Archive for April, 2008

New York Times Reports on Ag

Wednesday, April 30th, 2008

Below is a story from the NY Times today about food shortages and the need for more fertilizers. Even though we’ve had a bit of a selloff in Ag in the last week, this story (and our investment theme) show that the facts are too strong to ignore. Ag is a multi-year theme – with world-wide demographic causes – simply because of issues described below and should not be impacted by any slowing in the US.


April 30, 2008
The Food Chain

Shortages Threaten Farmers’ Key Tool: Fertilizer

XUAN CANH, Vietnam — Truong Thi Nha stands just four and a half feet tall. Her three grown children tower over her, just as many young people in this village outside Hanoi dwarf their parents.

The biggest reason the children are so robust: fertilizer.

Ms. Nha, her face weathered beyond its 51 years, said her growth was stunted by a childhood of hunger and malnutrition. Just a few decades ago, crop yields here were far lower and diets much worse.

Then the widespread use of inexpensive chemical fertilizer, coupled with market reforms, helped power an agricultural explosion here that had already occurred in other parts of the world. Yields of rice and corn rose, and diets grew richer.

Now those gains are threatened in many countries by spot shortages and soaring prices for fertilizer, the most essential ingredient of modern agriculture.

Some kinds of fertilizer have nearly tripled in price in the last year, keeping farmers from buying all they need. That is one of many factors contributing to a rise in food prices that, according to the United NationsWorld Food Program, threatens to push tens of millions of poor people into malnutrition.

Protests over high food prices have erupted across the developing world, and the stability of governments from Senegal to the Philippines is threatened.

In the United States, farmers in Iowa eager to replenish nutrients in the soil have increased the age-old practice of spreading hog manure on fields. In India, the cost of subsidizing fertilizer for farmers has soared, leading to political dispute. And in Africa, plans to stave off hunger by increasing crop yields are suddenly in jeopardy.

The squeeze on the supply of fertilizer has been building for roughly five years. Rising demand for food and biofuels prompted farmers everywhere to plant more crops. As demand grew, the fertilizer mines and factories of the world proved unable to keep up.

Some dealers in the Midwest ran out of fertilizer last fall, and they continue to restrict sales this spring because of a limited supply.

“If you want 10,000 tons, they’ll sell you 5,000 today, maybe 3,000,” said W. Scott Tinsman Jr., a fertilizer dealer in Davenport, Iowa. “The rubber band is stretched really far.”

Fertilizer companies are confident the shortage will be solved eventually, noting that they plan to build scores of new factories. But that will probably create fresh problems in the long run as the world grows more dependent on fossil fuels to produce chemical fertilizers. Intensified use of such fertilizers is certain to mean greater pollution of waterways, too.

Agriculture and development experts say the world has few alternatives to its growing dependence on fertilizer. As population increases and a rising global middle class demands more food, fertilizer is among the most effective strategies to increase crop yields.

“Putting fertilizer on the ground on a one-acre plot can, in typical cases, raise an extra ton of output,” said Jeffrey D. Sachs, the Columbia University economist who has focused on eradicating poverty. “That’s the difference between life and death.”

The demand for fertilizer has been driven by a confluence of events, including population growth, shrinking world grain stocks and the appetite for corn and palm oil to make biofuel. But experts say the biggest factor has been the growing demand for food, especially meat, in the developing world.

Recently, Ms. Nha, the tiny Vietnamese woman, stood in a field outside her village, her weather-beaten face shielded from the drizzle by a big straw hat. She took a break from wielding her wood-handled hoe and described the meager diets of her youth.

Her family, including six brothers and sisters, struggled to survive on rations from the commune where they lived, eating little protein. The occasional pigs they raised on rice stalks and mush “fattened very slowly,” Ms. Nha recalled.

But with market reforms, better seeds and increased fertilizer use, Vietnam’s rice yields per acre have doubled and corn yields have tripled, allowing farmers to fatten a growing herd of livestock.

Several times a season, Ms. Nha and her neighbors walk down their rows of corn with battered metal buckets full of chemical fertilizer, which looks like coarse gray sand, sprinkling a bit at the base of each plant. Ms. Nha’s husband, Le Van Son, remembers villagers’ amazement in the 1990s when they learned that a pound of chemical fertilizer contained more of the major nutrients than 100 pounds of manure.

Overall global consumption of fertilizer increased by an estimated 31 percent from 1996 to 2008, driven by a 56 percent increase in developing countries, according to the International Fertilizer Industry Association.

