Hope Blooms, and Green as Money

Imagine an Algae ETF one day -- perhaps a speculative one in the next couple of years -- even though only a couple of public companies today are trying to cultivate algae for energy. The potential of this energy source seems to exceed anything I've read about, within the realm of credibility.

Here's the dream:

• Given the right conditions, algae can double its volume [within days]. Unlike other biofuel feedstocks, such as soy or corn, it can be harvested day after day. Up to 50% of an alga's body weight is comprised of oil, whereas oil-palm trees--currently the largest producer of oil to make biofuels--yield just about 20% of their weight in oil. Across the board, yields are already impressive: Soy produces some 50 gallons of oil per acre per year; canola, 150 gallons; and palm, 650 gallons. But algae is expected to produce 10,000 gallons per acre per year, and eventually even more.
• "If we were to replace all of the diesel that we use in the United States with an algae derivative," says Solix CEO Douglast Henston, "we could do it on an area of land that's about one-half of 1% of the current farm land that we use now.

Algae is being grown today in large arrays that require sunlight, CO2 (which might even be taken from power plant exhaust instead of hitting the atmosphere), water at precise temperatures, conditions and volumes (a lot of volume for now, unfortunately), and the collection of biproducts that need to be fully accounted for. Costs of managing the process are far too high to be competitive with ethanol and oil, but coming down. Ultimately, the final product could be far, far more more productive, efficient, and environment-friendly than ethanol.

It's an industry that the U.S. leads in, judging from various sources I've read (even blog postings from Asia asking for help in getting started, citing vast quantities of pond scum!)

Here's a summary of some of the activity, gleaned from recent articles. Most of the data is from this article, from earth2tech.

Companies (nearly all private and most in early stages)

• Aquaflow Binomics - sources from algae-polluted waters (publicly held - New Zealand). Used its algae-based biodiesel to run a Land Rover driven by New Zealand's Minister of Climate Change, and has been working wtih Boeing on algae-to-bio-based jet fuel.
• Algae @ Work - formed by a splinter from Solix
• Aurora Biofuels - says can create biodiesel fuel with yields that are 125x higher and have 50% lower costs than current production methods. A developer is UCal Berkeley professor Tasios Melis.
• Bionavitas - says has technology for high-volume production.
• Blue Marble Energy - uses algae from polluted water systems.
• Bodega Algae.
• Cellena - joint venture between HR Biopetroleum and Shell.
• Global Green Solutions (see Vertigro, below)
• GreenFuel Technologies - announced construction of a commercial scale algae plant
• International Energy - claims to harvest oil without killing the algae stock
• Inventure Chemical - planning tests for 3-15 million gallons of biofuel/year
• Live Fuels - plans to commercialize its particular technology by 2010.
• Mighty Algae Biofuels
• PetroSun - announced it will be taking its pilot algae farm commercial on 4/1/08. Publicly held.
• Seambiotic - Israeli startup, working with Inventure Chemical, and Israeli Electric Company
• Solazyme - has done a deal with Chevron
• Solena - talking with Kansas power firm Sunflower to build a 40mw power plant run on gasified algae
• Solix Biofuels - says construction to begin shortly on a large-scale bioreactor
• Sunflower - Kansas power firm
• Valcent (see Vertigro, below)
• Vertigro (joint venture by Global Green Solutions and Valcent Products)
• XLTechGroup's PetroAlgae LLC

Some investors and partners include:

• Auttomatic CEO Toni Schneider
• Blue Crest Capital Finance
• Boeing (see Aquaflow note, above)
• Brighton Jones Wealth Management
• Cedar Grove investments
• Chevron (see Solazyme note, above)
• Engine and Energy Conversion Laboratory at Colorado State University
• Gabriel Venture Partners
• HR Biopetroleum (see Cellena note, above)
• Imperium Renewables (biodiesel maker)
• Inventure Chemical, and Israeli Electric Company (see Seambiotic note, above)
• New Belgian Brewery
• National Biofuels Energy Laboratory at Wayne State University
• National Renewable Energy Laboratory, and University of Hawaii - access to 3,000 strains of algae that's considered a core research tool
• Noventi
• Oak Investment Partners
• Quercus Trust
• The Roda Group
• Sandia National Labs
• Shell (see Cellena note, above)

There is bare-bones website, Oilgae.com, that seeks to become a hub of information for the industry.

And there are plenty of hard-core scientific skeptics, but their objections leave me guessing that those barriers could fall quickly in a world of entrepreneurs and major corporations who know that significant energy breakthroughs could create unparalleled fortune, fame, and contribution to sustainable life on earth.

The New S&P, and Earth's Fate

If potential ecological disaster could be neatly framed as a set of giant investment opportunities, then we save our species and make the investors a lot wealthier.

That's why I like Socolow and Pacala's (S&P) increasingly-famous conceptualization of how to save the world -- their concept that we need to prevent seven billion tons of CO2 from being emitted by 2054 or else we'll be sending offspring to the dungeons of the Dark Ages. (Google search "Socolow and Pacala & wedges" for the whole article.)

A new book on the topic -- Hell and High Water -- aroused the same manic concern and opportunism that Field Notes from a Catastrophe ignited within me last year.

Below are a few ways of the ways we can save one billions tons of CO2 from being emitted by 2054 -- though remember we need seven (more like eight or nine at this point), and we have to start immediately. Anyone can see that each "wedge" of a billion tons of CO2 creates enormous investment opportunities.

• Increase fuel economy for 2 billion cars from 30 to 60 mpg.
• Cut carbon emissions by one-fourth in buildings and appliances for 2054
• Produce twice today's coal power output at 60% instead of 40% efficiency (compared wtih 32% today)
• Replace 1400 Gigawatt 50%-efficient coal plants with gas plants (four times the current production of gas-based power
• Add 700 gigawatts of nuclear power (twice the current capacity)
  
• Add 2 million one-megawatt-peak windmills (50x the current capacity)
• Add 2000 gigawatt-peak photovoltaic (700x the current capacity)
• Decrease tropical deforestation to zero instead of today's rapid deforestation, and double the number of new tree plantings globally.
  

Following is a schematic diagram of the seven wedges -- or seven billions tons of CO2 we need to prevent from being emitted in order to hopefully stave-off irreversible ecological catastrophe. (Again, the figure now is probably north of eight billion tons, because of delay and "creeping normalcy" whereby we think everything is okay because the environment doesn't seem that much worse than we can remember in past times.)

Developing Markets' Inflation Beast Continues Growling

For two days we've cited anecdotes about how the Developing Economies' micro-mercantilist policies to address inflation aren't working, and won't engineer a soft landing (slower, less-inflationary economic growth rates). There will be financial crises along the path to slowdown, and that's why we're not raising our Developing Markets allocation from our current underweight.

Our post yesterday highlighted India and East Asia's widespread policies of limiting exports of inflationary goods (to retain more supply at home), and reduction of import taxes on those goods to encourage cheaper imports. We view these as potentially offsetting policies that don't address the root causes of inflation, namely the rapid growth in credit, currency manipulation in many Developing nations that artificially juices export growth and high import prices, and other policies. A previous post implicates Brazil, too.

Today, a WSJ article makes the same point about Argentina:

• The recent trouble [social unrest[ began not in Buenos Aires but in the provinces, where agriculture is the main economic activity. Farmers rebelled earlier this month when the government announced an increase in export taxes on agricultural products....
• Take, for example, soy beans. The new export tax will be raised to 44% from 35%. But since farmers also have to pay a 35% income tax on profits, the effective tax rate is significantly higher. "The farmer ends up paying essentially a 63% tax on gross income," says Pablo Guidotti, dean of the school of government at Argentina's DiTella University. If the price of soy goes up, Mr. Guidotti adds, the "retention rate" increases until the government can end up taking as much as 95% of any marginal increase in a farmer's gross income.
• In response to the tax increases, farmers have blocked roads in some 300 locations around the country, pledging not to allow their goods to reach markets. The effects of the action have been felt in the capital, where demonstrators have taken to the streets in sympathy for the farmers and against what they say is government arrogance. The strike is now in its third week.
• [President Cristina] Kirchner says the tax increase is a redistribution mechanism, suggesting that growers and ranchers have to be forced to share more of their good fortune with others. But the greater motivation behind the export-tax increase is inflation.
• This government, it seems, will do just about anything to reduce inflation except the one thing that would solve the problem: Let the peso strengthen. It has imposed price controls on businesses; frozen, and then subsidized, energy prices; and prohibited the export of beef. Last year it fired the director of the government's agency for inflation data because she refused to fudge the numbers. Even so, prices rose by an estimated 20% in 2007 and expectations for this year remain high. This would explain the new round of confiscatory export taxes. By discouraging farmers from sending food abroad, the government thinks it can increase food supplies inside the country and damp prices.

