"$200 Oil." For Real?

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.

Chinese Inflation Will Scare Investors More, Then Temper Demand

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.

Finally, "Real" Asset Allocation For Individuals

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.

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

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.

Contagion Spreading (and seeds of a US dollar base?)

We have written many times (such as here, here and other posts) that the financial crisis will be landing hard in various Developing Markets, and that inflation (food, fuel, etc) and could be the catalyst in the further "great unwind" of global pressures that have been building this decade.

Our main point in the posts was to say why we remain underweight equities, and that the coming global market selloffs would ultimately take us closer to "the beginning of the end" of the global financial crisis, and subsequently a better time to buy equities -- both globally and in the U.S.

Now, signs are clearer than ever that circumstances are creating the conditions for financial crisis in some developing markets. Acute food inflation, subsequent export barriers that are making matters, worse, food rioting in a half-dozen countries, and increased political risk (for example, note India's nervousness at the Maoist election victories in Nepal) are raising matters to a head. This comes on the heels of years of currency manipulation and hypercredit in certain countries, the slowing pace of trade & financial reform, and of course the continuing U.S. credit bubble implosion.

A Bloomberg update today contains implications that we're closer to cusp of true contagion into Developing Markets. The news may signify only the early stages of a continuing destabilization to the post-2000 trends:

• Rupia Weakens With Peso as Rice Jump Spurs Inflation (Bloomberg, April 14) At the end of last year, rice was selling at $13.865 per 100 pounds, the Philippine central bank had met its inflation target for the first time since 2003 and the peso was the world's second best-performing currency.

  By April 1, rice was surging toward a record $21.60, the inflation rate had almost doubled, and the peso suffered its biggest monthly decline in seven years.

  Record prices for rice, wheat, milk and cooking oil are wreaking havoc with currencies in Southeast Asia, causing a slump in the peso and Indonesia's rupiah. Investors from Deutsche Asset Management to Fortis Investments are dumping their bondholdings on concern inflation will erode returns, putting further pressure on exchange rates. The region has come to depend on strong currencies to contain the rising cost of food and fuel imports.

  ``You can't just rely on currencies to fight inflation, as there comes a time when they have no potential to appreciate further,'' said Nicolas Schlotthauer, a money manager who helps oversee $5 billion at Deutsche Asset Management, part of Germany's largest bank, in Frankfurt. ``Everyone is so complacent about the fact that if there's inflationary pressure, they will let their currencies appreciate. No one thought of potential currency weakness.''

  Currency Reversal

  The Philippine peso tumbled 3.2 percent in March, the most since June 2001. It fell 0.4 percent to 41.750 by the close of trading in Manila, according to data from the Bankers Association of the Philippines. That's a reversal for a currency that gained 9 percent in the fourth quarter, second only to the Armenian dram. In Indonesia, the central bank probably bought more than $2 billion of rupiah, limiting its decline since March 1 to 1.1 percent, according to Oversea-Chinese Banking Corp., Singapore's third-biggest bank. The rupiah slid 0.3 percent to 9,200 per dollar in Jakarta by 5:30 p.m. local time.

  International investors cut their holdings of Indonesian government bonds 3.2 percent in March to 80.7 trillion rupiah ($8.8 billion), according to finance ministry data. Foreign funds sold a net $154 million of stocks in the Philippines this year, helping drive the Philippine Stock Exchange Index down 19.5 percent.

  Deutsche Asset sold all its rupiah debt earlier this year and didn't buy peso bonds because of inflation, Schlotthauer said. Fortis Investments, a unit of Belgium's biggest financial group, expects the rupiah will weaken 3.2 percent to 9,500 per dollar within three months. The firm is ``short'' the rupiah, meaning it is betting the currency will depreciate.

  `Bearish on Indonesia'

  ``I'm really bearish on Indonesia,'' said Didier Lambert, a London-based money manager who helps oversee $4 billion in emerging-market debt at Fortis. ``You will see investor outflows that should weaken the currency.''

  The last time Indonesia's rupiah depreciated due to rising commodity costs was in August 2005, when a jump in global oil prices increased the cost of a state fuel-subsidy program. The rupiah slumped to a four-year low of 10,875.

  ``Subsidies can be very disruptive and expensive for a government to maintain,'' billionaire investor George Soros said in a teleconference from Washington on April 9. Rising food prices may cause ``social and political disruptions,'' he said.

  Emergency Meeting

  The Philippines is urging China, Japan, India and other Asian nations to convene an emergency meeting this month or next on the region's food crisis, Agriculture Secretary Arthur Yap said today. International Monetary Fund Managing Director Dominique Strauss-Kahn said April 12 that ``hundreds of thousands'' worldwide may starve as food costs jump.

  Philippine President Gloria Arroyo said on April 1 she may abandon plans to balance the budget. Two days later, Indonesia widened its 2008 deficit target to 2.1 percent of gross domestic product from an earlier 1.7 percent.

  Food accounts for 49 percent of the consumer price index in the Philippines, the world's biggest importer of rice, and 38 percent in Indonesia, according to Mirza Baig, an economist at Deutsche Bank AG in Singapore. In the U.S., it's 14 percent.

  Indonesian inflation surged to an 18-month high of 8.2 percent in March, breaching Bank Indonesia's target of 6.5 percent. It reached a 20-month high of 6.4 percent in the Philippines, above Bangko Sentral ng Pilipinas's 5 percent target.

  Asian central banks may be able to curb inflation by raising interest rates and seeking stronger currencies because of ``robust'' growth, the Washington-based IMF said on April 9. Excluding Japan, Asia will grow 7.5 percent in 2008, compared with 9.1 percent in 2007.

Commodity Prices, "Resource Nationalism" and Extended Economic Slowdown

The following chart from VoxEU.org shows the number of oil expropriations (the bars) and oil price deviation from long-run trend, 1910-2006. The gigantic wave of government expropriations in the 1970s, and the latest upticks to the far right of the chart, could indicate a very significant trend in the next few years.

(We think this is part of a trend toward greater protectionism. Our recent posts discussed this with regard to agriculture lately. The world noted the worrisome development of the U.S. postponing a trade agreement with Columbia this week. U.S. Democratic Presidential candidates are running on a protectionist ticket. Etc)

The consequence of continued nationalization of energy resources could be yet another impetus to commodity prices in the next couple of years -- via decreased production efficiency and less international trade -- until the growing bottlenecks result in a deepening global economic slowdown that significantly damps demand, as occurred in the '70s. We don't know when the impetus will be fully offset by the economic fallout. That is why we're not getting more bullish on Energy investments currently.

Chart (from VoxEU): Number of oil expropriations and oil price deviation from long-run trend, 1910-2006


Macro consequences: (1) another impetus to high energy prices despite the economic slowdown, (2) extended economic slowdown, (3) accelerating push toward "alternative energy," commodity yield enhancement of all kinds, booming resource optimization technologies and business practices.

Consequences for Asset Allocation: (1) Not overweight energy, but need to continue to guard against being underweight energy (see our previous post), (2) Need to identify investment opportunities in alternative energy and resource optimization, (3) Otherwise, need to be overweight counter-cyclical investments, rather than chase cyclical rallies that occur during the potential bear market -- We believe we're still only in the middle of the current financial crisis, which won't signal a "beginning of the end" until additional shoes drop. We don't plan to fully rebalance our underweight equity position at our mid-year rebalance, unless more of the crisis plays out before then.

When Are "Food Export Barriers" Simply "Protectionism"?

Despite the cracks in Alan Greenspan's reputation because of the credit bust and regulatory negligence he fostered, it's worth focusing instead on his repeated warnings against erecting barriers to trade. He frequently stated that a resurgence in trade barriers was the one poison he feared most. Today he reiterated those sentiments to the Senate Finance Committee, and how destructive it would be reverse the wealth-generating tide of the past two decades of trade liberalization.

If the rapid spike in food export barriers (part of what's been happening in the past couple of weeks) creates an even larger contagion of protectionism, ill-feelings, and tit-for-tat among nations than it already has, global economic prospects will quickly darken and become more volatile. This article on Asia Business Newswire today points how quickly the risk of protectionism is rising.