“Markets are asking farmers to step on the accelerator,” said Michael R. Rahm, vice president for market analysis and strategic planning at Mosaic, a fertilizer producer in Plymouth, Minn. “They’ve pressed on it, but the market has told them to step on it harder.”

Fertilizer is plant food, a combination of nutrients added to soil to help plants grow. The three most important are nitrogen, phosphorus and potassium. The latter two have long been available. But nitrogen in a form that plants can absorb is scarce, and the lack of it led to low crop yields for centuries.

That limitation ended in the early 20th century with the invention of a procedure, now primarily fueled by natural gas, that draws chemically inert nitrogen from the air and converts it into a usable form.

As the use of such fertilizer spread, it was accompanied by improved plant varieties and greater mechanization. From 1900 to 2000, worldwide food production jumped by 600 percent. Scientists said that increase was the fundamental reason world population was able to rise to about 6.7 billion today from 1.7 billion in 1900.

Vaclav Smil, a professor at the University of Manitoba, calculates that without nitrogen fertilizer, there would be insufficient food for 40 percent of the world’s population, at least based on today’s diets.

Initially, much of the increased producti
on of fertilizer went to grains like wheat and rice that served as the foundation of a basic diet. But recently, with world economic growth at a brisk 5 percent a year, hundreds of millions of people began earning enough money to buy more meat from animals fattened with grains. That occurred at the same time that rising production of biofuels, like ethanol, put new pressure on grain supplies.

These factors translated into rising fertilizer demand. Prices at a terminal in Tampa, Fla., for one fertilizer, diammonium phosphate, jumped to $1,102 a ton from $393 a ton in the last year, according to JPMorgan Securities, which tracks the prices. Urea, a type of granular nitrogen fertilizer, jumped to $505 a ton from $273 a ton in the last year.

Manufacturers are scrambling to increase supply. At least 50 plants to make nitrogen fertilizer are under construction, many in the Middle East where natural gas is abundant, and phosphorous and potassium mines are being expanded. But these projects are expensive and time-consuming, and supplies are expected to remain tight for years.

Fertilizer is vitally important in Iowa, whose farmers grow more corn than in any other state and depend on fertilizer to increase yields.

But the combination of high prices and spot shortages has forced some farmers to revert to older methods of fertilization, making hog manure a hot commodity. Farmers are cutting deals to have hog barns built on the edges of their corn and soybean fields.

On a tour of his rolling farm in Oxford Junction in eastern Iowa, Jayson Willimack pointed to the future sites of two buildings that will hold 2,400 hogs. Their manure will eventually replace commercial fertilizer on 400 acres, about 10 percent of his farm, and save him perhaps $50,000 annually. “Every little bit helps,” he said.

Such a strategy has severe limits — manure contains so little nitrogen that tons are required on each acre. That means farmers in Iowa and abroad have little choice but to pay the higher prices for commercial fertilizer.

In many countries, those cost increases have so far been offset by record high prices for crops. But fertilizer inflation has created a crisis in countries that subsidize fertilizer use for farmers. In India, for instance, the government’s subsidy bill could be as high as $22 billion in the coming year, up from $4 billion in 2004-5.

Once new supplies become available, the rising use of fertilizer will still pose difficulties.

Environmental groups fear increased use, particularly of nitrogen fertilizer made using fossil fuels. Because plants do not absorb all the nitrogen, much of it leaches into streams and groundwater. That runoff has long been recognized as a major pollution problem, and it is growing.

A barometer of the pollution is the rising number of dead zones where rivers meet the sea. In the Gulf of Mexico, for instance, nitrogen runoff from fields in the Corn Belt washes downstream and feeds plant life in the gulf. The algae blooms suck oxygen from the water, killing other marine life.

More than 400 dead zones have been identified, from the coasts of China to the Chesapeake Bay, and the primary reason is agricultural runoff, said Robert J. Diaz, a professor at the Virginia Institute of Marine Science.

“Nitrogen is nitrogen,” Professor Diaz said. “If it’s on land, it produces corn. If it gets in the water, it produces algae.”

This month, a United Nations panel called for changes in agricultural practices to make them less damaging. The panel recommended techniques that offer some of the same benefits as chemical fertilizer, like increased crop rotation with legumes that naturally add some nitrogen to the soil.

But others say those approaches, while helpful, will be not be enough to meet the world’s rapidly rising demand for food and biofuel.

“This is a basic problem, to feed 6.6 billion people,” said Norman Borlaug, an American scientist who was awarded a Nobel Peace Prize in 1970 for his role in spreading intensive agricultural practices to poor countries. “Without chemical fertilizer, forget it. The game is over.”