To repeat from our post last night:

This is a big reason why we're not adding to our Developing Markets weighting now, and it's also a reason why we're waiting-out the dollar weakness rather than piling-on the shorts. As instabilities and unsustainable policies within Developing Market economies become more apparent (very very soon), the dollar will give more reassuring signals. Financial seizures within Developing Markets will, we continue to believe, signify "the beginning of the end" of the global financial crisis, and a buying opportunity for equities worldwide.

Developing Markets' Inflation Beast Growling Louder, Even As Their Economies Decelerate

We're not ready to raise our underweight Developing Markets allocation, as we'll only believe the "soft landing" scenario when we see it.

Our post yesterday on Brazil expressed our concern that underlying inflation pressures are only exacerbated by government policies to micro-manage prices rather than slow down the credit and demand boom.

India presents the same concerns. Earlier today, India's inflation reached a 13-month high of 6.7%, exceeding estimates. The following form of micro-management of the economy -- discussed in today's FT report -- would seem to have be neutral to global inflation, which circles back to keep India in the inflationary net:

• The finance ministry is expected to cut import duties on commodities such as steel, while clamping down on exports. Last week it reduced import duty on edible oil and has limited export of non-basmati rice. "Large price increase portends significant government action," said economists at Goldman Sachs. "With inflation driven by high commodity prices, the government has reduced import duties, banned exports and increased minimum export prices of certain food commodities."

Reduce some prices, raise others ... How does that combat inflation?

This form of inflation micro-management seems to be becoming a lot more common across the Developing Markets, as shown by tonight's WSJ article titled "Rice Hoarding Pressures Supplies." While the world would benefit from increased free markets in goods that are in local short-supply, the "rational" reaction pursued by self-interested parties is to hoard. So:

• As prices hit new highs, farmers across Asia are hoarding their crops, raising the prospect of a shortage in Asia and Africa that could lead to widespread unrest.... Governments around the region are curbing exports to safeguard their domestic supply, putting further upward pressure on prices.

The greater the Developing Market inflationary pressures become -- ultimately caused by the rapid growth in credit, currency manipulation and other policies that favor very rapid growth over stable growth -- the harder they'll be to reign in without causing a few major dislocations along the way.

This is a big reason why we're not adding to our Developing Markets weighting now, and it's also a reason why we're waiting-out the dollar weakness rather than piling-on the shorts. As instabilities and unsustainable policies within Developing Market economies become more apparent (very very soon), the dollar will give more reassuring signals. Financial seizures within Developing Markets will, we continue to believe, signify "the beginning of the end" of the global financial crisis, and a buying opportunity for equities worldwide.


Keying-off the rice example used above, we'll reiterate that we think most major ag-related investments will remain less susceptable to the macro gyrations that we see continuing. See our post "Allocation and Agriculture," for instance.

Mental Challenge for Contrarians

Kiril Sokoloff of 13D Research, an extraordinary investment trend-spotter, tries to list the things that prevailing investor opinion thinks will or won't happen. The next step is to consider whether there's a case for the opposite view. So, here are a few of the "certainties" I think could be worth challenging, (starting with the most "macro"):

• The pace of technological innovation will gradually increase, but a significant acceleration from what we've already experienced isn't likely.
• We won't face serious consequences from rising ocean levels and atmospheric CO2 concentrations in our lifetime, and probably not in our children's lifetimes.
• Public equities will outperform all other asset classes over time.
• Emerging Markets and commodities are becoming more recession-proof.
• "Rogue states" like Iran, Venezuela and North Korea will remain pariahs for a very long time.
• Some alternative energy concepts such as algae energy are too far fetched to become a really major industry that changes the way we'll live in the next 10 or even the next 20-30 years.

Brazil: Internal Financial "Reform" Deformed?

After its '00s boom, Brazil is not as safe a haven for assets that its market indices show many investors believe.

In our March 25 post we cited a VoxEU article (Foreign Direct Investment, and Domestic Financial Reform: A Marriage Made in Heaven?) that concluded:

• Not only does financial reform matter, it is the most important reform a country can pursue in order to influence the decisions of foreign investors.

The linked article here on RGE Monitor describes how Brazil is making big mistakes in its internal financial management, as the country is facing increasing inflation pressures. Rather than take its medicine by making credit more expensive, it is making piecemeal efforts to band-aid problems, leaving higher risks that inflation pressure will build.

While Brazil's macro picture -- its wealth of water & land (agricultural production capacity), and infrastructure investment growth -- is enormously positive, at some point these positives will be fully factored into the skyrocketing equity prices there, and imbalances perpetuated by internal financial system mismanagement will end the bull market. We think the "at some point" may be nearer at hand than many investor suspect, due to contagion from the current financial crisis.

From RGE Monitor (originally published by Valor Economico), titled Brazil: Back to the Past:

• Different from the policy followed since 1999, which set the exchange rate floating according to the market and executed monetary policy horizontally, using classical tools, like interest rates, the current administration apparently prefer micro managing the system, with constant interventions. An increase in the price of iron ore? The government calls the iron-ore producers, with an implicit threat to impose price controls, instead. The exchange rate is appreciating? There is an increase of import tariffs and export subsidies in the sectors that are 'worthy', and the government issues internal debt to increase international reserves in a useless and expensive arbitrage for the country. Instead of increasing interest rates, they impose a selective control on credit. It is a mirror image of the economic policy from the '70s and '80s, with all the distortions and inefficiencies that led to disaster.

Brazil's year-over-year broad money growth is 16.2% means that a range of micro-management tactics may mask inflationary pressure for a while but probably can't contribute much to restoring balance. Our blog posts have raised similar questions about China; its M2 is growing at a 17.5% rate. The global slowdown that's starting to unfold will ultimately help restore something like a balance, but history tells us not to bet the farm on "soft landings" in emerging markets.

We continue to wait for lower levels in U.S. and non-U.S. equities before rebalancing to our long-term strategic targets.

"A Defining Moment for Iraq" Is a Renewed Risk for America (and for Financial Markets)

We've always viewed the U.S. war in Iraq as the historical moment when the world would plainly see a reversal of America's fortunes relative to other nations. America's trillion-dollar investment that produces zero return on principal -- and potentially nothing but future losses -- is also contributing to the demise of the dollar, greater risk that the Fed and Treasury won't be able to contain the credit crisis, a rising future tax burden, and higher oil prices into perpetuity.

So when George Bush said today that the current wave of fighting in Iraq presents "a defining moment in the history of Iraq," even he knows the situation is dire. And given my view of the Iraq war's significance for America, we must consider the corollary to Bush's statement -- that the wave of fighting is also a defining moment in the history of America.

Failing to help stabilize Iraq now, only months before the troop increase was to be tapered off, could significantly prolong the costs to the U.S. and Iraq, or present a new set of even less-appealing options, such as partitioning Iraq into militarily "self-governed" entities, which could cause a new wave of misery.

Incidentally, either of these scenarios would add pressure to the U.S. financial predicament, and to officials' attempts to head off the financial crisis. This would lend more sway to the bears. For example, to a very bearish NYU economist Nouriel Roubini, that would mean further movement down his "Twelve Steps to Financial Disaster," explained on his RGE Monitor website and here. According to Roubini, another breakdown of a major financial intermediary such as Bear Stearns would be Stop Nine, en-route to Step Ten, a severe downturn in stock markets.

We continue to postpone the rebalancing of our underweight equity allocations.

