Why Using Ethanol as a Fuel Source is Ill-Advised

This is a good interview with the CEO of Smithfield Foods that discusses why mandates to use ethanol as fuel are driving up food costs.  The article may only be available to subscribers of the Wall Street Journal.

http://online.wsj.com/article/SB10001424052748704330404576291772245610028.html?mod=djemEditorialPage_h

Progress On the Economy

The most recent GDP release this week suggested that the economy might be slowing down.  The 1.8% annualized rate of growth during the first quarter was down from 3.1% in the fourth quarter of 2010.  Most economists passed this off as temporary, and being due to bad weather and increasing prices (i.e. inflation).  But we feel that this slowdown was also due to the tsunami in Japan and its aftermath.  The Japanese economy ground almost to a halt in the days after the tsunami.  The crisis with the Fukushima nuclear reactors did not help, either.  

How does this affect the U. S. economy?  The Japanese auto companies are reporting parts shortages due to plant closures that will affect their auto production for several months. This includes auto plants in the U. S., such as the Toyota plant that was built on the outskirts of San Antonio, Texas and the plant in Georgetown, Kentucky.  My sources tell me that there are also certain food products (inputs to processed foods, such as spices) that are only, or mostly, produced in and around the Fukushima plant.  They will now be unavailable to food producers here in the U. S. for the forseeable future.

We also believe that this slowdown is temporary in nature.  One bellwether stock that we keep our eye on is Leggett & Platt.  Leggett & Plat is a producer of residential furnishings, commercial fixtures and components ( such as store fixtures and point-of-purchase displays), industrial materials (such as wire drawing, wire products and steel tubing) and specialized products (that serve the auto, machinery and commercial vehicle production industries).  This company blew past earnings estimates today, and its stock price increased over 7% on the announcement.


This tells me that the economy is getting stronger, even though the total growth in the economy seemed to slow down a bit.


For now, we are still constructive on the U. S. economic growth and believe that as earnings improve, so will stock prices.

Problems With Index Funds

If you invest in a Standard & Poor’s 500 index fund that is supposed to track “the market”, you are buying a fund that invests in all 500 stocks, with the same weighting as each stock has in the index.  This fund is managed by the Index Fund Manager, who is charged with buying and selling stocks as new money comes into the fund, as money leaves the fund, and when the specific common stocks in the S&P 500 change. Note that index funds are considered to be “passively invested”, as opposed to “actively invested” mutual funds where the fund manager has choices about which stocks to buy and sell, and how many dollars to invest in each stock.

The idea of an index fund is that you receive most of the return of the S&P 500 market index (which represents about 75% of the total dollars invested in the U.S. market).  This avoids the probability that your account will perform significantly worse than common stocks generally (or at least 75% of what is commonly referred to as “the market”).

But are you really receiving returns that are virtually identical to the S&P 500?  The answer is “no”, for a variety of reasons:

First, the fund charges a management fee.  For example, the Vanguard 500 Index Fund charges a management fee of 0.18%/year, probably the lowest management fee of any similar fund offering.  Vanguard claims that the average fee for similar funds is 1.02%!  So even if the manager’s investments are identical to those of the S&P 500 prior to the fee, your investment returns are somewhere between 0.18% and 1.02% (or more) behind.  So in the attempt to avoid a situation where your investments perform significantly worse than “the market”, you have virtually guaranteed that your investment performance will be worse than the market.  Under performance that accumulates over many years can eat into your nest egg by 30-40% or more.

Second, there are investors buying and selling the mutual fund all the time.  When these other investors buy and sell, it forces the fund manager to incur transaction fees (and possibly generate capital gains on which you will be taxed).

Third, an index fund has what is known as “low turnover”.  This means that if you buy in to the fund many years after it was initially offered, there may be a significant gain that is already built into the fund the day that you buy it.  If other investors in the fund suddenly sell, you may find yourself paying a tax on an investment that you yourself did not earn gains on. 