Market Over Extended

Monday, April 28th, 2008

Over the weekend, Barron’s had an article stating that 87% of poll respondents stated that they were bullish and ready to commit money to the market. Generally, an overly bullish sentiment is a contrary indicator that the market is ready for a correction.

Above, you see the Oscillator (courtesy of Helene Meisler) that I like to follow. The graphic showing that the reading is above the line and headed higher is an Overbought reading and technically means that we are likely to see the market correct in the near future.

If you’d like to follow an Oscillator in the management of your own accounts, you can cut/paste this link into your browser:

It is basically the same as the one pictured here, but I don’t have a way to put a jpeg of it into the blog, so you get the one from Helene which does give me a jpeg for you to view.

As the market has been going up, we’ve been using trailing stops to protect profits in the favored sectors (Ag, energy, metals, infrastructure). Some of those have hit as we’ve had a pull back in those areas and we are in the process of collecting the cash. We’ve put in a number of GTC purchase orders at key technical levels that will likely hit as the broader market pulls back from an overbought level. In a trading range market, this is the only way to achieve a positive return while managing risk levels.


A Buying Opportunity

Friday, April 25th, 2008

Below is an article written by Jim Cramer detailing why now is a great time to buy the commodity stocks. Given the sell off we are in, I thought this summed things up nicely. Please note that his political views in this article are his own and may or may not reflect my own – how’s that for hedging 🙂

A Dollar Rebound Won’t Kill the Ag Stocks

By Jim Cramer Columnist

4/25/2008 7:06 AM EDT

Better seeds and more fertilizer. That’s it. Those are the technology weapons in the war against food shortages caused in the short term by a worldwide obsession with biofuels (we are the worst offender, of course) and in the long term by the increased affluence in China and India, which leads to more nutritious, protein-filled diets. Both forces, when combined with worldwide droughts and failed harvests, not augmented by the U.S. — we are late to start with our corn season — are driving prices up to ridiculous levels.

I have no doubt that if tomorrow the president of the United States said he was suspending the biofuel mandates for ethanol that we would see a collapse in food pricing. But I also have no doubt that this inept administration could never figure that out.

So, the solution comes to all of the stocks that were crushed yesterday: Monsanto (MON) , Potash (POT) , Mosiac (MOS) and Agrium (AGU) . Without better seeds that produce higher yields, without more fertilizer that increases yields, we are going to be facing a long-term continuation of these price increases and the attendant inflation and food riots.

Inflation, by the way, that has nothing to do with the Fed, unless the Fed is also a big granary hoarding wheat and corn. The shortage didn’t happen overnight. We have been over-inventoried for years in this country and around the world. We had grain storage that was so high for so many years that farmers sold land or it lay fallow. It wasn’t worth it to produce.

But the increase in oil, the food-for-oil mandate of President Bush, continued even more aggressively by Obama and Clinton — we have no idea where McCain stands, as his politics seem more of a global cooling initiative — and the lack of inventories have produced the monstrosity that we have now.

To be sure, the ethanol mandate is controversial. Potash, on its call yesterday, said that biofuels account for only 5% of world demand and the raw cost of food is only 20% of the cost of the packaged goods you buy in stores. They blamed most of the increase on the India/China/Asia affluence theory and the need to feed more chicken and beef to meet middle-class demands for protein. However, the incremental 5% is huge when the incremental inventories in granaries are now exhausted and the world has a food imbalance. Particularly because what’s happening is biofuels are screwing production away from some grains, causing others to shoot up, including rice.

I go into all of this simply for one reason. Yesterday all of these stocks were down. The immediate causes were press reports — ones that have largely been wrong by the way — that the dollar will bottom because the Fed is done, as if the dollar were controlled by the Fed and not our massive budget deficits. That triggered a decline in gold, which then sent the “signal” that commodities had topped, which then led to the selloff in ag.

Now let me ask you, in the whole panoply of things I just outlined about what caused food prices to go up, was there anything in there about the weak dollar? Maybe an incremental price increase in oil? Dubious. The food issue has three cures:

  1. better harvests, which you can get from good weather, better seeds and more fertilizer;
  2. more plantings, which, amazingly still hasn’t happened yet; and
  3. the end of the ethanol obsession, a universally reviled fuel in this country because — unlike in Brazil, which is fully committed — we don’t have the buy-in of the auto companies, the gas stations or the people. We just have the government and the voters of certain ag states and an amazingly powerful farm lobby.

Is that a reason to sell POT, Deere (DE) , MON, Bunge (BG) , MOS, AGU and the like? Or to buy ’em? You decide.

