This is the best article I've read on the evils of ethanol:  http://www.nytimes.com/2011/06/25/opinion/25Rattner.html.  

A May 4 Bloomberg Television “Taking Stock” interview with financial author Larry Swedroe offers insights on housing, commodities and other topics of recent interest. Swedroe’s interview provides light where most others offer only heat.

Interested in how and where your Federal tax dollars are spent?  See http://www.whitehouse.gov/taxreceipt.  You enter your 2010 tax payments and the website provides a breakdown of (approximately) where your tax dollars are going.

Turbulent economic conditions are a recurring theme here and abroad -- and it doesn’t look like these concerns will blow away anytime soon.

• Inflation Worries -- As I have described before, I think inflation is likely on its way because the Fed has been pumping new money into the economy, and the monetary base more than doubled from mid-2008 through November 2010.
• Government Debt – U.S. and global indebtedness continue to mount.
• Government Intervention -- Government interventionism in the economy is on the rise, which likely will result in higher business costs and less business efficiency.

So, yes, there are plenty of worries. But what’s an investor to do? Well, if you have a well-diversified, low-cost index fund portfolio, expertly built and properly adjusted to suit your investment time horizon and risk tolerance, simply stick with it. Nobody can predict the future, but the evidence suggests that the long-term returns of a well-diversified index fund portfolio are likely to be more closely related to the returns offered in the capital markets than to economic conditions. Don’t believe it? Read this post: Good News, Bad News and Market Returns.

If you’re not sure whether your portfolio is built to last, this may be an excellent time to seek the advice of a professional fee-only advisor, to ensure you’ve got an appropriate allocation among stocks and fixed income (bonds). And, yes, you want some of each. Even if bonds aren’t exciting, and even if they’re a little scary with inflation on the horizon, they are an important part of the portfolio. They serve to reduce portfolio volatility – because one need only look back a couple of years to see that stocks have both a downside and an upside.

I will give you one additional tip, though: Especially in inflationary times, shorter-term bonds have less risk than long-term bonds. Want to know more about it? I’ll continue the conversation on this subject next week.

In the category of trivia that enlightens, my colleague Jeff Eschman recently forwarded an online illustration to me, which shows what country in the world each U.S. state most closely resembles in economic size. Check it out:

The Economist Online – US Equivalents

What country’s economy most closely equals Texas? Well, let’s just say, greetings from “Russia,” y’all. You may recall that last summer, while the media were hyperventilating about the financial crisis in Greece, I observed in an article that it was unlikely to sink the world economy simply because the Greek economy wasn’t big enough to matter that much. Indeed, Greece’s economy was smaller than Houston’s economy. The rest of the world (and even Greece) survived the crisis.

So these simple comparisons can sometimes help put things into their proper perspective.

Theologian and satirist Gilbert Keith Chesterton once observed, “The chief object of education is not to learn things; nay, [it] is to unlearn things.” I don’t think he was specifically referring to investing, but he might as well have been, with so many assumptions there to be “unlearned.”

In my recent quarterly client letter, I refuted one seemingly erroneous assumption that there is a clear, predictable relationship between economic news and market returns. The actual evidence reveals that, if you believe that they always march in close step to one another, you may have some rethinking to do. Or is that “unthinking”? Either way, I thought you’d enjoy a reprint of the report I shared with my clients, below.

But how much does a strong or weak economy affect stock market returns?  Less than you might think.

As a case in point, take Brazil.  In the late 1980’s, the Brazilian government was deeply in debt.  From 1988 to 1994, Brazil experienced extreme hyperinflation of the nightmare variety, averaging more than 1,100% per year.  Total inflation over the period was more than four billion percent. Yes, that’s billion, with a “b.”  Holders of cash in Brazil were decimated; in 1988, a billion Brazilian cruzados were worth $13,950 in US dollars.  Seven years later, a billion cruzados were worth $22. (1) 

Brazilian stock market investors must have lost their shirts, too, right?  Actually, no.  While inflation rose by four billion percent from 1988-94, Brazilian stocks rose by thirteen billion percent.  Adjusted for inflation, Brazilian stock values in local currency tripled, averaging a return of 17% per year. (2)

Of course not every market from every country in crisis is going to perform so well. But let’s explore the Brazilian phenomenon, and how you might apply lessons learned there to the current U.S. and world economy.

