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Michael Bodman
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Michael D. Bodman, M.B.A. in Finance I am the principal of Portfolio Muse blog and its publisher: Portfolio Economics LLC. My research starts with macroeconomics before proceeding to specific investment ideas. Before establishing my own research and publishing company, I was as a research... More
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  • What Are The Underlying Weaknesses Of Today's Labor Market

    The headline unemployment rate has dropped below 6%, according to the latest report from the U.S. Department of Labor. Standing at 5.9%, the official unemployment rate is now at its lowest point since July of 2008. Nonetheless, the Federal Reserve continues to fret about weakness or "slack" in the labor market.

    The headline unemployment rate of 5.9% conceals some basic weaknesses in the labor market. Looking beyond the 5.9% rate, economists are concerned about the labor-force participation rate, the average hours worked per week, hourly wages, and other indicators, according to a recent article in The New York Times.

    These numbers help to explain why people don't feel good about the U.S. economic recovery. At the same time that the unemployment rate is dropping to 5.9%, the labor-force participation rate is deteriorating to 62.7%. Not since 1978 has the labor-force participation rate been so low.

    A broader way of looking at things helps to explain the persistent slack in today's labor market. The picture changes when the unemployment rate includes the following:

    • Total unemployed.
    • Plus all those marginally participating in the labor force.
    • Plus all those forced to work part-time due to economic reasons.

    Based on these factors, the unemployment rate jumps to 11.6%, almost double the headline unemployment rate of 5.9%. No wonder the Federal Reserve continues to be concerned about weakness in the labor market. Until the economy gains sufficient traction to convert part-timers to full-time work, pull in discouraged workers, and mainstream those marginally attached to the job market, the Fed is likely to keep interest rates at historic lows.

    This post was originally published by Portfolio Muse blog at www.portfoliomuse.com.

    Oct 03 8:09 PM | Link | Comment!
  • How To Put Commodities To Work In Your Portfolio

    Commodities are an alternative asset class that can help to diversify your portfolio. Commodity prices are volatile, and investors should have enough risk tolerance to endure the ups and downs of the market. With this consideration in mind, adding an uncorrelated asset class, such as commodities, to your portfolio can help to reduce overall portfolio risk.

    Commodities are generally raw materials, where one unit is just like all other units, according to Iowa State University's Extension and Outreach center. Examples of commodities include soybeans, crude oil, orange juice, cotton, and iron ore. These raw materials are used to create finished goods, such as food, gasoline, and steel.

    Below is a image of agricultural commodities from the year 1936:

    Source: Wikimedia Commons

    In the old days, the market for agricultural commodities was made up of individuals bringing their goods to a farmer's market. Starting in the early part of the nineteenth century, standardized contracts were developed for trading commodities on centralized futures exchanges in faraway cities. The Chicago Board Options Exchange is the largest U.S. options exchange in the United States.

    Options confer the right, but not the obligation, to buy a certain commodity at a specified time in the future, while futures bind the seller to deliver a commodity to the buyer at a specified future date, according to the Library of Economics and Liberty. Futures and options contracts are available for a wide array of commodities.

    Investing in futures and options is complex. Moreover, using these instruments can create federal Schedule K-1 tax consequences, which means extra cost and complexity when tax season arrives.

    A better way to put commodities to work in your portfolio is through equity mutual funds and Exchange-Traded Funds (ETFs). These funds hold a wide range of companies engaged in various activities tied to commodities. Indexes have been created that track commodity-related companies, which facilitates low-cost ETF investing in this alternative asset class.

    Benefits of holding commodities

    A benefit of commodities is that they tend to be uncorrelated not only with stocks and bonds but with each other. Food, energy, and industrial metals are three commodity categories that are relatively uncorrelated with each other.

    Commodities can be used as a hedge against inflation risk. In contrast to stocks and bonds, commodities are real, tangible assets. Owning shares of a commodity-oriented fund is an indirect way of owning real assets. Commodities and other real assets, such as real estate, tend to perform well in an inflationary economic environment.

    Investment ideas

    The Market Vectors Agribusiness ETF (NYSEARCA:MOO) is one of the best food-oriented commodity ETFs. This fund has an expense ratio of 0.55%. The Market Vectors Agribusiness ETF tracks an index consisting of companies selling agricultural seeds, chemicals, and farming equipment.

    Concerning energy, a good choice is the Vanguard Energy ETF (NYSEARCA:VDE). This ETF carries an expense ratio of only 0.14%. The Vanguard Energy ETF tracks an index made up of energy-related companies.

    Finally, to capture the industrial-metals category, the iShares Global Materials ETF (NYSEARCA:MXI) is a good option for investors. The iShares Global Materials ETF has an expense ratio of 0.48%. This fund tracks an index that includes not only industrial-metals companies but also companies engaged in the business of forest products, chemicals, and construction materials.

    Discussion

    Rapid growth in emerging markets over the past two decades has caused a surge in demand for commodities. While economic globalization is being threatened by geopolitical factors, it is likely that the world economy will continue to expand. China is one of the biggest buyers of iron ore used in the production of steel.

    Allocating a portion of your portfolio to commodities is a good way to diversify your investment mix. Scarcity of arable land creates economic forces that are likely to drive commodity prices higher over the long term.

