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The past month has been a roller-coaster in the financial markets.

At the first hints of falling prices in the mortgage backed securities markets, Bear Sterns announced the bankruptcy of two large hedge funds, and 90% losses in a third fund which had $850 million invested in highly rated mortgage-backed securities. In the following weeks, other major funds also announced losses. Goldman Sachs’ Global Alpha hedge fund fell 27% this year through Aug. 13, prompting clients to ask for $1.6 billion in redemptions, investors told Bloomberg. DE Shaw, a pioneer of quantitative investing based on complex mathematical and computer techniques, has been hit hard in August. DE Shaw’s Valence fund is down more than 20% through August 24th, according to a fund of hedge fund manager.

These high-profile losses are prompting redemptions, and as cash flows out of hedge funds, managers must sell. Around the world, leveraged funds anticipate redemptions and are deleveraging (selling).

“When you can’t sell what you want, you sell what you can.”

Because the markets for mortgage-backed securities dried up so completely and so quickly, managers began selling positions that remained liquid and well-priced. In a sense, they had to sell good investments because they couldn’t sell the bad ones. What started as a series of collapsing mortgage strategies has spread into just about every other market that hedge funds touch. Prices fell in investments ranging from emerging market bonds to the price of hogs. In all, more than $1 trillion in value has been lost in US stock markets, alone. Many foreign markets and alternative asset classes suffered worse declines.

The trigger event is a credit tightening: mortgage issuers extended too much credit, were too loose with their lending standards, and may not have adequately communicated their loan terms. In response, lending standards have been increased and credit is tighter. US consumers might slow their spending, which might trigger a broader slowdown in the US economy, which might have implications for global growth. Uncertainty and fear prevail.

We view this fear as primarily psychological, wildly overestimated, and only loosely related to market fundamentals (See Figure 1). But that may not matter.

Contagion

The pricing of risk is driven by psychology. Investors require compensation for the possibility of loss and also for the inconvenience of uncertainty. So rising risk can cause capital to become scarce, lending rates to go up, and spending to slow. In this sense, the psychology can impact the fundamentals in what is sometimes called a "contagion".

The "Greenspan put" was like a safety net, providing the comfort that credit would be made available on those occasions when it was needed. Bernanke has reiterated this strategy, but it remains to be seen if he has the same appreciation for what Keynes called the "animal spirits" of the market. Contagion is a real phenomenon, generally starting with a crisis in one market or a large fund, then spreading to other asset classes as volatility rises and investors require higher premiums for risky investments.

In our view, the excessive lending in the mortgage industry could trigger a contagion in a variety of ways, such as:

• Rising rates and tightening lending standards leads to a contraction in home prices, reducing consumer spending and slowing economic growth.
• A new awareness for the risk of debt investments causes borrowing costs for corporations and governments to rise, reducing investment and slowing economic growth.

These risks can be self-reinforcing, and could change the fundamental characteristics of the economy. These are the type of events that could change our investment strategies if they appear to develop out of control.

So far, these contagions have not caused a significant slowdown in economic activity. Volatility triggered by major hedge fund failures is different; it generally causes sharp declines in recently popular asset classes followed by recovery. These declines can proceed in unexpected ways, and can continue for some time because each price shock runs the risk of triggering another failure. It is surprising how many hedge funds use leverage sufficient to make them incompatible with price shocks. As months pass, however, these shocks can be a blessing because they offer rare value opportunities.

We should all hope that a full-fledged contagion does not develop, and be thankful that the world’s central banks are standing guard.

The Federal Reserve

It is important for the government to intervene if a contagion might damage the economy in fundamental ways, but also important for the government to avoid interfering otherwise. The Federal Reserve and foreign central banks play an important role in managing the stability of economic growth by changing the availability of capital at money-center banks, but interventions can also cause distortions in currency exchange rates, changes in the money supply affect inflation expectations, and reliance upon government intervention can lead investors take excessive risks.

On the 17th, the Federal Reserve followed several foreign central banks (European Central Bank, Australia, Japan, and others) by pumping capital into their nations’ banking systems in response to the recent volatility. This intervention increases the monetary supply, but the psychology of selling is still driving down many market prices as global investors reduce their exposure to risk and shift their portfolios to hold more cash and US Treasury Bonds.

Credit tightening is a reasonable response to excessive lending, but the signal from global central banks is that they are ready to smooth the volatility, even if it means increasing the money supply. This indicates that they may intend to inflate their way out of potential economic pain. As a result, we are less concerned about a recession, but our long-term expectations for inflation have risen. This combination makes stocks and real assets more attractive because they are better hedges against inflation, and reduces the value of fixed income instruments (such as US Treasury Bonds). Meanwhile, the global investor crowd has been doing the opposite. If higher inflation will be the ultimate outcome of this recent roller coaster, then the massive global shift toward cash and fixed income may ultimately be reversed.

Labels: Credit, Economics, Investment, Psychology, Public Policy, The FED

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[The following article is part of a larger commentary, available here.]

After monitoring this calculation for a long time, I’m happy to announce this new and unusual arbitrage.

Pennies are composed of 97.6% zinc and 2.4% copper, with a total weight of 2.5 grams. After several years of rapid appreciation, copper prices have been stagnant for about 6 months, but zinc has been rising toward $4,000 per metric ton (or about 4/10 of a cent per gram). That places the value of the zinc at 0.994¢, and the value of the copper at 0.045¢, bringing to total cost of the raw metals to 1.04¢.

So if you collect pennies, melt them down, separate and purify the metals, then sell the metal on the public exchange, you make 4%. This is a new phenomenon, and may not last. I would expect to hear an announcement that the penny will be modified, replacing zinc with aluminum. This would bring the value of the metals down to less than 7/10 of a cent, and gives the government another couple years before they are forced to drop the penny as a unit of currency.

The new aluminum pennies will still be clad in copper, but will feel much lighter. You heard it here first.

Labels: Commodities, Freakonomics, Investment

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The Dow Jones Industrial Average is hitting new all-time highs while crude oil is making new lows for the year. Moving in opposite directions is normal for these markets, but recent movements may come as somewhat of a surprise against a backdrop in which core inflation has risen to levels not seen in a decade and the yield curve is inverted.