(It is also a reminder of how owning the food commodities and commodity-linked securities may become an even more important element in an optimal diversified portfolio.)

• Sydney, Apr 4, 2008 (ABN Newswire) - Across the developing and emerging economies of the world, and in some developed economies for that matter, governments are opting to shoulder some of the burden of higher food prices or try and control their immediate direction.
  
  The efforts are likely to be fruitless and very expensive for the countries involved, consumers and taxpayers.
  
  From India to Egypt governments are slashing import tariffs on foodstuffs and curbing exports, as well as boosting subsidies: all to try and ease the impact of what will be the big story of 2008 and 2009 - the soaring cost of food.
  
  As we reported this week, an exploding price for rice is the latest cause of much government action.
  
  Egypt, India, the Philippines, Vietnam, Indonesia, Cambodia, parts of Africa, Mexico, Italy, China, Russia, Argentina: the list is growing by the day of governments who now see the rising cost of food and all the social and political problems that brings, as far more important that good governance, low debt, the US recession, subprime debt or American foreign and economic policy.
  
  Even in the developed world the impact is startling. Biofuels in Asia, Europe and the US are withering because of rising costs for corn, canola and palm oil. Food riots have happened in Mexico over the cost of tortilla flour. Italians have protested about the sharp rise in the cost of flour for pasta and bread.
  
  Farmers are being blamed in some countries, such as Argentina and parts of Europe; in the US it's causing an explosion in land values and incomes in parts of the country that have been slowly withering away.
  
  The irony won't be lost on Americans that in the midst of a recession farmers and some of the biggest companies in the US (think Cargill and Archer Midland) will be booming, some with record incomes, and much of it (like Europe) subsidised.
  
  Longer term, however, the side-effects of this largesse will be ugly. Forgoing revenues and paying subsidies hurts national budgets.
  
  India, for example, spent $US600 million on rice and wheat subsidies in 2004-05. Given the surge in rice, maize and wheat prices since then, the cost could be up by a third to a half: something approaching $US1 billion, which a country like India can ill afford, even in the midst of its boom (which is slowing anyway).
  
  In the Philippines, the rice subsidy could top the half a billion dollar mark this year, according to the Asian Development Bank, and the country is scouring Asia and the US for around 1.5 million tonnes of rice at subsidised prices because its stocks have run down.
  
  Indonesia which is thinking of banning some rice exports, like China, India, Vietnam and Egypt, may have to pay $US2.2 billion in food subsidies this year, or around 3% of spending by the national government.
  
  That's three times earlier estimates.
  
  Nearby Malaysia is looking to boost rice imports and hitting a wall because the Philippines has been mopping up as much grain as it can get.
  
  Indonesia and many other countries in Asia also subsidise energy costs and they have skyrocketed with the rise in oil prices over the past three years.
  
  Indonesia is thinking of cutting rice exports, even though it will have a surplus this year of around two million tonnes (it imported just over 1 million tonnes in 2007).
  
  Soaring food and fuel prices are driving global inflation. Consumer prices in China hit an annual rate of 8.7% in February, an 11-year high, and reached a 13-month peak in India of 6.8%.
  
  World prices for rice, wheat, soybeans and corn have all increased sharply: rice and wheat prices have doubled in the year - rice is up 30% or more in a week....
  
  The World Bank said this week it considered soaring food and fuel prices as greater challenges to East Asian governments than the financial turmoil in the United States and slowing global growth.
  
  As we said yesterday, it's a similar outlook from the Asian Development Bank.
  
  "The major risk lies not so much in softer growth but in rising commodity prices and accelerating inflation,'' the Bank said yesterday. "Appropriate macroeconomic responses to accelerating inflation are likely to include tighter monetary policy and some exchange-rate appreciation.''
  
  "Indeed, published inflation rates disguise the true extent of underlying inflation pressures due to the presence of subsidies, administrative price controls and cuts in excise taxes," it said.
  
  The subsidies used by many governments in the region to cushion the impact of soaring fuel and food prices are posing a threat to budgets and the bank said that cash handouts to the poor may be a better and cheaper option.
  
