Incrementum AG

In Gold we Trust 2015 – Extended Version

June 25th, 2015

Classic

GOLD IN THE CONTEXT

OF PORTFOLIO
DIVERSIFICATION

This article originates from In Gold We Trust report 2015, which can be downloaded at
https://ingoldwetrust.report/reports-archive/in-gold-we-trust-2015/?lang=en

Subscribe to the In Gold We Trust report at https://ingoldwetrust.report/igwt/?lang=en

The In Gold We Trust report 2020 will be published on May 27, 2020.

Ronald-Peter Stöferle
& Mark J. Valek
“In GOLD we TRUST” 2015 - Extended Version
 Incrementum AG
In Gold we Trust 2015 – Extended Version
June 25th, 2015

“In no national economy which has advanced beyond the first stages
of development are there any commodities, the saleability of which is
so little restricted in such a number of respects—personally,
quantitatively, spatially, and temporally—as the precious metals.”
Carl Menger 1

a) The extraordninary portfolio characteristics

of gold 2

“The wise man plans ahead.” As we have done in our previous studies, we want to analyze the
Friedrich von Schiller advantages of gold in the context of portfolio diversification. Due
to its unique characteristics, we are firmly convinced that gold –
especially in the current environment – is an important portfolio
component. Below we once more summarize the major advantages:

► increased portfolio diversification: gold's correlation with

other assets is on average 0.1 3
► effective hedge against tail risk events 4
► highly liquid asset: gold's liquidity is significantly higher than
that of German Bunds, UK Gilts, US agencies and the most
liquid stocks
► portfolio hedge in times of rising price inflation rates as
well as during strongly deflationary periods (but not in times of
disinflation!) 5
► currency hedge: gold correlates negatively with FIAT-
currencies

„Most investors are primarily Below we take a brief look at the annual performance of the gold price
oriented toward return, how much since the beginning of the new monetary era, i.e., since the end of the
they can make and pay little Bretton Woods system. The annualized growth rate since 1971
attention to risk, how much they amounts to 8.1%.
can lose.“
Seth Klarman

1
See: “On the Origins of Money”, Carl Menger
2
We have already discussed the portfolio characteristics of gold in great detail in our
previous gold reports, see “The extraordinary portfolio characteristics of gold” - Gold
Report 2013, “Gold as a stabilizing portfolio component” - Gold Report 2012, as well as
“Gold as a Portfolio Hedge” - Gold Report 2011
3
See: “Gold: a commodity like no other”, World Gold Council
4
See: “Gold: hedging against tail risk”, World Gold Council
5
See: “The impact of inflation and deflation on the case for gold”, Oxford Economics

“In GOLD we TRUST” 2015 - Extended Version

 Incrementum AG
In Gold we Trust 2015 – Extended Version
June 25th, 2015

Annual performance of gold since 1971

127%
72%
66%
49%

37%

31%

30%
25%

24%
23%
22%

22%
20%

19%

18%
17%

17%
14%

14%

10%
7%

7%
6%
5%
3%

3%
1%

-2%
-2%
-2%

-2%
-4%

-5%

-5%
-6%
-10%

-11%
-15%
-17%
-19%

-21%
-25%

2013 -28%
1981 -32%
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980

1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012

2014
Sources: Federal Reserve St. Louis, Incrementum AG

The current correction is put into perspective in a longer term context

by the chart of average annual prices below.

Average annual gold price

1669
1 80 0

1561
1 60 0

1410
1289
1228
1 40 0

1208
1 20 0

974
867
1 00 0

701
8 00

608
604

6 00
458

447
446
436
417

412
387
385
384

383
382
378

367
364

363

362
360

344

333
317

316

310
294
280
278
271

4 00
194
164
160

148
125

2 00
98
58
41

Sources: Incrementum AG, Datastream

“Risk is not about what happens Numerous studies prove that adding gold lowers the volatility of a
but what could happen and what portfolio and hence improves statistical portfolio characteristics.
the consequences could be. This is also shown in the following chart. The annual performances of
Russian Roulette is statistically a the S&P 500 are sorted from left (weakest year) to right (strongest year)
6:1 winner…until you lose.” and contrasted with the respective performance of gold. One can see
Prof. Dave Collum that during the S&P's six worst performance years, gold clearly
outperformed not only on a relative, but also on an absolute basis. This
confirms its usefulness as a portfolio hedge. On the other hand, it
can also be seen that rally phases in the US stock market are
usually not a positive environment for the gold price. From this
perspective, it is plausible that the continuation of gold's bull
market should coincide with the end of, resp. a pause in the stock
market rally.