China and India seem to be in a race to secure energy reserves in anticipation that within three years, Asia's oil consumption will surpass North America's. Global economic production is expanding by about 4%, about double the average rate of the last 50 years. Growth rates are highest in the countries with the largest populations, and consumption is being subsidized by growing global debt markets.

Stock valuations anticipate strong growth while commodity prices anticipate adequate supplies. This is an intellectual error.

Only fools and economists believe in infinitely compounding growth

For major world markets to continue recent growth rates, many major supply-related hurdles would have to be overcome. Current capacity for energy supplies are insufficient to support more than a few years of continued growth at this rate; additional capacity will have to be created. However, whether or not one believes in the “peak oil” theory or not, it is indisputable that known oil reserves are shrinking while discoveries are taking longer and yielding less.

While the pendulum of stocks and commodities has swung toward stocks, the fundamentals seem set up to push the pendulum back the other way.

Stocks and Commodities; Owning Both

Commodities often move in the opposite direction from stocks over periods of three months or longer. Over longer periods, this negative correlation becomes quite strong; as much as -42% for five-year periods. The result is that these two asset classes have provided strong diversification benefits when combined in a portfolio. Their risks offset each other to a high degree, resulting in more consistent wealth accumulation.

The fundamental basis for this behavior is easy to understand: stocks do well when the resources they need are cheap. Similarly, profits are diminished as the prices of natural resources go up. In addition, as commodity prices rise central banks tend to raise lending rates and slow down corporate growth rates. For this reason, commodity prices tend to be a better hedge against unanticipated inflation than stocks, and much better than bonds.

Combinations of these two asset classes can be represented along an efficient frontier. This chart makes clear that risk was dramatically reduced by the introduction of commodity futures while having a very small impact on returns.

Risk-averse investors who are sensitive to maintaining their purchasing power should consider commodity futures as a component of their portfolios.

Ignored Risks

The risk to the value of the U.S. dollar should not be overlooked. Many countries own substantial foreign reserves in U.S. dollar denominated debt. If these countries decided to diversify into a broader basket of currencies or assets, the outflow of capital would put pressure on the value of the U.S dollar. Commodities provide a hedge against volatility in the value of the dollar by maintaining purchasing power.

Global Growth implies Unprecedented Demand

World population is rising at a rate of about 1.3% per annum, or about 10,000 new people every hour. At the same time, productivity in the U.S. is rising at about 2.6% annually. The U.S. has very high productivity relative to other countries, and it is growing. At the same time, the vast majority of the world population lives in countries where productivity is much lower – but catching up.

The process of productivity convergence has been dramatically accelerated by the opening of trade, reforms toward capitalism, and the growth of the internet to share information. The long-term trajectory is for developing countries to grow toward U.S. productivity levels. This simple dynamic has some profound implications: we’re not ready.

If Chinese productivity rises to even half of U.S. levels, that economy’s GDP will expand from less than one fifth that of the U.S. to more than double that of the U.S.

Consider 2 scenarios:

1) An unrealistically pessimistic scenario:
Assumptions:
a. World population suddenly stops growing.
b. The U.S. never innovates, and simply maintains existing productivity levels.
c. Other countries catch up to U.S. productivity levels in 50 years.
Implications:
a. China would average 6.6% growth for 50 years, raising its production by more than 24 times to more than four times the size of the U.S.
b. India would average 8.5% growth for 50 years, raising its production by almost 60 times to more than three times the size of the U.S.
c. Global production would rise by more than 5 times.

2) Constant population and productivity growth:
Assumptions:
a. World population continues to grow at 1.3%.
b. U.S. productivity continues to grow at 2.6%.
c. Other countries catch up to U.S. productivity levels in 50 years.
Implications:
a. China would average 10.8% growth for 50 years, raising its production by more than 169 times, to more than 30 times the current output of the U.S.
b. India would average 12.8% growth for 50 years, raising its production by more than 410 times, to more than 25 times the current output of the U.S.
c. Global production would rise by more than 41 times.

These long-standing and slow-moving global economic trends will almost certainly be interrupted by commodity shortages during this period. Even the most optimistic forecasts for natural resource capacity do not anticipate supporting even the conservative scenario for growth.

Something has got to give.

We expect that as population and productivity trends push demand higher, commodity prices will rise to keep demand lower. Equilibrium prices are likely to be driven increasingly by production capacity as shortages develop. Over time, this will likely slow global growth rates and provide advantages to companies and countries that are net suppliers.

Labels: Commodities, Economics, Investment

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[The following article is part of a larger commentary, available here.]

The key investment in the “green revolution” may be land. Wind farms require land, solar panels require land, bio-fuels grow on land, etc. Let’s inspect one specific use: using solar panels to generate hydrogen for fuel-cell cars:

As of last year, 700 sqft of Honda’s roadside solar generators produce enough hydrogen in one week to fuel one car for 175 miles. Clearly this is not enough, but it could be if you use more land.

If we assume that cars get about 25 mi/gallon of gas, then each acre produces the equivalent of about 62 gallons of gas per day. If gas costs $3/gallon, and hydrogen is priced to drive the same distance for the same cost, then each acre produces about $187/day in sales. That’s $68,140/year. Maintaining solar arrays is pretty cheap, let’s assume $5000/year/acre. If we discount the implied cash flow using a real rate of 5%, the value is $1.26m/acre. Obviously, an acre of solar arrays is expensive. Today, the cost would be about $1.5m, and exceed the net present value. But not for long!

Technology is progressing at a rapid rate. Today’s 6% efficiency may improve to 30% within 10 years. If the efficiency rises to 30%, the negative net present value of producing hydrogen turns positive. Very positive: $5 million per acre.

And don’t forget, for added upside you can install a wind farm over your solar arrays, and produce with both. Own some land.

Labels: Commodities, Freakonomics, Investment

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The following article is also available with charts, graphics, and additional information here.