GE – 10 Years Going Nowhere

Wednesday, April 16th, 2008

As a follow up to my Investment Strategies newsletter that many of you will be receiving in the mail today/tomorrow/at the whim of the post office (a copy of which is included in the previous post), I thought I’d give you a graphic illustration of why large cap blue chip stocks are likely to be a dangerous place to be in coming years.

The graph of GE above (courtesy of Gary Dvorchak) shows that over the course of a decade, GE – the bluest of blue chip stocks – has grown in price from $29 per share to $31 per share.

Americans will not be able to fund their retirement years with this sort of investment, particularly if they are buy-and-hold investors. If they actively managed their portfolios and sold when GE was at the top, then they could have made a nice profit. Unfortunately, that is not how most investors work.

This sort of pattern will likely be the norm going forward as our economy continues under pressure. Proper equity selection will be paramount to acceptable investment returns and risk management.


Investment Strategies

Friday, April 11th, 2008

For readers of this blog, below you are getting an early view of my Investment Strategies newsletter that is currently at the printer. I hope that you enjoy it and that you can use it to better manage your own investments.


The Credit Crisis Explained

We have had a wild ride so far in 2008 and a few things have started to become clear that will impact the management of investment portfolios for months or years to come.

The current crisis came about because Wall Street devised a way to package loans together into derivative securities based upon complex mathematical models. The theory behind these models was that good mortgages could be packaged with bad mortgages and the risk of loss from bad mortgages could be completely mitigated.

Based upon these models, the rating agencies (Standard and Poors, Moody’s, Fitch) could rate them as AAA rated investments. Wall Street could then sell these bonds to banks, insurance companies, mutual funds, hedge funds, pensions, and other buyers who had investment policies requiring some or all of their investment portfolios be in AAA rated securities.

For decades, AAA ratings had been saved for U. S. Treasury securities and those of a few corporations with the strongest balance sheets and income statements, like General Electric. Issuers with AAA ratings were finite in number given the requirements for financial strength, and based upon this strength, the interest rates they paid were at the bottom of the range.

With these models now in place, Wall Street could manufacture a nearly endless supply of AAA rated debt with yields above traditional U. S. Treasury securities. All they had to do was slice and dice repayment streams from the mortgages into various segments and sell these as a new AAA rated security. They could then take these new investments to some of their best clients, the hedge funds and investment banks that could leverage themselves at 30-to-1, and “guarantee” them a risk free return of 12% per year.

The hedge funds’ and investment banks’ appetites for this sort of investment was huge. In the early years, the models did work. The ratio of good mortgages to bad mortgages was such that the risks really were minimal. Then, as the demand for these bonds increased, there was a need to increase the pool of borrowers upon which these securities were based. So, the incentives grew to make loans to ever-riskier borrowers so that Wall Street could continue to market these securities. Unfortunately, no one revised the assumptions in the models to account for this increased risk at the borrower level.

Wall Street began to provide mortgage products designed to allow first-time homebuyers to more easily qualify for loans. These products had artificially low monthly payments in the first two years, which many borrowers could cash flow, but the remaining 28 years of the mortgage had monthly payments that were well above the borrowers ability to service.

These loans were nationwide, but mainly they were in the areas of the country with the fastest growing real estate prices – California, Florida, Nevada, Arizona. By increasing the pool of borrowers, this supported and exacerbated the upward spiral of house prices. Mortgage brokers were able to convince the borrowers to take these 2/28 mortgages based upon the “fact” that at the end of the first two years they could refinance into a more traditional fixed rate loan because the growth in the market value of the property would provide them with the 20% equity required for a conventional mortgage.

In the beginning, when few of these loans were being made they actually operated more or less as the mortgage brokers sold them. Then, more and more of these loans, along with other similar loan programs – interest only loans and NINJA loans (No Income No Job No Assets) – were made and they began comprising an ever-growing percentage of the AAA securities. Riskier and riskier borrowers were granted loans – one statistic showed that 19% of borrowers in early 2007 could not make their first mortgage payment on their new loans – and those loans were incorporated into the AAA securities.

Then, the defaults began on the riskiest mortgages, or those mortgages made to borrowers with the least ability to repay the debt. These defaults had a direct negative impact on real estate prices.

As the 2/28 mortgages began to reset with higher payments after the initial two years, the borrowers believed what they were told by their mortgage brokers and expected that they would be able to refinance. Unfortunately, the phantom equity they were promised did not exist. In fact, most borrowers in the hardest hit areas of the country saw their life savings, which they used as down payments, disappear with the falling value of their homes.

Since they were unable to refinance into a conventional mortgage, since they could not afford to cash flow the higher monthly payments, and since there were no buyers for their homes, they defaulted on the mortgages. Across the country, mortgage defaults are hitting record levels as more and more of these situations are playing out.

