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

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.

A Long Retreat from U.S. Equities is Continuing

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.

Long Run U.S. Outlook Not Much Improved

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.

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.

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

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

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.

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

We've read a few too many times in the past two weeks that equity markets can, even should, rise sharply in the middle of recessions. And we keep reading that a second-half '08 economic recovery may be back on the table after all.

If this sentiment is becoming too common, recently-bid-up equity markets are becoming more vulnerable to the rash of further economic slowdown headlines that are coming in the next couple of quarters. (That is why most of our efforts to narrow our equity-underweight in recent weeks have been focused on major secular trends with less economic sensitivity.)

Pending bad news often seems well-understood and discounted .... until it arrives and stares investors in the face. And arrive it will. Every day that the credit market remains tight -- and tightens in many parts of the world -- means there's less new investment going into the economic pipeline, and less economic activity in the future. The massive credit unwind in the past six months is stealing significant economic growth from the future, and the credit unwind is still occurring in a pronounced way. (Again, that's why we're sticking with areas of the economy that are grabbing a rising share of investment, such as agriculture, water, and energy efficiency.)

It may be true that there's less chance of an financial collapse now than perceived just a few weeks ago, and that the reduced "tail risk" has helped lift markets in recent weeks. But if (we think when) world economies slow more substantially later in '08, investors will become more fearful of equities. We're waiting for that "second wave" of equity market fear to significantly raise our equity weighting.

A brief FT article tonight adds a few more specifics our concerns about another wave of economic slowdown news hitting market sentiment soon:

• Treasury sell-off hits housing recovery hopes

  The Fed sees the rise in yields as signalling increased market confidence in US economic prospects.

  However, mortgage rates also moved higher, making it more expensive to buy homes and less likely that existing homeowners will be able to refinance mortgages. [Recall, perceiving "the beginning of the end" of the housing crisis has been seen as a necessary condition to end the financial crisis.]
  

  Rates on 30-year fixed-rate mortgages rose to 5.87 per cent from 5.63 per cent a week ago, Bankrate.com said. Jumbo mortgages, those of more than $417,000, rose to 7.19 per cent from 7.06 per cent.

  “The back-up in yields is a concern as it will damage the economic outlook,” said Jane Caron, strategist at Dwight Asset Management.

  The three-month London interbank offered rate – Libor [to which trillions of dollars of loan costs are tied]– increased to 2.91 per cent from 2.71 per cent this week, indicating underlying stress in the financial system.

  Stocks rallied, said Anthony Conroy, head of equity trading at BNYConvergEx, because “the equity market is focused on a second-half recovery...and is not paying attention to the rise in bond yields yet.

Adding Equity Exposure While "Muddling Through" Crisis

Each day that brings a bit more reassurance that the financial crisis won't turn into a catastrophic melt-down represents a good day for markets, after investors fear the worst for much of 2008.

So, even though we're arguing for being underweight equities until one's semi-annual asset allocation rebalance, we've posted about adding equity exposure gradually, and to gain exposure to major investment themes that should combat the economic cycle and provide high beta if markets turn bullish.

During the week of March 31-April 4, we highlighted the Agriculture theme [specifically agri-biotech Monsanto (MON) and Syngenta (SYT)], the length of the Africa & Middle East theme (TRAMX), and the value of adding some U.S. index exposure (VTI). We also were tracking Water, Solar, Genomics, China, Brazil, Canada and other areas.

This week we extended many of those themes, and are also highlighting Suez (SZEZY - a global utility and water infrastructure company), Lindsay (LNN - a high-tech irrigation equipment company), Itron (ITRI - a global utility metering equipment company), and Origin AgriTech (SEED - a Chinese seed company with substantial "option value"). This week we also saw decreased risk in adding exposure to European (VGK), Emerging Markets (VWO), and Brazil specifically (EWZ).

Environmental Boom Ignites Stocks

Earlier today (4/16/08) stocks of companies that address the world's biggest environmental challenges soared more than the market averages. It's as if thousands of investors suddenly read Jared Diamond's Collapse (focusing on agricultural productivity) and the Socolow and Pacala paper (on ways to save the earth seven billion tons of carbon emissions), then invested accordingly today...

