Commodities Act I: What are they?

I'm personally a strategic asset allocation, buy-and-hold, rebalance quarterly type of investor. This makes me boring and not care about what is happening in the markets. It helps me sleep at night too. The downside is whenever I hear about commodity funds achieving huge returns while the stock market has lingered at the same value for 10 years, I ask myself should I look into this a little more?

So I've decided to dedicate a series of blogs about commodities. This first blog in the series is about a primer of what commodities are and why they are considered an investment.

In the Beginning.....
When humans began to establish permenant settlements centered around grain producing regions it started a revolution in basic economics. Grains provided people an ability to store present production for future consumption on a more efficient scale relative to hunting and gathering. This is revolution was basicaly driven by the science behind the grains' ability to store its nutritional value for periods much longer than meat from hunted prey.

This way of life had many benefits, but the main benefit was to hedge against unanticipated events in the future such as famine. Imagine how much higher the price of wheat could be if the granary was completely empty. In ancient societies this would be extreme famine conditions from a series of bad crop yields. On the flipside imagine how much lower wheat prices would be if the granary was filled to capacity.

The ability to store production resulted in ancient societies "investing" their present grain production in order to consume it at a future date. That is the essence of today's modern commodities market where non-farmers are "investing" in excess production of commodities to consume in the future. Except rather than physically taking possession of the commodities and storing them in a granary in our backyards, the current mechanism is through financial instruments.

Back to the Future

Based on this simple premise of buying commodities then consuming it in the future the benefit of "investing" in commodities is to hedge against unanticipated events in the future. In the modern society this event is called inflation.

By now you might have noticed and wondered why I have been using quotes each time I wrote "investing." The simple answer is "investing" in commodities is not "investing." At the very core of this financial instrument is the fact that it is not a real "investment." In economics investing represents a use of production factors to create an asset to further enhance other production factors.

For example, a company decides to use its resources to develop a scheduling software system to improve efficiency of its production crews. The use of the scheduling software system is a true investment since it enhances a production factor. In this case it was labor.

Commodities on the other hand does not enhance a production factor. Therefore commodities cannot be considered an investment.

Conclusion

Obviously "investing" in commodities provides a real benefit of hedging against unanticipated events. Famine in ancient societies and inflation in modern society. If the intent of the individual is to allocate personal resources to holding commodities to hedge against unanticipated inflation, then any allocation of resources greater than the person's future consumption of those commodities would be considered speculation.

In the next article I will try and blog about modern portfolio practices and commodities' rightful place as an asset class in anyone's portfolio.

World Manufacturing: US, Germany, Japan v. BRIC

I was doing some research on an acquisition target the other week. The target was a US based materials manufacturer that primarily served the industrial sector in the US. During my research I asked myself.....is US industry dying? You hear in the media that US manufacturing has been fleeing to lower cost countries like China. Well.....here's what I found on the OECD website. This graph is from data I compiled on manufacturing output by country as a percent of the total world output using constant US dollars to take out exchange rate noise. Unfortunately the data does not have Russia or many of the ex-Soviet Union satellite countries. So I can not share with you how Russia affected the balance of manufacturing in this analysis. You can interpret the data in many ways but the economic history goes something like this.... The US was the dominant producer of manufactured goods after the second World War. It makes sense....every factory in Europe and Japan was essentially bombed to rubble and China was still a feudalistic country. Germany probably started its ascent to manufacturing dominance after the war. Unfortunately the data goes back only to 1970 but my gut tells me Germany climbed up to or past the 15% we see in 1970. Japan's ascendancy started in the late 1970s (14% in 1978) and their peak was in 1991 at 19%. During that time US declined from 25% in 1978 to 21% in 1991. But ever since then the US economy has held its own with the same 21% of the world's output in 2009. One can argue Japan's growth had a direct impact on US manufacturing. It makes sense since a sizable portion of Japan's manufacturing growth was automotive related and that was around the time the US automotive industry started to show cracks in the facade. But one can say the same thing about Germany. Their manufacturing output sank from 14% to 11% during the same period. What's even more baffling to me is the relationship Germany and China had on the world economy after 1990. Its clear that Germany had their lunch taken from them since the 1970. They went from 14% in 1970 to 11% in 1991 to a measly 6% in 2009. China grew like a new born baby! Going from 1% in 1970 to 4% in 1991 ending up at 19% in 2009.

So what about the other BRIC countries....

Brazil:  It might be growing in absolute terms but it doesn't look like the growth is in manufacturing. I guess I have another blog topic on my thoughts on why people are crazy about Brazil.

India: Probably the wrong type of analysis for India since much of the media about India has been about IT services.

Russia: I don't have the data but I have a feeling their money is coming from oil.

So I guess this is a long winded way of saying. China has probably help the US economy by providing cheap manufactured goods but have not taken the manufacturing from the US. Thoughts?