The AAA rated securities that were comprised of these mortgages began to have problems. When originally purchased, the computer models predicted certain payment streams to the investor so that the investor could pay down the debt they used to acquire the AAA’s. The debt repayment schedule was set to be consistent with the cash flow from the securities. As more and more of the mortgages comprising the AAA’s began to default, the AAA’s began to perform differently than the models predicted – the AAA’s did not pay out the cash flow the investors had counted on to service their leverage. The investors needed to sell the securities to pay off the borrowings, but there was no established market for them. Wall Street anticipated that they would be bought and held, so there was no established market to trade them and no private buyers were materializing at face value.

Last Summer, the first of the hedge funds began to implode from this. Given their huge leverage at 30-to-1, even a 4% reduction in the value of these securities was enough to wipe out the equity in the funds. All the investors lost their investment as the securities were liquidated at a loss to pay off the debt of the fund.

As the underlying loans that comprised the AAA securities became riskier, Wall Street obtained bond insurance in order to preserve the AAA ratings on the packaged derivative securities. The bond insurers were eager to insure these securities for two reasons: (1) traditionally they made their livin
g insuring municipal bonds, a boring but lucrative business, but they were looking for new avenues of business in order to increase the values of their companies; and (2) the AAA ratings and the projections by the models showed that this was a line of business where they would have little risk of having to pay claims.

The dominoes continued to fall as claims against the bond insurance have put the bond insurers equity at risk. The bond insurers have been securing new investors and lines of credit in order to fund the claims, but it is uncertain at this point if they will survive.

Since the primary business line of the bond insurers is to insure municipal bonds in order to provide them with AAA ratings, the municipal bond market has also been negatively impacted. The AAA ratings of municipals have been called into question – without the bond insurers ability to satisfy any claims for non-payment, the value of the bonds to investors has decreased and yields on the bonds have increased. As issuers have gone to the market to secure new financing or to refinance short-term obligations, they have encountered significantly higher rates than normal. The University of Illinois, for example, recently tried to refinance some of their short-term municipal loans and found rates of up to 8%.

The short-term commercial paper market that previously provided liquidity to a number of borrowers has virtually ground to a halt. This has caused significant liquidity problems for a number of companies, even ones that have solid balance sheets. Thornburg Mortgage is a prime example here: their primary line of business is providing high quality jumbo mortgages. Since they are not a bank with a deposit base, they have to fund the mortgages they make by borrowing in the commercial paper market. Even though their assets were of the highest quality, they could not renew existing borrowings. In order to pay back the borrowings, they had to sell assets to meet obligations. Even though the jumbo mortgages that Thornburg made were not in any risk of default, they had to sell them at a discount which impaired their capital. Consequently, their stock price has plummeted from $30 to $1 per share.

The most critical falling domino to date has come from the recently announced near-bankruptcy of Bear Stearns. Bear Stearns is an 80+ year-old Wall Street company that was one of the biggest players in the mortgage market. Also levered 30-to-1, they had billions of dollars of these mortgage securities on their books. Much like the hedge funds and Thornburg, as the securities began to under-perform and they were in need of renewing the underlying leverage, they could not.

Thursday night, March 13th, Bear Stearns called the Fed to advise that they would likely have to file bankruptcy due to their liquidity problems unless the Fed organized a massive intervention. The Fed knew that it had until Sunday night, before the Asian stock markets opened, to intervene and find a solution to the problem. They were able to broker a deal with J P Morgan to buy Bear Stearns for $2 per share with the Fed guaranteeing $30 billion of Bear Stearns’ securities.

The situation with Bear Stearns was extremely dire because Bear was a counter party to $2.5 trillion in credit default swaps. A credit default swap is an instrument to transfer the credit risk of fixed income products from one party to another party (the counter party). In essence, Bear Stearns was paid a fee to guarantee $2.5 trillion of loans for third parties. If Bear declared bankruptcy, the value of these swaps would be called into question and there would be doubts about the solvency of the lenders who were relying upon Bear’s guarantees.

The Fed could not allow this to occur, so they stepped in and crossed the line in the sand drawn by the Depression-era Glass-Stegall law. Even though Glass-Stegall was repealed in 1999, the assistance provided to an investment bank instead of to a deposit-taking bank was unprecedented.

Additionally, without the $30 billion guarantee and the J P Morgan liquidity, Bear would have needed to dump billions of dollars of derivative securities on the market. That would establish a market value for them well below face value and force other banks that own similar securities to value them on their balance sheets according to the mark to market rules established by the Basel Accords.

