Gold's 2016 rally was built on sand

2016 has been the most peculiar year for gold that I can remember.

On the surface, 2016 has been a typical year with a gain year-to-date of 11 pct in dollar terms (31 pct in GBP terms) which is a just shade lower than its annual average gain since 2001 at 12.8 pct. What makes the past year so unusual has been the powerful reversals in buying and indeed selling behaviour from otherwise reliable sectors … and, this is key … not all buying is equal and it therefore explains the recent price action and the outlook. I'll explain.

The collapse in demand from India, hitherto the world's largest gold offtake market is manifest. Demand is reportedly down about by about 40 pct with the Government at war with its black economy and they seem prepared to sacrifice bona fide individuals even to the extent of deeply damaging the economy in that pursuit. Gold buying has suffered severely as collateral damage.

Weakness in other physical markets is endemic – Central Bank demand is expected to be down about 15 pct from levels seen in recent years and even jewellery demand in China is down 27 pct to the lowest in 7 years, while Indian jewellery demand is at a 13 year low. One of the few brights spots is European investment demand with Degussa (our parent company) reporting an increase of about 35 pct year on year.

So what has filled the vacuum and more left by absent physical buyers … well it has been speculators … the flakey end of the market – never a good thing. As such, those wonderful gains we saw in H1 were, regrettably, built on sand.

In Jan 2016 the gold futures traders went for a neutral position to a record net long by buying close to 310,000 contracts or a little over 1,000 tonnes (in a market which only produces 3,000 tonnes) – added to which ETF buyers bought conversationally 700 tonnes taking the GLD holding from 1400 tonnes to 2100 tonnes. This is not a good thing, and to some extent explains gold's sideways movement during H2 2016. Essentially we had stale speculative longs overhanging the market and patient physical buyers under the market who would enter only if it was cheap enough … they offset each other. The price action of gold which mainly saw modest and short-lived price corrections supports this view.

Now the good news for gold bugs.

More recently the 'quality' buying, that is say the physical buyers have quietly and inexorably been consuming those stale spec longs. We have seen a roughly halving of the spec longs on COMEX and indeed the new ETF buying, to put the market in better balance to move ahead soon. If we are right then you might expect – political black swans aside – for gold to track sideways / a shade lower for a few more months before being well positioned for a more sustainable and meaningful move higher.

The headline word for 2017 will in our view be 'inflation' and wealth preservation will continue to be a watchword for those looking to position themselves strategically… and by extension gold is well priced and positioned to benefit.

In short, gold needs to get through a further short period of adjusting to what was always an unreliable price rally, before establishing solid foundations for a further move higher next year in our view.

** This article was first published in Sharpspixley.com