"China, If You Think the U.S. Real Estate Bust Is Bad..."

There's a big reason why, before rebalancing our underweight equity allocations, we're waiting for financial crisis to hit the Developing Economies. In particular, China's real estate boom could end very badly.

Today a WSJ article provides more fodder for this line of argument, especially because it's attracting so little attention from Developed investment markets, as this link sensibly points out.

Read the WSJ article today titled, "Tables Turn Quickly on Chinese Developers."

From our past readings, we understood that the inflationary roots in China's real estate development story run deep and wide: (1) an enormous amount of Chinese property development was premised on the certainty that values would increase in the future (sound familiar to the U.S. mortgage lending bubble?). We also understood that (2) a major source of financing for China's development boom has been city governments evicting poor residents and giving the land to property developers as partial compensation for developing the land (same as printing money) -- and that China's many large cities have been aggressively competing to add real estate capacity in this way for most of the last decade. We also understand that (3) low-to-negative real interest rates in China have financed a significant portion of China's stock market boom -- consumers have been borrowing to speculate in stocks despite the government's efforts to enforce rules (remember, China is a DevelpING economy), and the too-easy money has surely found its way into the pockets of individual home buyers. We've read that (4) there is almost nothing like a developed market "credit score" for individual Chinese borrowers. Isn't that even worse than the widespread "no-documentation" loans that epitomized the U.S. mortgage boom-bust?

The Chinese government is starting to pull out the stops to rectify these problems (at least they're being more proactive than U.S. financial regulators were during the boom), working desperately to prevent new real estate capacity from coming to market. But it may be too little too late.

From Jonathan Cheng's WSJ article:

• Three months into 2008, China's property developers are under siege. Property prices are showing signs of weakness in many of the country's key markets, and capital markets have all but seized up for these -- and other -- offerings. The Chinese government is on a high-profile campaign to clamp down on new bank loans, hoping to curb inflation, rising at its fastest clip in a decade.
• Companies that leveraged big last year are now strapped for cash, unable to build on the land they have accumulated. Beijing is breathing down their necks, having pledged earlier this year to tax and seize hoarded land.....
• The latest casualty of changed conditions: Guangzhou-based developer Evergrande Real Estate Group, which last week shelved an IPO it hoped would raise as much as $2.2 billion....
• Evergrande's woes illustrate many of the headwinds facing Chinese developers. Despite stock-market turmoil, the developer was so weighted down by debt it had no choice but to take a crack at an IPO. More than half the funds Evergrande was hoping to raise were set aside to pay for plots it accumulated during a furious land grab last year.
• "We are highly leveraged, and a deterioration of our cash-flow position could materially affect our ability to service our indebtedness and to continue our operations," Evergrande wrote in its listing prospectus. With the IPO shelved, the company hasn't said how it will seek funds.
• Even titans have had to trim their ambitions.... Soho China Ltd [co-founder] Pan Shiyi ... told Shanghai Securities News that Chinese developers this year will "find themsevels in extraordinarily difficult financial straits."....
• "The 'model' that worked in 2007 was predicated on prices for apartments growing faster than land costs," says Todd Schumbert, an analyst with Deutsche Bank in Singapore.... Now, with home prices faltering and funding sources scarce, "This game is over."....
• In the past few months, Wang Shi, the head of megadeveloper China Vanke, a Shenzhen-listed company based in that boomtown, surprised the market by slashing prices heavily on new flats and suggested in a recent television interview that people wait three to four years before purchasing a new home.
  

This topic is much bigger than any single article can tell. Back on September 18 '07, I clipped an article by Jamil Anderlini at the Financial Times. A few quotes:

• China Construction Bank, the country's second largest lender, is taking a cautious line on China's economy and is reducing its exposure to an overheating property market, the bank's chairman told the Financial Times.
• [CCB chairman Guo Shuqing said], "The real estate market is more overheated in the coastal areas and the annual price increase is too high." [Oh, only the "coastal areas" of China?]
• Investor interest [in real estate company equity, at the time the article was written] is partly driven by soaring profitability at China's newly reformed banks, but those profits are diverting attention from rising credit risks, according to Standard & Poor's, the rating agency. "The rapid industry-wide expansion of credit exposure suggests many banks prioritise expanding their asset base and market share over strengthening their capital," Ping Chew, S&P credit analyst, said.

A clip from another FT article by Anderlini, this one on 9/14/07:

• Wu Xiaoling, deputy central bank governor, said on Friday that Chinese banks were not heeding the central bank's directives to slow lending growth. Banks are lending out money much faster than the central bank's target, with new loans reaching Rmb3,080bn ($409bn) in the first eight months of [2007], 97% of the total for the whole of [2006].
  

The Chinese real estate situation seems to have the makings of another slow-motion train-wreck. CCB chairman Guo said his bank is 90.67% provisioned, but one wonders how thoroughly he's counting CCB's total exposure. And it's the second-largest lender in China. Smaller banks are probably far less provisioned than CCB.

A real estate banking crisis in China would perpetuate the global contagion, and also soak up a lot of the nation's reserves, creating a follow-on shock wave for the global financial system that China is a central player in.

The most hopeful case is that a serious cooling in China's real estate sector will offset its overheating in other sectors, to produce a "soft landing" for the economy. This isn't where our bets lie right now.

Canada and Russia

When we think of long-run asset allocation across countries, it makes more and more sense -- at least on the margin -- to incorporate global climate modeling and theories to project each country's total resources and costs under various scenarios.

We wrote a few days ago that climate change adaptation (rather than mitigation) is already a subject of war game scenarios. And a subsequent WSJ article also addresses the rising popularity of adaptation "heretics." It's easy to pick up the paper to see chatter about how highly populated coastal regions -- Bangladesh, Florida and Vietnam in the same paragraph -- will be higher-cost regions, and it's well known that Brazil's richness in water and land are giving the nation higher valuation multiples in the past few years.

But it's not clear yet that Canada and Russia have received their due in investment circles for their potentially increasing natural assets as global warming intensifies. Not only are they adjacent to deep reserves of fossil fuels around the Arctic areas that shedding their icy armors, but their land masses too are perhaps the prime beneficiaries of global warming, in an admittedly highly simplistic view of the future. This Reuters article points out a study by the British Meteorological Office that temperatures are rising the most across Canada and Siberia, which, we'd venture to guess, could further open those regions to agriculture and population expansion in the coming decades. In contrast, the Natural Resources Defense Council recently concluded that the U.S. West is heating up "at nearly twice the rate of the rest of the world and is likely to face more drought conditions in many of its fast-growing cities," according to a separate Reuters report.

My guesses are highly speculative, because I have no idea how changing patterns of rainfall or soil conservation will impact these areas, and I've also heard of some global warming studies that model new ice ages in these areas as a result of changing ocean currents and atmospheric patterns. But speculation on these topics may become increasingly interesting to long-term investors.

Stocks Sometimes Require VERY Patient Investors

Today's WSJ article on "the lost decade" in U.S. stocks (the S&P 500 is where it was nine years ago) is a depressant anyone who has been overweight equities and cash in the past decade.





















But lest one automatically concludes that U.S. stocks must be "cheap," I'm posting the following long-term (1871-present) P/E chart posted here today. Valuations are still quite high relative to the 130-year historical range:













The fact that valuations are high relative to history does NOT alone mean that stocks, or even their valuations, will decline. Instead, it means that investors' expectations for public companies' cash flow growth rates, cash flow growth longevity, and cash flow stability are currently higher than they've been for most of the past 130 years.

Are these relatively high expectations justified? NO, if you expect a deep or long recession, particularly one followed by U.S. companies' diminishing opportunities in a resource-scarce, increasingly competitive, and embattled world. YES, if you think a recession will be largely avoided, followed by a prosperous period for U.S. companies doing more business in an increasingly opportunity-filled world.