“In GOLD we TRUST” 2015 - Extended Version

 Incrementum AG
In Gold we Trust 2015 – Extended Version
June 25th, 2015

Comparison annual performance Gold vs. S&P

1 60 S&P50 0 Gold
1 40
1 20
1 00
80
60
40
20
0
-2 0
-4 0
-6 0
2008
1974
2002
1973
2001
1977
1981
2000
1990
1994
2011
2012
1978
1984
1987
2007
2005
1992
1993
2004
1971
2014
1979
1988
1982
2006
2010
1986
1972
1999
1976
1983
1996
2013
2009
1980
1991
1985
2003
1998
1989
1997
1975
1995
Sources: Federal Reserve St. Louis, Incrementum AG

“Only a desperate gambler stakes The fact that gold is an excellent “event hedge” can be discerned in the
everything on a single throw of the following chart. It compares the performance of different asset classes
dice.” during the weakest 20% of trading days in the S&P 500. Only gold and
Friedrich von Schiller other precious metals exhibit a positive performance during these crash
periods.

Return during S&P 500 worst 20% 6

4%
2%
0%
-2 %
-4 %
-6 %
-8 %

Sources: ETF Securities, Bloomberg, Incrementum AG

“It is a case of better having However, correlations are never immutable, which can be seen in the
insurance and not needing it, following table. It shows how strongly the correlations between gold and
than one day realizing that one other important asset classes have fluctuated in previous years. Thus
needs it but doesn’t have it.” the correlation between EUR/USD and gold stood between 0.10 (nigh
Acting-man.com insignificant) and 0.5. Against stocks, gold partly exhibited negative and
partly positive correlation. Only its correlation with silver appears stable,
having fluctuated between 0.74 and 0.90.

2009 2010 2011 2012 2013 2014

EUR/USD 0.32 0.16 0.10 0.50 0.34 0.33
Silver 0.82 0.81 0.74 0.84 0.90 0.80
Oil (WTI) 0.17 0.34 0.27 0.36 0.28 0.24
S&P500 0.03 0.21 -0.03 0.26 0.17 -0.16
Sources: GFMS, Thomson Reuters
Gold is often seen as a hedge against geopolitical crisis
When you’re a distressed seller situations. An analysis of the most important political and economic
of an illiquid asset in a market
panic, it’s not even like being in 6
Monthly data, 2005-2015
a crowded theatre that’s on fire.
It’s like being in a crowded
theatre that’swe
“In GOLD onTRUST”
fire and the
2015 - Extended Version
only way you can get out is by
persuading somebody outside
 Incrementum AG
In Gold we Trust 2015 – Extended Version
June 25th, 2015

crises since the beginning of the 1970s shows that such crises on
average result in a 13% rise in the price. However, it should be
noted here that such “geopolitical premiums” tend to be fleeting
affairs (often with the obvious exception of the region directly
affected). Only if an event actually clearly influences the monetary and
economic backdrop are such premiums sustainable (an example of
this would be the WTC attack, which likely contributed to the Fed
subsequently adopting a looser monetary policy stance than it would
have done otherwise). In this sense, financial market crises are more
likely to exert a lasting effect on gold prices, as they always provoke
an opening of the monetary spigots. If a geopolitical crisis takes place
when a gold bull market is already underway, it may affect the size of
the rally (the Iranian revolution/hostage crisis and the Soviet invasion
of Afghanistan are pertinent examples). However, in these cases it is
hard to prove the actual cause-effect relationship. In a gold bear
market, price spikes due to geopolitical events more often than
not create selling opportunities.

A major reason for our gold affinity is gold's high liquidity. As we

have already discussed in our previous reports, gold is among the most
liquid investment assets in the world, only three currency pairs
(USD/EUR, USD/JPY and USD/GBP) exhibit higher daily trading
volumes.

“Skill is successfully walking a Often liquidity is defined as saleability or marketability. Investopedia

tightrope over Niagara Falls. provides a better definition: “The degree to which an asset or security
Intelligence is not trying.” can be bought or sold in the market without affecting the asset's price.”
Marilyn Vos Savant The decisive question is therefore not “can I sell”, but rather, “can I sell
at a price that is close to the last traded price”. True liquidity thus means
that one can sell big positions without a significant price discount. 7

This feature is often also referred to as “ultimate liquidity”. In

mainstream analysis, the liquidity of an asset is however often
measured relative to normal situations, whereas we believe that
liquidity during stress situations is more important. In such
periods, it is never the offers, but always the bids that suddenly
disappear. Due to its high liquidity and tight bid/ask spreads, gold is
therefore often quickly sold in stress situations in order to obtain
liquidity.

According to a highly interesting study by Thomson Reuters

GFMS 8, global trading volume amounted to 550,000 tons of gold
last year. This is roughly equivalent to three times the total stock of
gold, resp. 188 times annual mine production. In terms of value, this
turnover amounts to USD 22tn, higher than the annual trading volume
in Dow Jones Industrial Average stocks, S&P 500 stocks or the entire
German stock market. It is rather interesting that trading is steadily
shifting East: While London a few years ago still accounted for
nearly 90% of all trading volume, this has declined to approx. 70%
today. 9

7
See: “Liquidity”, Howard Marks, Oaktree Memo
8
See GFMS Gold Survey 2015
9
See: “Annual gold trade reaches $ 22 trillion”, Frik Els, Mining.com

