Chinese demand profile and incremental commodity demand

I wanted to point out a few things about China from Michael Pettis' early May newsletter. Below are some really eye-popping statistics about China's demand profile. (Many thanks to Jeremy Grantham, to whom Pettis credits as the original source for the below statistics.)

	Share of global GDP
China’s GDP	9.4%
China’s GDP (PPP basis)	13.6%

"The next table lists China’s share of total global demand for a selected list of non-food commodities:

Non-food commodities	Share of global demand
Cement	53.2%
Iron Ore	47.7%
Coal	46.9%
Steel	45.4%
Lead	44.6%
Zinc	41.3%
Aluminum	40.6%
Copper	38.9%
Nickel	36.3%
Oil	10.3%

"Finally, the same table for food commodities:

Food commodities	Share of global demand
Pigs	46.4%
Eggs	37.2%
Rice	28.1%
Soybeans	24.6%
Wheat	16.6%
Chickens	15.6%
Cattle	9.5%

"What is most noteworthy about these tables, of course, is the disproportion between China’s share of global GDP and China’s commodity consumption."

Pettis, whose commentary is always original and borderline brilliant, goes on to comment about Chinese investment growth and how re-balancing of the economy in that country (from investment-led demand to consumption-led demand), could have significant effects on non-food commodities (second chart):

"Take iron, for example. If Chinese demand declines by 10%, this would represent a reduction in global demand of nearly 5%. I am not an expert in the commodity markets, but I guess that supply and demand considerations are fairly finely balanced, and a 5% reduction in demand should have significant price repercussions – especially if a material part of Chinese demand represents stockpiling and this stockpiling is reversed."

Some food (or non-food) for thought.

investors + love = farmland

As an Iowa native and investor, it’s almost requisite that we follow farmland. About 60% of our farms are owner-operated and over 80% are individual or family organizations. We supply 7% of nation’s food supply with farms that make up over 90% of our land (second only to Nebraska); roughly one-third of the best US farmland is located here. While manufacturing is the largest sector of the Iowa economy, the majority of that is related to food processing and machinery -- estimates put the indirect role of agriculture here around 25% of our total economic output. Needless to say, farming in one way or another comprises a large portion of our economic activity and state wealth, not to mention the knock-on effects as incomes in that space move higher.

In the first quarter of the year, farmland was up 16% in the Midwest. At first glance, it appears these increases were justified, since cash rents also gained 16%. Because of this, the price-earnings ratio for farmland was unchanged – which is a good thing given it’s already in the 25-27 range depending on the state. In Iowa, farmland values gained 20% while cash rents grew slightly less at 16%.

Not surprisingly, these year-over-year increases were driven by higher agricultural prices – corn up 50%, soybeans 29%, while milk, hog, and cattle gained at least 20%. Input prices, meanwhile, were up less than 10%, leading to higher profit margins.

We would worry about rising farmland values if bank balance sheets looked stretched, but the average loan-to-deposit ratio was at its lowest level in nearly 15 years (a period over which farmland values are up substantially). In other words, banks have more money to lend; some three-quarters of regional banks have actually lent less than they would like to. The fact that loan demand has actually come down while prices rise bodes well should farm values reverse in sudden fashion. Leverage can be particularly painful on the downside.

So who’s buying? Bankers report that it’s increasingly farmers, rather than investors. It also seems that the number and acreage of farms sold were larger than a year ago. This jibes with our comment in the last post about farmland that farmers know (1) dirt and (2) CDs, or bank certificates of deposit. Given the profile of the incremental farmland buyer, we’re watching CD rates as a leading indicator for farmland values. Should banks begin to pay substantially higher rates on CDs, watch for land values to decline – absent a major change in commodity prices, of course.

Napier comments from Edinburgh

Russell Napier is a brilliant guy and we love his book Anatomy of the Bear. While he is not always right - no strategist ever is - he has made some great calls with historical precedent to back it up. His recent comments from the 2011 CFA Annual Conference are worth a few minutes of time.

two years and investment professionals' mindset

Just returned from the CFA Annual Conference in Edinburgh, Scotland this past week and wanted to get a few thoughts down to maybe crystallize my takeaways. If you’d like a play-by-play, the conference was live-tweeted under @CFAIowa and also the #CFA2011 hashtag. I have found myself returning to these feeds and am likely to reference them several more times as I pen this.

The last conference we attended was 2009, and the world was just six months past a blow-up that brought down Lehman, Bear, and (almost) lots of others. The world had undergone a major shift, a ‘phase transition’. That year, it was as if the attendees were in a dark room, grasping around for the light switch. The various speakers proffered various suggestions on the location of the switch, and attendees were still forming their opinions of what exactly had happened and what was likely to transpire in the future. All we knew at the time was that the market had gained about 50% off the bottom in just two months but it was far from clear whether it was sustainable.

In retrospect, as usual, some forecasters were more right than others and the events since make reflecting on it much easier -- had the world collapsed we’d see things much differently today. Instead, equity markets are ahead by double their March 2009 lows and the gains we’ve seen have proven sustainable thus far. In many ways, the light switch has been located.

From the vantage point of 2011, investors seem to have a good grasp of the major (known, large) risks to the world economy. The risks are that are well known today were more or less on the fringe at this time in 2009 – Eurozone economic risks, sovereign credit risks, debt, deficits, over-leveraged consumers, debt-fueled spending, the threat of rising inflation and interest rates, the rise of emerging markets, commodity supply and demand dynamics. Each was more or less reflected to varying degrees in the speeches and seminars this go round. There were a few ‘fringe’ views at the 2011 conference but nothing that was extremely aberrant. (You might have a guy who only likes gold, for example, but even this is almost mainstream today.) Whereas in 2009 the presenters spanned the “31-flavors” gamut, most came in vanilla circa 2011.