...Stocks like Monsanto (+7%) and the agri-biotech sector (+3-4%), First Solar (+4%) and the solar sector (+3-7%), the broader alternative energy sector (+3-15%), Badger Meter (+20%) and the metering sector (+3-7%), Lindsay (+6%) and the water sector (+3-4%), the engine and air filtration industry sector (+3-5%), the green electronics sector (+3-15%), and so on.

We'd still be adding to equity weightings selectively in key industries backed by major secular trends, as suggested by several of our latest posts (including here). See also our post titled "Climate Change -- Investment Waves Will Keep Coming" and our April 4th post after an earlier increase in environment-related equity allocation.

Today it's as if investors were struck harder than ever by the imminent major implications of skyrocketing energy prices and global warming. It makes perfect sense. Crude oil punched to $115/barrel on supply projects. Yesterday, a paper presented at the European Geosciences Union conference predicted a rise in sea levels three times higher than predicted by the U.N.'s Intergovernmental Panel that won the '07 Nobel Prize -- a full 0.8-1.5 meters that would have massive consequences for hundreds of millions of people and economies. Today, Bush, seemingly the last and most important global-warming-denier, finally highlighted the need to constrain greenhouse-gas emissions, in a speech that emphasized the need to invest in technologies (such as carbon capture and sequestration -- see some of the market's inferences, above) and his seemingly increased willingness to sign binding international agreements.

Still Muddling Though Crisis, But Not Far Enough to Buy Aggressively

The dollar dodged more bullets today, which diminishes slightly the "tail risk" of a financial system collapse, at least for the moment. That's the underlying reason why equity markets rallied, despite the further spike in oil prices and the higher-than-expected U.S. inflation data. "Muddling through" the credit crisis represents the "bull case." We don't think we've muddled through enough to glimpse the light at the end of the tunnel, so we still aren't significantly raising our underweight equity stance ahead of our mid-year rebalance date. Instead, we've only added some high-quality and some relatively counter-cyclical equity exposure.

How did the dollar pull it off today? The Treasury's data on foreign purchases of U.S. assets in February showed foreigners aren't pulling the plug. The Fed's Empire State manufacturing index wasn't worse than expected, and earnings reports weren't bad today. Supporting the dollar relative to the euro, specifically, was the very weak German economic expenditures index. UK economic data was very weak. The continuing food price spiral and increased political instability in Developing Economies is also helping the dollar avoid a rout (see the latest here on food, and note the relenting opposition to genetically modified crops, a trend that continues to aid Monsanto, Syngenta and others).

To describe the market's somewhat surprising rally today a bit more boldly: equities acted as if a few more market participants believe the credit crisis won't deepen significantly, and will ultimately come to good by dampening demand and inflation, creating a "soft landing," and setting up for another long bull-run. This hopeful school of thought is represented by a column here. We'd like to believe it, because there are a few bright lights even as banks strangle their lending operations. After all, non-bank corporations have low inventories and are flush with cash -- the WSJ reports tonight that Microsoft is aggressively extending vendor financing to small business customers. But even Microsoft notes that the bad credit of its customers is "approaching materiality."

The longer the credit markets remain stressed (note that interbank spreads remain very wide), the further food and oil prices rise (increasingly from supply-shock, no less), the longer the U.S. (and increasingly foreign) housing slumps continue unabated, the more we'll see the conditioned bullishness of equity investors be challenged. The next leg down won't be fun. Not before we see fractures in some major Developing Economies will we be likely to declare "the beginning of the end" of the crisis.

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.

Allocation and Energy Update

As the case strengthens for a continuing long-run trend in higher energy prices -- even though the global economy will continue its cyclical slowdown -- many individual investors may be surprised at how lightly their diversified equity portfolios are weighted in the energy sector.

We reviewed this data again this week, and it was one of the reasons why we're rebalancing our overweight energy position in accordance with our strategic allocation, rather than cut too far.

• The U.S. Energy sector comprises only 12.7% of the Vanguard Total Market Index Fund, which tracks the Wilshire 5000. Although this is up from 9.1% a year ago, it is still roughly on part with Health Care and Industrials, and well below Technology (15.7%) and Financials (17.4%).
• The rest-of-world Energy sector comprises only 10.4% of the Vanguard FTSE All-World-ex-US fund. This is on a par with Industrials and Materials, and far below Financials (28.7%).

Another reason to adhere to one's strategic energy allocation, rather than market-time a cut in weighting, was yet another in a litany of "economic nationalism" updates: China's roughly $60bn deal to secure LNG from Qatar over 25 years. For perspective (from the FT article):

• “Three to four years ago, the Qatari projects were going to send this gas to the Atlantic Basin, particularly the US,” said Frank Harris, of Wood Mackenzie, the Edinburgh-based consulting firm. “What it means is that we are going to see a lot less LNG go to the US than we thought.”

The SPDRS Oil & Gas Exploration & Production ETF (XOP) is an equity investment that has typically provided the most leverage to changes in long-run oil and gas price forecasts. The companies are engaged in upstream activities to locate and produce, which is where the global bottleneck in the energy chain is. The tremendous intellectual property required of these companies -- particularly in the increasingly difficult-to-access geologies -- gives these companies more protection from price-based competition.

We are also weighing environmental issues. On one hand, profits generated from traditional energy are being invested increasingly in "alternative" energy projects, as the economics of alternative energy comes closer to parity with traditional energy. Some traditional energy companies are therefore becoming better positioned to benefit from the diversification of energy sources that the world is beginning to undergo. However, until world governments more effectively price the externalities of the energy business (such as C02 emissions, contaminant emissions, and water -- all of which energy companies use intensively), the energy companies will continue to benefit disproportionately at the expense of sustainable life on earth.

Slight Increases in Equity Allocation This Week, But Still Underweight

As the "muddle through the credit crisis" hypothesis gained a bit more credibility this week, it made sense to boost equity allocations somewhat, though we remain partial to the underweight argument.

We've tried to raise equity allocations via gaining exposure to diverse major investment trends, including:

• Agriculture - Monsanto (MON) and Syngenta (SYT), two of the leaders in agri-biotech. We summarize the major trends here ("Allocation and Agriculture"). We're also watching two agriculture ETNs: iPath Dow Jones AIG-Agriculture ETN (JJA) and ELEMENTS Linked to the Rogers International Commodity Index - Agriculture ETN (RJA).
  
• Africa & Middle East (a broad fund with some "frontier" market exposure.) See our previous post titled Allocation and Africa.
  
• U.S. - Vanguard Total Stock Market ETF (VTI), a Wilshire 5000 Index tracker - Selloff provided a better probability of a long-term entry point.

We're looking for further opportunities in these areas, as well as some additional ones, such as:

• Water and Industrial Processes - Flowserve (FLS), a leader in pumps, flow control and other flow solutions; sells into a diverse industrial end-market. Suez SA (SZE) a France-based utility planning to separate its diversified global water business.
  
• Solar - FirstSolar (FSLR) may pull back after recent flare-up after CEO's comments that he is in project talks with several large utilities. We certainly believe him -- coal-fired power projects are coming off the drawing boards as expected carbon costs rise, nuclear projects aren't being added quickly owing to NIMBY, and oil/gas/hydro prices continue their uptrends -- but collaborations with utilities may take a while to develop.
• Genomics - Illumina (ILMN), a leader in genetic analysis. Find a brief description of this super-trend here: "New Technologies Spur the Race to Affordable Genome Sequencing," as well as the backdrop for a very long-term view here on combating the increasing risk of plagues using new antibiotics, genetic testing, and anti viral drugs.
• China (PGJ, consisting of 25 ADRs) - 40% selloff from peak provided a more fair discounting of the risks, which we've discussed in several previous posts.
• Energy - SPDR S&P Oil & Gas Exploration & Production ETF (XOP), Vanguard Energy ETF (VDE), or iShares S&P Global Energy Sector (IXC)
  
• Canada - iShares MSCI Canada Index (EWC)
• Brazil - iShares MSCI Brazil Index (EWZ)
• Education - ITT Industries (ESI), a well-managed company at a 40% discount to its peak, and up sharply today after Congress introduced a new student loan aid bill. Good summary of Education credit issue here.

