What about commodities???

Here is a chart of the Reuters/Jefferies CRB Index which plots monthly returns from 1956 through the present (February 29, 2008 is latest data point). You can see that since February 28, 2002, the commodities index has been on an absolute tear, going almost straight up. In the past couple years, when stocks have not been doing so well, the continued rise in commodities has many investors asking "What about commodities for me?"

You may even be asking yourself (or hearing someone asking you) "What about commodities?"

However, if you look more closely at the long-term record of this commodities index, you will see that the index goes up and down quite reliably, but it doesn't ever really go anywhere. See the chart below:
















Commodities may be "hot" at the moment, but even with the tremendous run-up in commodities over the past few years, commodities are NOT a money-making long-term investment. In fact, as you can see from the chart above, the thirty-year track record works out to an annual rate of return of only 2.41% per year -- well below inflation of approximately 4% per year for that particular thirty-year period (according to the CPI website).
















Going back twenty years, you can see that the annual rate of return over the past twenty years was only 3.06% -- barely above the average inflation rate of 2.95% for that twenty-year period. (Note also that the annual rate of return between February 1978 and February 1988 was a mere 1.11% per year for ten years).

This aspect of commodities should be well-known to the investing public, and yet it seems that every time stocks are in a slump and commodities are rising, the "conventional wisdom" dictates "investing" some portion of your capital in commodities.

Unlike stocks, which represent a share in a business, commodities are the essence of a zero-sum game. By their very definition, a commodity is something to which no value has yet been added -- it is a "raw material".

Therefore, it is not surprising to learn that you cannot simply "buy commodities" and hold them for thirty years and stay ahead of inflation. You can do that in a company that continues to add value to its customers for thirty years, but you cannot do that in a commodity, which is a non-value-added entity. The only way to make money in commodities is illustrated in the chart below:

















Commodities are a perfect example of a "trading vehicle" rather than an investment vehicle. We explained the difference in an earlier post, entitled "Gambling, Speculation, and Investment."

Incidentally, although it is quite clear that the strategy depicted in the above slide is a trading strategy that relies on making the right call on when to get in and when to get out (very difficult to do), many people take the exact same approach to their stock portfolio and think that they are "investing" when in fact they are following a trading strategy.

That's because the general marketing machines of Wall Street and the financial media have conditioned investors to think that they need to substitute the above slide for one sector or another: BUY the energy sector! SELL the tech sector! BUY defensive stocks! SELL small-cap stocks! BUY the tech sector again! SELL the energy sector!

This is not investing -- it is trading, which is generally a form of either speculation or gambling. As we explained in our very first post, we believe in the exact opposite. The majority of the big fortunes of this country, whether in the past twenty years or the past one hundred years, were made by the ownership of shares in companies which added value over a long period of time.

[As a footnote, gold is one commodity which has served as a "store of value" for centuries, and it has done better than the overall CRB commodities index -- lately. For example, the precious metals sub-index of the CRB increased by an annual rate of return of 6.35% over the past 30 years, although it was generally flat until 2003 when the Fed decided to lower the funds rate to 1% for over a year; at that time precious metals took off. That still falls well behind the 9.52% annual rate of return of the S&P 500 for the same 30-year period -- and that doesn't even count the dividends over that period. Furthermore, as we have already discussed in this post, for long periods of staying ahead of inflation, nothing comes close to stocks: see the graphs and discussion by Jeremy Siegel here. Prior to 2003's explosion, the precious metals index had just finished a twenty-year period in which its annual rate of return was negative 0.78% per year for twenty years, meaning that even with precious metals you still have the problem of timing, otherwise known as speculation or gambling].


For later blog posts dealing with this same subject, see also:

• "What about commodities -- revisited" 09/02/2008.

• "The Fed's oversteering and the wreckage of the past decade" 07/23/2009.

• "A conversation with Gerry Frigon" 08/10/2009.

• "What 'sell in May / go away' has to do with the 'persistent delusion'" 08/11/2009.

• "The 97-pound weakling" 12/16/2009.

• "Avatar and long-term inflation" 03/02/2010.