“In GOLD we TRUST” 2015 - Extended Version

 Incrementum AG
In Gold we Trust 2015 – Extended Version
June 25th, 2015

Daily turnover as a percentage of the total stock 10

10 %

8%

6%

4%

2%

0%
Gold US Treasuries JGB's US Agencies German UK Gilts
Bunds

Sources: German finance agency, Japanese MOF, SIFMA, Thomson Reuters GFMS, UK
DMO, WGC

“Despite the generally It is difficult to make a generally valid statement as to the optimal
dismissive posture towards gold size of the gold allocation a portfolio should contain, as this
among global economists and depends on individual preferences, risk tolerance, time horizon
monetary authorities, and its and the economic backdrop. In order to get an idea, one could use
unpopularity among the great central banks as a model. Despite gold's official “demonetization”, the
majority of large capital bulk of strategic currency reserves continues to be held in the form of
allocators in the West, global gold. They serve as the ultimate insurance against risks in an
central banks continue to buy, increasingly virtual financial world, and oddly enough, it appears
re-patriate, and hoard it, which that in recent years, not Western central banks, but primarily
suggests the potential for future Western private investors have reduced their gold holdings.
use in a currency devaluation.“
Paul Brodsky Most recently, Germany's Bundesbank has pointed to the value,
characteristics and usefulness of gold. In a presentation by the
Bundesbank's board, the central functions of gold were summarized as
follows 11:

► Diversification
► Universal acceptance
► Robustness against shocks (country and currency risks)
► Confidence building
► Timeless classic in its function as a medium of exchange and
store of value
► We consider gold on the basis of monetary policy reasons as
part of Germany's currency reserves

Conclusion:
"Predicting rain doesn't count - Apart from these highly relevant portfolio characteristics, gold also has
building the ark does." a qualitative characteristic as an investment asset that differentiates it
Warren Buffett from most other assets. Gold is a debt-free asset and therefore in
contrast to bonds – but also bank deposits – is free from any inherent
counterparty risk. Gold is pure property. The paper market by
contrast is based on countless promises by a variety of
counterparties. The attractiveness of a liquid asset without
counterparty risk is valued less highly in periods of (perceived) security.
Once concerns over potential default risks increase (deflationary
environment), this characteristic of gold will once again be valued more
highly.
10
Daily turnover is calculated as daily average volume divided by total outstanding
value. In the case of gold, total outstanding is calculated using private and public bullion
holdings
11
See: Board presentation, Deutsche Bundesbank 2013

“In GOLD we TRUST” 2015 - Extended Version

Incrementum AG
In Gold we Trust 2015 – Extended Version
June 25th, 2015

b) The relationship between gold and interest

rates
Rising interest rates = declining gold price. This is a widely held
opinion. In the following chapter, we will analyze this topic and point out
both factors that support and contradict this thesis.

Rising rates = declining gold To come back to the initial statement, at first glance the
price? Fact or myth? assumption appears to make sense intuitively. As the level of
interest rates in an economy rise, investments producing a yield will
gain in attractiveness for many investors. By contrast, investment
assets such as gold or commodities that do not produce a steady return
become less attractive, so the argument goes.

However, one should not forget that interest rate levels are not
determined by market forces in the paper money era and therefore
are no longer a phenomenon of the market economy. The free
formation of interest rates, which would occur in a free market, is
hampered by the policies of central banks, as well as the extension of
circulation credit. 12

The Federal Funds rate is an important indicator of the Fed's monetary

policy and thus also of great importance to the trend in the gold price.
Declining rates signal an expansive monetary policy and rising rates a
tightening of the monetary reins. Gold, as the ultimate means of
payment, should therefore react counter-cyclically. As monetary policy
becomes loose, the gold price should strengthen, and it should weaken
in periods of tightening monetary policy. In order to illustrate this
relationship, we have created an overlay between the effective Federal
Funds rate and a logarithmic chart of the gold price.

Federal Funds target rate 13 and gold (right scale, log)

20 8

16 7

12 6

8 5

4 4

0 3

Fed Funds Rate Gold (ln)

Sources: Federal Reserve St. Louis, Incrementum AG

In order to examine the history of gold price performance in times of
rising interest rates, we have analyzed all eight tightening phases that
have taken place since 1971.

Gold price in monetary tightening cycles:

12 According to Mises, circulation credit consists of loans that are not backed by savings
13 Since the introduction of the target corridor, we have used the upper limit (0.25%) in
our calculations used in the charts and tables of this chapter.