We're currently leaning in the NO direction, as you can tell from our previous posts. The passing peak of U.S. influence and openness -- signified most concretely by the near-limitless and manifold costs of the Iraq war -- bother us enormously. The '80s-'90s stock market boom and the '00s credit booms could take years to work off, as booms have in the past (Regarding this last point, see comments in the WSJ article by Richard Sylla, who taught my U.S. Financial History course in '99, vocally called the tech-bubble burst, and showed us why he was a big deep-value buyer of U.S. equities in the very early-'80s.)

Despite leaning in the NO direction, I think that over the next few years, the U.S. will make some significant progress in solving its major problems, and partially break the apparent 30-40 year waves of valuation expansion and contraction shown by the chart above. In all, I'm ultimately striving for classic U.S. equity allocation weightings, but more tentatively than my semi-annual rebalancing discipline tells me.

Muddling Through "The Beginning of the Middle"

We've read numerous economists' road maps of an typical recession and are making our own observations -- and we believe we're only at "the beginning of the middle" of the current down-cycle. (That's why we're adding to underweight allocations gradually, despite the extra risk of market timing.)

Yet we're quick to acknowledge small signs of progress, the happy "muddling through" which gradually erodes the cases of doomsday-sayers. (For a brief summary of a highly credible super-bear, see this interview of Nouriel Roubini, NYU professor and founder of the RGE Monitor economic research boutique.) One such small sign of progress came from today's TIC data (U.S. Treasury International Capital data from January) that shows foreign governments were still buying U.S. assets in January at a fairly vigorous pace. A summary of the data is at this link.

It's fairly important to watch this data because one of the biggest concerns of the most dour forecasters is that foreign governments won't continue to recycle their reserves into U.S. assets, having reached a conclusion that the dollar will continue to erode the value of their investments. A corollary of the same fear is that countries will fairly rapidly de-peg their currencies from the dollar, which will viciously reinforce the foreign abandonment of U.S. assets. These are very legitimate and troubling fears, driven by years of under-saving by U.S. consumers, wildly speculative corporate and institutional lending and borrowing, the trillion-dollar Iraq war fiasco, and China's (and some other countries') enormous efforts to keep their currencies undervalued versus the dollar in order drive export growth and protect home markets.

But the dollar may well unravel slowly enough to avoid a financial calamity, and the January TIC data is one small datapoint affirming that. It's in the financial interests of foreign governments to continue investing heavily in the U.S., even if at a slower pace; meanwhile, foreign private entities will continue to have a significant allocation toward U.S. assets to meet their portfolio's diversification demands.

Although we're not calling for a calamitous dollar-unwind, we see risks that are large enough to justify only a gradual buying of asset classes where we're underweight. And ultimately, we expect to keep a somewhat larger-than-benchmark allocation in Developing Economies, but only after some of them experience financial shocks of their own, something we're waiting for in 2008 as a sign of "the beginning of the END" of the crisis.

"Do Traders Win?"

The March issue of Index Investor highlights a 2/17/08 Vanguard report titled, "Do Traders Win? Trading Behavior and 401(k) Portfolio Performance" that offers, at first glance, some hope for various 401(k) investment styles, but disappointment for active traders:

• Traders versus nontraders. 401(k) traders realized higher returns than nontraders but also assumed higher levels of risk. After adjusting for risk, the difference in returns between the two groups disappeared.
  
• Rebalancing. Passive rebalancers, who hold only balanced or life-cycle funds so are automatically rebalanced by their fund, realized excess annual returns of 84 basis points compared with nontraders on a risk-adjusted basis. Active rebalancers, who on their own move their 401(k) portfolio's equity allocation back to a given target, earned 26 basis points in excess risk-adjusted returns. However, we estimate that only 9% of participants rebalanced their 401(k) account on an active or passive basis.
• High turnover. While some level of trading is a risk-enhancing strategy, high portfolio turnover is not. Traders with the highest turnover rates lost 72 basis points per year compared with traders with the lowest turnover ratios.
• Implications. Our findings underscore the value of rebalancing as an essential strategy for 401(k) participants.

I write that the report offers hope at first glance for various 401(k) investment styles, note that Vanguard drew its data from only the 2003-2004 period for stocks, a bullish period for stocks that doesn't capture individual investors' tendency to sell close to cyclical troughs and buy near cyclical peaks. The vast majority of the broadly-conducted research we've seen favors disciplined rebalancing over active management even more compellingly than the Vanguard report does in its indication of an 84 bp/yr advantage for passive rebalancers.

Asset Allocation and Recessions

An article in the March issue of The Asset Allocation Advisor summarizes studies done of asset class performance (median total return) around recessions -- the ten recessions since 1947 for most asset classes, and for the five recessions since 1973, in the case of real estate and commodities. The key exhibit follows:










Since we don't know if or when the potentially current recession is beginning, and because every recession and set of market behaviors are different, trying to time one's asset rebalancing is risky to long-run performance. That said, the table presents a few reminders that stand out, at least to us:

(1) Stocks and Real Estate started to outperform only as it became clear that a recession had a good probability of ending (if one occurs at all). This is one reason why we've been very careful before raising our equity allocation.

(2) Commodities performed much better before recessions than within a year after -- Commodity run-ups were often contributors to recessions, and supply-demand tightness did not resume in the immediate aftermath of recessions, characterized by excess capacity. These are reasons why we haven't wanted to chase commodities, and why we're adding to underweight positions only cautiously, on pullbacks.

(3) Historically, Treasuries and Corporate Bonds performed better after recessions broke the back of inflationary worries characterized by most pre-recession periods. It's very hard to picture Treasury performance improving further after a 2008/2009 recession -- Unless inflation fears overtake the recent "flight to quality" prior to an upcoming recession. This could help make for a particularly nasty recession that would challenge many investors to maintain their asset allocation discipline. We view this as "entirely possible" and are happy to reduce overweight positions at our normal rebalancing intervals.

Despite our passive market timing (at least on the margin), we take to heart the article's final comments:

• Studies have well documented the risk of trying to time the stock market. Portfolio returns are more greatly reduced by missing just several of the upside movements in the market than they are enhanced by avoiding downside movements [highly dependent on how you measure]. For the investors who were lucky enough to reduce their domestic equity positions last October, the real test is whether they move back into the market at the right time to catch the upside. If they don't, their portfolios are likely to have lower returns than those who maintained their long-term equity allocations.
• In the last analysis, the best way to cope with the recession is to look forward and not backward, maintain asset allocations, and remind ourselves of the following lessons from history. Declines in the stock market are to be expected at the onset of a recession. Standard correlations among returns are likely to breakdown at the start of a recession with more classes producing negative returns than would normally be the case. Bonds will outperform stocks at the start of a recession, but within twelve months of the start of a recession, risky assets such as stocks and real estate will [normally] produce returns substantially in excess of bonds and reward investors for staying the course.

I added the world "normally" in the last sentence because an upcoming recession could be particularly long and nasty given the undoing of the enormous credit boom of the past five years, the "global imbalances" that threaten to unwind, the specter of peak oil production, and other factors. Thus, we think of ourselves as being a bit more willing to entertain a bit more market timing than we would otherwise.

Commodities and Asset Allocation

We've argued in favor of cautiously buying equities on dips, and only if you're underweight, because we think we're only at "the beginning of the middle" of the financial crisis. We're also wary about adding to deflation-hedge Treasuries or inflation-hedge TIPS because of the strong run-ups they've had and their historically lofty valuations. Only one major security type looks cheap to us -- Municipals -- and those carry greater default and call risks than Treasuries and thus probably shouldn't replace Treasuries in one's deflation-hedge allocation. That leaves us overweight cash right now, and cautious in re-apportioning that cash. It's a form of passive market timing that carries its own risks.

But what about commodities? We think makes sense to use to use bouts of price weakness in commodities to gradually increase one's allocation, and only if one is underweight inflation hedges. One the one hand, commodities' run-up has been even more powerful than equities' and can pull back very sharply if global demand continues to weaken. On the other hand, we believe global resource constraints have become even more severe (fossil fuels), new constraints have arisen, and it will take a great deal of high-cost human ingenuity to circumvent those resource constraints.

But, there is considerable debate over whether commodities belong within an investor's asset allocation at all.

(1) Regarding performance of commodities (returns and correlations), academic literature varies. The linked SeekingAlpha page provides a range of literature references at the bottom.