I will soon write another post on key takeaways – what might be gleaned from a contrarian viewpoint when 'everybody knows' the risks and issues facing investments. I think there are many broader implications for the investment profession as a whole. It seems clear that the powerful ‘institutional imperative’ will impede future performance even though managers, well aware of the potential headwinds facing market valuations and interest rates, believe they should not be 100% invested right now. Just because the risks are apparent doesn't mean everyone is acting to protect against them. Career risk, or The Risk of Poor Short-Term Performance - a major issue to investment industry credibility - sometimes leads managers do crazy things when viewed from a long-term perspective. Often, 'what's right' is not 'what's right now.'

Until next time!

Berkshire Hathaway, Sokol findings

For its ethical precepts, the just-released report on David Sokol's Lubrizol-related trading is an important read. Reading between the lines, this report sends a clear message: Buffett is pissed. Thankfully, it was released just ahead of the annual meeting this weekend. This ought to free up more time for questions about other matters and I'm very much looking forward to just that.

real interest rates fueling the M&A boom

With 7,834 mergers and acquisitions totaling $750 billion announced year-to-date, it's clear deal-making is back in full swing. These numbers clearly show business executives have increased confidence in their businesses, to be sure, and that capital markets are offering abundant capital, greasing the skids. But I think it's important to consider a higher-level fact to explain why we're seeing so many deals. Namely, real (inflation-adjusted) interest rates are near 30-year lows. Not such a great proposition for capital providers. With extremely low financing costs, discount rate assumptions fall and so new projects and takeovers have a much lower hurdle to overcome in order to post a positive net present value (NPV). Thus, more projects/deals brought to the C-suite make sense today. The key word is 'today' because capital market eagerness and rates can change abruptly. Today's baseline assumptions could be considered ridiculous tomorrow.

farmland values and the twenty-seven PE

In Iowa, farmland values are up 25% year-over-year, a boon to the financial health of the state and especially farmers’ net worth, of which farmland comprises the majority. I recently came across a very interesting paper that discussed farmland values. (The creative title “Farmland Values: Current and Future Prospects,” pretty much sums up its contents.) For those interested in more information on the asset class that has been speculated to hold the “next bubble”, it is an enlightening read. I wanted to touch on a few things mentioned in the paper and expound on a few points.

As with all assets, farmland value is derived from the income it generates as well as by the discount rate (opportunity cost of capital) and growth rate assumptions. First, and not surprisingly, current farm income is healthy. Commodity prices are high and cash contribution margins (roughly, profit/revenues) are elevated, increasing farm income and boosting current (and potential) cash rents - what an absentee landowner earns by renting the land for productive use. The discount rate is very low, with ten-year Treasury bonds, the ‘risk-free’(?) benchmark rate), at just 3.4%. I discuss the growth rate assumption more below.

I’ve used price-earnings ratios in past posts, mostly for stocks. They are valid, though, for a variety of assets. Today, stocks trade around 18 times trailing twelve-month earnings. Using the inverse of their interest rate, ten-year Treasuries trade at 29 times ‘earnings’ while farmland is 27 times. The latter two are pretty high numbers. Now, which has shown historically higher growth? The growth rate for corporate (stocks’) earnings tend to track nominal GDP, or about 6%. Bonds don’t grow in value, the yield is mostly fixed as is the payoff at maturity. Farmland, which has lower earnings volatility than stocks and, like them, a (theoretically) infinite life, has tended to grow with the general rise in inflation plus another 2% for productivity improvements (same land, more crop). On a price-earnings ratios alone, it looks like stocks are the best relative deal. Still, cash remains attractive given the below-average projected returns on several asset classes. Cash has the advantage of what I call the “opportunity yield” – the ability to take advantage of cheaper prices when investors revise their return requirements higher.

On the most striking revelations in the piece was that farmland turnover – the percentage of land stock that changes hands in a given year – was lower than its historical average of 3-5%. (Currently, turnover is estimated to be about 1.5% annually.) As we know, the more demand there is for an asset, the greater prices tend to rise. Couple this with a constrained supply of land being ‘offered to the market’ and prices can quickly rise. This is because the whole of the land stock is priced off these marginal, infrequent sales, making the whole appear more valuable on paper. Annually, 98.5% of landowners aren't buying/selling; it's the 1.5% that make the 98.5% a lot of paper wealth. This 'low turnover combined with high demand' phenomenon is also evident in the secondary market trading of several Web 2.0 companies today.

So is the current PE sustainable? As with most investment questions, the answer is nuanced. Farm income can experience sharp corrections when commodity prices sink. This would bring the multiple (land value/farm income) even higher than it is today. In addition, interest rates are very low and have been trending down for most of the last three decades. Should rates rise significantly, investors' opportunity costs rise and the cash rent 'yield' must rise, which means prices must fall. Today, I can't say we're in a bubble. What I can say is that the current expectations baked into the price - continuing high cash rents, low interest rates, and/or good growth rates - might prove to have been overly optimistic when viewed in hindsight.

Farmland is an intensely local market so each parcel is different. Further, prevailing prices are based (as mentioned above) on marginal sales which comprise a very small portion of the total land stock. As long as landowners don't lever up based on current land values to buy still more land, a sharp reduction in land values will not ripple through in the same fashion as the housing 'collapse'. Current evidence suggests those taking on incremental farm debt are mostly larger operators, with younger farmers and livestock producers in the least-optimum financial condition. But anecdotally, I've heard that farmers know two things, 'dirt' (land) and (bank) CDs. The rate on the CDs become their comparison and these folks think, let's buy more land with a 3% cash rent yield if a three-year CD is paying less than 1%. Thinking that way could put more than a few in trouble. So if there are to be detrimental economic impacts in the future should farmland prices come down, the $64B question is how much debt is being underwritten based on current values. Unfortunately, it's probably more than we think.

the deficit and our future

Great article by Greg Mankiw on our potential future as a nation. One of the scariest thoughts I had while reading it is that he's probably a bit late on the date.

