Links for Thought -- April 6, 2012

Disruptive Innovation: Can Health Care Learn from Other Industries? (HealthAffairs.org) -- This is a great conversation with Clayton Christensen on the impact that disruptive innovation can have on the health care industry.  Christensen gave us THE essential mental model for understanding innovation, and it's important to understand how this model will impact health care over the coming years.  One of my biggest critiques over the health care cost concern is that the entire conversation assumes the past growth rate will continue forward in perpetuity.  Meanwhile, right now there are rapid deflationary innovations sweeping through the industry that I think will not just mitigate, but realistically will drive down the cost of medical treatment over time.  In order to understand this, one needs to know the distinction between something that is merely an innovation, and something that is a DISRUPTIVE innovation.

Important Read on Franchise Investing and Investing "Gurus" (CS Investing) -- Important read is definitely the best way to describe this post.  Here CS Investing gives us a look at what a competitive moat is and what the concept means.  Plus we get a great glimpse into how some of the most prominent investment gurus, including Warren Buffett, analyze moats when making their own investments.

Keynes: One Mean Money Manager (Wall Street Journal) -- Jason Zweig takes a look at the investment track record John Maynard Keynes and wow was it fantastic.  Despite Keynes being a macroeconomist, his successes in investment were primarily driven on the micro level, combined with an understanding of the behavioral element to investing.  This closely aligns with the value investing school of thought on markets, that alpha is possible with scrupulous fundamental analysis.  

Climate Change Isn't Liberal or Conservative: It's Reality (Boing Boing) -- In all seriousness, the title of this article should go without saying.  I first learned that climate change was real when the family swimming pool, which had frozen every summer as a child for me to play hockey on, just stopped freezing enough to skate on.  This started happening in the late 1990s, but now things have been taken to a whole new level.  I am increasingly frustrated and sickened by the "questions" raised over this very real issue.

Cutting A Star Out of the Picture (Wall Street Journal) -- Speaking of my childhood days playing hockey, this article is about the Islanders severing ties to Pat LaFontaine.  I grew up a rabid Isles fan, and even bigger Pat LaFontaine fan.  Pat is one of the all-time great Islanders and a model citizen.  Charles Wang once again demonstrates why he is a despicable person.  While we're on the topic of Pat LaFontaine, go check out his Companions in Courage website to learn about (and perhaps contribute to) some of his charitable initiatives.

Commodities Supercycle or Bursting Bubble? (Pragmatic Capitalism) -- This has been my question of the week, and led to today's post on our country's subsidy for commodity speculation.  It's an important question, because the answer has serious implications for the global economy.  Give this a read to help prepare for a conversation on this blog in the coming months as to whether the commodities bull is a monetary policy phenomenon or an emerging market growth story (or a little bit of both).  

I typically conclude this weekly links post with a nature picture, but for a second week in a row I will depart with a twist.  Here is Van Morrison with The Band performing Caravan at The Last Waltz, rock out for the long weekend, and happy holidays to all:

Why Subsidize Speculation in Commodities?

If you follow me on Twitter @ElliotTurn, you know that commodities have been a big point of interest of late.  I’ve been spending some time trying to distill whether the driver of the commodities bull market for the last decade has been US monetary policy or China’s rapid acceleration in growth.  The answer to that question has significant implications for several different types of investments today, and is really just an interesting and important point in understanding today’s macroeconomy.  But today, with commodities a hot-topic and tax day quickly approaching, I want to take a glimpse at commodities through a different lens entirely.  With oil prices rising quickly in the face of our largest build in crude oil inventories since 2008, there are obvious questions being raised about the impact of speculation in commodity markets (see here for a good look at the question).  After all, how can something go up in the face of an overabundance of supply?  Rather than try to answer the question of how much of a premium in commodity prices is driven by speculation, to this too, I want to take a different angle altogether.

Whether one agrees or disagrees with speculation being a factor in commodity markets, I think we can all agree that such activity should not be subsidizes no matter what.  Yet, that is exactly what our tax code does—it incentivizes speculation in commodities over speculation in any other market.  Even more, speculation in commodities is a great way to guarantee a lower tax rate than the general income tax, when compared to any other profession in America.  There is a hot debate over carried interest, yet this loophole is at least as egregious. 

Broadly speaking, we are in a state of heightened global macroeconomic volatility, and that alone does yield way to increased volatility in demand and pricing for resources; however, that does not explain some of the radical swings in commodities ranging from oil to palladium to gold in recent times.  Since the 2003 Bush Tax Cuts, long-term capital gains are taxed at a 15% rate, while short-term capital gains are taxed as general income, at a 35% rate.  These capital gains apply to most forms of investment income; however, they do not apply on gains in futures contracts–the principle way in which commodities are traded.  Futures contracts, as prescribed by Section 1256 of the tax code, are taxed with a blended rate of long and short-term gains: 60% long-term capital gains and 40% short-term.  The blended rate results in an effective tax rate of 23% on income derived from futures/commodity trading (check out this site for more information on trading taxes).

