Category Archives: Commodities

What does “diversification” mean?

 

Diversification is key - Wealth Foundations

To many retail investors “diversification” means owning a collection of stocks, bonds, mutual funds or Exchange Traded Funds (ETFs).  But that’s really not what diversification is all about.

What’s the big deal about diversification anyhow?

Diversification means that you are spreading the risk of loss by putting your investment assets in several different categories of investments.  Examples include stocks, bonds, money market instruments, commodities, and real estate.  Within each of these categories you can slice even finer.  For example, stocks can be classified as large cap (big companies), mid cap (medium sized companies), small cap (smaller companies), domestic (U.S. companies), and foreign (non-U.S. companies).

And within each of these categories you can look for industry diversification.  Many people lost their savings in 2000 when the “Tech Bubble” burst because they owned too many technology-oriented stocks.  Others lost big when the real estate market crashed in late 2007 because they focused too much of their portfolio in bank stocks.

The idea behind owning a variety of asset classes is that different asset classes will go in different directions independent of each other.  Theoretically, if one goes down, another may go up or hold it’s value.  There is a term for this: “correlation.”  Investment assets that have a high correlation tend to move in the same direction, those with a low correlation do not.  These assumptions do not always hold true, but they are true often enough that proper diversification is a valuable tool to control risk.

Many investors believe that if they own a number of different mutual funds they are diversified.  They are, of course, more diversified than someone who owns only a single stock.  But many funds own the same stocks.  We have to look within the fund, to the things they own, and their investment styles, to find out if your funds are merely duplicates of each other or if you are properly diversified.

You need to look at a “portfolio x-ray” which will show you how much overlap there is between two or more mutual funds.

Only by looking at your portfolio with this view of diversification can you determine if you are diversified or if you have accidentally concentrated your portfolio without realizing it.

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Is OPEC Headed for the Ash Heap of History?

We read an intriguing essay by Brian Wesbury of First Trust today.  Using the phrase that Ronald Reagan used nearly 25 years ago about the Soviet Union about Marxism and Leninism being left on the “ash-heap of history,” Wesbury thinks that OPEC (Organization of Petroleum Exporting Countries) may be headed the same way.

Now it appears OPEC, another nemesis of the US from the prior century is heading for the ash heap of history as well, not because of geopolitics, but because of the hard work of engineers.

A combination of fracking, seismic imaging, and horizontal drilling has led to a huge reduction in the cost of drilling and an increase in the supply of oil and natural gas, not just in the US but around the world.

Case in point: in the past twelve months the US has run an $8.4 billion goods trade surplus with OPEC, including Algeria, Angola, Ecuador, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates, and Venezuela. What a difference from less than a decade ago. Back in 2007-08, the US ran a $190 billion goods trade deficit with OPEC. The reason for the change in the trade balance is that the US is importing much less from OPEC, $64.8 billion in the past twelve months versus $253.4 billion at the peak in 2007-08.

Those are amazing statistics.  A $200 billion dollar change in the balance of trade in just under a decade, all due to a technological revolution in the production of oil and gas.  We are accustomed to thinking about technology in terms of silicon chips, iPads and cell phones.  But the bigger sociopolitical change may have been in the dirty, greasy, un-glamorous field of petroleum engineering.

Who would have guessed?

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Stocks, Bonds, Currencies and Commodities at the End of the First Quarter

Markets at a Glance

Major Stock Indexes

9:22 AM EDT 4/1/2016

Last Change % CHG
DJIA 17685.09 -31.57 -0.18%
Nasdaq 4869.85 0.55 0.01%
S&P 500 2059.74 -4.21 -0.20%
Russell 2000 1114.03 3.59 0.32%
Global Dow 2285.09 -29.76 -1.29%
Japan: Nikkei 225 16164.16 -594.51 -3.55%
Stoxx Europe 600 329.64 -7.90 -2.34%
UK: FTSE 100 6086.65 -88.25 -1.43%

Currencies

9:22 AM EDT 4/1/2016

last(mid) change
Euro (EUR/USD) 1.1379 -0.0002
Yen (USD/JPY) 112.04 -0.54
Pound (GBP/USD) 1.4210 -0.0150
Australia $ (AUD/USD) 0.7621 -0.0036
Swiss Franc (USD/CHF) 0.9607 -0.0010
WSJ Dollar Index 86.79 0.21