For decades, the U.S. government has taken a bigger and bigger slice of our nation’s economic pie, with much of its largesse funded by borrowing.  This trend shows no signs of slowing.  Today, government indebtedness has grown to 90 percent of Gross Domestic Product.  In other words, our government's debt is almost as much as the value that the U.S. economy produces in a year.  Many other governments around the globe owe similar amounts relative to their economic footprints, as shown below. (3) 

Why does government debt matter?  Because the money the government borrows has to come from someplace.  Economic studies show that demands for debt funding by government can crimp availability of debt funding for private enterprises, resulting in slower economic growth. (4) The more indebted the government becomes, the more of a drag its debt becomes on the nation’s economy. 

So increasing U.S. government debt may result in slower U.S. economic growth.  What’s an investor to do? 

At first impression, you might assume that slower economic growth would dictate lower stock market returns.  The evidence suggests, however, that a country’s economy and its stock market march to different drummers.  Brazil is only one example.

The illustration below compares stock market returns in high-growth countries vs. low-growth countries.  Notice how stocks in the slow-growth countries, shown in blue, delivered higher average annual returns than their high-growth brethren shown in pink. (5)

Thus, a country’s economy and its stock market do not move in lock-step.  Market returns are most highly correlated with risk:  More risk, more return.  For those who are familiar with the phenomenon of smaller and value (higher-stressed) companies delivering higher expected returns as compensation for their higher perceived risk, this shouldn’t come as a complete surprise. Just as with individual stocks and general asset classes, when a country is on the ropes, investors demand a higher expected return before they’ll stay invested in that country’s future.

The investor’s best response to the uncertainty created by high U.S. government indebtedness is simple:  Stay invested in a well-diversified worldwide portfolio of stocks and bonds, designed with your risk tolerance and investment objectives in mind. 

Of course there’s nothing wrong with keeping an eye on the economy. After all, whether or not it impacts your investment portfolio, it does affect many other facets of your life. But let’s not let the economy overtake the larger goal of living our lives.

The numbers are in, so let’s take a last look at 2010. In retrospect, we can readily see the year-round events that caused us grief, both emotionally and financially. To name a few:

• A prominent researcher who had predicted the Great Recession, predicted the “biggest co-ordinated asset bust ever” for 2010.
• A January Economist cover story warning of asset price bubbles asserted that US stocks were “nearly 50% overvalued.”
• The “January Indicator” signaled negative stock market returns for the year.
• The Gulf oil spill threatened US shores, along with global market stability amidst the uncertainty.
• The May 6 “Flash Crash,” a sudden and unexpected plunge of about 700 points in the Dow, bewildered investors. 
• Hundreds of bank failures signaled continued weakness in the financial system.
• A divided Congress passed a complex and expensive healthcare reform bill.
• Residential housing remained weak.
• The “Hindenburg Omen” generated a “sell” signal in August, portending disaster in the markets.
• North Korea launched a deadly artillery assault against South Korea’s Yeonpyeong Island.
• A financial crisis with no clear resolution gripped governments in Greece, Portugal and Ireland.

Retrospect lets us neatly summarize a year of stomach-wrenching headlines. But it also affords us a better view of the end results. You bet, there were a lot of dips, dives, false starts and dashed hopes. But in the end, the U.S. stock market delivered a satisfying, nearly 17 percent annualized return.

Similarly, world markets (as measured by the MSCI All Country World Index) yielded just under 13 percent annualized returns. But – and this is crucial –investors who reacted to the never-ending onslaught of worrisome news by abandoning or remaining outside of the markets were far less likely to capture what the markets ultimately delivered.

Of course a year is a blink of the eye. My three-year-old son may not have figured that out yet, but I sure have. As such, one year of returns that happened to have played in our favor doesn’t necessarily “prove” my case -- no more so than a single year of bad returns would disprove it. But, 2010 does serve as a good, illustrative snapshot of how the market has generally performed over much longer periods.  It seems worth sharing for that reason.

In the short run, the hue and cry is loud, hard to ignore and impossible to predict. In the longer run, U.S. and global markets have delivered positive returns over time. Investors who remain focused on and steadily invested toward the horizon of their own financial goals are far more likely to reach their destination as planned. While capitalism is alive and breathing, investing according to these guidelines seems the best way to manage your personal assets in our global markets.