“In GOLD we TRUST” 2015 - Extended Version

Incrementum AG
In Gold we Trust 2015 – Extended Version
June 25th, 2015

Change Fed Funds Effective Rate Gold

Start End Change Return
Jan. 1977 - Apr. 1980 4.61 17.61 13.00 318.93%
Feb. 1972 - Aug. 1974 3.30 12.92 9.62 194.97%
Jun. 2004 - Jul. 2007 1.03 5.26 4.23 69.81%
Jan. 1994 - Apr. 1995 3.05 6.05 3.00 1.09%
Feb. 1987 - Mar. 1989 6.10 9.85 3.75 -2.69%
Apr. 1999 - Nov. 2000 4.74 6.51 1.77 -5.88%
Feb. 1983 - Aug. 1984 8.51 11.64 3.13 -29.55%
Jul. 1980 - Jul. 1981 9.03 19.10 10.07 -36.62%
Sources: Federal Reserve St. Louis, Incrementum AG

Although the Federal Funds rate and gold prices exhibit a clear
Tightening cycles can also be a
negative correlation, some periods can be observed during which
positive environment for gold
the relationship collapses. In the tightening phase between February
1972 and August 1974, the Fed Funds rate doubled from 5% to 10%,
and gold rose from USD 48 to USD 155. From January 1977 to April
1980, gold rallied from USD 132 to USD 520, and especially between
June 2004 and August 2007, the US base rate was raised from 1% to
5.25%, while gold rallied from USD 395 to USD 715.

Gold price in monetary tightening cycles: 1m/3m/12m change after

the first rate hike

50%
195% 319% 70%
40%

30%

20%

10%

0%

-10%

-20%

-30%

-40%
Feb. 1 972 - Jan. 1 977 - Jul. 1 980 - Feb. 1 983 - Feb. 1 987 - Jan. 1 994 - Apr. 1 999 - Jun. 2004 -
Aug. 1 974 Apr. 1 980 Jul. 1 981 Aug. 1 984 Mrz. 19 89 Apr. 1 995 Nov. 20 00 Jul. 2 007

1 Month 3 Month 12 Month Total

Sources: Federal Reserve St. Louis, Incrementum AG

“In GOLD we TRUST” 2015 - Extended Version

Incrementum AG
In Gold we Trust 2015 – Extended Version
June 25th, 2015

What are the reasons for the relationship breaking down in some time
periods?

► The Federal Funds rate is a nominal interest rate. Real interest

rates are however usually more important for the gold price
trend. The prime example for this is the period from 1977 to
1980, when the Federal Funds rate was hiked aggressively by
Paul Volcker, real interest rates however fell due to quickly
rising price inflation and Gold rallied.

► The desired effect which central banks expect from the

lowering or raising of interest rates, only unfolds as long as the
money multiplier works, i.e., as long as banks are willing to
pump more credit money into the economy. If the money
multiplier does not work (as was recently the case) and banks
only make loans reluctantly despite historically low interest rate
levels, the relationship between declining interest rates and a
rising money supply collapses. A historically very low Federal
Funds rate doesn't necessarily lead to an increase in the
money supply in such an environment (no additional fiduciary
media are created). The initial interpretation – that declining
interest rates represent an expansive monetary policy and with
that also an increase in the money supply – therefore isn't
applicable in this scenario.

Conclusion:
Three of the largest upward gold Although statistically, there clearly exists a negative correlation
moves occurred in rising rate between the effective Federal Funds rate and gold, we advise
environments caution. From a historical perspective, the correlation could be
observed in several interest rate cycles. Nevertheless, the initially
mentioned assumption that a rising level of interest rates is necessarily
reflected by a falling gold price, appears dubious. Three of the largest
gold rallies of the post 1971 era occurred in rising nominal rate
environments.

c) The relationship between gold and the dollar

As a rule the strength or weakness of a paper currency 14 relative to
another currency is expressed by the exchange rate. We regard this,
however, as a very limited measure. All major currencies have arrived
in the paper money age and especially since the financial crisis, are
caught up in a reciprocal devaluation competition. Exchange rates
thus provide very little information on the real trend in the
exchange value of a paper currency.

If one is interested in the actual strength or weakness of a

currency, one has to consult other indicators. One such indicator is
gold. As we have already pointed out in previous gold reports, we
regard gold not as a commodity, but rather as a currency. Due to its
special characteristics, gold was able to establish itself as the most
marketable commodity in the past, which is why it continues to occupy
an important role in the global financial system. Contrary to today's

14
As we have discussed in our book, we don't regard any of the currently existing paper
currencies as money, but as state-issued circulation media. These are “(...) according to
Ludwig von Mises bank notes that take the place of money, are however not fully
covered by money with respect to their maturity and liquidity” See: “Oesterreichische
Schule fuer Anleger” Taghizadegan, Stoeferle, Valek, p. 36, 69 („Austrian School for
Investors“)

“In GOLD we TRUST” 2015 - Extended Version

Incrementum AG
In Gold we Trust 2015 – Extended Version
June 25th, 2015

paper currencies, it is well-known that gold cannot be infinitely

multiplied 15 and is therefore especially useful as an informative
parameter for comparison purposes.

