Asset Allocation Insights & Major Investment Trends

Where to Look for Sustainable-Environment Investments

2008-04-30T13:11:00.004-04:00

Focus on existing technologies entering the marketplace.....not brand new breakthrough technologies that could be years away from commercial deployment.

That's a crucial point that Joseph Romm made again this morning in his Climate Progress blog. Personal Investors who are holding out to invest in totally new technologies will miss the highest-return investment opportunities available to them -- existing in recently-commercialized technologies, as we've seen (for example) in the past couple of years with wind and solar power. Focus on existing technologies -- the ones that are being deployed commercially now or are about to be commercially deployed.

Romm writes:

A critical historical fact was explained by Royal Dutch/Shell, in their 2001 scenarios for how energy use is likely to evolve over the next five decades (even with a carbon constraint): "Typically it has taken 25 years after commercial introduction for a primary energy form to obtain a 1% share of the global market."

Note that this tiny toe-hold comes 25 yeas after commercial introduction. The first transition from scientific breakthrough to commercial introduction may itself take decades. We still haven't seen commercial introduction of a hydrogen fuel cell car and have barely seen any commercial fuel cells -- over 160 years after they were first invented.

This tells you two important things. First, new breakthrough energy technologies simply don't enter the market fast enough to have a big impact in the time frame we care about. We are trying to get 5% to 10% market shares -- or more -- of the global market for energy, which means massive deployment by 2050 (if not sooner).

Second, if you are in the kind of hurry we are in, then you are going to have to take unusual measures to deploy technologies far more aggressively than has ever occurred historically. That is, speeding up the deployment side is much more important than generating new technologies. Why? Virtually every supply technology in history has a steadily declining cost curve, whereby greater volume leads to lower cost in a predictable fashion because of economies of scale and the manufacturing learning curve.

We believe it has become much easier than Romm says to develop a totally new technology and bring it to market, but we strongly agree with his overall point. Leave the investing in totally new technologies to institutional investors such as venture capital firms to seed arrays of technologies in order to achieve one big hit that pays for all the misses. Individual investors don't have access to arrays of seed-capital opportunities, or the ability to fund the investments -- unless they're entrepreneurs founding one of those businesses.

Asset Allocation and Dumb American "Energy Policy"

2008-04-30T11:24:00.007-04:00

The bankruptcy of American "energy policy" supports two major facets of our asset allocation strategy: (1) underweight U.S. equities relative to global equities because of bad U.S. policy and other unprecedented problems for the nation, and (2) invest aggressively in companies working to solve the energy crisis, which will exist for even longer thanks to America's bankrupt "energy policy" (see our Environment link).

Today's column by Thomas Friedman in the New York Times explains perfectly the vacuity of "energy policy" debate in the U.S. It's appropriately titled "Dumb as We Wanna Be":

It is great to see that we finally have some national unity on energy policy. Unfortunately, the unifying idea is so ridiculous, so unworthy of the people aspiring to lead our nation, it takes your breath away. Hillary Clinton has decided to line up with John McCain in pushing to suspend the federal excise tax on gasoline, 18.4 cents a gallon, for this summer's travel season. This is not an energy policy. This is money laundering: we borrow money from China and ship it to Saudi Arabia and take a little cut for ourselves as it goes through our gas tanks. What a way to build our country

When the summer is over, we will have increased our debt to China, increased our transfer of wealth to Saudi Arabia and increased our contribution to global warming for our kids to inherit.

No, no no, we'll just get the money by taxing Big Oil, says Mrs. Clinton. Even if you could do that, what a terrible way to spend precious tax dollars -- burning it up on the way to the beach rather than on innovation?

The McCain-Clinton gas holiday proposal is a perfect example of what energy expert Peter Schwartz of Global Business Network describes as the true American energy policy today: "Maximize demand, minimize supply and buy the rest from the people who hate us the most." Good for Barack Obama for resisting this shameful pandering.

But here's what's scary: our problem is so much worse than you think. We have no energy strategy. If you are going to use tax policy to shape energy strategy then you want to raise taxes on the things you want to discourage -- gasoline consumption and gas-guzzling cars -- and you want to lower taxes on the things you want to encourage -- new, renewable energy technologies. We are doing just the opposite.

Are you sitting down?

Few Americans know it, but for almost a year now, Congress has been bickering over whether and how to renew the investment tax credit to stimulate investment in solar energy and the production tax credit to encourage investment in wind energy. The bickering has been so poisonous hat when Congress passed the 2007 energy bill last December, it failed to extend any stimulus for wind and solar energy production. Oil and as kept all their credits, but those for wind and solar have been left to expire this December. I am not making this up. At a time when we should be throwing everything into clean power innovation, we are squabbling over pennies.

These credits are critical because they ensure that if oil prices slip back down again -- which often happens -- investments in wind and solar would still be profitable. That's how you launch a new energy technology and help it achieve scale, so it can compete without subsidies.

The Democrats wanted the wind and solar credits to be paid for by taking away tax credits from the oil industry. President Bush said he would veto that. Neither side would back down, and Mr. Bush -- showing not one iota of leadership -- refused to get all the adults together in a room and work out a compromise. Stalemate. Meanwhile, Germany has a 20-year solar incentive program; Japan 12 years. Ours, at best, run two years.

"It's a disaster," says Michael Polsky, founder of Invenergy, one of the biggest wind-power developers in America. "Wind is a very capital-intensive industry, and financial institutions are not ready to take 'Congressional risk.' They say if you don't get the [production tax credit] we will not lend you the money to buy more turbines and build projects."

It is also alarming, says Rhone Resch, the president of the Solar Energy Industries Association, that the U.S. has reached a point "where the priorities of Congress could become so distorted by politics" that it would turn its back on the next great global industry -- clean power-- "but that's exactly what's happening." If the wind and solar credits expire, says Resch, the impact in 2009 would be more than 100,000 jobs either lost or not created in these industries, and $20 billion worth of investments that won't be made [and another generation of debt-dependent energy import-dependence---this time dependent on imports of wind and solar instead of oil]

While all the presidential candidates were railing about lost manufacturing jobs in Ohio, no one noticed that America's premier solar company, First Solar, from Toledo, Ohio, was opening its newest factory in the former East German -- 540 high-paying engineering jobs -- because Germany had created a booming solar market and America has not.

In 1997, said Resch, America was the leader in solar energy technology, with 40% of global solar production. "Last year, we were less than 8%, and even most of that was manufacturing for overseas markets."

The McCain-Clinton proposal is a reminder to me that the biggest energy crisis we have in our country today is the energy to be serious -- the energy to do big things in a sustained, focused and intelligent way. We are in the midst of a national political brownout.