Futures

9:12 AM EDT 4/1/2016

last change % chg
Crude Oil 36.99 -1.35 -3.52%
Brent Crude 38.81 -1.52 -3.77%
Gold 1219.9 -15.7 -1.27%
Silver 14.980 -0.484 -3.13%
E-mini DJIA 17486 -109 -0.62%
E-mini S&P 500 2038.25 -13.25 -0.65%
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The Oil Price War

The talk on the Street is that there is an oil price war sparked by Saudi Arabia.  The surge in oil and gas production due to fracking in the US has increased the supply, putting downward pressure on prices.  The cost of producing oil by the Saudis is estimated at $20 per barrel, lower than the cost of production via fracking.

However, the Saudis, and many other producers have swollen public budgets which depend on the continuing profits from oil.  Throw those costs into consideration and some estimate that the Saudis need oil to be priced at $90 to $100 to cover all the services the government currently provides.

Other countries that depend heavily on high oil prices to support their public services are Russia and Venezuela.

Wood Mackenzie, a global energy consulting group, surveyed 2,222 oil fields worldwide and found that at $50 a barrel – around where Brent crude trades now, only 0.2% of oil supply faces negative cash flow. At $40, that figure rises, but only to 1.6%.

That means that oil prices would have to go a lot lower if the Saudis are to be successful in shutting down a lot of current production.

The Saudis have foreign-exchange reserves roughly equivalent to their annual gross domestic product.  It remains to be seen how this oil price war ends.

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Bitcoins

During a client meeting a few days ago we were asked about Bitcoins.  One of our clients had received a number of solicitations to buy Bitcoins over the last few months and he asked us for our opinion.

Bitcoins are an invented electronic “currency” that has attracted the attention of the financial press.  They are designed to appeal to people who are concerned about the value of more conventional currency.  Concerns about a national currency becoming worthless have been one of the main reasons that people have invested in gold, silver or other commodities.  These are said to have intrinsic value when paper currencies become worthless.  After all, gold and silver coins have been around a lot longer than pieces of paper with pictures of dead presidents.

Today’s transactions using conventional currency – like dollars – have largely been taken over by electronic transactions.  Every time you use a credit card, write a check, pay bills via your bank’s on-line bill pay program, you are moving ledger balances, not paper currency.  So why not use an alternative, global  electronic currency?

In my view, the problem with Bitcoins is not just that their value has gyrated even more widely than gold or silver, but that there is no national authority that stands behind their ultimate value.  The headline recently read: “Shutdown of Mt. Gox Rattles Bitcoin Market.” 

Once the pre-eminent marketplace for buyers and sellers of bitcoin, Mt. Gox stopped all transactions on Tuesday, and its website disappeared. The site later came back, carrying only a message that said the halt was “for the time being in order to protect the site and our users.”

We recognize that governments have often been guilty of debasing the value of their currencies.  However, we are not ready to jump on the Bitcoin bandwagon since they seem to be even more unstable and prone to failure and loss than all but the most irresponsible kleptocracies.

We advised our client to take a pass.

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Gold and Silver

Until the precious metals began going down, metal mania had gripped some investors.  Not only could you buy silver and gold bars, but you could buy mutual funds and ETFs that allowed you to own gold second-hand.  The problem with investing commodities is that they don’t produce any income and, in fact, cost money to store.

Both gold and silver have had a history of dizzying volatility.  It seems to go in spurts.  According to an article by Ann Marsh  in the December 2011 issue of Financial Planning magazine, adjusted for inflation gold reached a high of $2305 during the last bubble with ended in january 1980.

The rationale behind investing in gold (and silver to a lesser extent) is that it is a hedge against inflation.  Another driver is the rise of the Indian and Chinese middle class, both of which are buying more gold jewelry; and by industrial demand, for silver in particular.

There is nothing wrong with owning gold, silver, or the ETFs that are a substitute for buying the actual metal.  But keep in mind that these a speculative investments with a long history of wild swoops.  Don’t over-extend in these kinds of securities.

