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The golden mean

Stewart Cowley, head of fixed income at Old Mutual Asset Managers, considers the heat death of the universe and the relation of gold to other investments to assess how far bonds can continue on their bull run

In a recent interview, cosmologist Professor Stephen Hawking revealed he had been asked, at a speaking engagement in Japan, not to mention the end of the universe in case it had an effect on the Japanese stockmarket.

Such is the fickle and irrational nature of humanity that it rarely looks past narrow, short-term interests to see the bigger picture.

In the spirit of perspective and with the knowledge that all good things come to an end, we have to acknowledge that the great bond rally will itself finish at some point.

If timing is the essence of good comedy, then it is most definitely the essence of good investing so let us ask some questions about when this could happen. To answer this, let us start in a strange place – how much gold would it cost to buy a house?

If you do that calculation, the combined effect of a rising gold price and falling house prices means that today, in the US and UK, the cost of a house has fallen from a peak of around 800oz to just 200oz.

Houses (if we are comparing real assets) have not looked so cheap since the late 1980s.

But this is not the whole picture. Let’s now ask how many barrels of oil an ounce of gold has historically bought?

It turns out that in the past you could have bought between 15 and 25 barrels of oil with an ounce of gold.

Assuming a constant oil price, that means that gold could reach $1,600. As it is currently $1,300 an ounce, this implies a 23 per cent return from here just from the normalising of a relationship.

Plugging these numbers into our previous relationship means that, in the none too distant future, you may be able to buy a house for 155 ounces of gold. Our gold/ house price relationship would plummet from its current value of 195 to unprec-edented levels. If you want to visualise it, that would be a piece of gold the size of a standard packet of butter.

If investors are so concerned about the debasement of the security of real assets to the extent that they would prefer to own gold at elevated prices, it certainly tells you something about the level of fearfulness.

If the three great achievements of human thought have been Darwinian evolution, quantum mechanics and the normal distribution curve, then there should, by rights, be some kind of reversion to the mean at some point.

If gold reaches the heights discussed here, then other assets such as houses and equities will look like attractive investments.

There is a lot of money locked up in the banking system from depository institutions receiving a pittance of interest.

We should expect that, if quantitative easing is embraced by Western central banks, even the current fever for bond investment will come to an end and money will seek a new home.

The leakage of money out of the central banking system and bonds into other assets (such as real estate and equities) will have a corrective influence on asset prices, bringing to an end the great bond bull run and sending yields to higher levels.

If a bond fund does not have the ability to achieve positive returns in a rising yield environment (by having a negative duration position), the capital losses will be tangible.

On current evidence, we are not there yet and the bond bull run may yet continue into 2011.

But having said that, the choices for investors remain stark – sell gold, sell bonds, buy real estate, buy equities and, as each day passes, that reality ticks ever closer, as does the end of the universe precluded from Stephen Hawking’s discussion.



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