“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[2]
As we have done in our previous studies, we want to analyze the 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:
Below we take a brief look at the annual performance of the gold price since the beginning of the new monetary era, i.e., since the end of the Bretton Woods system. The annualized growth rate since 1971 amounts to 8.1%.
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.
Sources: Incrementum AG, Datastream
Numerous studies prove that adding gold lowers the volatility of a portfolio and hence improves statistical portfolio characteristics. This is also shown in the following chart. The annual performances of the S&P 500 are sorted from left (weakest year) to right (strongest year) and contrasted with the respective performance of gold. One can see 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.
Sources: Federal Reserve St. Louis, Incrementum AG
The fact that gold is an excellent “event hedge” can be discerned in the following chart. It compares the performance of different asset classes during the weakest 20% of trading days in the S&P 500. Only gold and other precious metals exhibit a positive performance during these crash periods.
Sources: ETF Securities, Bloomberg, Incrementum AG
However, correlations are never immutable, which can be seen in the following table. It shows how strongly the correlations between gold and other important asset classes have fluctuated in previous years. Thus the correlation between EUR/USD and gold stood between 0.10 (nigh 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.
Sources: GFMS, Thomson Reuters
Gold is often seen as a hedge against geopolitical crisis situations. An analysis of the most important political and economic 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.
Often liquidity is defined as saleability or marketability. Investopedia provides a better definition: “The degree to which an asset or security can be bought or sold in the market without affecting the asset’s price.” 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]
![Daily turnover as a percentage of the total stock[10]](https://ingoldwetrust.report/wp-content/uploads/2024/09/gold-im-portfoliokontext6.png)
Sources: German finance agency, Japanese MOF, SIFMA, Thomson Reuters GFMS, UK DMO, WGC
It is difficult to make a generally valid statement as to the optimal size of the gold allocation a portfolio should contain, as this depends on individual preferences, risk tolerance, time horizon and the economic backdrop. In order to get an idea, one could use central banks as a model. Despite gold’s official “demonetization”, the bulk of strategic currency reserves continues to be held in the form of gold. They serve as the ultimate insurance against risks in an increasingly virtual financial world, and oddly enough, it appears that in recent years, not Western central banks, but primarily Western private investors have reduced their gold holdings.
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]:
Apart from these highly relevant portfolio characteristics, gold also has a qualitative characteristic as an investment asset that differentiates it 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.
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.
To come back to the initial statement, at first glance the 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)](https://ingoldwetrust.report/wp-content/uploads/2024/09/gold-im-portfoliokontextE7.png)
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.
Sources: Federal Reserve St. Louis, Incrementum AG
Although the Federal Funds rate and gold prices exhibit a clear negative correlation, some periods can be observed during which 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.
Sources: Federal Reserve St. Louis, Incrementum AG
What are the reasons for the relationship breaking down in some time periods?
Although statistically, there clearly exists a negative correlation between the effective Federal Funds rate and gold, we advise 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.
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 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:
The USDX rises, when the dollar’s exchange value is upwardly revalued relative to the above listed basket of paper currencies and vice 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.
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.
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.
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.
Especially noteworthy – and hardly ever mentioned in public discourse – is the seemingly obvious asymmetry: Thus the gold price rises more than twice as much when the dollar is declining than it 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.
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.
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 of increase” – the rate of increase in the gold price 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]
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.
The chart below shows real interest rates[21] and the gold price. It can clearly be seen that negative real interest rates have prevailed in the 1970s, as well as since 2002, creating a positive environment for 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.
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.
Source: World Gold Council
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.
The bull market in stocks began in March 2009. In the course of the above-mentioned asset price inflation and the disinflationary environment, stocks have evidently been among the greatest beneficiaries of the zero interest rate policy. Last year we wrote: “The current “lowflation” environment that still prevails, which is characterized by low price inflation and growth figures that largely remain below expectations, has turned out to be a Land of Cockaigne for stock market investors.” As the disinflationary environment continued to persist, stocks were among the best performing asset classes over the past 12 months.
However, the fact that the stock market has advanced to an alarming extent is evident in numerous indicators and comparisons. Thus, the 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.
Sources: Prof. Robert Shiller, Incrementum AG
An analysis of the four historic peaks in the Shiller P/E ratio to date and the subsequent performance of the US stock market should dampen the optimism of investors who are currently bullish on stocks. Investors have made no money in the decades following these peaks, and suffered drawdowns up to a maximum of 81%.[23]
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.
Sources: Federal Reserve St. Louis, Incrementum AG
Tobin’s Q ratio (the ratio of market capitalization to book values) of US stocks is at an extreme level as well. The metric is calculated by dividing the enterprise value of a company (market capitalization plus liabilities) by the replacement costs of its assets[24].
Since 1900 the ratio’s median has stood at approx. 0.7x. Since 2009 (0.56x) a significant increase in Tobin’s Q can be observed. In the meantime, it has risen to 1.12x, the second highest peak in history. By 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]
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 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]
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.
Sources: Federal Reserve St. Louis, Incrementum AG
US stocks are trading at extremely generous valuations in comparison to historical levels. A reversion to the mean appears to 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 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.
[1] 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
[2] See: “On the Origins of Money”, Carl Menger
[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
[6] Monthly data, 2005-2015
[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
[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
[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.
[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“)
[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.
[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
[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
[21] Federal funds rate minus CPI
[22] See: “IMF tells regulators to brace for global ‘liquidity shock’”, Ambrose Evans-Pritchard, The Telegraph
[23] See: „Dire Straits: Money for Nothing – Debt for Free“, Jordan Eliseo
[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)
[26] See: „Ausblick 2015“, Wellenreiter-Invest study, Robert Rethfeld und Alexander Hirsekorn („2015 Outlook“)
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