This article first appeared in Money Morning, the free daily investment email from UK investment magazine, Moneyweek. Sign up here - it's free.
I had an email from a reader this week. He told me that he had sold a two-bedroom flat at the peak of the market in 2007. He bought gold with the proceeds.
This summer he sold the gold and bought himself a four-bedroom detached house. The thinking behind this trade was based entirely on the ratio of UK house prices to gold, which I wrote and he read about in MoneyWeek in 2007 and on the website House Price Crash.
Judging by the comments I get whenever I look at this subject, many of you are sceptical of the practice of comparing markets using ratios. But as the trade above shows, it can be a very useful exercise in establishing relative value.
And it's particularly useful in this era of central-bank-blown inflation. Policy-makers are deliberately devaluing their currencies, which is creating all sorts of distortions. Market ratios can be the lenses which clarify – the de-mister, if you like.
Oil, for example, at about $90 a barrel, is trading near its highs for the year. Many would, rightly, see that as a good reason not to buy – indeed, it looks a good reason to sell.
But relative to other markets, there is a strong argument that oil actually could go a lot higher from here...
How can you tell if oil is cheap?
First let's look at a long-term chart of oil, since 1965.
I subscribe to 'Peak Oil' by the way: the theory that there is a finite amount of oil in the world and, at a certain point, we will have consumed more than half of it, so supply will inevitably decline. Indeed, judging by all the deep-water exploration that goes on, it's not unreasonable to declare that the easy-to-find oil is already long gone.
However, the inexorable rise you see in the chart above is as much a result of the declining purchasing power of money as it is of oil 'running out'.
There are periods, such as the 1970s, early 1980s and the 2000s, when the oil price races ahead. And there are periods, such as the 1990s, where the oil price trades in a more limited range.
If you measure oil in a currency that governments, for all their efforts, cannot debase so easily by over-issuance – I'm talking about gold, of course – then you see that the oil price has in fact remained in a fairly constant range. Here we see a chart that shows how much gold you'd have to hand over in exchange for one barrel of oil, since 1959.
Broadly speaking, when you have to pay more than 0.1 ounces of gold for a barrel of oil, gold is cheap and oil is expensive. Below 0.06, oil is cheap and gold expensive. The all-time record occurred at the peak of the oil mania of 2008 when it took almost 0.17 ounces of gold to buy a barrel of oil.
Currently it takes 0.065 of an ounce of gold ( divided by ,400) to buy a barrel of oil. I would say that makes oil fairly, but not extremely, cheap, compared to gold.
That chart may look volatile at first glance, but a bit of scrutiny reveals how tight the range really is, unlike oil's inexorable rise when measured in US dollars. To illustrate this, I present the following chart, courtesy of James Turk of Goldmoney, which shows the relative cost of oil in pounds, dollars and gold. We see the comparatively flat price of oil when measured in gold, as per the lower red line. How much better for global trade and investment would it be if the price of the world's key commodity were this stable?
How does oil compare to the Dow Jones?
This next chart shows how many barrels of oil the Dow Jones (judged by its total points value) can buy you. Again broadly speaking, when that ratio is high, as in around 2000, you want to be selling stocks and buying oil. When it's low, as in the late '70s and early '80s, you want to be selling oil and buying stocks.
The long-term mean is 200 barrels of oil for the Dow. At oil and roughly 11,500 on the Dow, we are currently sitting below that mean, at around 130 barrels. The high point – where stocks were very expensive compared to oil – came at the turn of the century, as oil reached the end of its bear market and the dotcom boom peaked. Then, with the Dow nearing 12,000 and oil in the -15 zone, the Dow could buy you as much as 830 barrels of oil.
My thanks go to Tom Fischer, professor of financial mathematics at the University of Wuerzburg, for putting these charts together for me. It was Tom who first alerted me to the gold-to-UK-house-prices ratio. (His gold charts are well worth some study, by the way)
How low could these ratios go?
So right now, the oil price looks relatively expensive compared to stocks. Does that mean you should be buying the Dow?
Perhaps not. Tom is about as extreme an inflationist as you can get. Just as he sees the UK-house-price-gold ratio sinking to all-time lows in the course of this current chapter in financial history, he expects the Dow-to-oil ratio to fall back to somewhere near the lows of the late 1970s and early '80s. Then – with the Dow near 800 and oil spiking to $40 a barrel – the Dow would buy you a mere 20 barrels of oil.
I'm not as convinced as he is that we'll see these extremes, though I can see his logic. But when something is trading markedly below its long-term average (as the Dow-to-oil ratio is right now), I'm reluctant to bet too heavily on it.
But 'the trend is your friend' as they say, and this trend, which began in 2000, is clearly heading lower. Should rampant inflation coincide with fast-declining oil reserves, then Tom's target prices will be realised.
This is, of course, a very long-term trade. So – if it appeals to you – there is no rush to go out and do anything right now. And in the short-term the oil price could easily pull back. But one way to play this might be to buy quality oil stocks with growth potential which are not yet at full production. We'll be looking at promising oil stocks in a future edition of MoneyWeek magazine next year – and in the Christmas issue (out at the end of this week) one of our Roundtable experts tips his favourite energy plays.
Or there is Tom's strategy, which is to buy long-dated, out-of-the-money futures contracts. What does that mean? You buy a contract in the futures market that is not set to expire for another five years or more. That contract is to take delivery of oil at a considerably higher price than now. But you will need a broker who deals in futures. And I should stress that these contracts are only for the experienced – I've never bought one in my life – so buyer beware.