One way to depict the real strength of a currency is through

currency indexes. In currency indexes, certain exchange rates of
different currencies are bundled in a currency basket. The data thus
obtained provide a more comprehensive picture than individual
exchange rates, as they more clearly reflect the potential
interdependence of individual exchange rates in context. A measure
often used for the US dollar is the US dollar index (USDX). It measures
the dollar's relative value vis-a-vis a basket of foreign currencies. This
basket currently comprises the following currencies, with their
respective weightings indicated below:

► Euro at 57.8%
► Yen at 13.6%
► British pound at 11.9%
► Canadian dollar at 9.1%
► Swedish kroner at 4.2%
► Swiss franc at 3.6%

The USDX rises, when the dollar's exchange value is upwardly

US dollar index is flirting with the revalued relative to the above listed basket of paper currencies and vice
30-year downward trend versa. 16 On the following chart it can be seen that the dollar declined
by approx. 50% against this basket of currencies between 1985 and
2011. From there an impulsive upward move followed, which is now
flirting with the 30-year downward trend. The psychologically
important level of 100 has already been tested, and may well fall.

US-Dollar-Index (USDX)
160

140

120

100

80
USDX

60

Sources: Federal Reserve St. Louis, Incrementum AG

The relationship to gold is of interest. If one looks at the trends in the

USDX and gold, it is clear that the USDX exhibits a strong negative
correlation to gold. In the past, a rally in the USDX went hand in hand
with a decline in the gold price and vice versa in most cases. By
depicting the USDX inversely, the negative correlation can be very
clearly seen in the chart.

USDX and gold

15
See to this also our remarks in „In Gold we Trust 2013“, p. 16-18
16
To this end the geometric mean of the currency basket is calculated.

“In GOLD we TRUST” 2015 - Extended Version

Incrementum AG
In Gold we Trust 2015 – Extended Version
June 25th, 2015

65
7,5

75
7,0
85
6,5
95

6,0
105

115 5,5
USDX
125 5,0
Gold (ln)
135
4,5

145
4,0

Sources: Federal Reserve St. Louis, Incrementum AG

The relationship becomes even clearer if we measure strong trending

periods, i.e., strong bull and bear markets in the dollar and their effects
on the gold price.

Table: 1971 – 2015: Trend of gold during trending periods in the

USD
Period Change of USDX Return Gold Correlation
USDX vs Gold
1976 - 1980 -9.99% 412.23% -0.66
1980 - 1985 46.17% -55.11% -0.84
1985 - 1995 -37.35% 25.06% -0.43
1995 - 2002 27.96% -25.60% -0.90
2002 - 2011 -34.58% 382.84% -0.76
2011 - 2015 24.67% -11.92% -0.68
Total -16.01% 1,739.87% -0.63
Source: Incrementum AG

The inverse correlation between the USDX and gold can be clearly
discerned in the table above. In addition, it turns out that the USDX and
gold are not only negatively correlated in general (correlation
coefficient: -0.63 17), but also that this inverse correlation is especially
pronounced in times of USDX bull or bear markets.

A study by the World Gold Council 18 comes to a similar conclusion. The

study examines the annual performance of gold in different dollar
regimes (i.e., falling/rising and stable dollar). The result shows that the
gold price rises most (+14.9% p.a.) when the dollar is declining. In a
rising dollar environment, gold on average returned -6.5% p.a.

Interesting asymmetry: gold rises Especially noteworthy – and hardly ever mentioned in public
much more when dollar declines, discourse – is the seemingly obvious asymmetry: Thus the gold
than it falls when the dollar is price rises more than twice as much when the dollar is declining than it
rallying falls when the dollar is rallying. The WGC study moreover shows that
the correlation between gold and stocks, as well as commodities, is
lower in times of a rising dollar. This is, in our opinion, important
information in a portfolio construction context.

17
A value of -1 symbolizes perfect negative correlation, while a value of +1 signals
perfect positive correlation
18
See: „Gold Investor: Risk management and capital preservation, Volume 8“, World
Gold Council

“In GOLD we TRUST” 2015 - Extended Version

 Incrementum AG
In Gold we Trust 2015 – Extended Version
June 25th, 2015

Table: Annual gold price performance, volatility and correlation in

different dollar regimes
Overall Period Dollar Stable Dollar Dollar
depreciating (Trading Range) appreciating
Return 6.2% 14.9% 7.8% -6.5%
Volatility 19.5% 18.4% 20.2% 19.7%
Corr. Equities -0.06 0.07 -0.16 -0.11
Corr. vs Commodities 0.15 0.16 0.14 0.07
Sources: World Gold Council, Incrementum AG

The historically negative correlation between gold and dollar appears

to be weakening ever more though, this could be seen last year, when
the dollar rallied, and gold entered a sideways trend. This may be
connected with the ever greater importance of emerging markets (esp.
China, India) to the gold price. While gold demand in the 1970s and
1980s was confined to industrialized nations, almost two thirds of
demand comes from emerging markets these days. Our analysis
shows that changes in real interest rates in emerging markets
have an increasingly strong effect on investment demand for gold.

Conclusion:
The consensus opinion appears to be that a strong US dollar
automatically leads to lower gold prices. This thesis can be
buttressed with empirical data. However, our analysis shows that this
relationship is clearly asymmetrical: the damage a strong dollar inflicts
on the gold price is far weaker than the wind a weak dollar blows into
gold's sails.