    This post was originally published by Portfolio Muse blog at www.portfoliomuse.com.

    Disclosure: I am long MXI, VDE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

    May 18 10:36 AM | Link | Comment!
  • Basel III: Playing Cat And Mouse With Big Banks

    The Basel Accords are international policy recommendations. Basel III is the most recent update. The Basel Accords aim to ensure that banks have sufficient capital to meet monetary obligations and absorb financial losses.

    The Basel Accords are named after Basel, Switzerland, where the Bank for International Settlements is located and the accords are developed by participating nations. In the United States, the Federal Reserve recently developed final rules implementing Basel III for U.S. banks.

    Basel III has five main components:

    • New definitions of bank capital;
    • Improved measures to cover counterparty credit risk;
    • Appropriate levels for the leverage ratio;
    • A framework that is more countercyclical to the credit cycle; and
    • A new liquidity standard.

    This article summarizes these five components and discusses the implications of Basel III for bank stocks and the economy.

    New requirements for the capital base at financial institutions

    One of the lessons learned from the 2008 financial crisis was that banks did not have sufficient capital reserves to meet financial obligations and absorb losses. Moreover, banks' capital reserves often consisted of low quality assets. Basel III establishes a new, stricter definition of bank capital.

    Since credit writedowns and losses are absorbed by a bank's retained earnings, which is part of a bank's tangible common equity base, Basel III requires that common stock and retained earnings constitute the main ingredients of core reserves.

    This new requirement is designed to improve the quality, consistency, and transparency of capital reserves. Basel III also requires a capital conservation buffer on top of core capital reserves.

    Counterparty credit risk

    The crisis also showed the extent to which banks were exposed to counterparty credit risk. Credit Default Swaps (CDS) had sweeping effects throughout the financial system during the crisis. CDS are credit derivative contracts.

    A CDS buyer receives credit protection on a reference asset, while the seller guarantees the creditworthiness of the reference asset. In this way, default risk is transferred from the holder of the reference asset to the seller of the swap.

    However, the financial crisis demonstrated that CDS protection buyers had a false sense of security. Buyers of protection were exposed not only to underlying reference assets but also to the counterparty risk of credit protection sellers, such as American International Group (NYSE:AIG).

    In response to rising concerns in this area, Basel III strengthens requirements concerning management of counterparty credit risk. To promote sound credit valuations, Basel III recommends an additional capital charge for potential mark-to-market losses.

    Leverage ratio

    Years before the financial crisis, Warren Buffett warned: "financial derivatives are weapons of mass destruction." The market for derivatives continues to grow.

    The derivatives market is so big that it is hard to fathom. According to a recent article in the Atlantic, in 2012, the notional amount of derivatives for J.P. Morgan alone was about five times greater than the size of the entire U.S. economy.

    Excessive leverage (i.e., borrowed money) was widely considered to be a contributing factor in the financial crisis. Basel III introduces standards for appropriate levels of the leverage ratio and changes the components of the ratio to include derivatives.

    Previously, only on-balance sheet items were included in the denominator of the leverage ratio. Under Basel III, the denominator now includes all assets, including derivatives and off-balance sheet items.

    Countercyclical requirements

    Basel III introduces measures to enhance the ability of banks to weather the business cycle. Banks will need to maintain a buffer to conserve capital during the ups and downs of the economy. The basic idea is to protect against excess credit expansion in good times -- a factor contributing to systemic risk.

    New liquidity standard

    Basel III introduces a new liquidity standard designed to promote greater resiliency in the financial sector. The liquidity measure ensures that financial institutions have sufficient liquid assets to survive a stressful, short-term crisis lasting one month. To support longer-term resiliency, the liquidity standard offers incentives for banks to use more stable sources of capital to fund business undertakings.

    Bank stocks

    Banks have resisted increased regulation on the grounds that it stifles innovation and harms profitability. Proponents of Basel III maintain that increased regulation is necessary to protect against potential problems in the banking industry and the economy.

    Over the past eight years, neither J.P. Morgan Chase (NYSE:JPM) nor Goldman Sachs Group (NYSE:GS) has outperformed the market, as measured by the SPDR S&P 500 ETF (NYSEARCA:SPY). The following graph shows the results:

    The outlook for bank stocks is uncertain. But the banks are gaining admirers. As reported in a recent article by MSN Money, Warren Buffett of Berkshire Hathaway (NYSE:BRK.B) is bullish on big bank stocks. Wells Fargo (NYSE:WFC) is one of Berkshire Hathaway's largest holdings. Buffett's bullishness comes despite the new regulations under Basel III.

    Discussion

    While it would be good if Basel III could prevent another financial crisis, economic history shows the following pattern:

    • Crisis;
    • Regulation;
    • Innovation;
    • Deregulation;
    • Asset-price bubble;
    • New crisis; and
    • Reregulation.

    The cat-and-mouse game played out between big banks and their regulators runs in cycles. It is not likely that this time, it's different. Rules can accomplish only so much, especially when considering the size and complexity of the global banking system.

    This post was originally published by Portfolio Muse blog at www.portfoliomuse.com

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Apr 09 1:29 PM | Link | Comment!
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