Inverse and leveraged ETNs are more complex than ETFs. They track daily gold price changes by going in the opposite direction or magnifying price movements. Unfortunately, leveraged and inverse ETNs do not accurately track long-term gold price changes.

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