Moreover, it appears as though historical patterns are changing. The

Autonomous rate increase of
“autonomous rate of increase” – the rate of increase in the gold price
gold is likely to climb further
that is independent on exchange rate fluctuations 19 – is likely to climb
further. This is inter alia due to the fact that the influence of emerging
markets on gold demand has greatly increased. As a result, the
historical inverse relationship between the dollar and the gold price
could weaken further in the future. What is good for the dollar does
not necessarily always have to be bad for gold. 20

d) Opportunity costs of holding Gold

Opportunity costs are essential for gold's price trend. What are the
competing economic risks and opportunities one faces, resp. one
foregoes, when holding gold? Real interest rates, growth rates of
monetary aggregates, volume and quality of outstanding debt, political
risks, and the attractiveness of alternative asset classes (esp. stocks)
are the most important determining factors. We therefore want to
discuss the opportunity costs of holding gold in the following
pages.

19
See: “Das goldene Erbe des US-Dollar”, Prof. Dr. Thorsten Polleit (“The golden
heritage of the US dollar”)
20
See: „Gold Investor: Risk management and capital preservation“, Volume 8, World
Gold Council

“In GOLD we TRUST” 2015 - Extended Version

Incrementum AG
In Gold we Trust 2015 – Extended Version
June 25th, 2015

Real interest rates

“Amazingly, people are paying The chart below shows real interest rates 21 and the gold price. It can
Switzerland to warehouse their clearly be seen that negative real interest rates have prevailed in the
money for 10 years…That makes 1970s, as well as since 2002, creating a positive environment for gold.
gold a high-yielder, because it
Real interest rates vs. the gold price since 1971
yields zero.”
Jeff Gundlach 2000

10
1600

Real interest rate %

7

1200
4

Gold
800
1

-2 400

-5 0

Real Federal Funds Rate Gold

Sources: Federal Reserve St. Louis, Incrementum AG

In a shorter-term depiction of real interest rates, the assumption

formulated above can be discerned more clearly. The period since 2011
is characterized by rising real interest rates, which in turn resulted in a
declining gold price. In 2009, however, it can be seen that gold
correctly anticipated the change in the trend of real interest rates,
and it appears as though the current situation may be similar.

Gold vs. real interest rates (axis inverted)

1900 -4

1700 -2

1500 0

1300 2

1100 4

900 6

700 8

Gold Real interest rate (axis inverted)

Sources: Federal Reserve St. Louis, Incrementum AG

The following table shows the average monthly gold price performance
in times of low, moderate and high real interest rate levels. In addition,
it shows the trend in a context of rising and/or falling real interest rates.
The best environment for the gold price (+1.5% per month) is when
real interest rates are low and declining.

21
Federal funds rate minus CPI

“In GOLD we TRUST” 2015 - Extended Version

 Incrementum AG
In Gold we Trust 2015 – Extended Version
June 25th, 2015

Historical performance during different real interest rate regimes

Level of real yields Trend of real yields
Negativ Moderat High Trending Trending
(<0%) (0%-4%) (>4%) downward upward
Ø monthly.
1.5% 0.7% -1.0% 0.8% 0.3%
Return
Standard-
0.5% 0.4% 0.6% 0.3% 0.4%
deviation
Source: World Gold Council

Conclusion:
A long term negative gold price trend would have to go hand in
hand with rising, resp. consistently positive real interest rates.
Due to the levels of debt that have been amassed by developed nation
governments, companies and households, we regard this as scarcely
imaginable. Central banks have long become prisoners of the
policy of over-indebtedness.

Stocks

“The funny thing is there is a The bull market in stocks began in March 2009. In the course of the
disconnect between what above-mentioned asset price inflation and the disinflationary
investors are saying and what environment, stocks have evidently been among the greatest
they are doing. No one thinks all beneficiaries of the zero interest rate policy. Last year we wrote: “The
the problems the global current “lowflation” environment that still prevails, which is
financial crisis revealed have characterized by low price inflation and growth figures that largely
been healed. But when you have remain below expectations, has turned out to be a Land of
an equity rally like you've seen Cockaigne for stock market investors.” As the disinflationary
for the past four or five years, environment continued to persist, stocks were among the best
then everybody has had to performing asset classes over the past 12 months.
participate to some extent.
What you've had are fully However, the fact that the stock market has advanced to an alarming
invested bears.” extent is evident in numerous indicators and comparisons. Thus, the
Gerard Minack share of margin debt relative to market capitalization is by now at a far
higher level than at the peak of the dotcom bubble. 22

A look at long term valuation levels thus appears to be a good

idea. The so-called Shiller-PE or CAPE (cyclically adjusted P/E ratio)
is a suitable means of defining the market's long term position. In order
to smooth out the effects of the business cycle, it calculates the
inflation-adjusted average price-earnings ratio of the past 10 years.
According to this metric, the outlook for US stocks doesn't appear very
enticing, as valuations are far from cheap. The current level stands at
27x, which has been exceeded only two times in history. The long term
average stands at 16.6x, which is significantly below current levels.