Now, "The End of the Middle" of the Financial Crisis

2008-04-29T17:01:00.003-04:00

We've gradually crept back into equities in the past month as we've blogged that the financial crisis has moved from "the beginning" to "the beginning of the middle." We now think a new milestone has been reached: we've progressed to "the end of the middle." (We're just one-step closer to the ultimate buy-signal, "the beginning of the end.")

So, what's changed? There are now many more reasons for the Fed to diminish the pace of its rate cutting, the most important of which is that the financial crisis appears to be easing by many indicators. Furthermore, the main global disaster scenario is premised on a U.S. dollar that weakens to oblivion -- If the Fed is able to diminish its rate-cutting pace, the dollar will find a fresh source of support to reduce the chances of a dollar melt-down. All of this could well combine to moderate commodity prices for a while, and that would be a crucial element in a more stable macro-economic outlook -- a necessary condition for restoring more of a balance that most securities markets will find bullish.

In other words, we continue to "muddle through" the financial crisis, which is the bullish scenario for equities. We still face a potentially uncomfortable global economic slowdown that will raise additional risks, such as that of a Developing Market crisis in some areas. That, in our view, would signal the real "beginning of the end" of the crisis, and a very good buying opportunity in equities.

The following Bloomberg article summarizes why we believe the financial crisis has taken a step toward ultimate resolution:

Commodities Tumble Most in Five Weeks After Dollar Rebounds, by Ron Day
April 29 (Bloomberg) -- Commodities fell the most in five weeks as a rally by the dollar eroded demand for energy, metals, crops and livestock as alternative investments.

The weighted UBS Bloomberg Constant Maturity Commodity Index fell 1.9 percent to 1,508.21 at 4:11 p.m. New York time, the biggest drop since March 19. Wheat prices tumbled to a five- month low, crude oil slid more than $3 a barrel and silver dropped almost 3 percent.

The dollar was poised for the first monthly advance against the euro this year on speculation the Federal Reserve will signal that it has finished lowering U.S. interest rates after six reductions since September. A week ago, the dollar plunged to a record against the euro, boosting demand for raw materials as a hedge against inflation.

``This may be a major change in perception about the dollar,'' said Dale Durchholz, a market analyst for AgriVisor Services Inc. in Bloomington, Illinois. ``The run-up in commodities prices has been tied to a weakening, and now it appears it may be reaching a bottom.''

The UBS Bloomberg index has dropped 4.2 percent from a record 1,573.84 on Feb. 29. Before today, the gauge climbed 20 percent this year, while the Standard & Poor's 500 Index declined 4.9 percent and the dollar slid 5.5 percent against a weighted basket of the euro, yen, pound and three other major currencies.

Futures on the Chicago Board of Trade show an 82 percent chance the Fed will cut the target rate for overnight lending by a quarter-percentage point to 2 percent tomorrow and odds of 71 percent that the rate will be held at that level in June.

`Take Money Out'

Fed Chairman Ben S. Bernanke is persuading investors that the financial markets are working again, some analysts said.

The S&P 500 Index has rallied since the central bank backed the purchase of Bear Stearns Cos. on March 16. Companies sold $45.3 billion of debt last week, the most ever. High-yield bonds are poised for their best month in five years, and mortgage securities are outperforming Treasuries for the first time in 2008.

``Commodities have been the darlings of the investment space recently,'' said Eric Wittenauer, an energy and metals analyst at Wachovia Securities in St. Louis. ``Some investors may be looking at these developments as a sign to take money out of commodity markets.''

Oil, gold, copper and tin have climbed to records this year as demand outpaced supplies. Rice, corn, soybean and wheat prices have also jumped to records, partly because of adverse weather and soaring consumption in Asia. Suring food costs have sparked protests and riots in countries including Haiti, Indonesia, Mexico and Egypt.

`Fundamental Imbalance'

``The rising dollar won't change the fundamental imbalances driving commodity prices, but it may slow the climb as commodities traded in dollars become more expensive internationally,'' Matt Sena, co-manager of New York-based Castlestone Management LLC's Aliquot Commodity Fund, which oversees $900 billion in assets, said in an e-mail.

Crude-oil futures for June delivery dropped $3.14, or 2.6 percent, to $115.61 a barrel the New York Mercantile Exchange. Yesterday, the price surged to a record $119.93. Natural gas tumbled 3.9 percent, and gasoline declined 3 percent.

Wheat futures for July delivery fell 32.5 cents, or 3.9 percent, to $8.085 a bushel on the Chicago Board of Trade. Earlier, the price touched $8.0175, the lowest for a most-active contract since Nov. 21. Corn and soybeans also dropped.

Silver futures for July delivery declined 48.3 cents, or 2.8 percent, to $16.64 an ounce on the Comex division of the Nymex. Gold, which often moves in the opposite direction of the dollar, fell 2 percent to $876.80.

Climate Change Adaptation - A Growing Key to Personal Asset Allocation

2008-04-29T12:16:00.005-04:00

Some of our equity allocation is composed of companies whose technologies mitigate the effects of climate change -- clean energy companies, high-tech waste management, efficiency tools, etc. Our approach encompasses the widely held view that if capitalists do their job and if governments regulate more aggressively, the worst climate effects can be avoided.

However, we think investors would be foolish to ignore a uncommon, but growing, view that we must invest not only in mitigating the effects of climate change, but also adapting to the increasingly-likely scenario of unstoppable climate-induced devastation.

We broached the topic in our 3/26/08 post:

[More people are] taking very me 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, and pension funds.

We're seeing an increase in "past the tipping point" arguments, including a few more today after the latest atmospheric C02 report. This one on Celcias.com:

Worldwide, carbon dioxide (CO2) levels have risen again, according to the National Oceanic and Atmospheric Administration (NOAA).

The rise, a disturbing 2.6 parts per million over 2006 levels, is attributed primarily to the burning of fossil fuels. However, another factor, which may present its own tipping point, is global warming’s effect on forests.

When the earth warms, several things happen to forests. Boreal forests are displaced farther north, and the timberline (the altitude beyond which trees can’t grow) rises. Where warming is precipitous, forests fail to adapt and die, or are ravaged by pests which thrive in the absence of annual freezing. U.S. government reports indicate that temperate forests (maple-beech-birch) will shift north into Canada by the late 21st Century

Forests act as carbon sinks, or storage depots. When trees grow, they store CO2 in a complex process that uses sunlight (photosynthesis) to convert CO2 and water into carbohydrates (food) and oxygen. When trees die, the process is reversed. All plants do this, but trees – with their longer life spans and greater mass – do it on a more significant, and more observable, level.

Forest destruction is now happening all over Canada, as pine beetles destroy more than 50,000 square miles of forest, releasing an estimated 270 megatons of CO2 over the next 14 years. This represents the same amount that would potentially be reduced under the Kyoto Protocol, leaving a net gain to the environment of zero, at least on Canada’s part.