Google and innovation

Who says Google is falling behind on the innovation front?

http://mail.google.com/mail/help/motion.html

commodities and inflation protection

It’s clear from the commodity price increases experienced over the past couple years (see this post) and anecdotal evidence -- but not official government numbers -- that inflation has returned and that price increases will be making their way through the economy. Several consumer staples companies have already raised prices 5-7% (P&G, Kimberly-Clark, and Fruit of the Loom, for example). This is just the beginning.

Often, money moves into commodities as an inflation hedge, but do commodities actually protect one's purchasing power after the onset of rising consumer prices? Based on the last time we saw this in the U.S., the answer is "mostly, no". Commodity prices, not surprisingly, tend to lead increases in actual inflation. But once inflation emerges, their ability to purchasing power protection diminishes. Thus, commodity ‘investors’ (aka speculators) who get in near the end of the pricing uptrend do not tend to fare as well.

The above charts illustrate this phenomenon over the same period I discussed in the last two posts, 1964 through 1988. They show commodity prices (Commodity Research Bureau spot price index) rising prior to a major jump in CPI inflation, with the bulk of the price spike clustered into just a couple of years (up 22.1% in 1972 and 59.8% in 1973), while actual annual inflation was just around 4.0%. From 1964 through 1973, average annual inflation was just 2.5% while commodities rose 8.4% per annum. After 1973 and through year-end 1988, annual inflation averaged 7.1% while commodity prices rose just 1.9%. Today’s commodities investors might be disappointed in their future returns while consumers may similarly be displeased with future price increases.

I do not want to be fatalistic and state unequivocally that inflation is inevitable, but I am not optimistic that it can be avoided at this point. The longer commodity prices remain high, the more they lead to higher structural costs for the economy as a whole. Once companies raise prices, they do not tend to lower them. Likewise with wages.

The final chart illustrates commodity prices versus actual inflation since 2000. To me, this looks similar to the period from 1964 through 1974, when commodity prices rose ahead of actual inflation in the face of inflationary government policies (namely, deficit spending). We see similar policies in place today, coupled with unprecedented monetary intervention that isn’t likely to abate anytime soon, especially in the face of a still-stagnant economy. And our national balance sheet is in worse shape. Are the mistakes that led to stagflation in the 1970s being repeated? Unfortunately, it appears so.

stocks and inflation (part 2 of 2)

(This is an update from yesterday's discussion on inflation's effect on markets.)

To augment the information presented in yesterday's post, I wanted to add additional perspective with respect to earnings. Stock prices can be reduced to two components: (1) earnings and (2) a multiple against those earnings. Yesterday's post dealt with the latter without much discussion of the former. So, I've added the chart below to address this oversight.

Readers will note that earnings (dark blue) more than kept pace with inflation over the twenty-five year period from 1964 through 1988. Certainly, if it were possible to invest in corporate earnings alone during this period, an investor would have fared quite well. This is the crux of the argument made by those who believe stocks will keep pace with inflation -- that corporations will raise prices and earnings will largely keep pace. Unfortunately, it's the 'multiple' component that hurts investors during inflation - if ending valuations are meaningfully lower than beginning, an investor may not fare well even if earnings grow nicely. And over this period, they certainly did -- real earnings were 50% higher in 1988 than in 1964.

stocks: inflation hedge or vedge?

I want to spend a little time thinking about what markets do when inflation hits. Common knowledge seems to believe that when inflation rears its ugly head stocks will rise in line with inflation. I think we have seen the monetary stimulus from the Fed show up in financial asset prices lately and I want to dispel this fundamental misconception of stocks as a hedge for high inflation with some market history. Note that my comments are not valid for hyperinflation. Almost anything is better than paper money during such time periods. During Brazil's high inflation of the late 1980s and early 1990s the stock market roughly held its own with domestic paper money (but looked flat to a foreign investor). If you’re like me and believe we’ll see elevated, but not catastrophic inflation in the near future it makes good sense to look at what periods of elevated (again, not hyper-) inflation have done to the stock market.

I looked back at a period of time where inflation was low, rose to quite elevated levels, and fell back again to low average levels. In other words, a period containing three "regimes": before inflation reared its ugly head, during high inflation, and back again to more stable, predictable levels. I chose the twenty-five year period from 1964 through year-end 1988 because it nicely exhibits these characteristics.

The chart to the left shows inflation (consumer price index) in red, the S&P 500 total return in green and the real return (total return minus inflation) in purple. Each is indexed to 100 at 1/1/1964. Clearly, stocks (green) did not keep up with inflation over this time period while the real return on the market over was negative. That’s a pretty poor showing over a period when inflation boosted the consumer price level to almost 4 times its starting point. If stocks were a good inflation hedge we’d expect the green line to be persistently higher than the red, and meaningfully higher at 12/31/1988 if real returns were positive. However, this does not seem to have been the case.

Why were stocks such a poor inflation hedge over this period? The answer lies in valuation. Using Shiller’s cyclically-adjusted PE ratio, which I’ve cited often, the S&P 500 traded at 21.6 times earnings in 1964. By year-end 1988, they were just 14.7, a P/E decline of 32%. The chart below shows the inverse relationship between inflation (red) and stock valuations (cyclically-adjusted PE, green). Over this time period, the correlation between the two was negative 0.956, representing an almost perfect inverse correlation. High inflation proved to be an enemy when stock valuations started high.