22
See: “IMF tells regulators to brace for global ‘liquidity shock’”, Ambrose Evans-
Pritchard, The Telegraph

“In GOLD we TRUST” 2015 - Extended Version

 Incrementum AG
In Gold we Trust 2015 – Extended Version
June 25th, 2015

Shiller P/E ratio since 1881

50
1999: 44x

40

1929: 33x

30
1901: 25x 1966: 24x

20

10 2015: 27x

Average: 16.6x
0
1881 1889 1897 1906 1914 1922 1931 1939 1947 1956 1964 1972 1981 1989 1997 2006 2014

Shiller PE
Sources: Prof. Robert Shiller, Incrementum AG

“Ultimately, investors will need An analysis of the four historic peaks in the Shiller P/E ratio to date and
to choose where to place their the subsequent performance of the US stock market should dampen
faith – in history books or in the optimism of investors who are currently bullish on stocks. Investors
crystal balls.” have made no money in the decades following these peaks, and
Jordan Eliseo suffered drawdowns up to a maximum of 81%. 23

Shiller PE Return in the following Maximaler

peaking at decade p.a. Kursverlust
June 1901 25 -0.2% -38%
Sept. 1929 33 -6.7% -81%
Jan. 1966 24 -5.1% -56%
Dec. 1999 44 -4.9% -58%
??? ??? ??? ???
Sources: Jordan Eliseo – ABC Bullion, Incrementum AG

Another long term indicator – the so-called Buffett indicator –

likewise suggests caution is advisable. It shows the total market
capitalization of all corporations listed on US exchanges as a
percentage of US GDP. Only once in history, in the 1st quarter of 2000,
was this ratio higher than today. The indicator therefore confirms that
the valuation of US stocks is anything but favorable from a historical
perspective.

23
See: „Dire Straits: Money for Nothing – Debt for Free“, Jordan Eliseo

“In GOLD we TRUST” 2015 - Extended Version

Incrementum AG
In Gold we Trust 2015 – Extended Version
June 25th, 2015

Total US stock market capitalization as % of GDP

160%

140%
149% 127%
120%

100%
Average: 68%

80%

60%

40%

20%
Q4 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
1950
US Stock Market as % of US GDP
Sources: Federal Reserve St. Louis, Incrementum AG

“My fear is that because interest Tobin's Q ratio (the ratio of market capitalization to book values)
rates are suppressed, therefore of US stocks is at an extreme level as well. The metric is calculated
earnings are inflated. So when by dividing the enterprise value of a company (market capitalization
rates go up … the hall of mirrors plus liabilities) by the replacement costs of its assets 24.
is shattered and we look at each
other and see what actually is Since 1900 the ratio's median has stood at approx. 0.7x. Since 2009
real rather than what the Fed (0.56x) a significant increase in Tobin's Q can be observed. In the
wants us to believe.” meantime, it has risen to 1.12x, the second highest peak in history. By
James Grant now the ratio is two standard deviations above its mean. The further it
rises, the more likely it becomes that there will be a major price
correction or even an economic collapse. 25

Q-Ratio since 1900

Source: Doug Short – www.dshort.com

According to our analysis, the best environment for stocks

prevails if price inflation rates stand between +1% to +3%. This “feel
good corridor” was e.g. continually breached in the 1970s, and while
stock markets trended sideways in nominal terms, they lost significant

24
See “Tobin's Q”, Wikipedia
25
See “Oesterreichische Schule fuer Anleger”, Taghizadegan, Stoeferle, Valek, p. 263-
264 (an English version will become available later this year)

“In GOLD we TRUST” 2015 - Extended Version

Incrementum AG
In Gold we Trust 2015 – Extended Version
June 25th, 2015

ground in real terms. Periods exhibiting relatively high inflation rates

such as e.g. 2000-2002, 2005 or 2007 until mid-2008 also tend to
provide a negative environment for stock markets. 26

US price inflation and Dow Jones Index since 1971

17 100000

15

13

11
10000
9

5
1000
3

-1

-3 100
1971 1977 1983 1989 1995 2001 2007 2013
CPI Dow Jones Index

Sources: Incrementum AG, Wellenreiter Invest, Federal Reserve St. Louis

A look at the Dow/Gold ratio over the long term shows that gold is
relatively undervalued compared to stocks. With a value of slightly
over 15x the ratio is currently well above the long term median of 6x. In
1932 the ratio stood at 2x, at the end of the last bull market in 1980 it
stood at 1.3x. We expect that in the course of the current secular bull
market, levels near 2x can be attained again. The current trend in the
ratio reminds us – not least due to the pronounced disinflation
backdrop – of the mid-cycle correction from 1974 to 1976.