  "If governments do not rethink these expensive and inefficient subsidy programs, fiscal costs could escalate sharply and require painful adjustments (or accelerating inflation, or both) later," the ADB said.
  
  "Carefully targetted direct income support for the poor, within strict budgetary limits, might better alleviate stresses, and at much lower cost."
  
  Saudi Arabia has cut import taxes across a range of food products this week, slashing its wheat tariff from 25% to zero and reducing tariffs on poultry, dairy produce and vegetable oils.
  
  On Monday, India scrapped tariffs on edible oil and maize and banned exports of all rice except the high-value basmati variety, while Vietnam, the world's third biggest rice exporter, said it would cut rice exports by 11%.
  
  In Argentina, farmers called off a protest against attempts by the government of President Cristina Fernández to redistribute the benefits of rising commodity prices by increasing export taxes on soybeans and other crops.....
  
  

"Food" Smells Like "Oil"

We think Agriculture commodities are likely to deserve standalone designation in some asset allocations.

We expect food supplies to become less predictable and more expensive in the coming years because of the many trends we've highlighted (Food Prices, Continued and Allocation and Agriculture and elsewhere), such as increasing demand for grains and grain-intensive meat, biofuel demand, worsening water scarcity, higher fuel prices, soil conservation problems, climate changes and erratic weather, and other issues. When ag prices settle down, another circumstance or crisis will force them back up again, much as we've seen with oil prices in the past five years. We think new acreage and science will help solve the problem, so we're focused on some of the companies that should help (like Monsanto and Syngenta).

But even new capacity and science probably won't prevent a bullish multi-year trend in ag prices. Another update in the FT today regarding rice prices highlights the severity of the issue. Nations that are short rice supplies will be more assertive in procuring grain supplies from other sources, and that will keep an upward bias to food prices.

From the FT ("Rice jumps as Africa joins race for supplies")

• Rice prices rose more than 10 per cent on Friday to a fresh all-time high as African countries joined south-east Asian importers in the race to head off social unrest by securing supplies from the handful of exporters still selling the grain in the international market.

  The rise in prices – 50 per cent in two weeks – threatens upheaval and has resulted in riots and soldiers overseeing supplies in some emerging countries, where the grain is a staple food for about 3bn people.

  The increase also risks stoking further inflation in emerging countries, which have been suffering the impact of record oil prices and the rise in price of other agricultural commodities – including wheat, maize and vegetable oil – in the last year.

  Kamal Nath, India’s trade minister, said the government would crack down on hoarding of essential commodities to keep a lid on food prices. “We will not hesitate to take the strongest possible measures, including using some of the legal provisions that we have against hoarding,’’ he said on Friday.

  Thai medium-quality rice, a global benchmark, traded at about $850 a tonne on Friday, up from $760 a tonne last week, while the price of less representative top-quality aromatic rice broke the $1,000-a-tonne level for the first time, traders said. They added that the grain was being sold to African destinations.

  In Chicago, US rice futures hit an all-time high of $20.45 per 100 pounds.

  Although only a small amount of the grain is traded internationally, the rise in Thai prices signals the trend for the global market and also for domestic prices in countries where local production is enough to meet demand.

  The price jump came as leading exporting countries, including Vietnam, India, China and Egypt, banned foreign sales. Hanoi extended its ban for two extra months until June.

  Food aid officials said consumption could rise further because record food prices are forcing families to move from a diversified diet to just one staple.

  Farmers delaying their harvest and middleman hoarding stocks are also contributing to the crisis, said governments and traders.

  In the past weeks, traders and diplomats have warned that many West African countries, where rice is a staple, had yet to purchase the grain this year, leaving them subject to record prices now.

Tax-sensitive investors will look at ETNs rather than ETFs. Two of them are iPath Dow Jones AIG-Agriculture ETN (JJA) (and the narrower JJG - Grains) and ELEMENTS Linked to the Rogers International Commodity Index - Agriculture ETN (RJA).

We recognize that asset allocators will often want to inflation-hedge using TIPS, which hedges against broad CPI inflation. But we also think Ag prices could outrun CPI for years, and that Ag commodities will grant more robust inflation protection.