The global population participating in world markets has risen from about 500 million to about 5 billion since the end of the cold war. This 10-fold increase in the number of workers and consumers is the dominant force in the world economy, underlying many major trends such as:

• The boom in outsourcing and world trade
• The falling “real” cost of low-skilled labor
• Deflationary pressure
• The de-industrialization of the United States
• Overwhelming demand for natural resources

The political response from developed nations has been to embrace free trade, promote global growth, and fight deflation by increasing the money supply.

As the world adjusts to the new labor force and production capacity, we expect these trends will evolve naturally. Outsourcing will continue and broaden as technology continues to make distance and language less of an impediment. The real (inflation adjusted) wages of low-skilled labor will continue to lag. Deflationary pressure from expanding trade and improving productivity will be offset by an expanding capital base. The de-industrialization of the United States will slow as energy and commodity prices rise because U.S. industry is more energy-efficient than most competitors. The overwhelming demand for natural resources will continue to drive up prices, as demand continues to grow faster than supply.

There are still major unanswered questions that will guide global growth. For example:

• How quickly will emerging markets raise their consumption toward levels that are common in the developed world?
• Will the deflationary pressures of trade and productivity be offset by rising asset prices and an expanding monetary base, such that inflation can remain low and stable?
• As limited natural resources are bid up by new global demand, will market forces be able to restrain governments from nationalizing resources?
• Will developed nations be able to retain labor standards and a social safety net while competing freely with nations that do not?

Investors might consider the following strategies against this backdrop of trends and risks.

Overweight U.S. Stocks

We believe U.S. equities are generally cheap, with prices already anticipating a broad economic slowdown coupled with higher interest rates. While earnings have been growing very well, prices have lagged, leading to an earnings yield premium that looks more like the average of the 70s than any period in the 80s or 90s.

If the economic slowdown is less than expected, prices may rise substantially from these levels. If the slowdown is greater than expected, clearly there is risk to the downside, but the equity markets appear more attractive, on balance, than fixed income securities.

Within the U.S. equity markets, macroeconomic trends point us toward nimble multinationals and commodity producers. It might be wise to avoid owning companies that depend on the U.S. middle-class consumer. U.S. consumer spending has some structural disadvantages because of rising mortgage rates and an interruption of the rising real estate market, so is unlikely to continue growing in line with recent history. The deceleration in consumer spending may be gradual or dramatic, but it is very likely.

Underweight U.S. Bonds

The U.S. bond market may not be attractive at this time compared with equities. After a prolonged bull market in long-term bonds, the risk/reward balance, compared with stocks, appears unfavorable.

Foreign governments are buying U.S. bonds to stabilize the value of their currencies. Insurance companies and pension funds are buying bonds to offset predictable liabilities. These sources of demand are driving up bond prices independently from other investments, making bonds less attractive.

Demand from foreign governments may diminish because they may decide that holding a global portfolio of bonds is better than concentrating in U.S. bonds. Demand from insurance and pension funds may diminish because managers are migrating toward efficient asset allocation, as opposed to strictly offsetting their liabilities.

Any one of these changes could cause a drop in the price of U.S. bonds. For example, if Japan privatizes its postal saving system as planned, it would mean that more than ¥224 trillion ($2.1 trillion) in savings and ¥126 trillion ($1.2 trillion) in life insurance would no longer be invested by the Japanese government. Japanese citizens may be less eager to buy US bonds than the Japanese government has been. Indeed, they may redirect some of those assets into Japanese equities.

Investors who must hold bonds should restrict ownership to only the highest quality, short-term bonds. Even investors seeking tax-advantaged municipal bonds are cautioned that avoiding the inflation tax, which stealthily confiscates principal, is more important than avoiding taxes on mere income.

Lock in Your Mortgage

For the same reasons that long-term bonds are in a bubble, long-term mortgages are artificially cheap. The boom in adjustable rate mortgages was the result of a very accommodating Federal Reserve, and that time is past. Now that the yield curve is flat, locking in long-term financing within 1.25% of the overnight lending rate is a rare opportunity.

Diversify U.S. Dollar Exposure

Conservative investors should hold some investments that are linked to assets or are diversified among a variety of currencies.

The stability of the U.S. dollar is tenuous. The large trade deficit and large foreign ownership of U.S. debt and investments are a tribute to the strength of the US economy; however, they also represent a risk to the U.S. dollar. Interest payments to service these debts already exceed the budgets for the U.S. Department of Homeland Security, Department of Education, Department of Justice, Department of Transportation, the entire Legislative Branch, and NASA, combined. Then, at some point, foreign debts will have to be repaid. A more immediate risk is that foreign investors will sell their U.S. investments if they believe they can achieve better returns elsewhere.

A similar dynamic came to crisis in dozens of countries in Asia and Latin America in the last 20 years. The increased risk of U.S. dollar weakness justifies diversification. Even a gradual long-term resolution to this imbalance would richly reward asset-based and foreign currency investments.

Heavily Overweight Commodities

The risk to the value of the U.S. dollar is enough to justify an overweight position in commodities. The additional trends in global demand growth also suggest an overweight position. Also, many individual and institutional investors have long ignored this asset class, so increased interest from the investor community may provide additional upside potential.

For fundamental reasons, commodity prices may trend higher for a long time. Previously, there had been a sustained stagnation in real commodity spot prices from 1972 through the turn of the millennium. This stagnation was partly due to the collapse of the Soviet economy, and led to a slowdown in investment in new commodity production capacity. Global demand growth was widely overlooked as producers concentrated on meeting U.S. consumption patterns. This oversight was largely because emerging market commodity consumption had historically represented such a small fraction of the total market demand.

The 4.5 billion new members of the global economy are, on average, increasing consumption at a rate far exceeding that in the U.S. Per-capita demand for commodities in emerging markets is only about 10% that in the U.S., so total commodity demand could grow at an accelerated rate until they catch up. If emerging market demand rises to 20% of the per-capita consumption in the U.S., even while the U.S. does not grow at all, total commodity demand would increase by 47%. There is simply not enough production capacity to meet that demand. How long will it take global per-capita commodity demand to rise to half that of the U.S.? If that happens, global commodity demand will have almost tripled (even assuming the U.S. does not grow at all). Commodity producers (and investors), take notice.