Dow/gold ratio since 1900 (log scale)

100

10

Median: 6.1x

1
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
Dow/Gold-Ratio

Sources: Federal Reserve St. Louis, Incrementum AG

Conclusion:
US stocks: mean reversion US stocks are trading at extremely generous valuations in
only appears to be a question comparison to historical levels. A reversion to the mean appears to
of time be only a question of time. In our assessment the performance of stocks
currently represents one of the largest opportunity costs for holders of
gold. The conviction that one might be missing out on even greater
gains tends to rise in concert with a stock market advance, and these
26
See: „Ausblick 2015“, Wellenreiter-Invest study, Robert Rethfeld und Alexander
Hirsekorn („2015 Outlook“)

“In GOLD we TRUST” 2015 - Extended Version

Incrementum AG
In Gold we Trust 2015 – Extended Version
June 25th, 2015

potential gains must necessarily be foregone to the extent one is

holding gold instead of stocks. However, investors would do well to
keep a tight rein on their emotions and assess the situation as
calmly and rationally as possible. Historically, the stock market has
always suffered mean reversion after becoming overvalued, even
though it can never be forecast with precision just how much greater
the overvaluation will become. When such a mean reversion occurs,
gold's characteristics as a portfolio hedge will come to the fore.
As is always the case with insurance, it is better to have it and not
need it, than to suddenly find out that one needs it and doesn't
have it.

“In GOLD we TRUST” 2015 - Extended Version

Incrementum AG
In Gold we Trust 2015 – Extended Version
June 25th, 2015

About us

Ronald-Peter Stoeferle, CMT

Ronnie is managing partner of Incrementum AG and responsible for

Research and Portfolio Management.

He studied business administration and finance in the USA and at the Vienna University
of Economics and Business Administration, and also gained work experience at the
trading desk of a bank during his studies. Upon graduation he joined the research
department of Erste Group, where in 2007 he published his first In Gold We Trust report.
Over the years, the In Gold We Trust report has become one of the benchmark
publications on gold, money, and inflation.

Since 2013 he has held the position as reader at scholarium in Vienna, and he also speaks
at Wiener Börse Akademie (i.e. the Vienna Stock Exchange Academy). In 2014, he co-
authored the international bestseller “Austrian School for Investors”, and in 2019 “The
Zero Interest Trap”. Moreover, he is an advisor for Tudor Gold Corp. (TUD), a significant
explorer in British Columbia’s Golden Triangle, and a member of the advisory board of
Affinity Metals (AFF).

Mark J. Valek, CAIA

Mark is a partner of Incrementum AG and responsible for Portfolio

Management and Research.

While working full-time, Mark studied business administration at the Vienna University
of Business Administration and has continuously worked in financial markets and asset
management since 1999. Prior to the establishment of Incrementum AG, he was with
Raiffeisen Capital Management for ten years, most recently as fund manager in the area
of inflation protection and alternative investments. He gained entrepreneurial experience
as co-founder of philoro Edelmetalle GmbH.

Since 2013 he has held the position as reader at scholarium in Vienna, and he also speaks
at Wiener Börse Akademie (i.e. the Vienna Stock Exchange Academy). In 2014, he co-
authored the book “Austrian School for Investors”.

“In GOLD we TRUST” 2015 - Extended Version

Incrementum AG
In Gold we Trust 2015 – Extended Version
June 25th, 2015

Incrementum AG

Incrementum AG is an independent investment and asset management

company based in Liechtenstein. Independence and self-reliance are the
cornerstones of our philosophy, which is why the four managing partners own 100% of
the company. Prior to setting up Incrementum, we all worked in the investment and
finance industry for years in places like Frankfurt, Madrid, Toronto, Geneva, Zurich, and
Vienna.

We are very concerned about the economic developments in recent years, especially with
respect to the global rise in debt and extreme monetary measures taken by central banks.
We are reluctant to believe that the basis of today’s economy, i.e. the uncovered credit
money system, is sustainable. This means that particularly when it comes to investments,
acting parties should look beyond the horizon of the current monetary system. Our clients
appreciate the unbiased illustration and communication of our publications. Our goal is
to offer solid and innovative investment solutions that do justice to the
opportunities and risks of today’s prevalent complex and fragile
environment.

Contact
Incrementum AG
Im Alten Riet 102
9494 – Schaan/Liechtenstein

www.incrementum.li
www.ingoldwetrust.li
Email: [email protected]

Disclaimer
This publication is for information purposes only, and represents neither investment
advice, nor an investment analysis or an invitation to buy or sell financial instruments.
Specifically, the document does not serve as a substitute for individual investment or
other advice. The statements contained in this publication are based on the knowledge as
of the time of preparation and are subject to change at any time without further notice.

The authors have exercised the greatest possible care in the selection of the information
sources employed, however, they do not accept any responsibility (and neither does
Incrementum AG) for the correctness, completeness or timeliness of the information,
respectively the information sources, made available, as well as any liabilities or damages,
irrespective of their nature, that may result there from (including consequential or
indirect damages, loss of prospective profits or the accuracy of prepared forecasts).
Copyright: 2020 Incrementum AG. All rights reserved

“In GOLD we TRUST” 2015 - Extended Version

Incrementum AG
In Gold we Trust 2015 – Extended Version
25 June 2015

“In GOLD we TRUST” 2015 - Extended Version Page 21