How does this work?  Let’s say that when the fund was new, it sold for $10/unit.  Over time, the fund’s investments rose in value to $15/unit, and none of the shares had ever been sold.  You buy into the fund at $15/unit, and your units represent 1% of the fund.  That same day, one fund holder sells his units, and this represents 10% of the fund’s value.  The fund manager has to sell 9% of the investments in the fund to pay that investor off.  So the fund generates a capital gain on the common stocks that they sold of 45 cents/unit ($5 gain multiplied by 9%).  Your $15/unit value now has generated a 45 cent/unit capital gain, which at a 20% capital gains tax rate generate a 9 cent/unit tax to you.  If you held 1000 units, your tax would be $90, yet your original purchase price was $15, and it is still $15.  You are now liable for a tax on a capital gain that you yourself did not benefit from!  This is a weakness in all funds, but in particular, index funds and “tax managed” funds that minimize the capital gains that they generate (and in so doing, leaves a larger unrealized gain for future unitholders to pay).

Fourth, an index fund has what is known as “tracking error”.  This can occur when a common stock is added to or subtracted from the stock index that the fund is tracking.  For example, when Exxon bought Mobil, the S&P 500 no longer had 500 names in it, since both were in the S&P 500, and after the merger, one of them vanished.  So the management group that decides which stocks to own in the S&P 500 index had to add another stock to get back to the 500.  Although the fund does its best to buy and sell as stocks are added to or subtracted from the index, the fact is that the fund manager is being reactive, rather than proactive.

Some fund managers may cheat a little and only invest in the top 300 of the 500 stocks.  They can do this because the top 300 may be, say, 95% of the total value of the S&P 500, with the other 200 (the smaller companies) representing the other 5%.  This will also introduce tracking error into the mutual fund’s returns.

Other mutual funds invest in stock index futures rather than the actual stocks themselves.  This is a complex strategy that is beyond the scope of this article to explain.  But this is another way in which tracking error can be introduced into a mutual fund’s investment returns.

Often, just the public notice that a stock will be added to the S&P 500 will cause that stock’s price to spike in value, as other investors rush in to purchase the stock ahead of the Index Fund Manager.

Some Index Fund Mangers try to guess which stocks will be added to or subtracted from the S&P 500 Index and “front run” – that is to say, trade before the management group that decides which stocks will be included in the S&P 500 Index announces their decisions.  This, alone, can have a positive or negative effect on how the S&P 500 Index Fund tracks the S&P 500 Index.

A final issue is this:  is tracking the market really in keeping with your investment objectives.  If you are looking for more stability (in other words, less risk than the market), or if you are looking for income rather than growth, investing in an actively managed fund with investment objectives that are closer to yours may be a better option.

For investors who know little or nothing about investing, and do not feel comfortable in hiring an investment advisor, investing in an index fund may make sense.  Some investors who are just starting out and have small sums to invest may not find an investment advisor willing to advise them.  Others, such as Labrador Investments, LLC, are willing to work with newcomers with small amounts of cash to invest.

But for whatever reason you choose to invest in an index fund, be aware that the returns that you receive probably will not be equal to the Index’s returns, and more often than not, your returns will be somewhat less.

S&P 500 Economic Sector Weightings

Investors who follow stock markets are familiar with the Standard & Poor’s 500 Stock Index, which represents about 75% of the total U. S. stock market in terms of dollars invested.  The index, which always includes 500 stocks, is divided into Economic Sectors.  There are 10 Economic Sectors in the index, and each of the 500 stocks is slotted into one of the 10 Economic Sectors.

The Economic Sectors do not have an equal weight.  Their weights change, depending on a couple of things.  First, the relative investment performance of each sector will make the sectors’ weights change over time.  For example, when Financial Services stocks plummeted in value in the fall of 2008 during the financial crisis, and continued on a downward trend after that, this sector’s representation in the index, which had been over 20%, declined to about 10% at their low point.

Secondly, as stocks are added to or subtracted from the index, the new stock may be slotted in a different Economic Sector than the one that was replaced.

The Economic Sectors have the following dollar weights as of Friday, April 21, 2011:

Consumer Durables (autos, home builders, clothing manufacturers) – 10.6%

Consumer Staples (food, laundry detergent, toiletries) – 10.4%

Energy (oil and gas producers, oilfield equipment providers) – 13.1%

Financial (banks, insurance companies, REITs, brokerage firms) – 15.5%

Health Care (major pharmaceutical companies, medical equipment providers) – 11.2%

Industrials (machinery, railroads) – 11.1%

Information Technology (computer hardware, computer software) – 18.2%

Materials (precious metals producers, chemical companies, mining companies) – 3.7%

Telecommunications Services (major telecommunications companies such as Verizon, wireless telecom providers) – 3.0%

Utilities (electric utilities, gas utilities, independent power producers) – 3.2%

Note that the examples in parenthesis are not all of the industries represented; rather, they are a representative sample of the types of companies found in each Economic Sector.

