CROESUS:There has been no let-up this week in the flow of poor economic news. Very weak retail sales data in the US served to further support the view that the US economy may have already slipped into recession.

Some good corporate news from computer company IBM, which reported very good quarterly profits, gave the American equity market a brief fillip. However, the market came back with a bump the following day as Citibank announced an enormous $18 billion (€12.3 billion) write-off due to the sub-prime crisis and cut its dividend by 41 per cent.

Computer chip maker Intel followed with weaker than expected quarterly profits, which was enough to knock 10 per cent off the share price.

The flow of poor economic news was not confined to the US this week. From an Irish perspective, a growing concern is the apparently worsening economic situation in the UK. This week, for example, the Royal Institute of Chartered Surveyors' housing survey showed that December was the worst month for the UK housing market since 1992.

These are indeed extremely nervous times for those investors heavily exposed to equities and to property. Furthermore, news flow from the corporate sector is certain to be poor in coming months as the impact of the economic slowdown gets reflected in company profit and loss announcements.

The difficulty for investors now is to try to judge how much of the impending bad news is discounted into current market prices. The data in the accompanying table illustrates the divergent moves in equity and bond markets since June 2007.

There tends to be an identifiable pattern in the relative performance of bonds and equities over the course of an economic cycle. During the growth phase of the cycle, share prices rise strongly as corporate profits expand. Bond prices come under downward pressure as interest rates and consumer prices rise. During a growth slowdown or recession, the opposite occurs with equity prices falling and bond prices rising.

Since June equity markets have fallen across the board. Falls from the June levels in American and European markets are now approaching the 10 per cent mark. The Japanese market has fallen by a much sharper 25 per cent and readers hardly need reminding that the Irish market is now approximately one-third below its mid-2007 level.

Bond prices have risen steadily over this period.

Weaker economic growth normally leads central bankers to cut interest rates, and inflationary pressures tend to abate, which causes bond yields to drop. This is reflected in the rise of 9.1 per cent for the total return index for US Treasuries and a rise of 4.9 per cent in the index of euro zone sovereign bonds. Therefore, in the US markets, there has been an approximate 20 per cent relative swing between equity and bond prices.

Croesus concludes from this analysis that the American financial markets have now priced in a mild recession for 2008. However, if the US economy were to suffer a severe recession then the recent pattern of bond/equity relative performance would have further to go.

Unfortunately, it is impossible to predict with any degree of confidence the eventual economic outcome for 2008.

Many investors have responded by diversifying their portfolios into alternative assets such as hedge funds and commodities. The gold price in particular has been a major beneficiary of this trend. Since end-June 2007 the gold price has risen by 35 per cent from $651 per ounce to its current level of $881. On the way the gold price reached an all-time high in excess of $900. Many gold bulls are now predicting that the gold price will breach $1,000 this year.

The reasons put forward for gold price strength are varied and, at times, contradictory. Gold is considered by many investors to be an excellent hedge against inflation. During 2007, inflationary pressures were growing, so this would explain some of the rise in the gold price. Also, in times of economic and financial stress, gold is considered to be the ultimate safe-haven asset. Therefore, the unprecedented credit crunch that first emerged in the summer of last year would have generated significant extra investment demand for gold.

An extra source of long-term demand for gold is coming from mainstream investment funds that wish to build a position in gold for diversification purposes. The final source of demand has come from speculative traders who are chasing the strong upward momentum in the gold price.

In Croesus's view, the very recent spike in the price is mainly due to speculative demand that may well push the price beyond $1,000 in the short term. However, some of the fundamentals supporting demand for gold are turning. Slower economic growth will inevitably take pressure off inflation and there are real signs that wholesale money markets are beginning to return to normal.

Investors tempted into gold at this stage run the risk of being sucked in at what could prove to be almost the top of the gold bull market.