Why is inflation so hostile for stock valuations? It comes down to interest rates; nominal interest rates must include compensation for inflation plus a real return component. Investors ultimately compare this rate against the "coupon" available on stocks - that is, corporate returns on equity (ROE). Since ROE does not tend to fluctuate much over long periods and is more likely to fall than rise during high inflation, the yield available on stocks can only change if their prices move lower (coupon "yield" relative to book value moves higher). Maturities are also compared – bonds have a definite maturity while a stock’s maturity is infinite. I’ll defer to Warren Buffett for further clarification: “Because of the additional risk, the natural reaction of investors is to expect an equity return that is comfortably above the bond return – and 12 percent return on equity versus, say, 10 percent return on bonds issued by the same corporate universe does not seem to qualify as comfortable. As the spread narrows, equity investors start looking for the exits.”

Historical stock returns are likely to have looked much different if starting valuations were much lower than the 22 PE we see in the above illustrations. Because of these elevated levels, inflation had a demonstrably large impact on longer-term returns. While starting valuations always matter for subsequent returns, they seem to matter even more during high inflation.

Could this happen again? Well, today the cyclically-adjusted PE ratio is 23.7, so valuations are even higher than where these charts begin (1964). Even if you believe the Fed has everything under control and we won’t see high inflation anytime soon, it’s worthwhile to consider the aforementioned data when allocating your portfolio. The importance of stable prices is most noticeable when they go missing.

market bottom: feliz cumpleanos

Interesting perspective on the two-year bull run we've had since the market bottom.

earnings guidance not as extensive

Since I started investing I've always shaken my head at the quarterly guidance game, which seems to be played extensively. (Who cares if you the mid-point of your own guidance (which analysts home in on as their point estimate) by a penny?) Of course, it's always been concentrated among larger companies and these are disproportionately mentioned on CNBC. Speaking of CNBC, Herb Greenberg has some interesting statistics here that elucidates just how extensive (or not) this practice is.

Buffett on inflation

press reaction to the Buffett letter

Warren Buffett's annual letter came out Saturday and I found it to be one of his better. Amidst a wealth of insight, Buffett discussed the short- and long-term prospects for the U.S. economy. Not surprisingly, overwhelmingly the (mainstream) press reaction has focused on his bullishness about the United States' future prospects and the ingenuity of its people. Close followers know this is nothing new for Buffett.

I've observed this cheer-leading getting more frequent, and it's no surprise. Why? Berkshire is levered more than ever to the future prospects of the U.S. - rail, utilities, manufactured housing, building materials, furniture. In a major economic collapse, Berkshire would be hurt more than ever.

I'm not even implying that a major downturn is likely so Berkshire is a major risk. I am a personal stockholder so my own money is betting on my long-term belief in this company and its prospects.

I just don't think it's possible for Buffett to offer a completely candid view on broad issues like the economy. He will always be "talking his book" to some extent because he can actually influence how people behave. With public figures, as with researching investments, it's important to "read the footnotes."

Buffett letter out today

A few things that immediately struck us from Buffett's annual letter:

On the institutional imperative: "'The other guy is doing it so we must as well' spells trouble in any business, but none more so than insurance."

On housing policy: "Our country's social goal should not be to put families into the house of their dreams, but rather to put them into a house they can afford."

On market declines: "As one investor said in 2009: 'This is worse than divorce. I've lost half my net worth - and I still have my wife.'"

On value estimates: "It is appropriate, nevertheless, to including improved [interest] rates in an estimate of 'normal' earning power."

On investment managers: "It’s easy to identify many investment managers with great recent records. But past results, though important, do not suffice when prospective performance is being judged. How the record has been achieved is crucial, as is the manager’s understanding of – and sensitivity to – risk (which in no way should be measured by beta, the choice of too many academics). In respect to the risk criterion, we were looking for someone with a hard-to-evaluate skill: the ability to anticipate the effects of economic scenarios not previously observed."

On manager compensation:

"We have arrangements in place for deferrals and carryforwards that will prevent see-saw performance being met by undeserved payments."

"Should we [add one or two investment managers] we will probably have 80% of each manager's performance compensation be dependent on his or her own portfolio and 20% on that of the other manager(s). We want a compensation system that pays off big for individual success but that also fosters cooperation, not competition."

On false precision:

"Part of the appeal of Black-Scholes to auditors and regulators is that it produces a precise number. Charlie and I can’t supply one of those. We believe the true liability of our contracts to be far lower than that calculated by Black-Scholes, but we can’t come up with an exact figure – anymore than we can come up with a precise value for GEICO, BNSF, or for Berkshire Hathaway itself. Our inability to pinpoint a number doesn’t bother us: We would rather be approximately right than precisely wrong."

"You can be highly successful as an investor without having the slightest ability to value an option.'

On debt: "...to finish first, you must first finish."

There are more concepts we'll likely discuss at a later date, these were some initial highlights that resonated for one reason or another.

Great letter again this year. We never cease to be amazed at how after all this time, he nonetheless manages to discuss something he's not openly addressed in the past. That doesn't mean they haven't been speculated about and, often, nailed by others. But to read his own words about, for instance, GEICO, is fascinating. Thanks again, Warren.

the 21st century education

Since I was in college, I've been frustrated with the way the modern academic system works. Over time, that dissatisfaction has only grown more severe. As a value investor, my goal is to get the most value for the price paid. Yet formal education is an investment whose value seems to have decreased over time - it provides less and costs more every year. At my alma mater, students today are paying more than double the tuition I did to receive an education that is a commodity. I believe there are much better ways to deliver education that don't involve formal education or degrees, but rather systems that potential employers agree offer a comprehensive assessment of skills. In short, it'd be a, "I don't care how you learned it if you know it" approach. Folks with the wherewithal to learn the requisite skills through self- or small-group study would be encouraged to do so. Others could pursue a more formal path but not by following the pre-determined, formal curriculum that now exists.