Overweight Select Foreign Stocks

In many cases foreign stock valuations are low, yields are high, and prospects for growth are favorable. In addition, they are less dependent on U.S. consumer spending, and can be a good way to diversify currency exposure.

Neutral Position in Foreign Bonds

Foreign bonds offer the benefit of currency diversification, and may benefit from global central banks moving away from strictly using U.S. Treasuries. Long-term bonds issued in major currencies such as the Euro, Yen, and British Pound may benefit from flattening yield curves. However with rising global interest rates and inflation, shorter maturities may be preferable for bonds in other currencies.

Labels: Commodities, Investment

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Every time oil prices pull back, the financial press repeats the misguided mantra that crude inventories are too high. The fact is, inventories are far from excessive. Rather, they reflect the strategic importance of oil and America’s increasing dependence on foreign sources. Indeed, we believe that investors should expect crude oil inventories to continue rising along with prices. The higher inventories shield the economy from unexpected and uncontrollable disruptions in crude oil supply.

Oil inventories are strategic

As the chart below indicates, following the 1973 oil embargo, US crude oil inventories began rising steadily. Companies and the US Government correctly understood that maintaining larger inventories would help to avoid risks from further supply disruptions caused by OPEC. The increase in inventories continued for more than 16 years before stabilizing.

The attacks on September 11, 2001, triggered a similar change in perception – this time, the widespread recognition that inventories should be maintained to protect against supply disruptions resulting from terrorism or other political volatility. It is impossible to predict whether the current increasing trend of inventories will last as long or push as high as the previous one, but the increase appears ongoing.

CHART

Crude inventories in terms of months of supply

The slow-moving trends shown above may give false confidence in US crude oil inventory management. A more important measure of inventories is how long inventories would last during a supply disruption. Inventories would provide about two months’ supply at the current pace of consumption. This two-month period is up only slightly since September 11, 2001.

CHART

The US is increasingly dependent on foreign sources of oil

US oil production peaked in 1971. Since that time, growing demand for crude oil in the US has been satisfied by rapidly increasing imports. In 1991, imports surpassed domestic production, and since that time imports have grown to two-thirds of the total US crude oil supply.

CHART

In today’s world, the disruption of imports is a distinct risk. In the event of a war, embargo, or terrorist act, imports could be interrupted while domestic production might continue. Current US crude oil inventories would replace about 100 days of imports. This 100-day period has essentially remained the same since September 11, 2001.

If inventories do not grow in pace with demand, the period of protection against import disruptions will decline. As inventories shrink relative to imports, the US becomes increasingly vulnerable to import disruptions that could adversely affect the labor and lifestyles of Americans. By this measure, inventories have rarely been lower.

CHART

It is probably no coincidence that the|1973 oil embargo was triggered by OPEC when US inventories had fallen to less than three months of imports. A period of low inventories causes prices to respond dramatically to disruption. The oil crisis of 1979 resulted in long lines for scarce gasoline. Solar panels were actually installed on the roof of the White House.

In order to provide for the equivalent of six months of imports, inventories would have to rise by 79% over their current level.

Almost every aspect of modern living is tied to consumption of crude oil, directly or indirectly. The economy relies on the oil industry for gasoline, diesel, jet fuel, heating oil, natural gas, propane, asphalt, lubricants, fertilizers, antifreeze, pesticides, synthetic rubber, pharmaceuticals, and plastics. It is hard to imagine a functioning economy without these products.

Even the most optimistic experts anticipate that world crude oil production can only grow for a few more decades. After that time, production would decline as remaining sources became more difficult to recover from depleting reserves. Most prominent experts anticipate that global production will peak sooner; some even believe it peaked in 2005.

Already, energy efficiency is on the rise. We are increasingly using crude oil for applications that are best served specifically by crude oil. Other sources of energy are being exploited whenever possible and whenever the cost can be justified. The US economy has been growing faster than its rate of consumption of oil, but it is still highly dependent on crude.

CHART

In sum, America began coping with its dangerous dependency on oil after the Arab oil embargo of 1973. But management of this dependency is ongoing. War and terrorism, increasingly scarce supplies, and changing standards in the transportation industries are likely to lead to rising energy prices as America continues to struggle with its addiction to oil.

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Labels: Commodities, Investment, Public Policy

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Stable US growth

GDP and industrial production during the 3rd quarter grew at about 4% and 3%, respectively, with a relatively stable outlook, and consistent with long-term averages.

Innovation, trade, and competition are driving economic growth, while rising interest rates and commodity prices have hampered growth.

Strong earnings

Earnings-per-share (“EPS”) for the S&P 500 through June stood 30% above the peak reached in 2000.

Earnings have risen more rapidly than share prices, raising the earnings yield of stocks. Comparing the earnings yield of the S&P 500 with the yield of the 10-year bond (“earnings yield premium”), stocks look the most attractive in 25 years. From this perspective, the odds appear to favor equity outperformance.

We expect corporate profits in the United States to rise again in 2006, at a slower pace than in 2005 but better than consensus expectations. We expect that energy, other commodity stocks, and selected technology shares will provide particularly good gains.

Cheaper US equity valuations relative to earnings and to bonds have been driven in part by reduced overseas demand. Foreign investors moved aggressively into US stocks starting in 1997, but they have been reducing their purchases of stocks since 2002, focusing instead on bonds.

Bond bubble?

Foreign governments are buying US bonds to stabilize the value of their currencies. Insurance companies and pension funds are buying bonds to offset predictable liabilities. These sources of demand are driving up bond prices independently from other investments, making bonds less attractive.

Demand from foreign governments may diminish because they may decide that holding a global portfolio of bonds is better than concentrating in US bonds. Demand from insurance and pension funds may diminish because managers are migrating toward efficient asset allocation – as opposed to strictly offsetting their liabilities.

Any one of these changes could cause a drop in the price of US bonds. For example, if Japan privatizes its postal saving system as planned, it would mean that more than ¥224 trillion ($2.1 trillion) in savings and ¥126 trillion ($1.2 trillion) in life insurance would no longer be invested by the Japanese Government. Japanese citizens may be less eager to buy US bonds than the Japanese Government has been. Indeed, they may redirect some of those assets into Japanese equities.

