ETFs' Influence On Investment Demand

The whole premise behind this blog is that gold is in a nascent bubble, and that it's going to end up in a real one. Every bubble begins with an investment that is significantly overvalued, but trades as if it were undervalued. A cognitive-psychology buff would say that this disjoint introduces a sense of cognitive dissonance.

The explanation gap is resolved by what I call a "New Era story," which explains why traditional fundamental analysis supposedly ignores a significant source of added value. Typically, these stories are just that: narratives that justify persistent and seemingly perpetual overvaluation by standard fundamental measures. Although new accessory metrics are sometimes deployed, their newness and (often) lack of direct connection to the investment itself make then supplemental to the New Era story. At bottom, investors and speculators have only the narrative to go on.

Consequently, momentum trading comes into play. New details in the story, and new computations from those accessory metrics, become grist for momentum plays. The players typically think they're responding to "fundamentals," but the way they do it is consistent with momentum trading. Hence, they're really momentum traders.

The Internet bubble fits this template. Anyone around at the time - not just a market player! - remembers the New Era story: the Internet will change commerce forever. Net-based tech had unimaginable potential to move goods, improve management, co-ordinate product manufacturing and delivery, advertise - you name it, the Internet would improve it. Even Alan Greenspan bought into the Internet-as-transformative meme. For a time, most everyone did.

Actually, that New Era story has panned out. The Internet, along with intranets, has transformed commerce. Amazon and eBay are big business. Virtually every company has an Internet presence. And yes, the old-tech media is still suffering from its effects.

The trouble was, as the New Era story waxed into a New-Era delusion, the transformative effects were exaggerated. The hopes and dreams sometimes translated into fundamentals, but not as much as expected. For many, all that was left were those hopes and dreams. By 2002, those dreams had faded - along with many of the former Internet powerhouses as of 1999.

Nowadays, eBay and Amazon get the same treatment as other growth companies. So does Yahoo. Earthlink panned out, but it now trades like a public utility: it pays a dividend now, and the rate is about 6.5%. Earthlink is now a genuine low P/E, high-yield stock.

In gold's case, I originally fingered "the end of the greenback as a world reserve currency" as the New-Era story. There's another one that's surfaced, and it has to do with investment demand.

Yesterday's "Chart of the Day" at Clusterstock is a histogram of ETF-driven gold demand superimposed on a chart of the gold price itself. Vincent Fernando has this to say about it:

Anyone who thinks gold isn't driven by momentum right now should take a hard look at this chart.

While the chart isn't complete proof, it is at least a strong indication that a substantial part of gold's price rise since 2002 has been due to the birth of exchange traded funds and the new gold demand they created by letting anybody trade gold as easily as a stock....

See, the gold buyers of the past didn't have the hair-trigger trading capability of the present ETF group, and there was a time when gold was considered simply a store of value rather than a vehicle for making huge upside. Which is why some research firms have voiced concern about gold's suspected dependency on fund flows for price support. Note how 2009 ETF-driven gold demand soared. It might be hard for 2010 to repeat this performance, especially if recent investors who are in it for quick returns start to think gold might be boring.

Those words fit the format of a skeptic amazed at the persistent overvaluation of an asset, as measured by tried-and-true norms. So is the warning. So does the research-firm concern Fernando mentioned.

The blog post from which I got Fernando's commentary, "Do ETFs distort the gold market?", has data about the recent outflows from the SPDR Gold Trust:

GLD saw net cash outflows of $937 million during the first two months of 2010, according to the latest data from the National Stock Exchange. The ETF posted inflows of nearly $7.4 billion last year. GLD rose 24% in 2009 as gold prices marched higher on inflation concerns and other worries

Despite that outflow, gold has been basically neutral since its December plummet.


I may be wrong about gold being at the edge of a bubble. If I am, though, then the metal will descend to a level which treats investment demand as a non-essential. It doing so would require an all-out bear market, to about $800-$900. I don't see any sign of that happening.

Nor, though, do I see any driver on the horizon that would push gold into an all-out bubble. The only one that I believe would qualify would be a return to '70s-level inflation. So far, despite whatever's been baked into the cake, there hasn't been any real sign of it.


Note: One sign that high inflation is settling in is the first signs of it being treated as aberrational, particularly by the fixed-income market. The anti-high-inflation case depends upon the bond vigilantes being vigilant. If they decide to take a snooze at the switch, the market pressures will not impel the Fed to do much about it.