On the strongly affirmative side, we saw an article by Hard Assets Investor interviewing Bob Greer, PIMCO's commodities portfolio manager, cited a report that Ibbotson Associates did for PIMCO last year. (Ibbotson Associates, now owned by Morningstar, was founded by the Yale economist by the same name, who is among the world's leading researchers with respect to asset allocation.) That Ibbotson report -- summarized here -- seemed to leave little doubt that commodities can play a crucial role in an investor's asset allocation.

• Because commodities produced higher returns with low correlations to other assets [during the 1970-2004 period that Ibbotson studied], the study found that including commodities in a strategic asset allocation opportunity set produced returns that were significantly higher at any given level of risk relative to returns when commodities were excluded from the opportunity set.

Even when Ibbotson reduced the expected return from commodities from the historical period to only 2% above the return on Treasury bills, the optimal commodities allocation was no less than 11% in either the aggressive, moderate, or conservative portfolios that Ibbotson modeled. The study also affirmed that commodities belong in an investor's inflation-hedge category.

On the weakly affirmative side, we note for example an 8/2/07 report by Vanguard titled, "Understanding Alternative Investments: The Role of Commodities in a Portfolio":

• Commodity futures index returns may be broken down into collateral return (U.S. Treasury bills), spot return (the return from changes in commodity prices) and roll return (the return associated with rolling a futures contract forward). Over long periods, the spot return is on average not much higher than inflation, so the roll return is an important contributor to the equity-like returns achieved by some commodity investments. Unfortunately, there is evidence that the roll return is declining or even disappearing in markets where it traditionally has been strongest (such as energy futures markets). So, although a small allocation to commodities may provide some diversification benefits, we caution against making an allocation to commodity investments based on extrapolations of historical returns.
  

We'd also point out that management feeds are more considerable in most commodity index-tracking funds than in equity index funds.

(2) Regarding taxation, note that many commodity funds do not belong in taxable accounts. The problem is that an investor's short-term gains in commodity ETFs (Exchange Traded Funds) can be taxed at 40% and long-term gains can bet taxed at 60% because they use derivative contracts, although the law is not crystal clear gains according to the same SeekingAlpha summary and the prospectus of several commodity ETFs that I looked at. However, an investor's long-term gains in commodity ETNs (Exchange Traded Notes) are taxed at the long-term capital gains rate.

One of our posts yesterday, Allocation and Agriculture, explains why were favored Ag Commodity exposure rather than buying only a diversified commodity fund. Our preference constitutes an active management bet (and therefore more risk), but within a broader allocation framework that will plan to address during 2008.

Climate Change Adaptation -- Unheralded Super-Trend?

Investment dollars have flooded into technologies and areas that attempt to mitigate environmental damage and the impact of climate change -- cleaner sources of power, pollution control, resource-conserving technologies, resource-rich areas such as Brazil.

But a growing number of long-term strategists are starting to accept significant climate change as inevitable, and they may be at the leading edge of a crucial new investment trend that specifically invests in -- or directly hedges against -- the worst (call it "adaptation" for short) instead of working for a more sustainable future ("mitigation" of environmental damage).

For example, today I'm reading that the Center for a New American Security is leading a consortium to plan simulated war games in the event of climate change-driven disaster. (See a short blog post, linked here). The group also includes the Center for American Progress, the Heinrich Boell Foundation, the Power Center on Global Climate Change, the Rockefeller Brothers Fund, the Woods Hole Oceanographic Institution, and Brookings Global Economy and Development.

The group could be taking very seriously some scientists' predictions that large areas of land will be rendered uninhabitable by temperature change and flood, that large fertile areas could become infertile, that population migration and changing disease vectors could pose enormous new challenges, and that some nations may act militarily in their own interests rather than work within the international community. It's one thing to invest in Brazil because it has a lot of water and fertile land (I'd call this part of a "mitigation" investment strategy), but it's another thing to try to model a range of devastating potential outcomes from climate change in order to drive a portion of one's investment.

This latter type of speculation hopefully never occurs or is well beyond the time horizon of most investors, but some fairly dramatic changes are potentially within the time horizon of young home buyers choosing a location, insurance companies (particularly those that write or have stopped writing flood insurance in some areas), and pension funds. Looking shorter term, there is a small group of specialized consulting firms whose services might be in increasing demand. One that has turned up on many radar screens is Exponent, Inc. (EXPO).

Allocation and Agriculture

Our goal is to (1) asset-allocate optimally and (2) give the portfolio an extra push by focusing on major investment trends, particularly the "super-trends" aided by the world's recognition that the "externalities" are no longer external (see previous post, below).

One way to help accomplish both might be to invest further in the agriculture trend, via equities if investors are underweight equities generally, and via commodities (the foodstuffs themselves) if investors are underweight inflation-beneficiaries.

We're attracted to agriculture as a way to help accomplish one's asset-allocation goals because we believe agriculture is one of the "super-trends" for the 21st century: ag gives investors exposure to scarce resources that were until recently considered external, or near-costless -- arable land, fresh water, and a clean/disease-free environment. These scarce resources are becoming expensive and thus raising the cost of producing food, and ultimately food prices.

(We acknowledge risks of incorporating a major trend -- even one as broad as agriculture -- into one's asset allocation. (1) A single class of commodities will be more volatile and have more ultimate downside risk than the broadest inflation hedge -- TIPS -- and also will not directly protect an investor's purchasing power beyond potentially his purchasing power of food. Any historical returns and correlation work I have seen regarding commodities refers to the broadest commodity indices, not a single commodity group. (2) A single sub-industry within equities can face high correlation with the overall equity market and more volatility. Therefore, we'd typically invest in major trends as relatively small supplement to an investor's core asset allocation.)

We like to think of investing in a super-trend in two ways:
(1) invest in the scarce goods themselves; in this case, the agricultural commodities, and
(2) invest in the companies benefiting most from the world's need for more of those scarce goods; in this case, we'd highlight the crop yield-enhancing biotech companies.
The dual investment approach makes sense to us. An investment in only #1, commodities, is a bet that human ingenuity won't solve the nature's scarcity and thus won't cause prices of commodities to fall. We hate to bet against billions of dollars of research and many thousands of the world's top scientists. At the same time, an investment in only #2, crop yield-enhancing companies, is a bet that competition among companies will remain subdued enough to permit continuing high profitability for the companies. We want overall exposure to the super-trend, rather than a bet on nature versus technology. Also, an investment in both lets us keep score between nature's constraints on crop supply and technology's efforts to increase crop supply, a rivalry that will determine the performance of the overall investment trend.

Why invest long-term in agriculture commodities and equities in the first place? Some of the arguments are becoming well-known, and some may not be fully appreciated yet by investors: (1) Developing market demographic shifts and wealth accumulation that are causing more consumption of meat, which is up to ten times more land-intensive than consuming grain, (2) The global shift to Biofuels, (3) Global warming and weather volatility trends that are making production of food less dependable, (4) Less available fresh water in the form of predictable snowpack/rainfalls, and falling water tables, (5) Land degradation due to soil erosion connected to over-use, salination, deforestation and other factors, (6) Pollution, invasive species, new crop disease vectors and other factors, (7) Higher production and transportation costs owing to fuel costs, and (8) The lack of recognition of agriculture as an asset class until, in a very limited sense, the last year or so. We see this as potentially similar to how the institutional investment community viewed oil in 2003.

What are the long-term risks of investing in agriculture commodities and equities, generally? (1) Rapid mitigation of trends sited above, such as global warming, soil degradation, water scarcity, the biofuels trend, etc (which we view as unlikely), (2) A rapid conquest of technology over natural constraints in high-production areas that results in declining ag commodity prices, or at least higher penetration rates of ag biotech that effectively slows the growth rate for these companies and increases price competition among them. (We think this would take years to occur, and faces a moving target of changing conditions), (3) A rapid application of new production techniques in current low-production areas. (We think most of that production would feed rising local populations rather than supply the world market.) (4) Rapid increases of new acreage (which is difficult and expensive owing to required infrastructure developments), (5) A rapid movement to free trade (but there is a countervailing trend to increase trade barriers instead to shield domestic farmers), (6) A global recession and high demand elasticity (which could be a shorter-term issue rather than a long-term mitigation). Also recall that many of the risks are mitigated by owning not only the commodities but also the companies that would be responsible for raising output.