In the 1980’s, Fed Chairman Paul Volcker grew tired of banking crises like Penn Square and Continental Illinois reeking havoc on the U. S. economy. He convinced the other central bank heads from the developed world to adopt standardized regulations relative to financial reporting, which became knows as the Basel Accords. Consequently, across the developed world, once the rules governing balance sheets, risk ratings, and stress testing were adopted investors could make apples-to-apples comparisons of banks knowing that they were all subject to the same rules. On major component of the Basel Accords required banks to value the investment securities on their balance sheets at market value with an adjustment to capital for the fluctuations in market value –in a process known as mark to market.

In the late 1990’s, as U. S. banks grew their modeling capabilities, they convinced Fed Chairman Greenspan that the Basel rules were outdated. The Basel II rules were then adopted by the developed world that allowed banks to use computer models based upon risk-predicting formulas to value their balance sheets. Complex derivative securities, instead of being risk-weighted and marked to market according to set rules as happened in the original Basel Accords, now could be priced according to the computer models (known in the industry as “marked to model”).

These new rules had the unintended impact of allowing the banks to assume more risk than was prudent while pursuing profits like those being realized by the hedge funds and investment banks. The banks, as can now be seen, were required to have capital requirements under Basel that prevented them from assuming leverage at 30-to-1 (like hedge funds and investment banks). So, to skirt these rules they developed Structured Investment Vehicles (also known as SIV’s in the media) which are not required to be part of their balance sheets.

The SIV’s were, in essence, hedge funds that borrowed in the short-term commercial paper market or through other short-term sources and invested in these AAA rated securities. When the SIV’s began to experience the same cash flow and liquidity problems as the hedge funds, the banks tried to rescue their investments with capital injections, weakening their balance sheets. The share prices for many of the big banks have tanked, wiping out more than half the value of many of them.

Where We Are Today

So, this brief history of the problem takes us t
o where we are today. The real question is what will happen in coming days, weeks, months, and years. Certain things are clear that will impact the investment markets and the economy:

· Consumers had utilized the power of the real estate bull market to exchange the equity in their homes for debt and spend the proceeds. With the drop in real estate prices, the value of homes is dropping and reducing the remaining equity in many consumers homes, sometimes to negative levels. This source of cash that has helped to fund the economy the last few years is now gone, so some economic slowing is likely.

· The availability of credit to consumers, businesses, and municipalities was reduced by this crisis. Consumers’ access to credit through home equity loans is lessened at the same time that business’ access to credit through the commercial paper market and municipalities access to credit though the municipal markets is stifled.

· Reductions in access to credit help to support the argument that we are currently in or soon-to-be in an economic recession.

· In order to keep the economy growing, the Fed has cut interest rates significantly. This, along with the debt guarantees and the increased access to credit through the discount window, will pump liquidity into the system.

· In spite of an apparently slowing economy, commodities are signaling inflation is a bigger problem than the government is acknowledging. Gold topped $1,000 per ounce before falling back into the $900’s. Oil topped $110 per barrel on more than one occasion.

The Re-Pricing of Risk

As we look at the future of the investment markets, what we see is complete change coming in the arena of risk pricing. Traditionally, commodities and foreign stock markets were considered significantly risky investments whereas blue chip U. S. stocks, tech stocks, and treasury bonds were considered safe and conservative. To the detriment of their clients, many investment managers are going to continue to believe this and invest client monies accordingly. This is a mistake.

The fundamentals of the commodities-based stocks include real assets: corn, soybeans, copper, iron ore, gold, oil and natural gas. Each of these has an intrinsic value that will not drop to zero. The demand for these commodities is increasing based upon demographic shifts in the developing world. We have written about these demographic shifts over the past several years, so for long-time readers of our Investment Strategies, this is no surprise.

The demographics in these markets – Asia, South America, Eastern Europe, and the Middle East – are driving demand for basic comforts that the Western world has enjoyed since World War II. Homes, cars, roads, meat and dairy products are all items that the new consumers demand as they increase the quality of their lives. Companies that sell products there or provide the raw materials for products produced there are the new growth stocks. This is the key to the future of investment management.

By Wall Street standards, the commodity stocks are resource cyclicals that should be bought and sold with the U. S. economic cycle; the developing world carries too much risk and should be bought only by the most aggressive investors. Tech stocks, the bread and butter of Wall Street firms, are considered to be the only true engines of growth suitable for investment and large cap domestic companies are considered to be the only blue chip companies worth including in portfolios. There is still a lot of education that will need to be acquired before the commodity stocks and companies catering to the developing world cease to be considered exotic or aggressive. This is the opportunity we are capitalizing upon for our clients.