Of wider interest to asset allocators is the extent to which ag commodities are both signifying and creating greater risks to global equity and bond market returns. This increases the importance of owning commodities or commodity-linked securities in a high-performing optimal portfolio.

Food Prices, Continued

Several of our recent posts have highlighted many nations' somewhat counter-productive policies to restrict food prices. They're reducing import tariffs (a good response) but also raising export tariffs (which undoes the liberalization of reduced import tariffs). This afternoon, a new FT article recaps the issue nicely.

The trends in food prices have tremendous implications for asset allocation (see Allocation and Agriculture):

(1) Food prices have significant consequences for global inflation, particularly in the Developing Markets where food constitutes a high percentage of a person's spending.

(2) A healthy bull market in food prices -- rather than one that provokes unmanageable inflation and social unrest -- would sustain the massive global waves of investment in food research, cultivation, infrastructure and trade.

We continue to think that investments in parts of the agriculture chain will become a more significant part of investors' asset allocation in the coming years, even after the past year of accelerated price increases. Agriculture investment fits our thesis of investing disproportionately where the world's "externalities" are now being internalized (3/24/08), and put another way, where profits meet sustainability of human life on earth (3/25/08).

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.

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.

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.

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.

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.

Commodities Not Immune

Investors who have included commodities in their long-run asset allocations in the past few years may be feeling fully vindicated by the way they've held up better than equities in recent days, and even in the recent months. Other investors new to the commodity asset class may feel pressured to raise their commodity allocation because of how well commodities have held up. But we wouldn't be so fast to raise commodity weightings now, mainly because -- as we've posted in recent days -- the global economic weakness will take a big bite out of demand.

In addition, I see even more support of this cautionary notion in an article by Harvard Economist Jeff Frankel (hat tip to NakedCapitalism, a superb blog). It argues that commodity prices have stayed high lately not just because of a stronger demand/supply ratio (it has weakened, actually), but also because of the latest sharp decline in U.S. interest rates, something probably more fleeting than the "global demographics" arguments that long-run asset allocators would prefer.

To quote Frankel at some length:

• High interest rates reduce the demand for storable commodities, or increase the supply, through a variety of channels: *by increasing the incentive for extraction today rather than tomorrow, *by decreasing firms' desire to carry inventories, *by encouraging speculators to shift out of spot commodity contracts, and into treasury bills.
• All three mechanisms work to reduce the market price of commodities, as happened when real interest rates were high in the early 1980s. A decrease in real interest rates has the opposite effect, lowering the cost of carrying inventories, and raising commodity prices, as happened in the 1970s, and again during 2001-2004.
  
• The theoretical model can be summarized as follows. A monetary expansion temporarily lowers the real interest rate (whether via a fall in nominal rate, a rise in expected inflation, or both -- as now). Real commodity prices rise. How far? Until commodities are widely considered "overvalued" -- so overvalued that there is an expectation of future depreciation (together with the other costs of carrying inventories: storage costs plus any risk premium) that is sufficient to offset the lower interest rate (and other advantages of holding inventories, namely the "convenience yield"). Only then do firms feel they have enough inventories despite the low carrying cost. As a result, the real money supply, real interest rate, and real commodity price eventually return to where they were.

The following chart from Frankel's blog shows the negative correlation between interest rates (horizontal axis) and commodity prices (vertical axis); in other words, lower interest rates generally corresponded to higher commodity prices from 1950-2005, and certainly in the last year as well.


I think high prices for both commodities and bonds are both aided by excess liquidity, and I believe I've seen a tight correlation between prices of liquid assets and y/y % change in global broad minus narrow money supply. This measure of money supply is coming under pressure with the decline in equities and non-Treasury debt, and the weakening dollar is also draining some liquidity, and this will probably deflate commodity prices from their recent highs.

Implications for Asset Allocation: Although I believe that commodities will be a better investment class in the next 20 years than in the 20 years leading up to the recent boom, they shouldn't be treated as a safe haven now, when they're becoming more vulnerable to economic weakness and an excess liquidity drain.

Shifting Long-Run Asset Allocation Targets?

