The Tail That Wags the Dog in Gold

In yesterday's blog post (Gold Still Glitters While Sentiment Grows to a Bullish Extreme), I pointed out that sentiment in the gold market has grown to a bullish extreme. From a contrary perspective, this should make the gold bulls nervous. So far, the yellow metal is holding up well compared to stocks and some other commodities -- but volatility is on the rise.

Interestingly, one of the reasons for this increased volatility is commodity-backed ETFs that have become a popular alternative to investing in physical gold. A couple weeks ago when gold prices slid 1.5% in a day, investors in the StreetTracks Gold Shares ETF (symbol: GLD) yanked $600 million out of the fund – in turn forcing the fund to sell 21.5 tons of gold! That was the biggest single day liquidation in bullion holdings ever recorded by GLD.

According to a Street.com article detailing the episode, “Gold futures dropped over 3% at one point and reportedly caused order imbalances on the electronic exchanges.” This was at least in part due to the heavy selling in GLD shares.

Is GLD the Tail that’s Wagging the Dog

This brings up the question of just how much influence these physical-commodity backed ETFs have on the underlying asset. Since it was launched in 2004, GLD has accumulated over 630 tons of gold bullion, which is held in trust for shareholders.

That’s so much gold, that the fund is having trouble finding enough room to store all its bullion. In fact, GLD’s current gold holdings are about twice that held by the Bank of England!

This represents a serious “overhang” in the gold market. Over the last few years, buying interest in GLD was widely credited with helping push bullion prices higher. Now GLD may be blamed for amplifying a sell-off in gold, should GLD holders cut and run.

How Many Speculators in GLD Shares?

The virtue of ETFs like GLD is that they trade throughout the market day on a tick by tick basis, and can be sold short virtually at will. In other words, it’s very liquid with few “frictional” costs involved in buying and selling.

Just how much influence does StreetTracks Gold Shares have on the price of the commodity? The answer depends upon how many shares are held by “speculators” – who might sell in a panic at a moment’s notice - versus "long term investors" who are confident enough to hold on through a volatile market correction.

Up until the past few months, there used to be a lot of “long-term investors” in emerging market stocks, but now these markets appear to be in the grip of selling by panicked speculators.

The gold bulls certainly hope their fellow investors take a longer-term view on the yellow metal!