Global growth is on fire

Worldwide political reforms since 1989 have brought more than 4 billion people (almost 2/3 of the world population) into market-driven global economies, and productivity per person continues to grow rapidly. The result of these two trends is a very rapid rise in global production. Developing nations with low wages and taxes continue to gain access to capital and skilled labor enabling them to grow faster than their domestic competitors. Many international stock markets have been outperforming US markets, and international diversification will be even more important going forward than it has been in the past. The oversupply of global labor is not likely to be fully utilized in this decade. As global production grows, the voracious demand for commodities to fuel this expansion is driving up prices, particularly for energy and industrial metals where supply is tightly constrained (3rd Quarter ’05 commentary).

Digital Revolution

Rapidly changing technology is forcing many industries to evolve. The convergence of media and communications toward a common internet protocol means that phone, cable, and radio companies will suffer falling prices in a new competitive landscape. Wider accessibility of broadband connections should also spur the growth of internet services. This same trend is making information available across borders, accelerating learning and research, improving productivity growth, and accelerating political reforms. The fragmentation and expansion of the device market is opening up the semiconductor market to more competition. Intel is likely to maintain large market share in the PC and laptop markets, but handhelds, gaming, smart HDTV, and other new markets will allow more segmentation of semiconductor companies.

Fed tightening

In June 2004, the Federal Reserve began raising rates from 1% in 0.25% increments to a current rate of 4.25%. This pattern is widely expected to continue at least through Chairman Greenspan’s last meeting on January 31st.

Prices, as measured by the Consumer Price Index (CPI), rose by 3.4% in the year ending November, still within the low range in place since 1983. The inflation adjusted (or “real”) Fed target rate is still below average. Observing the historical average, a neutral real rate of about 1.9% might be expected (implying about 4 more rate hikes like the last 13).

Our expectation is that the Fed will stop raising rates before returning to a 1.9% real rate. Productivity gains, cheap imports, and outsourcing will continue to restrain inflation, suggesting the Fed can afford to keep rates low (4th Quarter ’05 commentary).

Housing boom or housing bubble?

Housing prices have been rising rapidly for several years, leading to predictions of a housing bubble. Irresponsible speculation and use of interest-only loans have been widely reported. The value of homes purchased has almost quadrupled since 1991 .

Speculation and rising prices are addressed in part by the Fed tightening because higher rates make mortgages more expensive. However, if the Fed remains concerned about housing prices when inflation is well controlled, tighter regulation of lending standards would be a better tool than continuing to raise the target rate.

But are housing prices a problem? There may be a regulatory problem with low-credit lending, but we don’t see evidence of overextended homebuyers or excess housing supply. Housing prices are rising in line with the general trend in other commodities and assets. Everything that goes into building a home, from cement and copper to lumber and land, is rising in price.

Alan Greenspan and James Kennedy recently published a study including historical loan-to-price ratios. Mortgages represent a smaller percentage of the value of the home than the average of the past 15 years.

What about all that new construction? The number of housing starts is near all-time highs. This headline is true, but misleading. When the number of housing starts is divided by the non-institutional population over the age of 20 in the US, it is far from all-time highs; instead it is below average, and recovering from a prolonged low period.

If mortgage rates rise rapidly, there will almost certainly be more mortgage defaults and foreclosures because of the current popularity of floating-rate mortgages. In that scenario, prices might stagnate on a national scale and could fall in some markets where negatively amortizing loans are popular.

The broader risk to the economy risk is that consumer spending could slow when housing prices return to a more normal rate of growth. Consumer spending is linked to housing prices because homeowners are extracting equity from their homes as the value rises. Equity is being extracted from homes at an annual rate of hundreds of billions of dollars – recently averaging more than 6% of disposable income. A drop in equity extraction has the potential to reduce disposable income by 6%. Offsetting this, consumer net worth is rising rapidly and is at an all-time high.

Fragile stability of the US dollar

World trade is rapidly expanding, and the US is importing far more than it is exporting, resulting in a trade deficit. The historically large trade deficit is a risk to the strength of the US dollar because at some point, all those foreign debts have to be repaid by buying foreign currencies. The magnitude of the risk grows with the magnitude of the debt.

The federal budget deficit is also historically large, but not relative to the size of the economy, and it has been improving since August 2004. In addition, Americans own much of the federal debt, so paying it back will have less effect on the currency. At the end of 2004, foreign holdings of US Treasury debt were $1.886 billion, 44% of the total public debt .

In aggregate, the dual deficits and foreign purchases of US investments create foreign demand for US dollars of about 14% of GDP. Having supported strength in the US dollar, this foreign demand also represents a substantial risk if it slows down or stops.

Exposure to a basket of global currencies, particularly those from countries that are net exporters of commodities, is probably a safer position than being concentrated 100% in US dollar-denominated assets.

Long-term outlook

We are optimistic about global economics and financial investments over the long term. Skilled labor is widely available, and international trade is increasingly cost-effective. Thoughtful diversification across sectors, asset classes, and countries remains a sound investment approach, although US bonds appear unattractive. Global tax and regulatory reforms are increasingly favorable to investors and the economy. The financial markets are increasingly capable of supporting production, distributing risks, and creating resilience against shocks like war and natural disaster. These trends point to higher asset values, lower downside risk, and higher returns on investments.

Labels: Commodities, Investment

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There has been a lot of talk about the impact of rising energy prices on corporate profit margins. This is over-rated.

Corporate costs in America are much more heavily weighted toward labor. And it is labor cost inflation that hurts corporate profit margins most. Corporate costs are, on average, 70% labor, 5% commodities, and 3% energy. Energy and commodity prices could continue to rise - even double from here - without changing the cost structure of American businesses in a drastic way. The same dynamic is not true in many other countries, including emerging markets, where labor costs represent a smaller proportion of corporate costs. As energy and commodity prices rise, those companies may encounter much more pressure on their profit margins.