• "The financial services timeline, 1977 to present, and what it means to you" 03/18/2010.

• "Gold versus Apple" 10/25/2010.

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What NOT to do right now about the economy

In the wake of the subprime lending frenzy and subsequent market turmoil (some of the causes of which we discussed here), many in Congress are now gearing up for increased regulation of the financial markets.

The fact that government regulation often has unintended consequences, and has been partly responsible for the recent problems in the financial system, does not deter those whose answer for every crisis is knee-jerk regulation. Yesterday the Wall Street Journal led with a front-page story entitled "Political Pendulum Swings Towards Stricter Regulation." It started out with the provocative assertion that: "The idea that less regulation is better for the economy has held sway in Washington since the Reagan administration. Now that consensus is crumbling [. . .]."

There were two other related stories in the same Journal, one called "Washington Sees Several Fronts for Attacking Mortgage Crisis" and one called "Mortgage Rescue Options." (Access to articles in the Wall Street Journal may require a subscription).

The Fed's most recent actions have probably ensured that the financial system will "unfreeze" and continue to operate. Such actions are appropriate in light of the fact that the Fed was created to prevent such failures in the banking system. Some of those who now want even greater government intrusion into the mortgage market are calling the Fed's action a "bailout" of Bear Stearns, saying that if the government "bails out" Wall Street it then has an obligation to "bail out" Main Street.

But the government did not "bail out" Bear Stearns; Bear Stearns shareholders got hammered (Bear may have survived intact if some of the Fed's new lending policies had been enacted a couple weeks earlier). The recent actions to thaw the banking system are akin to stepping in to keep the freeway system operating in the event of a severe storm.

However, a widespread rejection of "the idea that less regulation is better for the economy" that has "held sway" since the Reagan administration would be the wrong response. As Art Laffer wrote over the weekend, "[From 1981 up to 2002] The U.S. led the world with tax cuts, free trade, sound money and controlled spending." This environment led to tremendous prosperity and growth for twenty-five years.

Now, however, those who prefer to see a weak dollar because of concern over the meaningless "trade deficit" (otherwise known as a "capital surplus") as well as those who favor higher tax rates and greater government regulation are gaining influence.

Misguided government regulation was part of the cause of the most recent crisis. Creating additional legislation and regulation now is not a wise course of action especially since that is exactly what has caused much of the recent problem.

For later posts dealing with this same subject, see also:

• "The 97-pound weakling" 12/16/2009.

• "Reducing taxes is the best way open to us to increase revenues" 08/03/2010.

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Say tax rate cuts, not tax cuts (Part II)

As we wrote a couple of months ago, tax rates are a critical factor in the performance of the economy.

And yet, with all the talk in government about needing to "do something" for the economy right now, discussion of the impending tax rate increases has been notably absent.

Yesterday, the Center for Freedom and Prosperity released a new video detailing the reasons why the playing field is tilted against lower tax rates, due to congressional budget rules that ignore changes in behavior people make in response to changes in tax rates.

Watch the video -- it is astonishing!

For the first video in that three-part series, click here.

For the second video in that three-part series, click here.

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How to find a financial advisor who will build your foundation on businesses

When families are looking for a "financial advisor", "wealth manager" or "financial planner," the modern landscape is quite crowded.

However, as we have explained previously, the current environment is dominated by an arrangement like that pictured in diagram I above (the upper diagram). The investor (red circle marked A) deals with an intermediary (yellow circle marked B), who selects money managers (blue circle marked C). The intermediary is a "manager of managers".

The intermediary does not pick businesses for his investors. In fact, he usually makes this fact quite clear. He may back up his disavowal of selecting businesses with some discussion of various tenets of "modern portfolio theory."

Modern portfolio theory (MPT) began with the 1952 publication of an essay entitled "Portfolio Selection" by Harry Markowitz, a graduate student at the University of Chicago. Later, academics Bill Sharpe and Eugene Fama further expanded the tenets of MPT, including the central doctrine of the "efficient market" introduced by Fama. While the entirety of modern portfolio theory is more involved, essentially it suggests that risk can be explained using mathematics and that one can only improve return at the cost of greater risk.