The same infestations are being seen in the U.S. Northeast and Upper Midwest, with equally disastrous effects. In the West, entire stands of trees, weakened by drought (a regional side effect of global warming), have succumbed to pests, leaving the “stick-forests” of nightmares. From Washington to central Oregon, forests are dying from the top as trees turn an appalling shade of rust. In Japan, as recently as 2006, foresters were being encouraged to cull dead trees resulting from global warming (this in a country not known for its vast forests).

In addition to rising CO2, the NOAA reports a substantial rise in methane over the last decade. Methane escapes when Arctic permafrost melts. Although the NOAA admitted it was too soon to tell if the current methane increase signals rapid Arctic thawing, the evidence – flooded Alaskan villages suing energy companies, and images of polar bears stranded on ice floes – speaks for itself. Scientists know that, if the Arctic permafrost thaws, catastrophic amounts of methane will be released, as they were in Western Siberia in 2006.

When methane gets into the atmosphere, it increases the rate of global warming in a vicious cycle known as a “positive feedback loop”. According to Chris Field, the director of global ecology at the Carnegie Institution of Washington, this is an ominous development, because these warming mechanisms tend to be self-perpetuating.

Sergei Kirpotin of Tomsk State University in Western Siberia notes that melting permafrost is an “ecological landslide” which is likely irreversible, and Larry Smith from UCLA estimates that the westernmost portion of the Siberian bog alone contains about 77 billion tons of methane, or one quarter of all the methane stored in landmasses worldwide.

As forests die, releasing CO2, and permafrost melts, delivering methane, the earth – caught in this self-perpetuating loop – reaches a tipping point; a day and time beyond which it is no longer possible to restore the balance. This writer suspects we have already passed that point of no return. The results will be catastrophic climate change, increasing extinction of animal and beneficial insect species, crop failures, mass starvation and death from disease, all because we had to have SUVs and cities so bright they are visible from space.

Allocation and Africa -- II

2008-04-29T11:12:00.002-04:00

We continue to think "Frontier Markets" -- and African markets particularly -- will rise toward the status of an asset class for many investors. This stems from (1) low portfolio-correlation of many African stock markets owing to highly country-specific developments, and (2) the world's race for resources that is increasingly investing in African nations. We highlighted these trends here and primarily here.

A Bloomberg article today highlights the additional drive toward #2, investment in Africa. (It's also suggested in the article that China's model of investment, which does not concern itself with human rights, may still do more good than harm. It this standard continues to be adopted, it could clear-away a major hurdle to African economic that was not possible when America's liberal values predominated in previous decades.)

From Bloomberg: (China Fund May Pledge $1 Billion in African Investment in '08)

A Chinese fund set up to encourage investment in Africa may commit to spend $1 billion by the end of the year, Liliang Teng, president of the China-Africa Development Fund said today.
The fund is in discussions with Chinese companies on projects to improve energy infrastructure in South Africa, Mozambique, Zimbabwe and eastern Africa, Teng said in interview at a business forum in Tanzania's northern city of Arusha.

``Besides energy and power plants we will also focus on infrastructure, like rail, roads and airports as well as other areas, including agriculture and manufacturing,'' he said.

The China-Africa Development Fund, announced by Chinese President Hu Jintao in November 2006, will grow to $5 billion and may become bigger depending on its initial results, said Teng. Financed by the China Development Bank, it approved the first investments with four Chinese companies totaling $90 million on Jan. 15, according to a press release on its Web site.

Sino-Steel Group, the China Building Material Co., Shenzhen Energy Group Co., and the CGC Overseas Construction Ltd. will use the money to develop electricity, construction, and mining projects in Africa, the statement said, without elaborating.

China's trade with African nations will rise to $100 billion by 2010 from $73 billion last year and $2 billion in 1999, Khalid Malik, the United Nations resident coordinator in China, said at the opening of the China Africa Business Forum in Arusha today. The two-day summit is bringing together 300 trade officials and businesspeople.

Critics say China's push into Africa for oil and raw materials to feed its growing economy in some cases disregards environmental laws, labor standards and human rights.

Economist Jeffrey Sachs, the UN's special envoy on the Millennium Development Goals, said the positive impact of Chinese investment and skills transfer to Africa far outweigh the negatives.

``What is being promoted is a great increase in business development,'' Sachs said in a taped address.

To contact the reporter on this story: Sarah McGregor in Dar es Salaam via Johannesburg at 1933 or abolleurs@bloomberg.net

A Long Retreat from U.S. Equities is Continuing

2008-04-28T16:55:00.005-04:00

In the last 25 years, Americans have steadfastly increased their exposure the U.S. equities, as the mutual fund industry matured and the cost of investing directly into stocks dropped. In 1980, only 6% of households held mutual funds, rising to 25% in 1990 to about 50% today. And far more people trade individual equities now than in the early-1980s.

That's the type of accumulation of an asset class that limits future returns, because there's less "money on the sidelines" available to drive demand for equities much beyond supply.

This trends are reflected in the following long-term P/E chart (below), which, toward the far right, shows valuations rising sharply from 1981 through 2001 (as investors raised their exposure to the asset class), and then retreating somewhat since then, and still not near a classic bear-market bottom by any means:

For a decade already, many of the world's savviest and nimble investors have owned far less U.S. equities as a percentage of total assets than the typical recommendation of 40-80% advocated for Americans saving for retirement, as referenced here for example. Lately, more of the largest and slower-moving institutional investors are shifting away from U.S. equities, as covered by Pension Risk Matters:

[D]efined benefit plans are moving assets away from equity to alternatives and fixed income. In "CalPERS to shift $44 billion" (December 24, 2007), Pensions & Investments reporter Raquel Pichardo describes the giant retirement plan's move into international equity, real estate, private equity and a "new inflation-linked asset class." On April 17, 2008, New York Times reporter Mary Williams Walsh offers insight into what some of American's biggest plan sponsors are doing to manage market volatility. Referring to a new study by Evaluation Associates in "Market Turmoil Has Taken a Toll on Big Pension Funds," Walsh writes that General Motors, Ford, Boeing and Deere are a few of the large plans to turn from equities.

Retail investors, usually the last to move en masse, have also begun (but only just begun in the past year or two) to diversify away from U.S. equities, according to the latest fund flow data, and judging from the amount of money being injected into global, commodity and other new ETF varieties.

This process could have a ways to go before U.S. equities bottom, from a long-term perspective. Barclays Treasurer John Porter, being interviewed in Inside the House of Money, says:

From a financial markets point of view, we're in a range type of stock market with a downward bias. People will become quite disillusioned with the financial markets. At some point, people are going to look to other things, like public service, the Peace Corps, or that type of thing, as opposed to getting an MBA or going into investment banking. These things tend to go in waves."

The process of moving toward this notion of a market bottom sounds painful for portfolios. But economic and financial dynamism will prevent a washout. In other words, we think investors will still make money in U.S. equity indices in the next five (+) years, but the trends we discuss above -- and other risks we discuss in previous posts -- will probably keep U.S. index returns in the low-single-digits.

