Kendall Anderson, CFA June 5, 2008
"Nothing is difficult to a man who wills" -Chinese Proverb
On May 25th, a tornado ripped through Parkersburg, Iowa destroying a third of the town. Parkersburg is located approximately 80 miles northeast of Des Moines and about 50 miles directly east of the town I grew up in. With a population of 1889 people it is the largest town in Butler County and smack dab in the middle of the greatest corn producing soil in the United States. With over 1000 farms and ethanol driven corn prices, things in Parkersburg were moving along quite nicely. The town, like many in Iowa is the home of a regional high school where the students come from Aplington (pop. 1054), Parkersburg and the farms in between. With grades 9 through 12, the school has 278 students, with 142 boys and 136 girls. There were 71 seniors. There is something amazing about this school. It has produced four, yes four NFL football players, including Aaron Kampman the Pro Bowl Packers defensive end, Brad Meester, Jacksonville's center and the Denver Broncos' Casey Wiegmann. This farmland not only produces some tall corn, but also some pretty big boys.
Football is the big sport in this part of the country. Although I played a little football, being tall and skinny I enjoyed the game of basketball and spent most of my youth involved in the sport. Since basketball started after the football season ended, some of these big boys joined in and played my game. Every central Iowa team had one or two of them. They had a very special job, which I fondly remember as the enforcer. If anyone on the opposing team was playing well, one of the enforcers would amble off the bench, and come into the game with only one goal, to play football, using an opposing player as the ball. Three fouls in a minute or two was not uncommon. Their goal was to destroy your will (or your ability) to play.
This human trait, having the will to survive, to succeed, to overcome adversity is universal. Without it, we are doomed. It is positive will power that drove the four young men from Aplington-Parkersburg high school to reach the pinnacle of football success. It is this power that gave their football coach, Ed Thomas, the ability to state after the storm, "We'll put this town back together. We're going to rebuild and stay here, coaching and teaching. God give me help."
How I love small town America. Hope, desire, and the belief that you can obtain anything is still accepted as truth. This attitude and this great country's freedom to pursue happiness are alive and well. It just might be the answer to Dr. Ed Yardeni's (Yardeni Research, Inc.) question in his May 20th morning briefing, He asked it this way; "Why is the the US economy so resilient? In the classic sci-fi movie Alien, and its three sequels, astronaut Ellen Ripley, played by Sigourney Weaver, repeatedly battles a truly creepy intergalactic reptile. Every time she blasts the creature, it comes back stronger than ever dripping molecular acid. The US economy has been blasted by an ugly credit crunch, a scary drop in home prices, and unnerving increases in energy and food prices. It's been wounded by a severe housing recession and a downturn in auto production. Single-family housing starts plunged a whopping 62.3% from a peak of 1.87 million units during January 2006 to 692,000 units during April. Motor vehicle production is down nearly 20% from July 2007 through April. In the past, such declines in these important industries were always associated with economy-wide recessions."
Well Dr. Yardeni, I believe that it is the will of the American people to look beyond the current problems and plan on their own future. This is the only explanation I have for the fact that the Index of Leading Economic Indicators (LEI) rose in both March and April after falling five months in a row. It is the only explanation I have for the fact that our stock markets produced positive results in the month of May. Given the opportunity and the freedom to solve problems, the American people truly believe that "Nothing is difficult to a man who wills".
In a free economy, the laws of supply and demand set prices. If the supply of an item is less than the public demands, prices will rise. When the supply of an item is greater than the public demands, prices decline. Over the years, our government has modified this basic tenant through our tax and regulatory system. Tax policy can and does affect both supply and demand. If our government wants to encourage an increase in demand it will provide tax incentives, thus lowering prices. If our government wants to discourage demand it will add a tax, or through regulation, limit supply, thus increasing prices. Because our need to consume energy is mandatory, it has been a prime target throughout the years for government tax and regulatory intervention. Most of you have heard about the testimony of major oil company executives before the Select Committee on Oil Prices and Energy Independence. What you may not have heard is the testimony of Michael Master before the Congressional Committee on Homeland Security and Governmental Affairs. More on this later.
In that oil prices have surged from $87.00 per barrel in January to over $130.00 per barrel in May, just about everyone is wondering why or even how this is possible. Most of the comments I hear rationalize the price increase to the belief that there is not enough oil to meet demand. So lets find out if that is indeed the case. On a worldwide basis the US Department of Energy collects and distributes information on oil production. They indicate that worldwide production has held steady for two and one-half years at 85.0 MBD (million barrels per day). The Oil Market Intelligence data shows oil production at 85.9 MBD for the twelve-month period through April 2008. World oil consumption has grown just 1% year over year to 85.8 MBD. From these numbers, it looks as if oil supply over the past two years has been sufficient to meet the demand. This alone should not have had any impact on oil prices, yet they still have appreciated substantially.