Money managers generally ignored modern portfolio theory until the recession of 1973-1974, one of the longest and deepest since WWII, when the combination of a painful bear market and government regulation began modern portfolio theory's move into the mainstream.

Today, the intermediaries -- who owe their existence in part to MPT and who generally accept it wholeheartedly -- are often focused on the manager and the manager's recent performance rather than the individual businesses that the manager places in investors' portfolios. This serves to undermine the very process managers try to emphasize which is built upon longer-term ownership of businesses. As studies have shown, the intermediary's tendency to switch managers and investment styles within a fairly short-term window work at odds with the long-term growth potential of business ownership.

In challenging financial markets, just as much as in better business environments, we know what works: ownership of good businesses.

It may not seem like it, when commodities are soaring and stocks are plunging, but history shows that business ownership has proven itself through the various crises of the past century, as Jeremy Siegel explains here.

The question then becomes, "How do you find good businesses?" The investment process you follow should have a way of selecting business based on a consistent set of criteria, and the best reason to hire a professional is to gain access to a consistent process.

First, make sure you don't already have a consistent process without knowing it! If your advisor has been disciplined in executing his process, over the course of many market cycles, you should probably remain right where you are. Don't go down the road of "churning" processes or strategies by switching every couple of years -- that is the main cause of unsatisfactory long-term performance.

Unfortunately, due to the prevalence of the situation shown in diagram I and the extent to which modern portfolio theory has influenced the behavior of the intermediaries, it is far more difficult for investors to work directly with someone who builds their financial foundation primarily on the ownership of businesses. It may be possible to find an arrangement like that shown in diagram II, in which you work directly with your money manager. Otherwise, the other option is for the investor to act as his own money manager (circle A and circle C become the same).

Perhaps at some point the landscape will be less like diagram I and more like diagram II (as it was before 1973-1974). But don't hold your breath. In a related discussion in his 1988 letter to shareholders, Warren Buffet said:

"This doctrine ["efficient market theory" or EMT] became highly fashionable -- indeed almost holy scripture in academic circles during the 1970s. Essentially it said that analyzing stocks was useless because all public information was appropriately reflected in their prices. In other words, the market always knew everything. As a corollary, the professors who taught EMT said that someone throwing darts at the stock tables could select a stock portfolio having prospects just as good as one selected by the brightest, most hard-working security analyst. Amazingly, EMT was embraced not only by academics, but by many investment professionals and corporate managers as well. [. . .] In my opinion, the 63-year arbitrage experience of Graham-Newman Corp, Buffet Partnership, and Berkshire illustrates just how foolish EMT is. (There is plenty of other evidence, also). [. . .] Apparently, a reluctance to recant, and thereby to demystify the priesthood, is not limited to theologians."

If that was true in 1988, it is even more so today. Understanding the current landscape, and the role modern portfolio theory plays in the often-harmful behavior of many intermediaries, is important in finding a process that will work to build wealth for decades to come.

For later posts dealing with the same topic, see also:

• "Beware of the witch doctors of modern finance" 12/15/2009.
  

• "The bonfire of the intermediaries" 01/29/2009.
  

• "Professor Amar Bhide and his Praise of More Primitive Finance" 02/23/2009.

• "Investor Behavior or Advisor Behavior -- 2009" 06/26/2009.

• "Melanie Oudin, Billy Beane, and the portfolio management process" 09/09/2009.

• "What a farmers' market can teach us about money management" 01/18/2010.

• "Another black swan?" 05/13/2010.

• "Free markets, free enterprise, Friedrich Hayek, and active allocation of investment capital" 07/13/2010.

• "The dance of the hippos" 08/10/2010.

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It's not worth zero, but if the market says it is . . .

If you put your nice leather jacket on eBay, which you believe to be worth some sum in the hundreds of dollars, and nobody will bid anything for it, how much is it worth?

When it comes to valuing an asset, the simple fact is that the asset is worth whatever somebody will pay for it. If the highest bid for your jacket is only eleven dollars in any market that you can shop your jacket to, then your jacket is worth only eleven dollars until you can get someone to pay twelve dollars for it. Of course, if you have some fame or notoriety, people may be willing to bid thousands of dollars (or much more) for a jacket that you have worn.