We're overweight cash now, and gradually adding funds to a broad array of asset classes when each of them dips. In the last two months, we've added a bit to Developed Europe equities, Emerging Markets equities, Frontier Markets equities, municipal bonds, and environmental trend-driven equities (rather than high-yielding "real assets," as of yet). We're watching for entry points in Real Estate, U.S. Treasuries and TIPS (Treasury Inflation Protection Securities), and we're hunting for a top-performing and uncorrelated market-neutral equity fund and private equity fund.

"$200 Oil." For Real?

2008-04-28T16:31:00.004-04:00

On the surface, it would appear that global stagflation arguments are strengthening. On top of recent supply warnings from Russia, Saudi Arabia, Nigeria and others, the FT reports:

Opec’s president warned on Monday that oil prices could hit $200 a barrel and there would be little the cartel could do to help.
The comments made by Chakib Khelil, Algeria’s energy minister, came as oil prices hit a historic peak close to $120 a barrel, putting further pressure on global economies.
His remarks suggest Algeria wants Opec to continue to resist calls by US and European leaders for the cartel to pump more oil to help ease prices. But Mr Khelil blamed record oil prices on the weak dollar and global political insecurity.
He told El Moudjahid, Algeria’s government newspaper: “I don’t think that an increase in production would help lower prices, because there is a balance between supply and demand, and the stocks of gasoline in the United States have recorded a surplus and are at their highest level for five years.”

Economies are slowing almost everywhere around the world, yet energy commodity prices continue to rise due to limited production, political problems, the weak dollar, monetary growth in Developing Markets, the increasing role of oil as a "store of value" for investors, and an astonishing lack of new conservation initiatives.

The pressure of higher oil prices will continue to slow the global economy until economic demand softens enough to cause investors to temper their long-run forecasts for the price of oil (because it's the long-run forecasts that are driving oil prices now). We think this time is near, so we haven't gone overweight oil or any other economic-growth-sensitive asset classes such as equities, commodities generally, or real estate. When we have increased weightings, it has been mainly to gain a foothold in the solutions to high commodity prices, such as the tech-driven companies that are energy & agricultural efficiency plays.

Now the big question -- Does a "$200 oil" comment by an Opec president signal a "top" in the oil price trend? We think, "quite possibly." It's doubtful whether any leading Opec figure has suggested that a 67% rise in oil prices is possible. Often, big "stretch" projections such as these, as underlying demand is slowing, signal a bull-market top. And perhaps the Opec president is posturing for the Fed to stop cutting rates, which is fueling the price of oil to the detriment of oil buyers and fueling inflation (slashing purchasing power) in the many Mideast nations whose currencies are pegged to the dollar. The latter trend could undermine social stability in Mideast nations.

So, on the surface, the "$200 oil" comment appears to contradict our caution on commodities, in reality the lofty claim could support our caution.

Underlying Risks to China (and its Trading Partners) Still Growing

2008-04-28T15:47:00.007-04:00

We've been arguing that (1) the Developing Markets' "inflation beast keeps growling" (click and scroll down) due to structural problems such as oil prices and governments' trade and regulatory policies, (2) Chinese equities' still have an adverse risk/reward ratio, and that (3) we probably won't go overweight equities until we see contagion from the U.S. & European financial crisis result in real crisis in some of the Developing Markets (noted throughout this section).

A post from Michael Pettis in "China Financial Markets" supports our overall caution quite strongly. He continues to see the Chinese yuan on a freight train higher (which will increasingly destabilize global inflation, trade, and demand trends) -- and he sees decreasing chances of anyone stopping it. The consequence of a painful revaluation of the yuan would be another major "leg" to the global financial/economic contagion:

Speaking about exports, I am increasingly concerned that the trade surplus in China is actually beginning to decline, and much faster than people think. My reasoning is simple and completely intuitive – i.e. there is not a shred of hard evidence to back it up – but I nonetheless think it highly plausible. I contributed the following (somewhat edited) comment to today’s discussion on Chinese reserves on Brad Setser’s blog (http://www.rgemonitor.com/blog/setser):

“Given the rapid increase in various proxies for hot money inflow, it is probably pretty safe to assume that hot money disguised as FDI [foreign direct investment] and/or trade is also growing quickly. Certainly the nearly 70% growth in FDI during the first quarter suggests that there has been an increase in speculative inflows disguised as FDI. After all there was no very good fundamental reason for this growth – in fact it is not hard to argue that FDI in China is less, not more attractive today than in the past few years. If this is true and a big chunk of FDI is simply hot money, it is probably also plausible to argue that hot money disguised as trade has also increased significantly.”

“From that it follows that export growth and the trade surplus have probably declined much faster than the small decline in headline numbers suggest. If true, this complicates matters. Thanks to deteriorating global conditions China may actually already be running a narrow trade surplus or even a small trade deficit, which could make the authorities all the more afraid of a maxi-revaluation [a deliberate, sharp strengthening of the Chinese currency, to ward of speculation/"hot money" that it will continue to rise], and yet for the reasons we have been discussing over the past fifteen months the maxi-revaluation is probably inevitable because of the crazy monetary consequences of hot money inflow. The cost of a maxi-revaluation may be rising even as the cost of steady appreciation is. The longer they wait the worse the options become.”

In other words, if we are starting to see Chinese monetary growth powered exclusively by hot money inflows, instead of by the trade surplus as it was in the past, we are entering into a far more volatile stage of the game, where the consequence of a policy misjudgment may be higher than it has been in the past because the outcome is likely to be much more heavily determined by very volatile and hard-to-control and hard-to-judge hot money flows. The risk associated with an adjustment is rising, in other words, even as the cost of not adjusting is too. I worry that another quarter or two of $200 billion plus increases in reserves is going to make the adjustment process for China much more difficult. It is increasingly important that the recession in Europe and the US be as brief as possible if China is going to have room to adjust. If we see additional weakness in the global environment, I think China’s room for maneuvering declines substantially.

Stepping Back: The Ultimate Wealth-Building Counsel

2008-04-26T10:43:00.004-04:00

From The Autobiography of Benjamin Franklin (Chapter 8):

1. Temperance.

Eat not to dullness; drink not to elevation.

2. Silence.

Speak not but what may benefit others or yourself; avoid trifling conversation.

3. Order.

Let all your things have their places; let each part of your business have its time.

4. Resolution.

Resolve to perform what you ought; perform without fail what you resolve.

5. Frugality.

Make no expense but to do good to others or yourself; i.e., waste nothing.

6. Industry.

Lose no time; be always employ'd in something useful; cut off all unnecessary actions.

7. Sincerity.

Use no hurtful deceit; think innocently and justly; and, if you speak, speak accordingly.