Securities - A VERY Brief Look

In commodities, numerous ETFs and ETNs (strongly prefer ETNs in taxable accounts) track futures values for a wide variety of contracts. A commonly-cited ETF is Powershares DB Agriculture ETF (ticker: DBA), which tracks the corn, soybean, wheat and sugar futures. A popularly-cited ETN is the iPath Dow Jones AIG-Agriculture ETN (JJA).

In equities, there are many ways to invest in agriculture, ranging from fertilizer companies to ag equipment makers. We're most interested in ag-biotech companies because of their ability to raise the barriers-to-entry by adding more and more biotech traits within seeds.

Among the ag-biotech companies, Monsanto (MON) and Syngenta (SYT) are two of the leaders with high exposure. Their largest U.S. and European competitors include Dow (DOW) AgroSciences, BASF (BASFY) Crop Protection, Bayer (BAYRY) CropScience, and DuPont (DD) Agriculture.

Monsanto filings acknowledge the likely long-term competition from Chinese and Indian ag-biotech efforts in particular. For example, a quick review of China's efforts in the area reveals billions of dollars of research efforts to build an industry in the past decade, nearly all government funded, with some movement toward private companies in the past few years. Origin Agritech Limited (SEED) is a NASDAQ-listed Chinese company, and YaSheng Group trades in pink sheets as YHGG. Agria (GRO), based in China, is partly an ag-biotech company. Taiwan is also becoming a large player biotech generally, with an ag-biotech subindustry.

Framing an Investment Super-trend of the 21st Century

The world has crossed a threshold in the economic boom of the last five years: "externalities" are no longer external.

Global resource depletion -- oil, water, clean air, the ozone layer, arable land -- has become so pronounced that governments are now realizing that these things we consumed indiscriminately (because of seemingly infinite supply), are no longer free.

The world is increasingly paying the price for treating these resources as largely "external" to us, and that price is scarcity. (See today's WSJ for some recent musings.)

The world's reaction to scarcity of these precious resources is now creating tremendous investment payoffs and losses, and will continue to do so for decades. Suddenly a vast portion of the globe that we thought was near-free will have more definite prices, and rising prices. The race to be in these businesses, to broker between these businesses, and to avoid the impact of the new prices will be the fastest, largest race ever run -- and one with the most consequences too. For the investment implications are only one large part of the story; the other is the implication for sustainable life on earth.

This is not to say that human civilization has reached its Malthusian limits. Each time the world has seemed to hit its limits in the past, economic and/or population growth slowed, and innovation helped civilization move through its apparent bottleneck.

Often this de-bottlenecking took decades, even centuries. And now there are two new dimensions to the scarcity issue that have never existed before in human history. First, we're coping with a single environment; for example, emissions in one part of the world are a cost borne by most other parts of the world (via toxicity now and rising oceans over time). Second, wars of conquest will probably not expand the resource base for any one entity, but will probably contract economic opportunities for everybody, as a result of tightly interconnected finance and trade. These two factors leave little option but to deal with the core issue, which is to move closer to market pricing for the previously-external goods. As a result, this is the investment "super-trend" that we expect will consume the majority of our attention in the future.

For Country Allocation, Focus on Financial Reform (and Deform)

A new study referenced by Voxeu.org concludes:

• Not only does financial reform matter, it is the most important reform a country can pursue in order to influence the decisions of foreign investors.

After a powerful bull run in emerging markets, it will become more crucial to take into consideration which countries continue to adopt financial reform, rather than suffer the "reform fatigue" which often plays a role in ending bull markets.

More from the research abstract:

• What are the main determinants of the geographical distribution of foreign direct investment (FDI) across emerging economies in the two regions [Latin America and transition economies in Eastern Europe]? First there are classical sources of comparative advantages such as market size, the level of economic development, infrastructure, natural resource abundance, and macroeconomic stability. Second, there are institutional quality of the host countries such as rule of law, quality of bureaucracy, and executive constraints. Third, we argue in our research, the host government's structural reforms may play a crucial role in attracting foreign investment - we focus on financial sector reforms, trade reforms, and privatization efforts.
• Using the newly constructed data panel [see link above], we estimate the effects of structural reforms on FDI inflows along with other standard determinants. We find that, in addition to the classical sources of comparative advantages, structural reforms in the financial sector and privatisation are particularly important for FDI in emerging markets. The former is significant after controlling for institutional differences across countries (i.e. rule of law, quality of bureaucracy, executive constraints). We also examine various policies in financial sector reforms to see which policy is more important to foreign investment decisions. In particular, we find that reform policies to strengthen banking sector supervision, to reduce credit ceilings for banks, and to liberalize securities markets have a positive impact on FDI inflows. By the same token, privatisation efforts measured as governments' proceeds from privatisation also give an impetus to FDI inflows. Finally, we find that trde liberalization raised the ability to attract FDI in Latin American countries, not in [Eastern Europe]
• The fact that financial reforms have a stronger effect on FDI than privatisation and trade liberalisation suggests that foreign investors highly value a host country's financial system that is able to allocate capital efficiently, monitor firms, ameliorate, diversify and share risk, and ultimately mobilize savings. Financial reform is arguably a pre-condition for the maximisation of the benefits of spillovers to foreign investors via backward linkages as an efficient domestic financial system greatly facilitates the establishment and gorwth of domestic suppliers of the foreign firms.....

There's also a perverse implication for Developed Markets. If more financial reform is crucial to foreign investors in Developing Markets, then increasing financial DEFORM, as is being exposed now in the U.S. in particular, will continue to lead to selling by foreign investors. (We continue to believe we're only in "the beginning of the middle" of the financial crisis, because (1) the transition of bad assets to better balance sheets has only just begun -- accumulated leverage mountains and liability holes are enormous, as is the systemic risk, (2) the Fed and U.S. government are somewhat restricted in their rescue efforts by the failing dollar, (3) the crisis hasn't even yet caused areas of financial crisis in developing markets.)

Still "The Beginning of the Middle" (of the Bear Trend)

We've written several times about the stages of a bear and bull market.

Here is another simple way to look at it, highlighted in the WSJ's Deal Journal. From Howard Marks's memo to his Oaktree investors:

• I've formulated...the three stages of a bear market: (1) when just a few prudent investors recognize that, despite the prevailing bullishness, things won't be that rosy, (2) when most investors recognize things are deteriorating, and (3) when everyone's convinced things can only get worse. Certainly we're well into the second of these three stages.

But the key is to add to equity allocations well into the third of these stages.

More Signs We're Still Deep in the Woods

Our posts for the past week argue that until some of the Developing Markets experience financial crisis, global equity markets can't begin another bull run. It will be the last shoe to drop; we're waiting for it.

China is the most important to watch. It's a very immature market economy, where the global financial crisis will expose major cracks. It's battle with inflation needs to end in tears before we'll be ready to significantly boost our equity allocation.

An indication of weakness is the Chinese government's continuing blatant efforts to manipulate the stock market. It's a sign of serious weakness and the government's worry. On Thursday, China suspended tax collection on mutual fund shares to bolster share prices. Retail "investors" in China borrow amid near-zero real interest rates and speculate in the stock market. Down 40% from its peak (down merely to October '07 levels), the market could drain savings and cause serious financial and social dislocation. Yves Smith summarizes it well, as usual.

Yet Another Damper on Commodity Prices (For Now)

Cold winter, better snowpack, more water for the crops in the Northern Hemisphere this spring. The winter weather recap was a conclusion published today by NOAA's National Climatic Data Center. Investors taking profits in commodities this week owing to economic concerns, now have another reason to take profits in a growing asset class -- agricultural commodities.

Our view continues to be it's NOT time to raise one's allocation in commodities, unless you're zero-weighted.

In the long-term, the literature we're reading leads us to believe that crop prices will trend higher. But now may not be the moment to raise the weighting significantly.