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The Price of Gold

Gold has dropped precipitously in the last two days.   Many individuals and institutions own gold as part of their portfolio.   Those who owned gold for speculative reasons may have been scared out of their positions or forced to sell because of margin calls.  There were rumors about hedge funds with gold exposure who might have to sell other assets to raise cash.  Markets reacted to this risk of contagion other than gold causing a broad stock sell-off.

If you own gold you should evaluate why you own it.  Here is one mutual fund’s rationale for owning it.

There is a key reason for this investment: Exposure to gold provides a hedge against what the portfolio managers believe are structurally weak developed market fiat currencies ‒ the yen, the U.S. dollar and the euro. These currencies appear even weaker now in the face of several years of aggressive central bank monetary policies.

What is their position in face of gold’s weakness?

Gold’s position in the Fund is used as a hedge against these inflationary policies, not simply as a means of obtaining additional portfolio alpha via price appreciation. As such, the portfolio managers plan to maintain the gold position because the aggressive monetary policies from global central bankers remain in place.

Is the rise of gold over or is this a temporary blip?  It depends on many factors and we’re not sure whether gold will prove to be a hedge against the creation of a massive amount of fiat currency by Central Bankers.  It’s not even certain that inflation rather than deflation is in our future.   In an uncertain world it’s usually wise to give yourself lots of alternatives and stay alert.

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Real Assets

I once heard someone define real assets as things that when you drop them on your foot they hurt.  These are things that represent tangible stuff, unlike financial assets which are mostly marks on paper or records stored in computer files.  An example of a tangible asset that most people own is a car, or a home.  Keep in mind that cars deteriorate in value and homes can do the same, but many tangible assets increase in value because of scarcity coupled with increased demand.  An example of a real asset that has grown in value over the past decade is gold.

While many people collect actual physical tangible assets, in most cases it’s not practical for most people to collect, say, barrels of oil.  For these, the financial services industry created investments products that are backed by real assets such as gold, silver, oil and many other assets that are, or may become, scarcer or more valuable.

You can buy funds or ETFs that are backed by precious metals, by oil or natural gas, by real estate, by timber or lumber, by soybeans or cattle, by collectibles and even by toll roads.

The attraction of many tangible assets is that if inflation picks up, “real” assets are usually beneficiaries of price increases.  On the other hand, be careful of speculative excesses.  As large new oil and gas reserves are discovered and opened up, the scarcity value quickly dissipates and prices of these commodities can drop quickly. 

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A few facts about gold ETFs

Gold is probably not going to do you much good if the Mayan calendar is right about the end of  the world tomorrow.  However, many people have become very interested in owning some of the metal in the last decade, which partially explains the increase in price.   One way people have invested in gold is via ETFs (Exchange Traded Funds) which can be bought and sold like a stock, avoiding the need to pay for storage or the risk of theft.

So what are some of the things that people should know about gold?

  • Emerging market demand. In the third quarter, India’s consumer demand was 223.1 tons and Greater China, including China, Hong Kong and Taiwan, hit 185.1 tons.

  • Central banks. The U.S. sits on 8,333 tons of gold, India 557.7 tons, Netherlands 612.5 tons, Japan 765.2 tons, China 1,054.1 tons and France 2,435.4 tons.

  • Investment demand. Jewelry made up 78.5% of total demand in 2002. In the third quarter of 2012, jewelry demand was 59.9% while investments accounted for the other 40.1%. According to the World Gold Council, 91% of European gold demand was in physical investment vehicles over the third quarter as a safe hedge against the euro currency.

  • Exchange traded funds. ETFs are the fastest growing market for gold demand, increasing 58% over the year ended in the third quarter 2012.

  • Supply. While 171,300 tons of gold has been extracted since mining began, the U.S. geological society estimates that about 51,000 tons still sit underground and the World Gold Council expects about 730 tons mined each year.

  • Inflation. Gold has appreciated from $18.92 in 1911 to over $1,700 in 2012.

  • Diversification. Gold is that rare investment product which is historically uncorrelated to financial assets.

  • Recyclable. Around 40% of total supply is recycled gold in 2012.

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