A Fuzzy Positive for Equities: SWF Competition

Increased competition among massive Chinese funds to achieve a more optimal portfolio (in a Markowitz sense, seeking higher returns through diversification, which mitigates risk) helps demonstrate another sense in which equities may have underlying bid.

A story in the FT today and comments in economist Brad Setser's blog highlight the point about competition between China's State Administration of Foreign Exchange (SAFE, with $1.65 trillion) and the China Investment Corporation (CIC, with $200bn).

It makes sense that competition among SAFE and CIC isn't limited to these two entities, but that there's also increasing implicit competition among the worlds other SFWs (Sovereign Wealth Funds) to push out their efficiency frontiers. When thought about in the light of competition, it's easier to see that how the wealth funds could provide a stronger underlying bid to equities, as long as financial crisis isn't reigning. As the SWFs undergo the long process of raising their equity allocations -- i.e., steer an increasing percentage of their trillions of dollars in currency reserves toward securities (such as equities) that historically return more than government bonds.

The size of the SWFs has been one of the biggest topics in international finance in the past couple of years, but the implications of the competitive spirit may be a less-considered aspect of the topic.

From the FT today:

• The body that manages the bulk of China's $1.65bn in foreign exchange reserves [SAFE] has bought a 1.6% stake in France's Total, the fourth largest oil group, in a sign of its more aggressive approach to investing the funds under its control....
• In China, the revelation of SAFE's purchase will highten tensions between it and the [CIC], the country's sovereign wealth fund established last September, with $200bn of funds under its control.
• SAFE's more aggressive investment posture after the establishment of the sovereign wealth fund [CIC] has caused divisions at the top of the Chinese government because of concerns that two agencies could be competing in what Beijing recognises as a geopolitically sensitive area.
• The CIC's attempt to establish itself in the global investment community as a transparent and independent investment entity, a challenge given the focus both on China and sovereign funds generally, is being damaged by SAFE's assertiveness, according to officials in Beijing.
  

And from economist Brad Setser's blog:

• [T]here are growing signs that the [SAFE] is becoming more aggressive. It has brought a set of stakes in Australian companies. It recently indicated that it had bought a sizable stake in the French oil company of Total. The latest US capital flows data also suggest a meaningful increase in China's purchases of US equities. That increase preceded the formation of the CIC, and best I can tell, most of the ongoing purchases are coming from SAFE not the CIC. Until it gets the last tranche of its initial round of funding (something that should be marked by a noticeable fall in China's reserves), the CIC doesn't actually have all that money to invest -- mos has already been committed to Huijin, China Development Bank, Blackstone and Morgan Stanley.
• SAFE's growing willingness to take risks isn't a total surprise -- it already has way more liquid assets than it needs, and it was reasonably clear when I visited Beijing that SAFE views the CIC as a rival. SAFE likely wants to show that it can invest as well as CIC, at a far lower cost....
  

Implications for Equity Allocation

We're still underweight because we continue to expect additional cathartic weeks and months in the markets, given the bond-market seize-up, the rarely-smooth path to slower economic growth, and worrying inflation trends (particularly in Developing Markets). Yet every day that comes and goes without significant negative news for markets strengthens the bullish "muddling through" thesis. We've been "muddling" nicely for about a week, and cautiously adding equity exposure. Themes such as SWF competition for returns and portfolio efficiency help alleviate our concerns about equities, as well. We're still underweight though, and bracing for more significant buying opportunities.

Stocks Sometimes Require VERY Patient Investors

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





















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













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

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

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

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

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.

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.

More Signs We're Still Deep in the Woods

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

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

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

Power Stalemate -- And Prices to Keep Trending Higher

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

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

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

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