The S&P 500 is likely to perform worse than foreign markets for the foreseeable future. Yes, there will be times when you see short-term out performance by U. S. stocks, but the fundamentals show that U. S. stocks will be a riskier place to be invested than most people realize. The type of financial crisis we are experiencing is not something that resolves itself easily. We will likely see tight credit for some time to come. With limited access to credit, businesses will be limited in their growth. Earnings pressures will likely result, and since stock prices are a function of earnings and investor confidence, portfolios that overweight the blue chips and tech stocks will suffer.


One of the most problematic issues for portfolios of stocks and bonds is inflation. In times of rising inflation, P/E ratios contract, bringing down the value of stocks. During inflationary periods, bond yields rise to compensate investors with an interest rate that is above the inflation rate. As yields rise, bond prices fall, and bonds within portfolios lose value. Historically, however, real assets and commodity stocks increase in value as inflation expectations increase.

Both the core Consumer Price Index (CPI) and the core Producer Price Index (PPI) are reporting increases in inflation. The February CPI reported inflation of 4.03%, the highest level in 17 years. Food and energy prices are rising even faster than the core CPI and PPI rates of inflation.

As explained by economist Anna Schwartz, “an increase in the supply of money puts more money in the hands of consumers, making them feel wealthier, thus stimulating increased spending. Business firms respond to increased sales by ordering more raw materials and increasing production. The spread of business activity increases the demand for labor and raises the demand for capital goods. In a buoyant economy, stock market prices rise and firms issue equity and debt. If the money supply continues to expand, prices begin to rise, esp
ecially if output growth reaches capacity limits. As the public begins to expect inflation, lenders insist on higher interest rates to offset an expected decline in purchasing power over the life of their loans.”

The government reports that M2 (a broad based measure of money supply) has grown by $274 billion during the last 10 weeks – a 21% annualized rate. Money with zero maturity (MZM), like cash and checking accounts, is up even more, growing by $515 billion the last 10 weeks – a 38% annualized rate.

Even though a 4.03% inflation seems manageable, look for increases in the CPI and PPI to continue based upon the growth in money supply. The resulting impact of inflation on investment management cannot be ignored from both a risk management and an expected return standpoint.

Investment Considerations

From an investment standpoint, we are experiencing a changing of the guard. Risk management techniques that were proper in the past will not be work now. In an era of rising inflation and slow growth, a traditional portfolio of blue chip stocks, tech stocks, and bonds will not provide the return that an investor requires nor will it protect them against loss.

To manage risk and receive an expected return, an investor must have a portfolio designed to address the main investment themes of the coming decade: inflation, food shortages, developing world growth, dollar weakness, infrastructure, energy demand, a dangerous world, and increased emphasis on medical needs of baby boomers.

Our client portfolios will continue to reflect:

· Agriculture stocks – in the news this week there have been reports of food shortages in Asia along with food price inflation in excess of 20% in the first quarter of 2008.

· Energy stocks – demand continues to outstrip supply, and we see an increasing need for energy to produce fertilizers for the agriculture industry (Jubak’s Journal reports that “It takes about 4,600 calories of fossil fuel to grow, chill, wash, package and ship a 1-pound box of salad greens — about 80 calories of food — from California to New York”). Extrapolate this across the planet.

· Base metal stocks – miners continue to report that demand from the developing world is increasing, yet the big players in the industry have no new mines under development. This will continue to limit supply and keep upward pressure on base metals prices.

· Gold stocks – inflation will keep gold prices rising as this is the traditional hedge against the devaluation of currencies caused by inflation.

· Defense stocks – in spite of all the rhetoric of the campaign season, anyone that becomes our next President will want to protect our country from a second 9/11. It is a dangerous world and our country will continue to have a strong defense to accompany the reinstatement of diplomacy that all three candidates advocate.

· Biotech and Medical Device stocks – the baby boomers have begun to retire, and with that we have a wave of potential business for new innovations that will allow them to lead active and satisfying lives.

· Global infrastructure stocks – the demographic changes in the developing world are creating a huge demand for infrastructure, not the least of which is new ports and oil refining facilities. The companies that can design, engineer and construct these multi-billion dollar projects have billions of dollars of projects in the pipeline, and they will continue to experience significant levels of earnings growth.

· Multinational U. S. stocks that have significant overseas sales – the profligate spending by the U. S. government and much of the consuming public has caused us to be the world’s most significant debtor nation. Our dollar is in a multi-year bear market and will likely continue to drop in value against stronger currencies. The strengthening of developing world currencies against the dollar is the next leg in the dollar’s fall, and it has just started. The multinationals that have significant Asian, South American, Middle Eastern, and Eastern European sales will see their earnings growth continue to accelerate, even if the dollar rebounds against the Euro and the Yen.