So what's the bottom line? Energy and commodities can continue to rally without significantly damaging corporate profit margins. Furthermore, rising energy and commodity prices will give a relative advantage to the most efficient producers.

Labels: Commodities, Investment, Public Policy

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My latest quarterly investment commentary discusses some longer term global demographic trends, and implications for investors.

Download: 2005 Q3 Investment Commentary

Recent global growth rates are unprecedented in economic history.

Economic growth at this pace will put predictable strains on resources.

Population, productivity, economic growth, and production capacity point to long-term commodity gains.

Labels: Commodities, Investment

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Flat to Down to Way Down:

• Music: sales last year were down 21% from their peak in 1999
• Television: network TV's audience share has fallen by a third since 1985
• Radio: listenership is at a 27-year low
• Newspapers: circulation peaked in 1987, and the decline is accelerating
• Magazines: total circulation peaked in 2000 and is now back to 1994 levels (but a few premier titles are bucking the trend!)
• Books: sales growth is lagging the economy as whole

Up:

• Movies: 2004 was another record year, both for theaters and DVDs
• Videogames: even in the last year of this generation of consoles, sales hit a new record
• Web: online ads will grow 30% this year, breaking $10 billion (5.4% of all advertising)
  

Exerpt from: The Long Tail
See also: Telecom Watchlist / Industrial Evolution

Labels: Investment, Tech

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Forbes reports on Warren Buffet's currency perspective:

Heed the Sage of Omaha. Warren Buffett, whose investment acumen seems unerring, had a caveat for America: Barring "a major change" in policies, the trade deficit will further undermine the U.S. dollar.

The billionaire spoke in a Wednesday interview with CNBC, the cable TV news channel owned by General Electric (nyse: GE - news - people).

Without shifting current trade policy, "I don't see how the dollar avoids going down," he mused, warning of inflation risks posed by an anemic Yankee currency.

The prairie-born genius also confessed he's having a "hard time" identifying stocks to buy, and isn't purchasing commodities. His cash swelled to $43 billion in the third quarter, by one account, because he couldn't find many investment opportunities.

Buffett, 74, is chairman of Berkshire Hathaway (nyse: BRKa - news - people), the immensely successful investment vehicle that acquired a new--and immensely successful--board member in December: Microsoft (nasdaq: MSFT - news - people) Chairman Bill Gates. The latter also enjoys a personal friendship with Buffett, and takes part in his bridge games. (see: "Gates: Buffett's Pal Bill Elected To Berkshire's Board")

Labels: Investment

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This market scares me.

There are always strange internal inconsistencies in markets -- efficient markets are a myth -- but not usually like this.

6 straight days of down days on the Dow, and the financial news is pinning this on dollar strength and inflation fears. That reasoning does not hold water.

If inflation is the underlying issue, then why are commodity prices falling? Specifically, why aren't we seeing the flight to quality that normally lifts the price of gold. And if this is a strong dollar story, then why are foreign stock markets falling essentially in line with US markets? And why is the VIX (Volatility index) down? Normally, with trending stocks, the VIX moves up. When the VIX moves down, options prices generally fall.

It's a strange combination: Stocks down, bonds flat, options down, commodities down, foreign stocks down.

Pure conjecture:

Maybe some big funds had to do some major asset allocation. For example, if i maintain both stocks and bonds at specific percentages of my portfolio, and my stocks went up more than my bonds in 2004, then rebalancing would mean selling some stocks to buy bonds just to keep my asset allocation constant. If the asset allocation included global stocks, bonds, and commodities, then clumsy execution of that kind of trading could lead to the kinds of moves we saw today.

Another possibility might be that large scale selling of global stock markets, commodities, and options (to a smaller degree) by smaller investors is moving capital into US dollar-based cash.

Implications:

Prices are lower and the risks do not seem to have fundamentally changed. However, this feels like a red flag for possible crash in order of 8 to 15%. I'd put those odds at 5% for the next month. If markets right themselves - or at least reestablish their normal linkages - then I'll feel much more comfortable again, and would overweight international equity beta with a weak dollar emphasis.

Labels: Commodities, Investment

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Exchange traded funds can be a good way to access you international stock markets. This is particularly helpful in markets where you should be seeking broad diversification. EWT and EWH can give you access to the Taiwan and Hong Kong Indices; two markets.

CHU is actually China Unicom. China Mobile is CHL. I hold both, but about 2x as much CHL as CHU. CHU is smaller, more volatile, and between the two, you can cover CDMA and GSM systems in China.

Japan is pretty negative in world view right now, but I still like it very much. I think their currency is overvalued relative to the dollar, and that their stock market is simply not considered by Japanese individuals to be an investment option. Cash is still king there. Also, in terms of international investment characteristics, I think they will become to the rest of Asia in the next 20 years what the United States was to Europe in the last 20 years.

I do like Taiwan. I think that the long term conflict with China will be resolved as China ironically moves more toward Taiwanese policies. They are receiving smart and hard working people like Singapore and Hong Kong. I like all those places. The companies in their indexes probably represent the companies that will be serving major new populations of consumers. These economic centers of influence are the indexes I'm trying to focus on. My time horizon is 10-20 years, though, and I'm sure it will be a bumpy ride.

I sold ECA. I think my positive energy view is really a growth story in electricity, rather than fossil fuels.

Labels: Investment

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Honda rocks.

They announced yesterday the development of new technologies for the next-generation ASIMO humanoid robot, targeting a new level of mobility that will better enable ASIMO to function and interact with people by quickly processing information and acting more nimbly in real-world environments.

Key technologies include:
1) "Posture Control" technology* making it possible to run in a natural human-like way
2) "Autonomous Continuous Movement" technology enabling flexible route to destination
3) Enhanced visual and force sensor technologies enabling smoother interaction with people

1.Posture Control technology:
The combination of newly developed high-response hardware and the new Posture Control technology enables ASIMO to proactively bend or twist its torso to maintain its balance and prevent the problems of foot slippage and spinning in the air, which accompany movement at higher speeds. ASIMO is now capable of running at a speed of 3km/hour. In addition, walking speed has been increased from the previous 1.6 km/hour to 2.5 km/hour.