Power Stalemate -- And Prices to Keep Trending Higher

In a sign of the times (reported by Reuters today):

• In a big win for environmentalists, the Democratic governor of Kansas on Friday vetoed legislation that would have allowed a huge coal-fired power plant to expand in in the state and spew 11 million more tons of greenhouse gas emissions a year....Environmental groups hope Kansas will influence more states to reject new coal-fired power plants.... [The utility] said "If not resolved, this veto will unnecessarily raise electric rates...."

Alternative energy capacity isn't coming on fast enough to satisfy the concerns of people worried about the long-run impact of carbon emissions. That means -- at the very least -- higher power prices, and a continued investment boom in alternative energy. Economic growth rates will also continue to suffer.

It's no wonder that institutional asset allocators are getting some of their best returns from select projects in natural resources, rather than public equities generally. It's easy to imagine a further narrowing of equity sector outperformance in the years ahead.

Economy Still Choking on a Bone

Chinese Premier Wen Jiabao's comments today should tell investors that the U.S. equities rally this week was probably a fools rally.

We've been writing that ISI's Ed Hyman probably has it right when he says that oil prices have to pull back and general deflation discussions have to arise if today's economy is to follow the typical steps of past economic crises to recovery.

The commodities selloff this week was a good start, but just a small start. A deep wellspring of inflationary pressure still exists in China, as Premier Wen Jiabao stated today. According to the Wall Street Journal:

• "We will strive to maintain basic price stability," Mr. Wen told the cabinet, according to the government statement. "The crux is to use every possible means to increase market supplies and to grasp the organization and market regulation of such essentials as grain, oil, meat and vegetables." ... Mr. Wen acknowledged at a nationally televised news conference this week that China faces pressure for inflation to accelerate still further. But he tried to reassure an anxious Chinese public, saying the government can hold price rises to its 4.8% target this year.

Far easier said than done. China has tried to enforce price controls more strictly in recent months, but that only serves to restrict supply and keep demand artificially high (because demand isn't dampened by the higher prices that should be occurring, but aren't). Meanwhile, China "exports" higher prices to the U.S. by the mechanism of passing along their higher costs through the price of their goods, and by seeing their currency appreciate.

As long as there are few signs of China's inflation settling down, equity markets are very unlikely to re-enter a bull market.

What's more, the slowdown in the Chinese economy that's necessary to diminish inflation will expose a host of major problems that have been papered over by China's rapid growth, such as profit margins, bank loans and accounting issues that prove to be lower quality than thought. When these problems begin to be exposed at major Chinese companies previously held to be impervious to trouble, we will say the global crisis at "the end of the middle."

And when these kinds of problems -- once exposed -- within Developing Markets appear to be capable of causing a collapse of confidence, then we'll say the global credit & economic crisis are finally at "the beginning of the end," which is the big buying opportunity in equities we're waiting for, in order to take our equity allocation back up to our strategic target.

What Ignites a Boom?

Why should individual investors interested in long-term wealth accumulation wait for new asset classes to become large and obvious before apportioning their assets to them? By the time the idea was popularized in 2005-2006 that REITs, Energy and Emerging Markets were huge asset classes that required more than marginal exposure, it was nearly time to sell REITs, stop adding to Emerging Markets positions if you had a 1+ year time horizon, and hope you were smart enough to concentrate in Energy.

Now I'm seeing asset allocation recommendations out there for amping up to 15-20% weights in commodities, right when the global economy is slowing down. Many of the portfolio optimization tools I see available to individual investors rely on the past 3-5 years of data as primary inputs to produce an expected return....HARDLY a time horizon that affords anything more than cyclical speculation.

So, what are the seeds of a Major Investment Trend? What should an investor look for in attempting be early to allocate to that asset class, rather than pile on more than half-way through? We have a few basic ideas that will be obvious to many observers -- but most of us would have invested more aggressively if we'd fully considered the import of the changes at hand:

• New economic liberalization. For example, the economic liberalization in China under Deng Xiaoping in the mid-'90s, which continued after the emerging markets crisis in the late-'90s. These events in China stimulated the Emerging Markets boom. Investors looking for investment opportunities in a nation's changing competitiveness can start with this report by the World Economic Forum. They should also beware of "reform fatigue" which sets in after long bull-runs.
  
• New trade & integration agreements. China's very significant entry into the WTO. NAFTA. Many others, all early indicators of the Emerging Markets boom. (The pace of new trade treaties has clearly slowed, a concerning indicator).
  
• Tax code changes. For example, Bush's tax cuts generally, and dividend tax cut specifically, were very important seeds to the boom in all dividend-yielding investments, particularly REITs and Utilities. It took a while for the market to catch on because we were in the middle of a recession, so investors who thought of the idea didn't see "confirmation" right away. Another big example: The Taxpayer Relief Act of 1997 eased taxes on the sale of homes for millions of taxpayers. Thus, the homes became more valuable with the stroke of a pen, and this was a major contributor of the U.S. Housing Boom.
• Shocks. There's a long list of "shocks" of many kinds that have led to booms. For example: Military: the 9/11/01 attacks led to the re-militarization of the U.S. (a boon for military companies and the oil industry). Corporate: Royal Dutch/Shell's massive reserve writedowns disclosed on 1/9/04 showed the world had much less oil than thought (especially of one of the highest-regarded exploration teams had to take such a big writedown). Natural: Hurricane Katrina's impact on New Orleans did more than any other event to usher-in widespread acceptance of global warming and the need for new "green" technologies and infrastructure.
• Technological breakthroughs. The ability to map human genes, utilize stem cells, make solar power economical, carry data wirelessly....
  

More generally, how can investors improve their way of thinking in order to identify major trends EARLY? A superb and eloquent source of ideas is Kiril Sokoloff's (13D Research) "How We Think" statement, subtitled "How To Think Outside The Box." A few tidbits:

• "The Power of Contrary Thinking." "We tried to think of all the things that everyone knew was going to happen or knew for sure could never happen" (then consider the merits of the opposite thing happening). "Despite the passage of only a little more than six months, many of these certainties have been shown to be on very shaky ground" and the corresponding investments were beginning huge moves.
• "My Theory of Contagion." "Whenever I see a bull or bear market occurring in a country, or some unusual development, I watch closely for a contagion. Two or three confirmations is usually all I need. My theory is this: contagion will spread until proven otherwise."
• "My Theory on Anomalies." "I've found anomalies to be highly useful in getting at the truth."
• "My Theory of Investor Psychology." "A long time ago, I came to the conclusion that investors base their attitudes on their last traumatic experience. That says a lot about the past, but virtually nothing about the future. The more traumatic the losses, inevitably, the bigger the bull market in the aftermath." [I worked on a trading desk throughout the early-'00s bull market,when virtually every person I worked with was significantly underweight equities in his personal portfolio because they had been traumatized by the Internet bubble burst. This trauma-overhang extended the bull market longer than most people thought.]
• "How I Process Information." "The common theme among all of [the stock market gurus who have risen and fallen" is that their biases ended up destroying them....One of the reasons for George Soros' immense success is his recognition of his own fallibility, aand his willingness to change his opinions in a nanosecond."
• "My Theory on Change." "I am agnostic about change. Neither good nor bad -- it's simply inevitable, and if you fight it, you will be crushed. How do I recognize change? (A) An unsustainable rate of change always brings a major change in direction ..... (B) Unanimity of opinion signals a change in direction.... (C) Longevity of a trend signals a growing potential for a change in direction,....(D) Excesses and extremism almost always usher in change.... (E) Imagination helps you understand change....The answer is unknown, but it's only through imagination that you can escape the manacles of conventional thinking."
  

Equities: Will the Next 10 Years Be Any Better?

I'm still reviewing the asset allocations of a couple of the top-performing university endowments. Equities is the second-worst performing asset class, and Fixed Income is the worst performing asset class out of the six asset classes.