Many of the massive, multi-year bull- and bear-moves in asset classes occur when huge institutional investors and big consulting firms change their asset allocation targets. WE WANT TO IDENTIFY THESE, AND REFLECT THAT WITHIN OUR LONG-RUN STRATEGIC ASSET ALLOCATION TARGETS BEFORE SOME OF THE BIG INSTITUTIONS DO.

Dramatically, we've seen this kind of asset allocation shift in the past five years as investors dispensed traditional guidelines of 5-10% weights in Developing Markets (upon seeing demographic shifts, capitalism's emergence, geopolitical stability, and early-stage growth), and near-0% weights in Commodities (upon seeing Developing Economies' demand and inflationary policies, scarcity of commodities, and the potential/reality of declining oil production). These two asset classes have soared, and investors who missed these major shifts in the past few years are paying dearly.

The shifts toward Developing Markets and Commodities may continue in the coming years, albeit with risk of a cyclical pullback in the next year or so.

The question is, what other massive trends could create similarly dramatic changes in big investors' long-term asset allocation targets? We're keenly interested in locating great sources of information.

One great source is undoubtedly 13D Research (see "Sample Reports"), whose founder Kiril Sokoloff offers a few choice reports for non-clients. Check them out. Print and read. They may significantly change your outlook on the world and your assets.

13D's Sokoloff called the Emerging Markets boom in very, very convincing fashion.

He called the oil boom in a report that blew away any doubts I had, and even earlier than that, he table-pounded in 2001 on the coming bull market in commodities.

Those two asset may be due for a cyclical pullback (Sokoloff might rightly say "who cares, the trend is bigger than the cycle"), but look at these two reports as well:

"How To Invest In The Coming Global Food Crisis" and "Water: World's Most Common Resource Could Become Its Most Precious Commodity." These two papers struck a powerful chord after we also read Jared Diamond's Collapse: How Societies Choose to Fail or Succeed.

The reports convince me that TIPS, reflecting CPI inflation, may continue to underperform Commodities for a long time, meaning that investors should apportion some of their inflation-hedge allocation to Commodities. The latter group of reports mentioned above (Food and Water) helps convince us that Agricultural Commodities can play a role in investors' Inflation Hedging strategies because they may particularly to outperform TIPS in the coming decades, especially given the coming soil management trouble and weather volatility induced by deforestation and global warming. It also helps convince us of 13D's compelling reasons to be overweight Brazil in one's Developing Markets allocation (see the 1-31-08 and 1-3-08 reports).

13D reports compel us to pay attention to other trends as well, though it may take some time before a broad "asset class" develops around these trends. They are Infrastructure trends (traditional airports/railroads/ports as well as "the coming biorefinery revolution" and desalination revolution see 1-3-08 and others), Health Care trends (Brain Science -- see his 1-17-08 report -- as well as "The Coming Plagues...Beneficiaries: New Antibiotics, Genetic Testing, and Antiviral Drugs" and Stem Cells), the world's Power shortfalls (see his 1-31-08 report) and shift to nuclear power (1-3-08 report), the need to rapidly build-out Internet infrastructure (1-17-08) and the push into nanotech and need to counter the threat of cyberterrorism (same 1-31-08) report, the investment case for the Gulf States (1-17-08 report), and a heavy sprinkling of data supporting growth trends in High-Tech Military industries as a result of increasing competitiveness among nations in a world with less-abundant resources (see also this Martin Wolf article), and others.

Happy Day, But The Snake Lurks

Market commentators tonight will say what an "important" equity rally occurred today, +4% or so. "Important" to see afternoon follow-through after the Fed's cuts, and "important" that the dollar didn't crater amid lower rates, and how "important" it was that "disaster was averted again." A bullish line of reasoning goes like this: "the more days the market can avoid a total breakdown, the more confidence investors will have to buy equity and debt securities, the more confidence bankers will have to make loans....The more reason to hope that we can gradually push our way through the crisis."

There's truth to that. We do live to see another day. "What doesn't kill us makes us stronger."

But the Problem is Still Oil

Oil rallied $3 today rather than continue yesterday's dip. In our last few posts