2.Autonomous Continuous Movement technology:
The next-generation ASIMO can maneuver toward its destination without stopping by comparing any deviation between the input map information and the information obtained about the surrounding area from its floor surface sensor. Moreover, ASIMO can now autonomously change its path when its floor surface sensor and visual sensors located in its head detect obstacles.

3.Enhanced visual sensor and force sensor technologies allow for smoother interaction with people:
By detecting people's movements through visual sensors in its head and force (kinesthetic) sensors which have been newly added to its wrists, ASIMO can now move in sync with people allowing it to give or receive an object, shake hands in concert with a person's movement and step forward or backward in response to the direction its hand is pulled or pushed.

By continuing to advance these new technologies, Honda will pursue development of an ASIMO that will be useful to people.--Key specifications of the new model:
1. Running speed: 3km/hour (airborne time: 0.05 second)
2. Normal walking speed: current model 1.6km/hour --- new model 2.5km/hour
3. Height: 130cm (current model: 120cm)
4. Weight: 54kg (current model 52kg)
5. Continuous operating time: 1hour (current model 30 min)
6. Operating degrees of freedom: Total 34 degrees of freedom (current model: Total 26)

--Hip rotational joint:
Increased walking speed was achieved by the proactive rotation of the hips in addition to swinging of the arms, which cancel the reaction force generated when the legs swing forward during running or walking.

--Wrist bending joint:
Due to two additional axes in each wrist, the movement of the wrist area is more flexible.--Thumb joint: Previously, one motor operated all five fingers. With addition of a motor that operates the thumb independently, ASIMO can now hold objects of various shapes.

--Neck joint:
With an additional axis added to its neck joint, ASIMO's expressiveness has been enhanced.

*More about the new Posture Control technology:
In order to realize "running," two major obstacles had to be overcome. One was an accurate leap and the absorption of the landing impact, and the second was prevention of the slipping and spinning which accompany movement at higher speeds.

1. Accurate leap and absorption of landing impact:
In order to run, a robot has to be able to repeat the movements of pushing off the ground, swinging its legs forward, landing within a very short time cycle and without any delay, absorbing the instantaneous impact shock of landing. With a newly developed high-speed processing circuit, highly-responsive and high-power motor drive unit, in addition to light-weight and highly rigid leg structure, Honda realized highly accurate and responsive hardware with performance levels more than four times faster compared to that of the previous model.

2. Prevention of spinning and slipping:
Due to reduced pressure between the bottom of the feet and floor, spinning and slipping are more likely to happen right before the foot leaves the floor and right after the foot lands on the floor.

Overcoming the problem of spinning and slipping was the biggest control element challenge related to increasing running speed. Combining Honda's independently developed theory of bipedal walking control with proactive bending and twisting of the torso, Honda developed a new control theory which enables stable running, while preventing slipping.

Through these technologies, ASIMO is now capable of smooth human-like running at a speed of 3km/hour. Moreover, walking speed was increased from the previous 1.6 km/hour to 2.5 km/hour.

When a human runs, the step cycle is 0.2 to 0.4 seconds depending on one's speed, and the airborne time, when both feet are off the ground, varies between 0.05 to 0.1 seconds. The step cycle of ASIMO is 0.36 seconds with an airborne time of 0.05 seconds, which are equivalent to that of a person jogging.

Labels: Investment, Tech

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The renminbi is pegged to the US Dollar, and has been for a long time, so what would a revaluation of the Chinese currency mean? Without an exchange rate determined by the marketplace, how can we anticipate the magnitude of the difference between the pegged rate and the appropriate market rate?

It is clear that the yuan is cheap relative to the dollar, but by how much? Our economies are different, and these differences lead to different relative pricing, but looking at a variety of prices can give us some sense of purchasing price parity.

Unskilled Labor:
Textile workers in China are paid about 1/30 of the amount paid for equivalent work in the United States. If this ratio were to equalize through currency revaluation, the yuan would increase by 3000%. However this is almost certainly too high, as China has an oversupply of unskilled labor. This number provides the high-end boundary on the scope of the question.

Gold:
Gold can be purchased in yuan At the time of this writing, $442 worth of gold costs 3670 yuan, implying an exchange rate of about 8.303 Yuan/$. If this ratio were reflected in the currency echange rate, the yuan would increase a negligible amount (Because the exchange rate peg is currently 8.27 Yuan/$). However this is almost certainly too low, as it is illegal for chinese citizens to invest in Gold. This number provides an low-end boundary on the scope of the question.

Basket of goods:
Depending on the basket you select, purchasing price parity implies different undervaluation of Yuan. I estimate approximately 40% undervaluation, clearly with different classes of goods and services.

Trading:
Under a fair and open market, I envision a 40% inflation on Cinese imports would greatly imporove the stature of US companies that have been drowning under Chinese import competition. Similarly, Chinese companies that earn their revenues from Chinese will see a US Dollar denominated revenue increase of 40%.

[UPDATE 1/25/2005]
Senator Lindsey Graham, (R) Judiary Committee and
Senator Charles (Chuck) Schumer, (D) Finance Committee
are announcing bill to impose a 27.5% tarif on Chinese imports, implying their view that the Renminbi is near 27.5% discounted against the Dollar.
[END UPDATE]

Let's speculate that Chinese currency will reflect market forces within 2 years. In this speculative possible environment, investors might benefit from:

underweight Chinese companies with revenues largely based on exports

overweight Chinese companies with revenues largely based in China

underweight US companies who import from China

overweight US companies who compete with Chinese imports

Now let's speculate that Chinese currency will remain pegged to the US Dollar. In this speculative possible environment, investors might benefit from exactly the opposite positions.

How can the US exploit a currency peg that is clearly an unfair trade practice?
Cut taxes and issue more debt.
This increases the Federal deficit, diminishing the value of the US Dollar, and also increases the after-tax pay rates for US workers.

Labels: Investment, Public Policy

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There are clear innovations and implementations of current technology that can be safely called inevitable. One of these is ubiquitous wireless. We will be surrounded by secure broadband available by subscription, and compatible with wireless devices. Wireless devices compatible with broadband will include laptops, PDAs, phones, and electronics built into vehicles, etc.