One university is taking some concrete steps to shift the model, and it sounds promising. Steve Blank wrote a nice blog entry about it. It's available here.

a couple quotes

A couple recent quotes that speak volumes.

Michael Pettis, in this week’s research note, on the economics of China’s growth :

“Not only do I believe that the combination of very low cost of capital, socialized credit risks, and strong short-term political incentives to fund massive projects always leads to capital misallocation, but I also believe that the explosion in [Non-Performing Loans] a decade ago, and the fact that total [State Owned Enterprise] profits are just a fraction of the interest rate subsidy they receive, is strong evidence that misallocated capital has long been a serious problem in China.”

Jeffrey Gundlach, on high-yield bonds (Barron's):

“The current 300 basis-point, or three percentage-point, spread between yields in the high-yield market and on 20-year (Treasury) bonds is as narrow as it has been at any time in the latest credit cycle.”

friday afternoon filing fun

It's always fun to see what filings roll in around 6 pm eastern on a Friday.

Todays is Wellcare (WCG), which despite making the decisions on bonuses and an increase in base salary on Monday (the 14th), just now got around to filing the paperwork. (emphasis and additions mine)

On February 14, 2011, the Compensation Committee (the “Committee”) of the Board of Directors of WellCare Health Plans, Inc. (the “Company”) determined bonuses under the Company’s annual cash bonus plan for 2010 of $1,015,625 for Alec Cunningham, the Company’s Chief Executive Officer; $546,250 for Thomas L. Tran, the Company’s Senior Vice President and Chief Financial Officer; and $320,000 for Scott D. Law, the Company’s Senior Vice President, Health Care Delivery. These bonuses are expected to be paid on March 4, 2011.

The Committee also approved increases to base salary for Mr. Cunningham from $650,000 to $800,000 (note: +23%) and for Mr. Tran from$475,000 to $500,000, each effective as of February 13, 2011. For 2011, Mr. Cunningham’s short-term and long-term incentive targets will remain as 125% and 300%, respectively, but will be applied to his new annual base salary. Mr. Tran’s short-term and long-term incentive targets will remain as 100% and 150%, respectively, but will be applied to his new annual base salary.

a few words about inflation

The basket of goods and services consumed is different for everyone, so inflation is experienced uniquely by all. The person who lives in a lower-cost area and drives into a high-cost one for work might have above-average transportation expenses but below-average housing costs. The retiree might spend less on housing but much more on medical care. College students spend a lot on education.

Here is the “basket” used to compute the Consumer Price Index (CPI):

I see glaring differences between what I personally spend on many of these categories, and I suspect a lot of the population would, too. The CPI is used “adjust incomes, lease payments, retirement benefits, food stamp and school lunch benefits, alimony, and tax brackets.” But the government is keeping the books. So what’s the incentive here? It goes without saying that they stand to benefit most by keeping it as low as possible.

The current commodity environment is undoubtedly inflationary. The rising prices of base metals, food inputs, cotton prices, among others, don’t just affect electronics, food and apparel costs but ripple into other areas as well. The longer high prices persist the more they have the potential to permanently raise structural costs (including wages). It may be a while before these increases show up in the official statistics, though, as the most recent 1.6% year-over-year print indicates. Nonetheless, these increases can profoundly affect consumers without a commensurate increase in the Consumer Price Index (CPI).

Below are year-over-year prices changes (through yesterday) on several basic commodities. Not a pretty picture if these prices are sustained for a length of time. Even grease is up almost 80%. Grease!

To close I’ll mention one of my favorite statistics the BLS publishes, the Special Index called “Purchasing power of the consumer dollar (1967=$1.00)”. That number -- $0.152. Purchasing power clearly erodes over time, even if it doesn’t show up in the statistics in real time.

complacency built, and building

Yesterday, the NYSE saw 365 new 52-week highs and just 9 new lows.

How much longer can this relentless, low volatility run continue? Since the end of September, we have seen only six days where the market has declined by 1% or more (just two of those this year). And the last time the market declined 2% or more was on August 11th -- and it's happened only twice since the end of June last year! That's a long time to go without substantial downside volatility.

Now, it's one thing to see the market climbing but we must consider its context. To do that we juxtapose this against prevailing valuations. On that front, it’s not encouraging. The S&P 500 stands at 18.5x earnings (over 24 cyclically adjusted) and is discounting decade-ahead per annum returns under 5% (1.8% of which is from dividends). Sure, interest rates are low which means stock *should be* worth more, but I don't buy it because investors can revise their return expectations relatively easily (and quickly).

So volatility is low and valuations are elevated, but the market keeps going up?

"It feels safer."

"There is money to be made."

Low volatility to the investor, to borrow from N.N. Taleb, is like the farmer feeding the soon-to-be-Thanksgiving-dinner turkey. Just as the safety appears greatest (based on backward-looking data), the danger is actually at its highest.

private market froth-iness

While it's not clear there is a bubble yet, some of the private market valuations I've seen are bubble-icious. My evidence is more anecdotal since I'm not an "on the ground" venture capitalist. But here is something from Fred Wilson, offering a good overview from a very credible source that there is a froth in the private markets. Money is sloshing around the bathtub, and I'd argue it's spilling over into all asset classes.

Remember W.B.: "The first rule of investing: Don't lose money. The second rule: Don't forget Rule #1." Remember the downside, grasshopper.

the Fed and housing

Whoops.