8. Justice.

Wrong none by doing injuries, or omitting the benefits that are your duty.

9. Moderation.

Avoid extremes; forbear resenting injuries so much as you think they deserve.

10. Cleanliness.

Tolerate no uncleanliness in body, cloaths, or habitation.

11. Tranquility.

Be not disturbed at trifles, or at accidents common or unavoidable.

12. Chastity.

Rarely use venery but for health or offspring, never to dullness, weakness, or the injury of your own or another's peace or reputation.

13. Humility

Imitate Jesus and Socrates.

From Common Sense to Wealth

2008-04-26T08:34:00.003-04:00

Money saving strategies can be highly potent wealth drivers.

For example, our blog posts have highlighted this in terms of buying index funds rather than managed funds because the annual fee differentials can halve an investor's lifetime wealth accumulation.

On the topic of saving, we also recall that Warren Buffett once said he thinks about spending money: Before buying something -- any frivolous item or depreciating good -- he thinks about his foregone interest accumulation as a result of spending the money. Instead of buying a $10,000 watch, he's recall that investing the money in stocks would normally allow him to clip annual coupons of $1,000 a year into perpetuity. Put another way, a saver would remind himself that the same $10,000 invested in equities has typically accumulated to $11,000 in year 2, $12,100 in year 3, roughly $20,000 in year 7, $40,000 in year 14, and $160,000 at the retirement age of a 37 year old (in 28 years).

It also makes sense to consider the long-run carrying cost of any asset before purchasing it. The $10,000 carrying cost of a second home equates to $200,000 sunk cost after 20 years, assuming zero inflation.

Along the same lines of thinking, we loved the short article by Scott Burns on AssetBuilder.com about the compelling economics of saving on carry-cost, titled Pruis at Five. It highlights another way to consider the real asset value of a dollar saved (in bold):

According to the trip meter on our 2003 Prius, my wife and I have covered the last 2,200 miles at an average of 46.1 miles per gallon. That’s pretty typical of the mileage we’ve enjoyed since buying the car five years and 62,800 miles ago....
When we bought it, our expectation was that it would cut our gasoline consumption by about 500 gallons a year, saving us $750 a year based on the $1.50-a-gallon price of gasoline at the time. (Those were the good old days…) If gasoline prices rose to $2 a gallon, as many expected, we might save $1,000 a year.
Figuring $3.20 a gallon---well below the current national average price of $3.39--- the Prius is saving us about $1,600 a year of after-tax income.
It’s interesting to look at the $1,600-a-year savings in terms of what you’d have to invest to enjoy the same income. An investor in the 25 percent tax bracket buying a 10-year Treasury obligation, recently yielding 3.76 percent, would have to invest $56,738 to get the same net cash benefit. At the end of the ten years, if inflation averaged 4 percent, his original investment would have lost about a third of its purchasing power, providing more depreciation than income. More important, he wouldn’t have had transportation.
We figure, by the way, that we saved the $3,500 cost of a replacement battery in the first 30 months or so of driving. The battery, like the rest of the car, is doing fine. So a big “yes, but” question is behind us.
The Prius, over the same 10-year period, will depreciate more than a Treasury obligation--- probably about 70 percent--- but it will also have provided actual transportation. According to autotrader.com the recent average offering price of the 49 used 2003 Priuses for sale in the entire country was $14,309. The NADA value for a clean retail car is $13,600. That’s dirt cheap for five-year depreciation.
ExxonMobil shares were recently selling at $94 with a dividend of $1.40 to yield 1.49 percent. Since the dividend is taxed at 15 percent, you’d have to own 1,344 shares to get the same spendable income benefit that the Prius is now providing. That means you’d have to invest a whopping $126,386 to “produce” the income benefit of a 2003 Prius. As energy guru Amory Lovins has pointed out relentlessly since 1973, the cheapest way to produce more energy is to use it more efficiently. Sounds like a plan to me.
Which brings me to the future.
There have been rumors that the 2009 Prius will be a plug-in car with enough battery power for short commutes. Instead of refilling the gas tank, drivers will recharge the car at night, reserving the gasoline motor for highway trips. Problems with the development of more powerful batteries, however, appear to have delayed the plug-in and its potential to achieve 100 mpg.
A car like that… well, it could get us to think trade-in.

Long Run U.S. Outlook Not Much Improved

2008-04-26T00:21:00.004-04:00

It's been a long time (in blog terms) since we've argued for a strategic underweight of U.S. versus non-U.S. assets, but our view remains. America's serial indebtedness, its multi-trillion dollar war in Iraq, its narrowing borders to foreigners relative to its size, its stagnant state of public education, and its increasingly polarizing political tones are the main drivers. In our view, these major negatives slightly counter-balance America's tremendous entrepreneurial power (innovation and access to capital), its information intensity, and its economic diversity.

One of our favorite conduits, NakedCapitalism.com, has just produced a bevy of citations that make us increasingly concerned about the financial risks facing America. A few of the citations:

An academic paper reviewing several hundred years of world history repeatedly found waves of sovereign debt criss hitting nations that (1) had received very large capital inflows to support very large indebtedness, and (2) existed in a global context of financial liberalization.
A list of luminaries predicting worse-to-come as result of household and government debt.
The risks and downsides of a currency losing its reserve status -- "Debasing the Dollar Will Accelerate America's Decline."

It seems that the blog's author, having correctly predicted (repeatedly) a severe financial crisis such as we experienced since late-'07, has now turned his guns on the longer-term fallout from the underlying problems that contributed to the near-term crisis.

There is a best course: America can reign in spending, and can save its way out of its debt. But the cost will be slower economic growth and higher taxes for years. We'd need to see strong evidence that it's happening before giving the nation credit for it, so to speak.

In the next five years, we think more funds (which have led the way already), financial planners, and self-proclaimed investment gurus will cite "world equity" as the core long-term asset allocation, rather than U.S. equities. Of course this shift has already begun to occur, but it has a lot further to go. We think we're still on the early side of the multi-decade "trade."

Another aspect of this "trade" will be the continued outperformance of well-run U.S. companies with superior international growth trajectories.

Investing and Earth's Fate, x2

2008-04-24T18:05:00.004-04:00

Last month we wrote how Socolow and Pacala's concept of C02 "stabilization wedges" also presents a powerful investment framework. Since civilization as we know it depends on stabilizing C02 production, and since humanity is girding for the challenge already, we would like to be fully invested in companies working toward each solution.