If this is true, then some industries will join the buggy-whip industry:

Phone companies: why pay for phone service if your wireless phone is a tiny part of a cheap broadband service. Internet traffic incurred by telephone quality duplex audio is a drop in the bucket.

Cable providers: If I have access to streaming video straight from the media companies, why pay a cable company for anything? I might pay HBO for access to their channel, but there is no room for Comcast. The old line between broadcast and cable TV will be irrelevant.

Traditional and Satellite Radio: Internet radio is already catching on. When devices and wireless grow to maturity, there is no need for radio. Your music preferences will be targeted much more specifically than a set of 20 FM stations can satisfy, making the listening experience far better. The 2-way directionality of streaming radio (broadcasters know what IP addresses are listening, and when) make the value proposition for advertisers far better. Finally, the global nature of IP eliminates the problems of range and signal quality.

I don't mean to sound gloomy, in fact, this is not a gloomy forecast. Leaving horse drawn buggies for cars was a major milestone in economic advancement. So too, leaving single-application wires for IP-based wireless broadband is going to be a great milestone. Communications technology is the lubricant of innovation and trade. I would expect global growth to accelerate into these advancements, and remain at a generally accelerated pace thereafter.

In this speculative possible state of the world, investors might benefit from:

underweight companies with revenues largely based on phone, cable, and radio
underweight traditional-radio advertising companies
overweight equities
overweight internet advertisers and IP-intelligence aggregators
overweight internet applications providers

Labels: Investment, Tech

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Recommended reading: Mark Faber's analysis of agricultural commodities (MP3 Audio / Transcript).

Favorite Excerpt:

Some commodities may have overshot already, but agriculture is one of my favourites because food production in China has been declining. They have a water problem, and through the industrialisation and the construction of golf courses there’s less land available for agriculture.

So I would go and look at some agricultural commodity prices that haven’t moved much yet like corn, soya beans, wheat, sugar. The Swiss drink 50 times more coffee per capita than the Chinese, but the Chinese have a population 200 times larger than the Swiss so their market is already larger. If they go to the per capita consumption level of the South Koreans, Taiwanese, Japanese – non-traditional coffee drinkers – they will take up three times the coffee crop in the world.

Labels: Commodities, Investment

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The rise of the investment industry drives up competition, drives down prices, and ends up subsidising consumer spending.

As capital has become more available, fixed costs have become less important in competitive industries. Overcoming a billion-dollar fixed cost to achieve gross margins above the market ROI has become commonplace. As investments lead to market expansion for companies, competition becomes more intense. The impact is even stronger with smaller fixed-cost businesses. As competition increases, profit margins fall and consumers are the ultimate beneficiaries.

When profit margins fall in an industry, companies may not achieve the ROI they expected, and investments grow increasing downside risk.

In this speculative possible state of the world, investors might expect:

• more downside risk from the equity markets,
  (underweight equities relative to other asset classes)

• more default risk from the corporate bond markets,
  (underweight credit risk relative to high credit quality)

• more downward pricing pressure (aka lower inflation),
  (overweight bonds relative to other asset classes)

• higher profit margins available to larger-cap companies
  (overweight large cap relative to small cap)

I left out another impact: as competition lowers prices for consumers, consumption goes up even if spending stays the same. More consumption means more demand for commodities. Supplies of commodities may grow, too, if investment improves mining, agriculture, etc. If demand growth exceeds supply growth, expect commodity prices to rise.

Labels: Investment, Public Policy

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The past couple days of US dollar strength has corresponded with a sharp drop in the prices of many precious and industrial metals, among other commodities. Oil has rebounded a bit from its more recent downward trend. It feels to me like a buying opportunity. Dollar weakness is not done yet; I don't see the fundamental causes of dollar weakness subsiding for many years. Commodity demand should also continue to grow for many years. Together, these point to higher dollar denominated prices for commodities. Precious and industrial metals prices, in my view, are particularly well suited for growth. As the economic production of the globe grows, so too does the percentage of metals used in production. Silver acts both as a precious metal and an industrial metal. I anticipate it will see increasing demand from investors trying to avoid US dollar weakness, as well as manufacturers.

One of the great industrial benefits of silver is its exceptional heat conductivity. In an age of growing demand for electronics, heat dissipation is a core concern. Silver is a major ingredient in thermal conductive paste that is used to connect heat sinks. In some cases, recycling can recover traces of silver for reuse, but the demand is high and growing.

Silver is supplied in large part as a byproduct of mining for other metals. The mining of new silver has not grown much in the last 75 years. As the US Gov't has depleted its silver reserves, that supply has satisfied the industrial and investor demand to such a degree that the price has not trended upward beyond an inflationary-type growth rate. Low, slow-growth supply combined with higher, faster growth demand points to a good long term opportunity.

As always, a lot of things could go wrong with this story. The world could become enamoured once again by US investments, and drive up the value of the dollar. The world could experience a production slowdown, reducing the demand for commodities. Synthetic replacements could reduce the demand for silver in manufacturing. Precious metals could fall in favor with investors who shift toward more economically productive investments. All of these could hurt silver prices. But I like the odds.

Labels: Commodities, Investment

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Commodity prices are falling today, but don't join the selling momentum.

Productivity is rising rapidly. Manufacturing techniques are being shared globally at a faster rate then ever before.

Almost 1/2 of the entire human population entered the global economy since 1990. Trade has opened up in previously closed economies. The new labor is bringing labor costs down globally, simultaneously raising per capita consumption by many multiples in many countries.

Low interest rates mean that debt is cheap. Equity investments are also readily available because taxes on capital are down.

To review: Productivity up, labor costs down, global demand up, and cost of capital down. The implication is a very large increase in commodity demand. Prices have already risen quite a bit in many commodities markets, but the causal factors are long-term, and we should expect the effect to be long-term as well.

Finally, if you are investing in commodities using US dollars (I know I am), then you should also consider the currency value. The dollar has fallen more against many major currencies than the commodity prices have risen. This implies that commodity prices have even further to rise.

Labels: Commodities, Investment

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