BUSTED: Unsealed Docs Show The Fed Was Fully Warned Of A Housing Crisis

commodities running a marathon or sprint?

Commodities have been on a spectacular run since August. The Wall Street Journal’s front page story this morning specifically addresses agricultural commodities, including wheat, soybeans and corn. Along with precious metals, agriculture has led commodities’ price rise and helped incite continued inflows into these markets over the past several years. Traders cite on the ground reasons that prices have gone up so far so fast – including increasing consumption from China, multi-decade low reserves and higher corn ethanol production. Also, backwardation (future prices less than spot prices) in one-third of the GSCI commodities boosts the case for tight supply/demand conditions. But these supply/demand theses are valid regardless of price. (As with all non-income generating “assets,” pricing is an elusive exercise.)

Regardless of the specifically-cited reasons today, what I question is whether this is a modern incarnation of Gresham’s law, bad money driving out good. A hundred years ago, on a bi-metallic standard in countries that accepted other countries’ currencies as legal tender, the most “fine” or pure currency would be hoarded and the less pure (“bad” money) would be spent. Thus, as the debased money was used to buy the stronger currency, its relative price decreased and became even less valuable. The market saw to it that the worse currency was worth the least and the “good” money fell from circulation. Of course, this generally occurred in a system of fixed exchange rates and (mostly) convertible currencies. Today’s free-floating currencies are a relatively new development in monetary history.

Today, it looks like (“good”) physical assets are driving out (“bad”) fiat currency. Stated in terms of the dollar (because that’s how we measure them), commodities are clearly on the rise. Gold, silver, and copper, which as recently as a hundred years ago were used as a medium of exchange, were up 29%, 82% and 30%, respectively. Cotton and coffee gained 92% and 77%. As Standard & Poor’s observes, “2010 year can be broken down into two distinct periods – one extending from January through August and another covering the remainder of the year. The announcement of quantitative easing from the U.S. Federal Reserve has helped provide a bid for most commodities.” On one hand, it looks to me like the market is saying that fiat currencies are less valuable and/or are being debased. Or, we could have a speculative almost-bubble on our hands.

Bolstering the case for the latter is that ten years ago about $6 billion was invested in commodities. Today, it’s nearly $300 billion. Money flows tend to drive prices higher, all things equal, and it appears to be the same today. And where the money is flowing isn’t necessarily in the right direction. This Businessweek article elucidates some good points about commodity exposure. As someone smarter than me said, there is no asset class that enough money can’t spoil.

Whether these price increases are well-founded or not is open to debate, but there is a clear correlation between the announcement of “QE2” and the snapback in financial markets, including equities (correlation of commodities with stocks is near all-time highs). But not all commodities are moving higher – one that has bucked the trend is natural gas, which is abundant and experiencing low demand. Its price fell 40% last year. If the behavior Gresham discussed was occurring, we shouldn't expect its price to languish for long.

Still, we can't ignore the "hot money" going into commodities. For these, Wal-Mart may have said it best: "Watch for falling prices." What the wise man does in the beginning, the fool does in the end.

predicting economic data points

As usual, they got it wrong. According to the Wall Street Journal, economists in Dow Jones Newswires’ survey had forecast payrolls would rise by 150,000 and the jobless rate would fall to 9.5%. The actual numbers came in at 103,000 and 9.4%, respectively, meaning they were off the actual number by nearly one-third. In typical fashion, CNBC spent most of the morning speculating about the release. The repartee between two folks is classic “time filling” television when the number is only an hour or so from release.

This offers a case in point on why it’s best to ignore prognosticators, especially on metrics like jobs. These numbers may move one way or another, but there is no point in trying to trade on such information because we can’t know beforehand. Forecasters tend to be within a tight range of each other, so when there are big numbers they are just as surprised as the markets might be.

Of the 103,000 jobs created (statistically, at a 90% level of confidence) this month, 113,000 of them were private. About half the decline in the rate was due to folks leaving the labor force, the other half was actually increases in payrolls. Service-providing industries were by far the largest area that saw job creation, up 115,000. We can quibble over 10 or 20 basis point down tick in the headline number, but 16.7% is the number on which to focus. This is the so-called U-6, and it represents unemployed but also those who are working part time but want full-time work. Thus, it’s more comprehensive.

To get back to the point: it’s mostly pointless to focus on predictions, which tend to introduce noise into an investment process. Remember this the next time economic data is close to release and the media fills time with speculation.

how much is a trillion dollars?

I found this page through Greg Mankiw. It's a great way to visualize a number that is being tossed around a bit too casually these days.

quick market snapshot, new highs/lows

Yesterday's trading:

NYSE:

New Highs: 375

New Lows: 2

Nasdaq:

New Highs: 296

New Lows: 5

Juxtaposed against prevailing market valuations, it's telling to see new highs outnumbering new lows by such a wide margin.

title for a 2011 year-end entry

Another year has passed, while a new one begins. Each annual turn is often a time of reflection as well as prediction. In keeping with that tradition, today’s entry will comprise some of the former, but mostly the latter, and some of neither.

The S&P 500 ends the year up about 15%, the Nasdaq about 17% and the Dow 11%. From where I stand, that’s a banner year, especially considering that average annual returns are more like 8-9% and long-term expected returns from today’s levels look to be under 6%. (Thus we can say this one year’s returns represent two years' expected.) Commodities and other risky assets also had a great year. Bonds and stocks, both foreign and domestic, performed well. Commodities, in some cases, knocked it out of the park (think cotton, up 90%). Gold rose about 30%, oil 13%. Housing prices did not do so well, however, and the economy limped along.