If I were a betting man, I’d lay odds that inflation lies ahead, with the Fed pumping newly printed money into the economy, and with high government deficits making it difficult for the Fed to stop or reverse the flow.

Given that I expect inflation, am I changing my investment strategy? Buying gold, shorting the dollar and bulking up on fixed-rate loans?

No. Instead of making inflation bets, I’m betting on capitalism by retaining my well-diversified portfolio of stocks and bonds, which has delivered long-term gains across lots of economic environments in both inflationary and non-inflationary times.

Another reason I’m not placing a big bet on inflation is that it is not certain to occur. The following article, reprinted with permission from Dimensional Fund Advisors, shows why. According to monetary theory there should be a strong relationship between expansion of the money supply and increasing inflation. But in reality, so many variables come into play that the “obvious” results of monetary expansion may not be so obvious after all.

So I’m sticking with the tried-and-true investment strategies as the safest bet for continuing to reward disciplined investors over the long run – whether inflation is in the cards or not. Read on to learn more.

Does Monetary Expansion Stoke Inflation?

Since the financial crisis hit in late 2008, the US monetary base has more than doubled, from about $800 billion in mid-2008 to about $2 trillion in November 2010.¹ When the Federal Reserve announced a second round of quantitative easing (QE2), it raised investor concerns that such actions would stoke inflation.

The chart below shows that the US monetary base has spiked since 2009. While inflation has fluctuated considerably, it has not tracked the changes in the monetary base. Although no one can reliably forecast inflation, we think markets do a pretty good job of sorting through all the macroeconomic data. At present (mid December), the markets do not appear to reflect expectations of runaway inflation in the near future.²

US Monetary Policy since 2000

 Source: Federal Reserve Board

Nevertheless, investors may be growing anxious in response to media coverage of the Fed’s continuing expansionary policy. For those who are certain QE2 will be inflationary, perhaps the recent example of Sweden’s monetary base run-up will offer some reassurance.

In the 1990s, Sweden’s central bank, the Riksbank, more than doubled the country’s monetary base during the Nordic banking crisis, but inflation remained moderate during and after the expansionary period. The graph below documents that even as the monetary base jumped from 1994 to late 1996, inflation did not follow suit, and in fact, remained flat before falling in 1996.

Swedish Monetary Policy in the 1990s

Source: Sveriges Riksbank

Sweden’s monetary base expansion is one of several international examples of quantitative easing over the past two decades. These case studies, which include past expansionary periods in the UK, Switzerland, Japan, Australia, New Zealand, and Iceland, are discussed in a recent Federal Reserve Bank of St. Louis review.³ The researchers concluded that doubling or tripling a country’s monetary base does not lead to high inflation if the public views the increase as temporary and expects the central bank to maintain a low-inflation policy.

Of course, many factors may come into play, and we cannot know whether the US will share the same fortune. But at least we know that quantitative easing has occurred without triggering high inflation.

1. Monetary base is the total amount of the liquid currencies circulating in the hands of the public, deposits in financial institutions, and the deposits of the commercial banks in the central bank of the respective country.

2. One indicator of expected future inflation is the difference in rates between US Treasury bonds and Treasury Inflation Protected Securities (TIPS), also known as the TIPS spread. As of December 16, the 10-year zero-coupon TIPS spread was 2.35% (http://www.federalreserve.gov/econresdata/researchdata.htm). Consider, however, that the spread also includes an inflation risk premium, so the spread is not an exact measure of the market’s inflation expectations.

3. Richard G. Anderson, Charles S. Cascon, and Yang Liu, “Doubling Your Monetary Base and Surviving: Some International Experience,” Federal Reserve Bank of St. Louis Review 92, no. 6 (November/December 2010): 481-505.

Remember the “Flash Crash” from last spring, May 6, 2010, to be precise? For reasons that are still being sorted out, the Dow Jones tripped hard in an already turbulent market, plunged about 700 points and then recovered its footing within minutes. The media buzzed about it for days, but the end result for long-term investors who didn’t budge was, essentially, much ado about nothing.

But wait. On September 27, there was another disquieting little event. A recent New York Times article called it a “mini flash crash.” Shares of a venerable, 102-year-old utility company called Progress Energy lost 90 percent of their value in seconds — probably due to the human error of a misplaced decimal. Trading in the shares was halted for a few minutes. Once it was resumed, things were back to normal. Whew.

