Monday, February 18, 2008

Boys with Toys

January 18, 2008

My wife, who designs landscapes with an artist’s eye, used to lament that much of her time was spent undoing the efforts of those who had preceded her at a client’s home with backhoes and bobcats. Sweeping power in the end turns out often to be no match for care and nuance in producing an end result to live with. In the investment landscape and now the economy as a whole the same is holding true.

I am afraid we now need to undo the damage of kids with calculators who have been long on cleverness and short on wisdom. The sheer pleasure of creating an investment that is constructed using mathematical models and derivatives cannot be overestimated. Add to that the financial benefit of selling it as the perfect investment to institutions large and small and you’ve got a potent mixture. In investment speak we are now dealing with a “long tail event.” That is, one statistically unlikely and in often uncharted waters. I recently read the comment, “it is the dumbest people and the smartest people who lose the most money.” Like the 1998 Longterm Capital hedge fund collapse that nearly unraveled the global financial system, we are seeing a similar event unfolding. That collapse led by several Nobel Prize winners inspired the book, When Genius Fails.

The idea that housing values could fall on a national basis was deemed so unlikely that an entire country based its economy on the inevitable rise of real estate. Teaser loans that could be refinanced with the increased equity in a home drew any and all into the great American dream of homeownership. Political and central bank policies encouraged it and until the past few weeks cautionary signals were ignored by those who were entrusted with the roles of leadership.

In the past few weeks we have seen a seismic shift in the global economy. Many won’t notice for years to come, but it seems that national economies are on a path to irrelevance. Look at the names of companies that have become part of a growing list of internationally owned institutions as firms desperate for capital infusions scoured the globe; Morgan Stanley, Merrill Lynch, Citibank, Standard Bank. These are the names of the bulwarks of global capital creation. Names now further immersed in the global needs of sovereign nations like Singapore, China, Saudi Arabia and the United Arab Emirates as those investors substantially increased holdings and influence in these financial titans.

What does it mean for the United States? No one really knows yet. But as investors, we need to be sifting through the wreckage for the beneficiaries and watching as the powers that be seek solutions to problems often of their own making. Already policy moves are beginning to invoke the law of unintended consequences in other areas.

Where the opportunities will arise from the ashes of the subprime mortgage debacle isn’t yet clear. However in another area, I believe investors should be exploring. In December, President Bush signed into law the new energy bill. Among the various aspects of the law are massive changes which have not yet been fully felt and have the potential to reverberate strongly through the economy.

In 2005 14% of the corn crop was dedicated to ethanol. For 2008 that figure will increase to 32%. The amount of US agricultural land employed for energy production will increase from 10 million acres to 26 million acres. These are jaw dropping long term changes in the balances within our economy.

Grains have been rising steadily and beef cattle ranchers are feeling pain already, in many cases culling herds because the expense of feed has become prohibitive. As the price movements work their way through the protein chain, watch for additional effects on price and availability of agricultural produce and products. Consider some the investment options available to profit and diversify within that sector as our clients have.

John F. Barnyak