So 2010 looked good for the markets. Does that have any relation to a 2011? As we have to disclose often, past performance is not necessarily an indicator of future results. Still, the two are often related. Specifically, past performance can be a contrary indicator of future results. As the saying goes, if something can’t continue, it won’t. I am optimistic about the future overall, but I see several areas that appear stretched and where future results may not be as robust as the recent past.

Today we learned that that Groupon accepted about $500 million of a $1 billion funding round. This is a two-year old company is an industry that doesn’t have a lot of barriers to entry. Sure, they were the first, but their margins are artificially high and their labor-intensive strategy depends a lot on street-level salespeople. There is a lot of panache here; Groupon is cool and retailers want to be associated with them - now. But “cool” is ephemeral and in business competition does not lay down just because you're bigger. Especially when the business model is so easily copied and the space nascent. Competitor LivingSocial has received investment from Amazon and it’s not a stretch to believe my favorite online retailer could move into that market. Yet Groupon is raising a billion dollars. To me, it’s unbelievable and is probably a sign of too-heady times in the private markets.

Meanwhile, the commodities rose still has its bloom on the ever-present investment thesis of increasing consumerism in emerging markets. I think there could be several surprises on the “emerging” front in the new year that will surprise a lot of the gung-ho investors in this space. I speak specifically about gold and rare-earth metals here, but I get the feeling that a lot of the agricultural commodities have run up too high (and so have some of the ag-related stocks). A thesis that makes sense at a price does not make sense at any price.

Oil seems fairly priced to me at present.

As for stocks, a previous post pretty well elucidates my thoughts here. Bonds are something I’ve also recently written at length about and my feelings here haven’t changed a whole lot. I think surprises to the downside on bonds and stocks await. Put premiums are low as markets near their recent highs amid high levels of investor bullishness. This tends to be the case near market peaks.

Are there any bubbles (other than in the use of the word “bubble”)? I think there is one in concerns over our fiscal and monetary situation. That is a funny thing to say because I, too, am concerned. It just seems to me that “everyone” is concerned about these two things and so they are probably somewhat overblown. Such things have a way of working themselves out. While it’s often felt that the good folks in Washington live in a different world, I’m not convinced they won’t take care of these problems. A year ago, I wouldn’t have dreamed Obama would break his campaign promises by passing a law that was largely deferential to Republicans. But it doesn’t take much to change Washington’s mind and/or direction these days and our problems will not just get worse in a linear fashion. However, fiscal and monetary issues should lead investors to plan for contingencies, protecting from downside deviation.

The solutions aren’t linear, either. Think protection from phase transitions, or more popularly, tipping points. Securities trading below intrinsic value. Healthy balance sheets. Excess cash. Opportunistic management teams with flexible operating philosophies. Don’t try and time the market, but be ready to pounce when Mr. Market turns manic.

Most of the economic data coming out is noisy. The bottom line is the economy isn't going gangbusters and I'd expect that activity would remain at a similar pace. Of course, that's the easiest expectation. Unemployment just can't come down as fast as we'd all like without some significant retraining and job creation in other sectors. It’s a structural issue which will take years to resolve. At the same time, corporate profit margins are well above their historic highs.

2010 was a fantastic year, personally as well as professionally. Each day is a chance to learn something new and I'd like to think I was able to do so. I hope 2011, despite its being an odd year, holds similar promise. Happy New Year.

the stock market ahead

In 2011, I don't think the stock market deserves to rally. Now, that doesn’t mean it won’t. (To be any good at making predictions, I must hedge.)

I see a few things. Abundant in the media are calls for stocks to rise and bonds to fall, with stocks being cheap. But why can’t stocks and bonds be expensive concurrently? Money will move out of bonds, so the story goes, and into stocks, making one less expensive and the other moreso. (One of my) problem(s) with this is that money flows don’t really tell the story. The stock market is simply trading of already-offered shares held by others. The company is not involved (excluding share buybacks and recaps). When A sells his shares he must sell to B, who pays money to A. B then owns shares and A holds cash. As John Hussman has pointed out, the fact that A brings his cash into the market doesn't make prices go up, since no cash has actually been added to the market. Instead of A holding shares, B holds them. The same amount of cash is “on the sidelines.” It is the eagerness of the buyer (or seller) that makes prices fluctuate, as stock prices are priced on the marginal trade. Okay, that was a little long to make the point but I think it was necessary.

When I look at stocks broadly speaking (S&P 500 Index) today, I see a market that discounts decade-ahead total returns of just under 6% over the next decade. Since returns tend to be more stable when predicting for longer periods of time, I am most comfortable with this 6%-for-the-decade number. But I’ll list a few others. Five year: 4.5%. Three year: 1.6%. One year: -8.9%.

(A couple things to note here: these numbers are based on my calculation of the intrinsic value of the market and include the current S&P 500 dividend yield of 1.89%. Intrinsic value is based on normal earnings, which use numbers representing long-term averages for earnings growth rates, returns on equity and cost of capital.)

What these numbers tells me is that over a decade returns might end up decent, but not spectacular given the potential drawdowns inherent to stock markets. And it also says if your time horizon is shorter than five years, return prospects don’t look to spectacular (negative on a price-change basis for one- and three-year periods). To use a holiday metaphor, these returns look like a fruit cake. I'd rather have sugar cookies.

It’s always best to judge each asset class relative to the cafeteria menu of available investment options. On that front, bonds don’t look much better. A ten-year Treasury yields 3.3% today, not spectacular and especially with a duration close to 7 certainly not worth a large risk, again, on a risk-adjusted basis. Shorter-term bonds seem the best place to reduce risks in this space - the most salient of which appears to be reinvestment risk. Too, interesting opportunities are emerging in municipal bonds. I may expound on this later.

start-up-tomism

It strikes me today that optimism in the professional investment community remains at a relatively low level. Why? Out-of-control government spending. The $1.4 trillion federal deficit. $13 trillion in national debt. Eurozone economic concerns and the implications for the future of the euro currency. Not to mention the Federal Reserve’s actions which could spur inflation. The potential for an abrupt rise in interest rates. Rising commodity prices. The rise of China and India as competitors to the U.S. An equity market still meaningfully below its 2007 highs.