Here is how the Yale Endowment distinguishes asset classes, and how its benchmarks have done (roughly eyeballing Yale's charts) in the 10 years through 6/30/07: (1) Private Equity +21%/yr, (2) Real Assets (incl Commodities, other) +12%/yr, (3) Absolute Return +12%/yr, (4) Foreign Equity +10%/yr, (5) Domestic Equity +7.5%/yr, (6) Fixed Income +6%/yr.

Here is how Stanford's endowment distinguishes asset classes, and how its benchmarks have done in the 10 years through 6/30/07: (1) Private Equity +19.9%/yr, (2) Natural Resources +17.0%/yr, (3) Real Estate +15.5%/yr, (4) Absolute Return +9.3%/yr, (5) Public Equity +8.5%/yr, (6). Fixed Income +6.0%/yr.

It's probably no coincidence that the retail investing public's liquid assets are disproportionately concentrated in the two worst-performing asset classes. The most easily-accessed areas to invest often become the most overvalued, and contain the least inefficiency. Moreover, compensation to managers of public companies are coming under increased scrutiny by their broad public ownership base and by clumsy legislative oversight generally, so the top managers may have been migrating toward the higher rewards in the other asset classes, where the public-at-large is absent, and where institutional investors know how to align their interests with the highly incentive-driven interests of the managers.

But fast-forward a decade. Now that retail investors are gaining the tools to invest in Natural Resources and even some basic Absolute Return characteristics (via ETFs), and also Private Equity to a limited extent (via the public equities of private equity firms such as BX), and even to gradually liquidate their homes (via reverse-mortgages), I'm left wondering whether these asset classes' returns will significantly compress in the next 10 years.

What's a retail investor with a 10-year time-horizon to do now? It's easier to say what NOT to do: As we enter a period when global liquidity may continue to slow its growth rate, and even drain out, now is probably not the time to chase the highest-performing asset classes of the last 10 years, unless an investor begins with small allocations at current levels, and does intensive work to gain an "edge" in a certain asset class. And perhaps Public Equity and Fixed Income will present more compelling buying opportunities at certain points.

Or perhaps most interestingly, "new" asset classes will arise. For hints, we look back to our previous articles -- and to our future ones -- about major investment trends.

"Quality" to Outperform--Seven Year View

GMO is one of the world's most successful asset managers, and one of the most famous asset allocation practitioners. They take a very long-term view and buy undervalued asset classes and sell overvalued classes even if they know they could be a year or more before the market turns their way. GMO's strategy and execution has been excellent by any reasonable standards.

GMO's "Recent Market Commentary" page is a treasure trove. A major standout is the extent to which GMO thinks "Quality" U.S. stocks will significantly outperform the U.S. equity market overall, and small-caps in particular. Pull up "GMO 7-Year Asset Class Forecasts (Jan 2008)" to see this in color. GMO believes "U.S. High Quality" will return 5.7%/year in the next seven years, versus only 1.9% for U.S. large cap equities and 1.3% for U.S. small cap equities. Thus GMO is calling for a dramatic reversal of the small-cap outperformance we've seen in the bull market we are now exiting.

GMO's call is driven partly by their 2007 call -- now proving correct -- that the credit bubble has propped up lower-quality assets to unsustainable levels. They believe it will take until 2010 to unwind enough of the excesses to create a U.S. stock market bottom. Jeremy Grantham's 4Q07 investment letter explains this point in detail.

Grantham explains how he would implement his Quality strategy:

• If you can do it, hedging out 100% of these positions with, say, a short on the Russell 2000 or equivalent would be much, much safer and probably more profitable [than owning the U.S. equity market at large].
  

He also mentions the upside/downside to this strategy: "The bigger the fundamental problems [with the economy] the more quality stocks are likely to outperform. The more the economy manages to muddle through the better emerging markets [and I would surmise lower-quality stocks] are likely to do."

Yale and You

It's generally well-known -- and famous among asset allocators -- that Yale University's endowment has crushed the benchmarks in the past 22 years since David Swensen has been running it. Swensen is up 16.1% versus the S&P 500's 12.3% during the period, and he his volatility has been much lower.

First I'll transmit a few nuggets on how they do it (see the report), then I'll quote a terrific article by Geoff Considine on how individual investors might try to imitate.

• Read about how Swensen's team does it, here in the Yale Endowment 2007 report. Its 6/30/07 asset allocations were: 23.3% Absolute Return (vs 19.5% Educational Institution Mean), Domestic Equity 11.0% (vs 26.3% EIM), 4% Fixed Income (vs 12.7% EIM), 14.1% Foreign Equity (vs 22.1% EIM), 18.7% Private Equity (vs 7.0% EIM), 27.1% Real Assets (vs 10.1% EIM), and 1.9% cash (vs 2.3% EIM). A few nuggets from the report: In all its investing, Yale goes to great lengths to seek investments managers whose interests are aligned with their investors. Alpha comes largely from security selection. Intelligent diversification is crucial. Absolute Return: actively managed funds, half event-driven, half value-driven, involving hedges that make these funds essentially no correlation to domestic stock and bond markets. Domestic Equity: underweight because it's a highly efficient market, and hard to find what they're looking for: investment managers "with exceptional bottom-up fundamental research capabilities....with high integrity, sound investment philosophies, strong track records, superior organizations, and sustainable competitive advantages. Fixed Income: underweight because "they have the lowest historical and expected returns of the six asset classes that make up the Endowment." Foreign Equity: similar comment to Domestic Equity. Private Equity: overweight "stemming from the University's strong stable of value-added managers that exploit market inefficiencies (not ones that simply add financial leverage to their acquisitions). Real Assets: (Real estate, oil and gas, timberland) sensitivity to inflationary forces, high and visible cash flow, and opportunity to exploit market inefficiencies owing partly to Yale's long-term partnerships with managers.

Next, from Considine's article, on helping retail investors translate Yale's approach to their own portfolios. [Considine runs Quantext (portfolio management software, highlighted below), and his SeekingAlpha articles can be found here.]

• Swensen discusses what he thinks individual investors should be doing. notably, he does not suggest that retail investors take on non-equity assets like timber that have made Yale's performance so strong. Instead, he proposes a plain vanilla portfolio that did not look all that great to my eye (below)
• 

• ....When I ran this portfolio through our forward-looking portfolio management software, Quantext Portfolio Planner (QPP), the results were essentially what I expected. QPP projects that this portfolio will match the expected return of the S&P 500 on a going forward basis (8.2% per year) , with less risk (the projected standard deviation is 11.8% vs. 15% for the S&P 500). This is okay, but far from spectacular -- and, notably, far below the 1-to-1 ratio between expected return and standard deviation that Mr. Swensen is planning for with the Yale endowment.
• Mr. Swensen is famous for seeking out asset classes with low correlation to broad equity indices, such as a range of commodities, timberland and other real assets. Where are these in the retail portfolio? Mr. Swensen only has 12% of Yale's portfolio in domestic equities but he is proposing that retail investors put 30% of their assets in domestic equities. Whilte it is true that Mr. Swensen has access to private equity and other assets that the average retail investor cannot easily include in his/her portfolio, it is certainly possible to get a lot closer to the Yale model.
• To broadly replicate the kind of performance that Mr. Swensen has engineered for Yale in the retail portfolio, I replaced all the Vanguard funds with ETFs and then added commodities (via DJP), a timber REIT (PCL), a very large electrical utility (EXC) and a large oil company (COP). The idea here is to provide a significant exposure to commodities and real assets. I have also ditched the short-term bond fund. our New model portfolio looks like this:
  
• 

Here I'd note that substituting individual securities for asset classes significantly diminishes diversification, but I'll continue to quote Considine below because ETFs can be easily substituted for the individual companies he has chosen. Considine adds:

• Quantext Portfolio Planner projects that this portfolio has an expected return of 10.1% per year, with a standard deviation of 11.6% per year -- almost exactly what Mr. Swensen says that he has targeted for the Yale portfolio.

He concludes:

• Forward-looking models (like Quantext Portfolio Planner) are the standard of practice in institutional money management, and the technology is gradually making its presence known among retail investors and their advisors (as shown by the Stein-DeMuth book [called Yes, You Can Supercharge Your Portfolio]. What would your portfolio look like in one of these forward-looking models?