When the Energy sector peaked in the late 1970’s and early 1980’s, Energy represented over 30% of the S&P 500.  When Information Technology peaked in 2000, it, too, represented over 30% of the S&P 500.   So it is pretty safe to say that when a sector reaches almost 1/3 of the S&P 500, it is probably one that is overvalued and due for a fall.

Interestingly, so-called “Index” funds that are intended to provide investment returns similar to that of the S&P 500 Index must invest in these sectors, even if they appear to be overvalued.  These index funds also are probably obliged to hold onto stocks of companies that “everyone knows” is headed for bankruptcy, or is strongly suspected of being headed towards bankruptcy.  Enron, WorldCom and some of the financial stocks that went bust in 2008 come to mind as silly investments for these index funds.

Also, if you invest in an S&P 500 Index Fund, keep in mind that about 13% of your fortunes in this fund are tied to Energy stocks, which are commonly demonized by politicians.  The same is true of Telecommunications Services, Health Care, Food and many other industries that are heavily regulated by Federal or state governments.

Is Gold a Good Investment?

Gold prices have been on an almost steady upward trend since 2001.  See the following link.

http://www.onlygold.com/tutorialpages/PicesSince1972FS.htm).

Gold has become the investment darling of the conservative talk radio hosts, and numerous gold sellers have been hawking their product on television and talk radio broadcasts for several years.  It does not matter if the investor is rich or poor, or if they are conservatives, liberals, libertarians, Republicans, Democrats or Independents, it seems that everyone has either thought about, or actually purchased, gold as an investment vehicle.

In fact, “gold bugs”, as they are affectionately known, adhere to the policy of buying and holding gold in good times and bad.  For gold bugs, gold is as much a religion as an investment.

The first question in an investor’s mind should be whether or not this is a classic investment bubble, similar to the Internet phenomenon that ended badly in March 2000, the biotechnology stock bubble, the real estate investment trust (REIT) bubble, the gaming stock bubble, and every other bubble that occurred over the last 25 years.  Bubbles end badly.  They are the example of the “bigger fool” theory:  you can make money on your investment as long as you sell your investment at a higher price to a bigger fool than you!

Second, ask yourself if gold bullion is really an investment.  It used to be considered a store of value, before countries established central banks to control the value of their currency and avoid debasement (weakening) of their country’s currency.  Paper was “only worth what it was printed on”, but gold tended to retain its value.  Until Franklin Delano Roosevelt suspended the exchange of dollars into gold, and made it illegal for US citizens to hold gold coins, the US dollar was readily exchangeable into gold bullion at a fixed rate of exchange.  This fixed rate of exchange served to provide discipline to the Federal government: unwise creation of an excessive number of dollar bills would cause a run on Fort Knox’s gold hoard, as inflation reared its ugly head, and investors lost faith in the value of the dollar and traded in dollars for gold.

In fact, that very thing happened during Richard Nixon’s administration, in response to inflationary forces caused by spending on the Viet Nam War and Lyndon Johnson’s Great Society programs which vastly expanded Federal government spending.  Nixon suspended the conversion of dollars into gold on August 15, 1971 as France, Germany and other countries made demands to convert dollars (that they had obtained in trade with the US) into gold.  Nixon suspended convertibility to save US gold supplies.

I am skeptical that gold really is an investment.  I believe it is a total speculation for several reasons:

1.   Gold does not provide a stream of income, as do common stocks,  bonds, mutual funds, exchange traded funds (ETFs), money market instruments and Certificates of Deposit.  In fact, it costs money to hold gold – investors must pay to store gold in a safe place, such as a safe deposit box at their bank.

2.   Nothing about gold is remotely productive.  Common stock, which is by definition an ownership interest in a corporation, reflects the earnings of the company after all expenses have been paid.  Land, labor and capital (as in capital stock, such as manufacturing plants) are the input costs, and their productive use results in the creation of goods and services that add value above and beyond the input costs.  Bonds issued by corporations pay a fixed (or variable) income, depending on the terms of the bond indenture.  ETFs and mutual funds are collections of common stock or other financial assets that are tied to income producing assets as well as assets that grow in value over time.  Money market funds and Certificates of Deposit pay income, too.

