Sunday, March 31

Week 91 - A Capitalization-weighted Index of 10 Key Food Stocks

Situation: Investors are always on the lookout for a “safe haven” for investments that will beat inflation during good times and bad. Why? Because they’re afraid that the value of the dollar will fall relative to other major currencies such as occurs when the government runs a budget deficit that is greater than the growth rate of the economy (~3%/yr). Since the US budget is currently in such a position, investors are afraid that inflation is just around the corner. The standard solution to this problem is to choose commodity-related investments because commodities are priced on world markets. Any instance of “currency debasement” will make commodities priced in that currency more expensive. The most sought after commodities are oil & gas, copper, grain (e.g. rice, wheat, corn, soybeans) and gold, and spot prices of all exhibit marked volatility. As a result, 10-yr US Treasury Notes have historically been the safest of safe havens. To make matters worse, even though a government does a great deal of deficit spending in order to correct an economic downturn, that spending does not guarantee that its currency will become debased (i.e., devalued relative to other currencies). Adam Smith pointed out long ago that when one country is more efficient at creating a product than a second country, the second country will have to accept the fact that country #1 has a “comparative advantage.” As long as the US government is #1 in managing its economy, heavy deficit spending during an economic downturn will not debase the US dollar.

Undoubtedly, some investors will decide that the US government doesn’t handle its economy as well as other major governments handle theirs. Those investors will conclude that 10-yr US Treasury Notes are no longer a “zero risk” investment for beating inflation over time, and will tend to see gold as a substitute. Indeed, gold has outperformed 10-yr Treasury Notes since 2000, when the US government began the first of two cycles of deficit spending in an attempt to reverse two recessions. 

Why is gold considered to be a substitute safe haven? Because it will more reliably beat inflation over the very long term than will 10-yr Treasury Notes. Since 1972, when the US came off the Gold Standard, the value of gold has grown 8%/yr vs. 4.5%/yr for inflation and 6.5%/yr for 10-yr Treasury Notes. But now that the US government’s deficit spending is down to 7% of GDP and headed lower (after peaking at 9.5% of GDP in the second quarter of 2009), investors might think about looking beyond gold for ways to more safely beat inflation. Inflation-protected 10-yr Treasury Notes or Savings Bonds (ISBs) should be their first consideration, given the very low standard deviation (volatility).

Among commodities, the government predicts that grains will beat inflation by 1-2% over the coming years--along with the necessary inputs: farm equipment, seeds, fertilizer, animal feed, crop protection products and land. In this week’s blog, we’ve set up a capitalization-weighted index of 10 key food-related stocks (Table) and compare these to gold bullion, the largest oil & gas company (Exxon Mobil), the largest copper producer (Freeport-McMoRan), the S&P 500 Index, Vanguard’s Balanced Index Fund (VBINX), Vanguard’s intermediate-term US Treasury Funds (VFIUX, VIPSX), and the largest hedge fund issuing its own stock (Berkshire Hathaway). From the Table, it is clear that our Food Index outperforms all of those.

Bottom Line: Gold is a bubble-maker that is best avoided: From January 1977 to January 1980, the price of gold surged 482% to a high of $850/oz. In January 1981, it was $578/oz and by January of 1982 it was $376/oz. Our current situation looks like we are in another gold bubble, one that peaked on 9/5/11 (per the afternoon London Gold Fixing) at $1895/oz. Gold's peak-to-peak growth rate is 2.6%/yr, i.e., less than the 3.3% inflation over those 31+ yrs. All commodities form bubbles in the face of scarcity, and scarcity leads to higher production, but gold is not a necessity and its industrial uses consume only 10% of its production. Food, however, is a necessity and twice as much per year will be needed by 2050. There are no substitutes for food and starvation is not an option. Global grain reserves have been falling 4%/yr since 2000. That is why spot prices for grain commodities have been growing faster than core inflation and will continue doing so. Those price increases are being passed along to the consumer because food products have almost no price elasticity (e.g. people may buy less meat and substitute a cheaper protein-rich product like Greek yogurt, but they’re unlikely to opt for eating less animal protein). 

Risk Rating for the food index is 3.

Full Disclosure: I have shares in KO, PEP, DD, MKC, GIS, HRL, and FLS.

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