Frame: GLD Looks Bright Again

March 27, 2014

After last year’s brutal sell-off, the macroeconomic situation looks to favor gold once again, Cougar’s Frame says.

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article features Deborah Frame, vice president of investments at Toronto-based Cougar Global Investments.

Gold was a big winner in the aftermath of the financial crisis, as prices rallied nearly 170 percent from late 2008 to late 2011, boosted by ultra-loose monetary policies and risk aversion.

Following a massive correction of 28 percent in 2013, gold went on to recover by more than 10 percent in just over two months in 2014.

So, is gold back as an asset class, and is it time to give the big gold bullion ETF, SPDR Gold Shares (GLD | A-100), a fresh look? To answer this question, we need to look at where the economy is heading and where sentiment currently stands.

Our research tells us that gold behaves best in chaos, followed by growth, inflation, recession and finally stagnation. As we move from stagnation to growth after five long years of mixed economic indicators, it’s not surprising to see the price of gold rising again.

But without a definitive shift in sentiment that lines up with this view, the recovery is unlikely to be sustained.

Fund flows help with this, but they provide two very different types of insights. Traditional mutual fund flows provide us with a window into more persistent trends coming from longer-term investors. By contrast, ETFs—often used as short-term trading vehicles, give us an indication of sentiment shifts among institutional traders.

ETF flows are thus especially helpful in identifying changes in investor attitudes at the asset class level, and help to explain the correction in the gold price post-2011 as well as the recovery that we’re seeing in 2014.

Lessons Learned From 2008-2009

Economic events can create structural shifts in the perception and acceptance level of risk. The global financial crisis of 2008-2009 is one example of these structural changes, which, in our modeling, we refer to as “chaos.”

Gold tends to reduce losses that may be incurred during tail-risk events. While gold bullion has no credit or counterparty risk, there are additional attributes that make gold a superior portfolio diversifier. When estimating the appropriate mix of assets that go into a portfolio, most investors assume that the distribution of asset returns is close to “normal.”

By normal, we mean that returns are symmetric, and the majority of them—95 percent, to be precise—fall within two standard deviations. In practice, this is rarely the case. Most asset class returns have skewed distributions and are commonly negatively skewed. So-called heavy tails, where investors experience returns beyond two standard deviations, occur more frequently than a normal distribution would predict.

Gold provides diversification benefits by having far less probability of negative returns (fewer heavy tails) in environments when other asset classes are heavily negatively skewed.

Looking back at events including Black Monday in 1987; the Long Term Capital Management crisis in 1998; and the global financial crisis of 2008-2009, World Gold Council analysis shows that gold mitigated portfolio losses incurred by investors during almost all tail events under consideration.

Why does the diversification benefit of gold appear to have disappeared completely in 2013?


Quantitative Easing Market Distortions, ETF Selling And Futures Trading

From a pure fundamental supply-and-demand standpoint, gold’s sharp drop in 2013 was widely attributable to record gold-ETF selling by mainstream money managers and stock traders. The World Gold Council's comprehensive 2013 data showed that global gold-ETF outflows from epic share selling was actually a third greater than the total worldwide drop in gold demand.

This selling was instigated by the parameters of quantitative easing 3 (infinity), announced in September 2012 that guaranteed open-ended continuance until U.S. unemployment declined to 6.5 percent and the Consumer Price Index rose to 2 percent. The U.S. equity market was the clear beneficiary of capital flowing out of low- or non-yielding financial instruments including gold, which were guaranteed to remain out of favor as long as QE3 existed.

Without those extreme gold-ETF liquidations, gold’s worst loss in a third of a century would not have occurred. Fueling this were U.S. futures speculators who also dumped gold at record rates. The increasingly poor gold sentiment, as capital rotated out of the metal to chase attractive stock mark returns, eventually triggered serious selling pressure in the leading gold ETF, GLD.

Stock investors were selling GLD shares much faster than gold was being sold, creating the biggest correction in GLD’s physical-gold-bullion holdings since the stock panic of 2008-2009.

This gold selling was completely futures-based initially, as the panic started cascading through the highly leveraged futures markets. The maintenance margin on Comex gold futures was just $5,400 per contract when the panic began. That means futures traders could control 100 ounces of gold worth $156,100 for just 3.5 percent down. That’s a risky 29-to-1 leverage!

By comparison, in the stock markets, the Federal Reserve has limited margin to 2-to-1 since 1974. Yet even with 50 percent down, panics are still possible, as we learned in 2008—picture gold futures traders taking 100 percent losses on a 3.5 percent gold swoon. When gold fell 7 percent, speculators would lose twice the capital they originally risked. This is a reminder that leverage is an unforgiving game to play.

The 2013 gold panic was a forced-selling phenomenon driven by a support break crushing over-leveraged futures players. The Fed’s decision in December to start making measured changes (tapering) to its stimulus program boosted sentiment, and the strengthened commitment to keeping short-term rates near low as long as inflation is not an issue, and has greatly benefited gold in 2014.

Our conclusion is that the economy is on track for growth and trading in ETFs such as GLD and the futures market, and central bank behavior will contribute to the current gold-price recovery for as long as the economy supports this growth environment.



Cougar Global Investments, founded by Dr. James Breech, is a Toronto-based money management firm that uses only ETFs in its top-down global asset allocating strategies. He perfected a downside risk management system since founding Cougar in 1993. Contact Cougar Global at 800-387-3779 or [email protected]. Deborah Frame is a portfolio manager at Cougar Global, responsible for model creation using tactical asset allocation and downside risk optimization. [email protected]


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