In regards to the current credit crisis, there are now assets on the books of many companies for which nobody knows the price. In many cases, because buyers across the board are refusing to buy certain assets (mainly those composed of mortgage loans), there is no market at all.

Buyers are afraid to buy asset-backed loans because they don't know what they are worth. In the absence of any buyers, it's hard to say what the real market value is for those assets, but based on the "eBay definition" above, they aren't really worth anything if nobody will pay anything for them.

However, different from the jacket on eBay example, in this case the mortgages actually pay a certain yield. It's as if you had a jacket in which magically every morning a one-hundred-dollar bill showed up in the pocket. If you had a jacket which did that, and you put it on eBay, you would be shocked if the highest bid you could get was eleven or twelve dollars.

Yet that is the situation that is taking place in financial companies who own such assets. Because the market for those assets has frozen in place, they are suddenly forced to write down their balance sheets to reflect the fact that, according to the markets, certain of their assets are worth much less than they may be worth in future months.

If you had a "magic hundred-dollar-bill jacket" and nobody would pay you more than eleven dollars for it, you would probably just shrug and say, "I'll hold on to it for a year or two and then try again." But if you are a public company, and you have to mark all your assets "to market" periodically, you would have to write down your balance sheet accordingly, and that might impact your credit rating and your ability to obtain loans that you need in order to run your business.

At the heart of the problem is the uncertainty as to how long those hundred-dollar bills are going to keep appearing in the jackets, because the jackets in question are actually composed of mortgage loans, the value of which are subject to the ability of borrowers to keep making payments. In the wake of the Federal Reserve's easy money policy of 2003-2004, the strength of instruments composed of those loans may be well below what the rating agencies once said they were.

Yet they are not zero, though in the absence of a market companies may have to mark their balance sheets as though they are zero or close to it, and companies -- even those with all high-quality mortgages on their balance sheets -- are being treated as though they are worth zero by their creditors, and some may go under because of it.

In the wake of all this, there are calls for the government to enact tighter regulation of mortgage lending and of the packaging and securitization and marketing of mortgage loans in the financial world.

But it may be that the real problem was the government in the first place. It was not all that long ago that congressional committees chastened lenders for so-called "discriminatory lending". In many ways this pressure removed the natural self-regulation lenders have against making loans to people who can't repay them. It is notable that the reprimand eminating from congress today is for "predatory lending" supposedly practiced by lenders. It strikes us that this presents an impossible dilemma for a lender to negotiate.

In addition, government regulation exacerbated the fallout from loose lending, with the 1991 requirement enacted by the Financial Accounting Standards Board (FASB) that corporations mark to market all assets on their balance sheet. Another contributor to the problem is the requirement for rating debt-instruments by just three government-approved ratings agencies (S&P, Moody's and Fitch) which also helped short-circuit the "self-regulating" due diligence that would have taken place in a market where buyers of assets judge the risk of lending or of buying loan-based securities for themselves.

It is likely that the level of defaults will be much lower than the market for mortgage-based instruments currently suggests, because the market for those assets has failed. The Fed's creation of a swap for those assets this week was a major step in the right direction. Eventually, people will realize that these assets are not worthless, just because the market right now says that they are. However, the damage is serious, and some good firms may go under because of it.

For later posts dealing with the same topic, see also:

• "This week is not an indictment of free markets" 09/19/2008.
  

• "Stimulus package, revisited" 11/25/2008.
  

• "Understanding the uptick rule can help you see the big picture" 12/10/2008.

• "Taking stock of 2008" 12/31/2008.

• "It's a panic, not a Great Depression" 01/21/2009.
  

• "First, do no harm" 02/02/2009.

• "Managing Investments in the New Era" 02/18/2009.

• "What Rube Goldberg could teach us about economics" 12/08/2009.

• "The end of 2009" 12/30/2009.

• "How your view of 2008-2009 impacts your understanding of today's big events" 02/03/2010.

Subscribe (no cost) to receive new posts from the Taylor Frigon Advisor via email -- click here.

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