If the amount of production meets the level of consumption, then non-users of oil must drive price appreciation. In other words, speculators who are taking a bet that the current supply of oil and the ability to recover additional oil in the future will not be enough to meet a growing demand. Given the growth of the emerging economies of Asia, Eastern Europe and South America, I can understand this story. But how long will it take for them to "grow" enough to consume so much oil that warrants a 50% increase in prices in the last 5 months.
We have gone through two major price bubbles since 1999. Is a third one in the works? Speculators almost always drive bubbles. People who believe that an asset's value will appreciate forever. It takes one other element, easy money. The tech bubble and the real-estate bubble had both of these drivers present. Today, in the oil market I believe that enough people believe prices will go up forever and will buy at any price. However, we know that money for speculation is not readily available. Or is it?
Back to Mr. Masters and his testimony. (His entire testimony can be read at this link)
http://hsgac.senate.gov/public/_files/052008Masters.pdf
He stated, "What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets; Institutional Investors. Specifically, these are Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments and other institutional investors. Collectively, these investors now account on average for a larger share of outstanding commodities future contracts than any other market participant."
"These parties, who I call Index Speculators, allocate a portion of their portfolios to "Investments" in the commodities futures market and behave very differently from the traditional speculators that have always existed in this marketplace. I refer to them as "Index" Speculators because of their investing strategy; they distribute their allocation of dollars across the 25 key commodities futures according to the popular indices - Standard & Poors - Goldman Sachs Commodity Index and the Dow Jones - AIG Commodity Index."
"These index funds are composed of a number of commodities. While oil is the biggest component of the various funds, they also have exposure to grains, base metals, precious metals and livestock. When you buy one of these funds you are buying a basket of commodities."
This action by fiduciaries is massive and at the same time disturbing. For the first 52 trading days of this year, demand for commodity funds grew by more that $55 billion, or more than $1 billion per day. For the past five years China's demand for oil has been 920 million barrels of oil per year. But index demand (Masters word) for oil has risen by 848 million barrels. Think of this, guardians of other peoples' money have placed almost as many dollars into commodity funds as the entire new demand for oil from over 1Billion people. There is a rational for this movement if you believe in modern portfolio theory. On the other hand, any sane person would understand that investing in commodities without being a producer or a user of the commodity is nothing more than speculation. The pure buying power of these institutional investors is adding the second necessary ingredient to create our price bubble, easy money.
We need to pay attention to the producers of oil and the valuation of oil currently in the ground, not oil that may or may not be pumped out in the future. If the CEO's of ExxonMobil and Royal Dutch Shell believed that oil prices were going to be at $135 per barrel over the next few years, they would be drilling everywhere and anywhere they could, even in places where it would be extremely expensive to the get the oil out and into the market. They simply are not doing that. Secondly, Wall Street is valuing oil company assets at $75 per barrel, for oil found and available. In reality, valuations are probably somewhere in between. If institutional investors are pushing up future prices, then we are in for a pretty big shock on the downside. As a firm, we are keeping our investments at an equal weight to the market. Bubble prices can and will appreciate much further and faster than anyone can gage. So we will stay the course but not overweight our position.
I will admit without reservation, that I am an optimist when it comes to the future of America and the world. Given this bias I find it harder and harder to maintain a positive outlook when daily I am bombarded with negative news and dire warnings of impending doom. This comes in all forms, from my 5:00 am viewing of CNBC, to my occasional participation of talk radio, or the reading of the newspaper. Of course the Internet is awash with blogs that somehow find their way into my inbox. This brings us to the Nash Equilibrium. This concept is named for John Forbes Nash Jr., a mathematician who was made famous through the film "A Beautiful Mind". In game theory, if no player has anything to gain by unilaterally changing strategies, the game is said to be in a Nash equilibrium. (Just a reminder to all my clients and readers, especially those PhD's, I am not a mathematician and think most individual can get by just fine with basic math skills). When it comes to business news, it seems that advertisers will pay a little more for the bad news. In order for good news to have equal representation, the payoff has to be equal to the payoff for bad news. I can only hope that at some time in the future advertisers will begin to see a benefit of good news. Until then, I will have to step in and try to equalize the message.
Many of you have heard the saying "Buy straw hats in the winter, when nobody wants them, and sell them in the summer when everybody needs them". This is a quote attributed to Russell Sage, who for a time in the late 19th century was heralded as the "greatest stock trader who ever lived". The current "greatest stock picker who ever lived" is one of the world's richest men (as was Mr. Sage in his time) Warren Buffet. Mr. Buffet said many years ago, "when people are greedy, you should be fearful, and when people are fearful, you should be greedy". I do believe that people are afraid of the economic future right now. Buying in a time of fear worked in the 19th Century, the 20th Century, and I believe it will work again in the 21st Century.