Socolow and Pacala propose seven C02 "stabilization wedges" (a reduction of a billion metrics tons of C02/year) are necessary to prevent dramatic changes to humanity's life on earth. Joseph Romm summarizes here on Grist.org why that actual number is 14 wedges. To us they represent a powerful investment framework:

Efficiency & Conservation:
Increased transport efficiency
Reducing miles traveled
Increased heating efficiency
Increased efficiency of electricity production

Fossil-Fuel-Based Strategies:
Fuel switching (coal to gas)
Fossil-based electricity with carbon capture & storage (CSS)
Coal synfuels with CCS
Fossil-based hydrogen fuel with CCS

Nuclear Energy:
Nuclear Electricity

Renewables and Biostorage:
Wind-generated electricity
Solar electricity
Wind-generated hydrogen fuel
Biofuels
Forest storage
Soil storage

And there are more possibilities, but this represents an outstanding list for investors wanting to participate in major secular trends and allocate capital to businesses working to sustain human life on earth.

Real Estate and Timing the Rebalance

2008-04-24T17:21:00.003-04:00

Since Real Estate is an important asset class in any serious allocation, we are providing this link to a very good article on when to fill one's allocation to Real Estate (specifically via REITs, for anyone whose home equity does not fulfill the allocation).

Historically, they key has been to look at REIT yields versus Treasuries, and buy when the yields are high. While this is naturally intuitive, the article does a nice job laying this out.

Chinese Inflation Will Scare Investors More, Then Temper Demand

2008-04-23T08:53:00.003-04:00

China's artificially low currency and domestic price control program is one of the world's largest "imbalances." (Of course, it goes hand-in-glove with excessive American credit and borrowing.) Now the world is waking up to those imbalances more than ever, which means securities market volatility remain high while the resolution is pending but uncertain.

Specifically, we see increasing risk of more acute Chinese inflation fear in newspaper headlines, and subsequently some demand moderation in China as the normal function of higher prices finally kicks in. This outlook contributes to our (1) unwillingness to fully re-balance our underweight equities allocation until we see more evidence of "crisis" on some Developing Markets, and (2) unwillingness to go overweight energy now, believing that they're becoming more vulnerable to the global slowdown that's unfolding.

To elaborate, we'll offer a few snippets from Professor Michael Pettis' blog in the past two days. Shortages as a result of price controls are becoming more acute, such that prices will have to rise, which should ultimately lead to a "demand response." This process has been taking far too long, but it may accelerate. From Pettis' post today:

I had lunch with a senior banker from a major Chinese bank today. He is based in Shenzhen, across the border from Hong Kong in the southern province of Guangdong. Among other things he told me that lines at gasoline stations are getting terrible, in part because a lot of Hong Kong residents drive to the mainland to fill their gas tanks. Gasoline on the mainland is at less than the half global price, so this isn’t much of a surprise. He also told me that he thinks actual inflation is higher than the headline CPI number. That isn’t a big surprise either, I guess.

Finally we discussed concerns about a coal shortage, and I read in today’s Xinhua a confirming article that claims that coal reserves have fallen to a 12-day supply, which I think I understand from the Xinhua article is a record low level, even less than March’s already-worrisome 15-day supply. The combination of low coal reserves and gasoline shortages means, I think, that it is going to be hard to keep a lid on energy prices. I wouldn’t be surprised to see energy prices, which are controlled in China, rise in the next few weeks, even amid all the worry about spreading inflation.

And from yesterday's post:

I noted two other interesting pieces today. Xinhua reports that the authorities are announcing new measures to crack down on “profiteers.” They say:

China’s oil regulators are ready to launch a nationwide crackdown on wholesalers who sell to illegal filling stations and dealers in the wake of supply shortages…

…Illegal dealers and filling stations are believed to have aggravated the situation by hoarding oil and jacking up prices to drivers wanting to avoid the long queues at licensed stations.

Aside from the obvious point that shortages are a common consequence of price controls, it is clear that an inflation purist would insist that the long queues, from which people are willing to pay money to escape, are a form of reduction in the quality of good or service that is as much a component of inflation as higher prices, and so headline inflation is being disguised as waiting time. Real inflation is higher than the official numbers, and Chinese motorists are paying this higher cost, but it is not showing up correctly in CPI.

Coal "Renaissance" In Europe -- Keep Investing in Amelioration

2008-04-22T23:32:00.003-04:00

The New York Times today summarized the coal plant building boom in Europe -- 50 plants on the drawing board over the next five years, and the numbers are growing because of rising prices for natural gas (a more carbon-efficient fuel source) and fears over energy security. This from a continent assumed to be leading the green movement make clear that the world is barreling down the path toward global warming. (Our post on Socolow and Pacala's "wedges" makes this clear.) Warming brings problems stemming from water loss, weather volatility, crop unpredictability and many other issues.

From The Times:

The fast-expanding developing economies of India and China, where coal remains a major fuel source for more than two billion people, have long been regarded as among the biggest challenges to reducing carbon emissions. But the return now to coal even in eco-conscious Europe is sowing real alarm among environmentalists who warn that it is setting the world on a disastrous trajectory that will make controlling global warming impossible....
“Building new coal-fired power plants is ill conceived,” said James E. Hansen, a leading climatologist at the NASA Goddard Institute for Space Studies. “Given our knowledge about what needs to be done to stabilize climate, this plan is like barging into a war without having a plan for how it should be conducted, even though information is available.

Reminders such as these keep us focused on the major investment themes we highlight under the Environment subject of this blog, including agri-biotech, solar, tech-driven energy efficiency, water, filtration and other areas. (We'll go so far as to keep an eye on speculative startups such as CO2 Solution (CST), which is trying to develop a form of carbon sequestration. At some point in the future, it will become clear to governments that it will be far cheaper to sequester coal-plant CO2 than to replace existing capacity with alternative energy, above and beyond what's already being installed.)

Finally, "Real" Asset Allocation For Individuals

2008-04-21T18:21:00.008-04:00

The famously successful asset allocation strategies of top investors and university endowments such as Yale have been the envy and goal of many sophisticated individual investors for years. Yale's endowment, for example, is up an astonishing 16.1% per year for the past 22 years, with remarkably low volatility, since current head David Swensen took over. Look at the Yale annual report and our blog summary "Yale and You" here to see how Yale does it.

But individual investors haven't been able to participate directly in such diverse and exclusive funds, and instead have had to (1) try to construct their own sophisticated asset allocation from the bottom-up, (2) hire professionals for enormous fees and scant accountability, or (3) settle for the badly inferior "life-cycle" funds that offer a simplistic mix of stocks vs bonds as individuals age.

Happily, today Vanguard announced its Managed Payout Funds, which will help individuals gain access to more of the true diversification benefits that professional asset allocators achieve. Vanguard will offer three funds containing not only U.S. stocks & bonds (which are often highly correlated and therefore far from optimal), but also international stocks, REITs, Treasury Inflation Protection Securities (TIPS), commodity-linked investments, and market-neutral equity funds. These additional asset classes have different return and correlation characteristics in comparison to U.S. stocks & bonds; institutional investors have been exploiting them for years to obtain higher returns and lower variability of returns year-to-year.