· Very Short Duration Fixed Income and Cash – bonds are a dangerous place to be right now. If you look at the treasury yield curve, you will see that the flight to quality out of the esoteric fixed income investments and out of the stock market has driven yields down significantly, even below the overnight Fed Funds rate for maturities approaching five-years. Additionally, the ten-year treasury this morning is yielding 3.55%, well below the current inflation rate. You should expect bond prices to fall as yields begin to reflect the increase in inflation discussed earlier.

In Closing

2008 is the beginning of a new investment era – the era where investors will begin to realize that it is riskier to own blue chip stocks, tech stocks, and 10-year treasury bonds than to have exposure to developing markets – either through commodity stocks or through companies with significant revenues generated there.

Over the last several years, our clients were able to take advantage of the beginning years
of the change. We explained in these Investment Strategies how the demographic changes across the world were going to impact investment decisions. We detailed our shifts in portfolios, first to overweight the energy companies, then the base metals companies, and then the agriculture companies. All of these decisions gave our clients the opportunity to build positions in these industries at low prices before the trends were spotted by most in the investment community.

Over the next several years, investors will stop thinking of exposure to the developing world as aggressive. They will realize that this is the primary catalyst to earnings growth available in investment management and that real assets of commodity companies provide a hedge against inflation and a base level of value that can not fall to zero – like many AAA securities have lately.

If you are currently our client, we want to thank you for your continued business and we look forward to coming years of achieving well-above average returns on your investment portfolios.

If you are not yet a client and you would like to have your investments managed according to the Investment Strategies you have just read, please call Mark Ballard, John Clausen, or Andy Thorman at (217) 351-2870. We would be happy to discuss with you how we can put our strategies to work for you.

Housing Crisis in Denver

Thursday, April 10th, 2008

If you haven’t seen this graphic in the USA Today Online of the Denver housing crisis, it will be startling. The houses in red are foreclosed properties…

Just cut/paste the above link into your browser and go to it…


Index Funds Vs. Active Management

Wednesday, April 9th, 2008

I often read in the paper and hear from individual investors that index funds are the best investment for them given the funds low expense ratios.

When I make a presentation to someone and they are indignant about the fact that they may have to pay us 1.25% to manage their stock portfolio compared to 0.25% to own an index fund, I am amazed at how good of a job the index fund providers do in their marketing.

Our clients have enjoyed a > 14% annual average return over the last 9 years. As you can see from the graph above, people investing in the Vanguard 500 Index fund have averaged 0% over the last 9 years.

Hire us or any competent manager, don’t just passively sit back and earn nothing.


Rally Continues But We Get Cautious

Friday, April 4th, 2008

Today’s employment number showed a third month in a row with increasing unemployment. The consensus estimate was for 50,000 jobs lost compared to actual losses of 80,000. One of the lesser accepted definitions of a recession is three months of increasing unemployment.

This, combined with an Oscillator (thanks to Helene Meisler for the graph) showing that we are overbought, leads me to be a bit cautious.

We’ve started to books some profits in things we bought recently that have 15% to 30% gains over their lows a few weeks ago.

We are selling incremental positions in some of the Ag stocks that have soared in recent weeks: Monsanto, Potash, Syngenta, all for big gains.

We are booking 20% to 30% profits in some positions or partial positions that we bought in good companies that were unfairly pummeled in the market correction but which we thought would easily come back: Game Stop, St. Joe.

We raised trailing stops on whole or partial positions in some companies that have jumped 20% or so recent weeks: Apple, Research in Motion.

Our goal in selling partial positions and/or taking profits is to get a bit cautious on the short-term market direction, but maintain core positions in companies that will thrive once the market has fully discounted a recession into equity prices. In earlier posts, I’ve described how I like to use the Oscillator as an indicator of short-term market direction and combine it with fundamentals (like government employment reports) to make sound decisions about the mid- and long-term.

In a market that is likely range bound and reacting (over-reacting to news) it is always prudent to book some profits when you have a chance and reinvest when given opportunities. Plus, its important to have some cash on hand if new macro-trends present themselves so that you can invest with them.

When we come out of the current turmoil, the strongest areas and strongest companies will be the ones that profit the most. We will maintain our core positions in these areas and companies, and build positions back up if the market pulls back and the Oscillator shows we are oversold.

Keep enjoying the rally while it lasts, but be smart about your own portfolio!