Contrary to all the current hype, the world's wealth creation mechanisms are in place and expanding. History has taught us, when economic freedom to pursue personal gain is given to individuals, all people are rewarded. It is when freedom is stifled that economies fail. Granted, in the short term economies will grow and contract. But it is people and their needs and desire that grow economies.
Those western developed countries with an aging population, an entrenched bureaucracy, and fear of the unknown will be long-term losers. Countries that increase economic and personal freedom encouraging population growth and provide incentive to create new and exciting products or services to meet the needs of the world's population will be the winners. I place the United States in that category. Some of the emerging Asian countries, although small in economic power today, are taking steps to increase and encourage personal incentives. Some of the former members of the Soviet Union have discovered the power of the individual and if continued, will grow rapidly throughout this century.
Although Mr. Sage created his wealth during the unregulated and cutthroat business environment of the 19th Century, Mr. Buffet accomplished his in the highly and evolving regulatory environment of the 20th Century. They both understood that buying when a bargain is available with an eye for the long term is rewarding. So as Mr. Buffet stated, it is time to be greedy.
Our youngest daughter Elizabeth just returned from a ten-day tour of China. When the opportunity came about I was pleasantly surprised that she took it upon herself to make this trip. Libby has a Philosophy and Religion degree from Winthrop University. Seeking out and understanding other cultures is something that has always been important to her. Reading and listening to others can give you some basic knowledge of a culture, but it takes first hand visitation to give perspective. Given all the emphasis on the emerging Chinese economy, I was very interested in increasing my basic knowledge of this country and more importantly their citizens. It is such an interesting and important topic that I plan on spending some time with it in future letters.
Grace Kennington, Justin Anderson, 2008
From Lake Wobegon, Minnesota "the little town that time forgot and the decades cannot improve...where all women are strong, all the men are good-looking, and all the children are above average". If the Prairie Home Companion was a radio show about the investment business, the opening words would only need one change; substitute "portfolio managers" for "children". For us in the business, overconfidence is one of the most dangerous behavior characteristics we can possess. In a 2006 study entitled "Behaving Badly" researcher James Montier found that 74% of 300 professional mutual fund managers surveyed believed that they had delivered above-average performance. It is easy to see that at the most, only 50% could deliver above average performance. An earlier study completed in 1998, entitled "Volume, Volatility, Price, and Profit When All
Traders Are Above Average" by Terrence Odean found that overconfident investors tend to believe they are better than others at choosing the best stocks and the best time to buy or sell a position and conducted more trades than less confident investors. The results found that more active trader's returns were substantially less than both the less confident individuals, and the market's return.
My number one research assistant, Justin (I may be a bit biased as Justin is also my son) along with an associate Grace Kennington, explored overconfidence in the above referenced paper. An abstract of the research was published in Winthrop University's Book of Abstracts 2008 and a presentation of the paper was given at the Southeastern Psychological Association Convention held earlier this year. Their work examined the relationship between early academic feedback and young adults' tendency for overconfidence. This original work has already made its way into our rules based investment management process. We can only encourage Justin to continue with original research. All of us will benefit.
I wanted to leave you with an enjoyable view of this great county. This is a compliment of our Firms CPA, my friends at MTF and the one and only Johnny Cash. If you receive our email version of this letter, just click on this link:
http://www.mei.net/~mtf/IveBeenEverywhere.wmv
For the rest of you, just type this into your browser.
Until next month...
Kendall J. Anderson, CFA
Anderson Griggs & Company, Inc., doing business as Anderson Griggs Portfolio Management is a registered investment adviser with the US Securities & Exchange Commission. Pursuant to laws and regulations Anderson Griggs also maintains notice filing with several individuals state regulators including North and South Carolina. Anderson Griggs only conducts business in states and locations where it is properly registered or meets state requirements for advisors. This commentary is for information purposes only and is not an offer of investment advice. We will only render advice after we deliver our Form ADV Part II to a client in an authorized jurisdiction and receive a properly executed investment Management Agreement. Any reference to performance is historical in nature and no assumption about future performance should be made based on the past performance of any Anderson Griggs Investment Objective, individual account, or index. The authors of publication are expressing general opinions and commentary. They are not attempting to provide legal, accounting, or specific advice to any individual concerning their personal situation. Anderson Griggs Portfolio Management's office is located at 113 E. Main St., Suite 310, Rock Hill, SC 29730. The local phone number is 803-324-5044 and nationally can be reached via its toll-free number 800-254-0874.