In grim tones, the article pointed out how the very nature of our trading mechanisms may mean that we’ll be seeing more of these sorts of hiccups in the future.

What should you do with this information?

Short-term investors, the type who jump in and out of the markets trying to time them, must beware of the occasional flash crash. To illustrate, short-term investors may place “stop-loss orders” under the positions in their portfolios. If the stock price drops by a certain percentage, bang: a market order is placed and the stock is sold. The idea is to limit the loss if the stock price craters. This tactic might seem smart … but if a flash crash occurs, the stock price could drop momentarily, just long enough to trigger the stop-loss and sell the position at a discount, and then go right back up. The investor has just outsmarted himself, selling his stock at a discount.

Does the flash crash worry you? Then don’t be a short-term investor. Be a long-term investor. Think about is this way. As a long-term investor, you buy at one price and you sell considerably later. You sell because you are rebalancing your portfolio, you’re revising your overall allocations because something in your own life has changed, or you’re beginning to spend your wealth. Any flash crash along the way, whether mini or major, is of no consequence to you.

Yet another reason to be a long-term investor.

Many in the media have laid the blame for recent stock market volatility at Greece’s door.

The fact is that, economically at least, what happens to Greece just doesn’t matter much to the rest of the world. Why? According to the World Bank, the total economic output of Greece is less than 2% of the European economy and only 0.6% of the world economy.(1) The economy of the Dallas-Fort Worth metropolitan area is the same size as Greece. Houston’s economy is bigger.(2)

With that perspective, the Greek debt situation doesn’t seem as alarming for U.S. investors as many of the news headlines have made it out to be. A Greek debt default would be no more likely to sink the U.S. economy than a Dallas- or Houston-based default would be to sink Europe.

That said, it would be more serious if a Greek default precipitated defaults in other countries — Spain, Italy, Ireland, Hungary and Portugal being those most often named. The economies of Ireland, Hungary and Portugal are no more significant than Greece, but taken together Spain and Italy make up 20% of Europe’s economy, and 6.8% of the world. A default in Spain and Italy would be much more serious than a default in Greece.

Spain and Italy, however, are far stronger than Greece. Greece is simply a third-world country that, having vastly overspent for years, has no hope of ever repaying its debts. Apparently Greece had to manufacture fraudulent figures even to gain admission into the EU.(3) Spain and Italy, in contrast, are core EU members whose economies are much stronger and more resilient.  Thus, the odds that Spain or Italy will default on their sovereign debt at this time seem remote.

Also bear in mind that even a government default in an economic basket-case like Greece would not mean that all sovereign debt would go unpaid. Recent publications suggest that even with no EU assistance the Greek government could repay all but about a quarter of its debt. Even worst-case, debt strain in Spain and Italy is far less severe.

This is not to deny that there is real investment risk in Europe. Indeed, the European debt situation is likely to result in austerity programs across the continent that will somewhat reduce European economic activity for the next few years. And reduced economic activity in Europe will probably reduce economic activity around the world, simply because the Europeans will be buying fewer products and services. It’s reasonable to expect the market to factor these considerations into stock prices, as it apparently has lately.

But ultimately the question is, what should you do about the European debt situation as an investor? Sell European stocks? Sell all stocks? Sit tight?

If you have a well thought out, well-diversified portfolio, my recommendation is to sit tight. Current stock prices already reflect all the information that is known today. Remember that the markets don’t go down on bad news. They go down when news is worse than expected. Stock market participants already expect a worsening European economy, and stock prices reflect that prospect too. So while markets may go down further this summer, there is no guarantee that they will. In the short term markets are unpredictable. They could turn around at any moment and start back up. If you dumped all your stocks just before a market recovery, where would that leave you?

Remember why you are in the stock market in the first place. The best reason to invest in stocks is for long-term inflation protection. Inflation seems dormant now … but it could pick up at any time. Personally I think that rising inflation will become a significant concern within the next two to three years, fueled by all of the government budget deficits around the world.

And remember why you own European stocks. All the data available indicate stocks worldwide provide good diversification. Stocks in all countries have their good times and bad times, but spreading one’s assets around the world has been shown to increase long-term return while reducing portfolio volatility. That’s a hard combination to beat.

Assuming your allocation to European stocks is part of a sensible plan that continues to reflect your long-term goals, I recommend you hold onto them. Now is not the time to bail.