Vanguard will construct its Managed Payout portfolios to achieve closer-to-optimal portfolios (in a Markowitz sense) than most investors can achieve for themselves. The new funds will pay out a percentage each year to investors needing retirement income and (probably) better risk-adjusted returns than are widely available to them otherwise. Vanguard will re-balance each asset class regularly to accord with long-run allocation targets, something individual investors also fail to do. Astonishingly (though perhaps not for Vanguard), annual fees will be only 0.57-0.58%.

Of course, the new funds' reward/risk tradeoffs won't come close to the characteristics of the best institutional asset allocators, who beat market-averages within traditional asset classes, and push into private investments and emerging asset classes that Vanguard's public funds will not be able to incorporate. But Vanguard's Managed Payout product will open a new efficiency frontier to many individual investors.

Why We're Still Underweight Equities (Just Less-So) - III

2008-04-21T17:42:00.005-04:00

Equity markets' rally in the past month seems to reflect diminished fear of a financial system collapse (which we agree with, for now), but also shows little concern for the pending significant pressure we expect to see on corporate profits, fallout from the continuing credit crisis.

We articulated this view more fully in our post here.

A short FT article today summarizing the opinion of a Morgan Stanley strategist puts some additional figures on essentially the same view as ours:

The bear market rally in European equities is over and corporate earnings over the coming year are likely to fall well short of expectations, says Teun Draaisma, strategist at Morgan Stanley.
He points out that the MSCI Europe index has risen 11 per cent since hitting a trough on March 17, and believes there is limited further upside to the current rally.
“We expected a bear market rally of at least 10 per cent on the back of a drastic policy reaction to the problems at hand,” he says.
“Most policy action has been taken or is fully expected, while our all-important market timing indicators have given us the warning that the rally is over.”
Mr Draaisma says inflation in Europe has been surprisingly strong, and that there have been tentative signs of the earnings downturn spreading beyond financials. He adds that money market stresses have not healed.
“The biggest certainty for the next 12 months is that there will be a big earnings miss, as margins are at all-time high levels while top-line growth is slowing and costs are rising, and expectations are too high.
“We forecast a 16 per cent fall in European earnings in 2008. Consensus earnings expectations have been cut 6 per cent so far this year but still imply 6 per cent growth, which is unrealistic.
“The ‘financial end of the world’ has been avoided, but that still leaves us with a big earnings recession.”

To raise our equity allocations somewhat during the pullback of the past week, we've focused on the major trend toward investing for environmental sustainability, particularly companies we see as less vulnerable in the economic slowdown we expect to continue into 2009. (We've noted some of those companies under our Corporations subject link.) We'll continue to do so in the coming weeks, but with even greater selectivity after the equity markets' recent run run.

China Equities -49% From Peak, But Still Adverse Risk/Reward

2008-04-21T01:43:00.005-04:00

We continue to wait for the financial crisis to hit some of the Developing Markets before we'll be more comfortable fully rebalancing our somewhat underweight equity allocations. We see a crisis-of-confidence in some Developing Markets as just one of the signposts that it's safer to raise weightings significantly, but an important signpost.

We see China as the bellweather for our call, and we still see the risks somewhat outweighing reward for a 1-2 year time horizon. One the one hand, its economic dynamism continues in many regards, and its equity market has gotten a lot cheaper, nearly cut in half since its peak, and with P/Es in the low-20s for example. On the other hand, we worry about the effects of China's artificially weak currency, its inflation problem, its opaque financial statements, its immature banking system, its real estate bubble, and so on.

An insightful post by professor Michael Pettis at Peking University adds to our view that the economic slowdown that is spreading around the world could treat the Developing Markets more harshly than is generally believed. First, he details the spike in "hot money" flows to China, which will make it more difficult for China to keep its currency weak and its export machine well lubricated.

Second, Pettis describes why he thinks Chinese companies' financial conditions have deteriorated, perhaps more than the much-reduced equity markets discount. It gets to the heart of our reason for slowly raising our Developing Market weightings specifically, and equity weightings generally, following the selloff since the peak in '07:

In [the 4/19 edition of the South China Morning Post, reporter Shirley Yam] wonders about the much-repeated claim among many of the mainland’s larger firms that “profits and profit margins have dropped because of raw material and fuel cost increases.”

Displaying a journalist’s cynicism she decides to look at a number of companies to check to see if their margin declines have really been caused by commodity price increases or other factors over which managers have no control. “Is this the sole reason, or just a convenient excuse for inefficient management to pass the buck?” she asks. As she explains in her article,

This is an increasingly relevant question given the global business environment has turned from deflationary to inflationary where raising costs is the norm. I read through the 2007 annual reports of 10 major state-owned enterprises. The results were disappointing.

It turns out that the companies she examines have all seen distribution expenses, administrative costs and staff expenses shoot up much faster than revenues – two to eight times as fast. Rather than enjoy economies of scale they seem to be suffering massive diseconomies of scale.

This kind of thing worries me not because I care about the how managers choose to spend and/or waste money. It worries me because boom times like the one we have enjoyed in China since 2003 often lead to rigidities and excesses in corporate activity and balance sheets that make it very difficult for them to survive sharp turndowns, and this is precisely one very common such type of rigidity.

Corporate costs can grow much more rapidly than revenues while still allowing the company to show significant increases in net profits as long as revenues are surging, as they have been for Chinese companies in recent years. In case however of a slowdown and a decline in revenues, or at least a sharp reduction in revenue growth, it can take a long time for management to get rising costs under control. The result can be a collapse in cashflow, profitability, and perhaps creditworthiness.

This is likely both to increase the risk of a sharp, adverse financial adjustment (as companies ability to withstand a downturn is seriously weakened) and to increase the adjustment cost if such a downturn takes place (deteriorating creditworthiness immediately increases financial distress costs and causes corporates to engage in systemically adverse behavior).

Readers of my blog might easily accuse me of always focusing on the worst case scenario and always looking for problems. Perhaps that is because as a former bond trader I tend naturally to pessimism – after all bond prices tend to have limited upside and nearly unlimited downside, so it pays to worry about the downside more than the upside. But as someone who has experienced too many financial crises and who has written extensively about the history of capital flows and financial crises, I am also pretty sure that when things go wrong nearly everything goes wrong at the same time. This is not a coincidence. It is simply the way unstable balance sheets work, and during boom times companies tend systematically to build risky balance sheets – by, among other things, letting costs get out of control.

Another Stake In the Heart of "Peak Oil" Deniers

2008-04-20T01:29:00.006-04:00

If last week's confession by a Lukoil official that Russian oil production has peaked weren't enough to convert "peak oil" deniers, today's comments by Saudia Arabia ought to do the trick. (See the WSJ article here.) As a result, energy prices should continue their steady march upward at a much faster clip than other asset classes (at least until the oil "supply shock" hurts demand enough, which we think will happen later in '08).