3.   Gold is not readily tradable for goods and services.  Imagine trying to take a gold bar into the grocery store, shaving off a sliver and handing the sliver to the cashier in exchange for a loaf of bread and a carton of milk.  It just doesn’t happen.

4.   Gold is used in industrial applications, medical applications, and in jewelry.

5.   The gold supply is not fixed, it is variable.  The supply depends on central bankers, who have, in the past, put pressure on gold prices by selling gold out of their vaults.   In fact, part of the reason that gold prices were low throughout much of the 1990’s was that central banks and governments, particularly in Europe, were executing a plan over a period of years to reduce the gold stocks in their vaults.  Russia is one of the key countries that mines and produces gold.  If they decided to flood the market with new inventory, the price of gold would plummet.  Do you really want your investment portfolio to be tied to the whims of a country such as Russia?

6.   Gold demand varies throughout the year.  India, in particular, is a country whose people like their gold jewelry, and there is a seasonal demand in early spring each year for gold to produce gold jewelry for Indians.

7.   The rather new exchange traded funds (ETFs) that invest in gold bullion, such as the SPDR Gold ETF (GLD), have allowed mom and pop investors an easy way to invest in gold, albeit indirectly.  Instead of holding the physical gold, investors with small amounts of cash to invest have the chance to own gold on paper.  This is actually a Trust, and each ETF unit represents an ownership interest in the Trust, which is sponsored by the World Gold Council.  There is actual physical gold that backs up the SPDR Gold ETF which is held in a vault.  The Bank of New York Mellon actually administers the trust.

The prospectus for the SPDR Gold ETF can be viewed at the following link:

http://online.wsj.com/article/SB10001424052748704396904576226820013417298.html?mod=djemEditorialPage_h

8.   The newly-created ETFs that invest in gold have resulted in rising demand for gold bullion due to this “democratization” of the investment in gold, as previously mentioned.  In fact, analysts have estimated that at least $100 of the price increase that has been seen in gold over the last few years is directly attributable to the availability of these new gold ETFs.

9.   Gold is not an investment security, and as such, sellers of gold are not subject to SEC regulation.  Therefore, purveyors of gold are not subject to the same laws and ethical rules that govern investment advisory firms and brokerage firms who assist investors who invest in financial assets.  Gold sellers are able to advertise and make claims that would not be permissible to investment advisors, including puffery and outright deception. 

 

There are several firms that advertise heavily about investing in gold. These firms advertise investment return statistics that are very selective in terms of the time frame that they use to calculate returns.  For example, if you took the gold price as of December 31, 2001 of $272.65/oz. and calculated the investment return as of December 31, 2010 ($1420.25/oz.), the total return would be 20.13%/year, or a rise of 520.9%.  This compares to a price change only return for the Dow Jones Industrial Average of 1.62%/year, or 15.53% for the entire period.  Keep in mind that this number excludes the dividend income figure, which would increase the total return considerably.  But if you took the gold price as of December 31, 1980 ($594.90/oz.) and compared it to the gold price on December 31, 2010, the price return would be 3.05%/year, or only 238.7%.  This compares to the price change only return for the Dow Jones Industrial Average of 8.64%/year, or an increase of1193.5% for the entire 30 year period.  Keep in mind that the last time that gold was an investment darling, it peaked at a price of $850.00 in 1980.  If you had purchased gold at its peak in 1980, your return would have only been 167.1%, and approximately 1.7%/year!

There is also the difference between what the gold purveyors will sell the gold to you for (the "ask" price), and what they will repurchase the gold from you for (the "bid" price).  The spread (or difference) between these two amounts is probably considerable and should be asked about before you buy.

Gold is all the rage, and, as professional investors would state, it is a “crowded trade”.  The definition of a “crowded trade” is that many investors are taking the same view: that gold should be bought, not sold.  Gold is in a bubble right now.  As with any bubble, it is hard to know when this will end, but when it does, I suspect that there will be a lot of mom and pop investors whose gold investment did not provide the returns that they were expecting.   

Can the gold price increase from here?  Yes.  When will it be time to sell?  It is impossible to know, but probably can only be determined in hindsight.