Many of the above are valid concerns and indeed are areas that need work. The equity markets today are implying decade ahead returns around 5%, certainly not a place to take unmitigated risk. Interest rates are low (but rising), benefiting borrowers/spenders at the expense of savers. The volume of the above factors is loud and the focus on them disproportionately high among investors and the public at large. They can lead us to forget a couple of things.

First, most of them we can’t control. We simply can’t, other than through elected officials, reduce government spending. We can, however, get ourselves into better financial shape through our own actions and position ourselves for worse economic times through higher savings, for instance.

Furthermore, these things tend to work on one way or another. Let’s take it to the extreme and say that government debt continues to rise and short-term interest rates go to 10.0%. With the government rolling over roughly a third of its total debt each year we’re looking at another $300 billion in interest expenses each year just on short-term debt. Say we print money and devalue the dollar in world markets to pay for this extra debt. Interest rates rise across the country, prices rise for consumers and unemployment rises dramatically. We couldn’t have stopped it, but we could have assets invested and liquid assets available to ameliorate the personal impact. Okay, enough of that since it detracts from what I’m really trying to say.

That is, in the fog of our short-term focus on the above issues and the maddening tendencies of the media to bloviate about them 24/7, we forget the ingenuity of the U.S. spirit and what’s going on in the entrepreneurial community today.

At this point, startups are being created like wildfire and funding is rabid. Several prominent venture capitalists have declared that there could be a bubble forming in early-stage technology companies, especially so-called Web 2.0 companies. I’ve heard many write and speak about the prices at which early funding rounds are taking place. Apparently, they’re not grounded in reality at this point and to some it “feels” like 1998-1999 again. (However, there are certain fundamental differences that differentiates this period from then. I may touch on this at a later date, but it mostly relates to valid business models and actual earnings.)

Anecdotally, it’s becoming more prevalent to see local articles about new companies being started dealing with the tech space. I’m encouraged by these signs. Let me point out that first and foremost I am a value investor. I try and figure out the stream of cash flows (both positive and negative) that can be expected over the life of an investment and discount it at an appropriate interest rate. Startups don’t have the luxury of much visibility on this front and so I haven’t (not yet, at least) invested in them. Also, I understand macro and micro-economics that makes me reticent about trying to pick winners.

Surely, there is no way that all startups receiving attention and/or funding today can reach the level of the most popular examples – such as Groupon, Twitter and Facebook. It doesn’t work like that. Many, if not most, won’t survive another year. As Warren Buffett has said, first come the innovators, then the imitators, then the idiots. Probably a lot of the incremental funding is coming from those in the third category and when the level of sophistication falls, so does the quality of the overall pool.

My broader point can get lost in the micro discussion, so I’ll finish here. Just because the effects of competition will ensure that most of these businesses fail (90% as goes the statistic?), the activity speaks to an entrepreneurial spirit that is alive and well in this country. And it’s a spirit that will endure in spite of the broad economic, fiscal, and monetary concerns that receive disproportionate attention in media coverage.

no sabbatical excuse

I wish I could say I was on sabbatical this past year but that hasn't been the case. I simply haven't put enough effort into getting a few thoughts down "on screen" on a regular basis. I intend to remedy that.

I intend to write a bit more frequently after a hiatus that comes down mostly to reticence in sharing new investment ideas, as was the prior focus. With growing compliance concerns in the investment industry and given the inherent competitiveness of the market I cannot often write about original ideas I’m pursuing. Though I will certainly comment on specific companies I will not necessarily do so often, especially those I own for myself or clients. Nor will I present performance information of any type, as has always been my penchant. In fact, I intend to sometimes put down ideas that are only tangentially - or not at all - related to investing, but interesting nonetheless.

Concurrent with more frequent writing comes a couple thoughts:

(1) It can be a waste of time to do extensive editing to text, so expect some grammatical and spelling flaws to emerge from time to time (or just all the time). People generally understand the point without it being encased in perfect prose and spelling, each of which aren’t immutable anyway.

(2) Writing a blog on a frequent basis comes within the context of a busy schedule. Against this backdrop, just getting something type and posted is as remarkable as what is actually written. Still I hope, but can’t promise, that each post is worthwhile and presents at least a new kernel of insight that makes my comments worth reading. I fully realize this a difficult standard, but I will do my best to meet it.

How Long Will Gold Glitter?

I want to spend a little more time on gold here.

Fundamental demand, including Jewelry, Industrial and Dental, is down significantly year over year (8% and 19%, respectively, on a volume basis) while mining supply is up 18% and recycled gold supply is up 31%. Supply is not constrained and the demand from traditional users is very low.

Amidst this fundamental backdrop, investment demand is up 133% and ETF/investment product demand is up 159% year-over-year. At the same time, central bank sales are down 39% year-over-year and the lowest since 1997, meaning a normal source of sales has slowed dramatically. By not selling a normal amount of gold, central banks have become another source of investment demand because of the supply constraints it puts on the gold market.

The data shows that investment (speculation?) seems to be the only source of demand at this point and that its significant growth (and lack of central bank sales) seems to have moved the price higher. One may make money in gold, but only if there is someone later willing to pay a higher price. (This is also known as the greater fool theory.) Gold has a negative yield (it costs money to store), no intrinsic value (it generates no cash flows), and at the current time appears quite speculative despite the claims that it is a good inflation hedge.