So, strictly speaking, our market-weight energy position since starting this blog will remain a drag on relative performance, unless it becomes clear that oil demand is slowing down much more sharply than oil supply. That probably won't happen in the next couple of months, at the rate nations are pursuing inflationary and energy-inefficient policies around the world, and given the rising cost of extracting an incremental barrel of oil.

That said, we haven't raised our energy weighting. We're seeking to "mimic" the performance of rising energy assets with assets that instead improve resource efficiency, reduce industry's carbon & pollution footprints, and create a more sustainable world. To that end, we've written about investments along several major themes, such as agri-biotech, solar power & some other alternative energy platforms, water infrastructure & irrigation technology, green electronics, and others (scroll through our Environment subject for detail).

In addition to "mimic-ing" the performance of rising energy assets, we think these investments could decline less than the energy sector if the global economy slows down enough to drag the energy sector down, because the major environmental investment theme should remain intact.

But we have a lot more work to do before making up for being market-weight energy, rather than overweight, because traditional energy can get more expensive, and still be cheaper than alternative energies. So we're extending our environmental investment themes to include another industrial efficiency play (FLIR Systems - FLIR), and several high barrier-to-entry environmental collection and processing networks (including Clean Harbors - CLHB, and Darling International - DAR). Note that Darling, which collects and processes animal bi-products from thousands of sources, sells into many product categories as a replacement of fossil fuels, and enjoys rising average prices as a result.

REITs and Commodities -- Key For Personal Investors (At Least, So Far)

2008-04-19T08:59:00.004-04:00

The following interview with BYU professor Craig Israelsen makes it very easy to see why REITs and Commodities have been crucial to asset allocation strategies, at least historically. The interview keys off this article in the Journal of Indexes (Nov/Dec '07 issue).

HardAssetsInvestor.com (HAI): What did your study on correlations show?

Craig Israelsen (Israelsen): Basically that diversification really works. That's a real stunner, isn't it?

HAI: Shocking. But seriously, how did it work?

Israelsen: I built equal-weighted portfolios out of up to seven different asset classes: large-cap U.S. equities, small-cap U.S. equities, non-U.S. equities, U.S. intermediate-term bonds, cash, REITs and commodities.

For commodities, I used the S&P GSCI commodities index going back to 1970. I'd note that before 2001 or 2000, the GSCI was not investable, so I'm making the assumption that there could have been an actual portfolio tracking that index back in 1970.

In my original analysis, I started with an equally weighted two-asset class portfolio composed of large-cap and small-cap U.S. stocks, and I looked at the returns. Then I started adding more asset classes: non-U.S. stocks, bonds, cash, REITs and commodities. I found that as you added the additional asset classes, you improved the returns and limited the worst one-year drawdown of the total portfolio. But importantly, it was not a linear relationship.

HAI: How so?

Israelsen: There's a major change when you get to commodities and REITs.

With the five-asset portfolio - large-cap U.S. stocks, small-cap U.S. stocks, non-U.S. stocks, bonds and cash - which is about what the typical target date portfolio held three years ago, you get a 10% internal rate of return while sustaining retirement withdrawals. The worst one-year drawdown since 1970 is 17%.

When you add REITs and commodities, the internal rate of return rises to 11.3%, which is nice. But the worst one-year drawdown falls to 10%. That's a 40% reduction!

Most people wouldn't immediately notice a 1.3% increase in the annual return. But they would notice a 40% reduction in the worst one-year drawdown. You can feel that.

HAI: Why does that happen?

Israelsen: Commodities and real estate have fairly low correlations to the core assets of large-cap U.S. stocks, small-cap U.S stocks and developed markets international equities.

When people buy foreign stocks, they think they are diversified. But the three main equity asset classes have correlations of 0.7 to 0.9. You don't get a lot of correlation benefit from adding more equities to an equity portfolio.

Cash is a good diversifier, and so are bonds. But they don't have a very attractive long-term return. The real benefit comes when you add REITs and commodities. They have equity-like returns, but low correlations ... and in one important way, they have lower risk than equities.

That's the crux of it. What follows is more detail. It's very helpful to finally have a researcher discuss volatility in terms of "the worst year you'll sustain" rather than standard deviation, because it's easier to understand "worst year" in terms of one's real-life financial needs and risk tolerance:

HAI: Lower risk for commodities?

Israelsen: In a way.

I've recently updated the data on this study. Between 1970 and 2006, large-cap U.S. equities had about an 11% return. But there were eight years in that 37-year period where large-cap stocks had a negative return. Moreover, the worst 3-year cumulative return was about 38%, from 2000-2002.

Over that same time period, commodities had an average annual return of 11.5%. They had nine years with a loss, so one more than large-cap U.S. stocks. But the worst 3-year return for commodities was only 26% - much better than equities.

I think that surprises people. It runs up again the idea of commodities being risky investments.

Another important factor is timing. Take foreign stocks. The worst 3-year drawdown for non-U.S. stocks was 43%. That drawdown came at the same time as the worst 3-year drawdown for large-cap U.S. stocks: 2000-2002. When you have two assets that both have their worst 3-year periods at the same time, that's not helpful.

By contrast, the worst 3-year period for commodities was 1996-1998. That offset was helpful for portfolios.

Raw correlation is only a starting point. Most people use it as a starting and ending point. You really have to look at year-to-year returns and look at the patterns of major upside moves and major downside moved. If they don't overlap, I'm willing to be less worried about high correlations. If the correlations are high and the worst-case periods occur at the same time, that's not good.

HAI: What do you hope people take away from your study?

Israelsen: That retirement portfolio may be improved by being a little bit more exotic.

One of the things people have objected to about my seven-asset class portfolio is that it has a pretty high commitment to so-called alternative assets. It sounds pretty iffy. But over this 37-year period, the worst 3-year return for large-cap U.S. stocks was bigger than the worst 3-year return for commodities. So which is more risky?

Commodities live with a stigma that they are incredibly volatile. I think that's because people look at short time periods. I haven't studied it, but I think commodities may have more upside and downside moves over short time frames, but when you measure them annually, I would make the argument that commodities have demonstrated lower volatility than large-cap U.S. stocks.

I think what happens in equities is that you get momentum that stays. If you have a bad year in equities, you might have another bad year after that. But with commodities, it can turn around more quickly. The year after the worst 1-year drawdown in commodities, for instance, commodities returned 41%.

Volatility is often measured by standard deviation, and on that measure, commodities do poorly: They have a standard deviation of 24% versus 17% for large-cap U.S. stocks.

But standard deviation is more a mathematical concept than a useful investment figure. I would argue that the worst 1-year return or worst 3-year drawdown is a more compelling statistic. Most investors would have no idea how to calculate standard deviation, or what it means. But they all know what a drawdown feels like.

If you look at other measures of risk besides standard deviation, commodities aren't as radical as we want to believe.