In essence, the tax code promotes short-term speculation in commodities markets, and it does so in several ways.  People who are speculating in commodity future markets are inherently short-run, and care far more about the discount on the short term capital gains tax rate than they do the increased cost of long-term commodity ownership.  Whereas a short-term equity speculator is taxed at the general income rate, a commodities/futures speculator is taxed at 23%.  The consequences of this are two-fold: first, there is an economic incentive for speculators to ply their craft in commodities markets as opposed to equity markets, and second, speculators desire volatility in the short-run in order to maximize their capacity to make money, such that there is a serious misalignment of incentives between speculative market participants and the purpose of commodity markets. 

The goal of commodity futures markets is to provide a venue through which buyers and sellers of raw materials can share some of the risks in price fluctuations and both can secure some sort of certainty for longer-term budgetary purposes.  Fundamental commodity market particpants are not necessarily trying to make money on each transaction, but rather their aim is to gain security in price on both sides of the equation in order to more efficiently plan and manage their business.  Because this is the existential purpose of commodity markets, it should be noted that volatility poses dangerous risks to the players who need smooth functioning in these markets most. 

Meanwhile, short-term transactions that result in realized gains in commodity markets are not done with the intention ever taking or giving delivery of the underlying goods themselves.  Rather, these transactions are done for the purpose of realizing a gain off of changes in price.  These transactions require inefficiencies between supplier and buyer PLUS volatility in order to generate a profit.  In seeking volatility, such transactions promote yet further volatility.  Because of this fact, volatility and market dislocations lead directly to more opportunities for speculative gains.  Pushing such actors into commodity markets creates a situation where volatility becomes a self-fulfilling prophecy for the benefit of a significant portion of market participants, but a detriment to society at large. 

Speculative traders do play an important role in that they provide liquidity for the true suppliers and consumers of commodities; however, there is no reason for the government to provide a direct subsidy in inducing speculators to prefer commodity rather than any other market.  And there’s really no reason that speculators who engage in these markets for a living should pay a lower tax rate than any other hard working American.

Since markets like these are zero-sum, where one actor must inherently make money at the expense of another, there is unquestionably at least some coefficient of a speculative cost in the price of commodities.  No one these days is seriously concerned about a lack of liquidity in commodity markets, if anything we as a society acknowledge the abundance of this liquidity between the proliferation of commodity-based ETFs.  While we can’t necessarily weed out all speculation from these markets, we can realign the incentive structure to be symmetrical with every other profession in our country.  This is a question to which both Democrats and Republicans should be able to find some common ground.

Links for Thought -- March 30, 2012

A Template for Understanding: How the Economic Machine Works... (Bridgewater) -- This is a MUST READ, and I mean that to the fullest. Ray Dalio and Bridgewater lay out a more complete, robust and accurate assessment for how an economy works than anything we see in the financial presses.  Plus the write-up is concise and written in layman's terms so that anyone and everyone can extract real value.  Reading this report should be a prerequisite for ANY candidate who runs for office, maybe then our economic rhetoric would be a bit more complex, but way more rational? One can dream!

Google Cloud: Coming Soon to Robots Near You (Seeking Alpha) -- To date, the robotics story has primarily been hardware driven, based on innovation in mimicking human movements and/or actions based on necessity. Now the rapid advance in software is adding a whole new dimension and setting the stage for the dawn of widespread adoption of robotics. While on the topic, check out this awesome video of a robot that can jump over 30 feet if need be! 

World's Changed Man, World's Changed-China Edition (Financial Times) -- This is from earlier in March, but still just as relevant.  Throughout the month, each market downtick was more a reflection of concerns over China than Europe.  That's quite the change from this past summer.  What are the consequences?  Well one might be the end of the big commodity bull that's lasted over a decade.  Can the commodity bull persist if China slows?  Does this bode as a positive, or a negative for the US?  These have been the questions that I spent the majority of my attention on this past week.  I should have some charts and analysis within the next two weeks.

Insane in the Membrane (Outside Magazine via Readability) -- This is a fascinating long read on the history of Gore-Tex and the state of the waterproof, breathable fabric market.  There is an intense battle being waged for market dominance that includes some interesting twists and turns.

How the Natural Gas Craze Will Impact Clean Energy (GigaOM) -- This is an issue I have spent quite a bit of time contemplating myself.  Is natural gas a transitory or enduring shift in terms of efficiency, cost and environmental cleanliness?  If so, what are the consequences for clean energy on each of those variables as well?  We seem to be at a big inflection point in the adoption of both.  Is this an "either or" proposition, or can both succeed?  There are way more questions than answers right now, and in these answers lies considerable opportunity.

Why Minsky Matters (EconoMonitor) -- In my book, Minsky is the most important economist today.  Yet, there's a bit of a debate going no amongst the new age Keynesians as to how exactly Minsky is relevant.  Here is L. Wrandall Wray's analysis as to why Minsky is so damn important.  It's slightly wonky, but a must read for anyone interested in macroeconomics.

Praise is Fleeting, but Brickbats We Recall (NY Times) -- Really fascinating psychological analysis of how the mind processes negatives in contrast to positives.  We tend to recall negatives more frequently and with more clarity and this has to do with how the brain works.  Understanding psychology generally speaking is very important in improving as an investor.

I usually close with one of my nature pictures, but today I will leave you all with this awesome video presentation taking advantage of the power of the iPad: