summitV I E W Lisa Randall, first tenured woman theoretical physicist at MIT and Harvard. Warped Passages: Unraveling the Mysteries of the Universe’s Hidden dimensions.
As we define our system of concepts more precisely, as we streamline it and make the connections more and more rigorous, it becomes increasingly detached from the real world. Fritjof Capra, The Tao of Physics
The financial markets paid a lot of people extremely well for narrow expertise and a few people, poorly, for the big, global views you needed to have if you were to allocate capital across markets. Michael Lewis, The Big Short
I was right 70 percent of the time, but I was wrong 30 percent of the time,” said Alan Greenspan as he testified last week on Capitol Hill. Greenspan - aka the Oracle during his 18-year-plus tenure as the Fed chairman - could not have more vividly illustrated how and why geniuses of his stature were out to lunch while Wall Street imploded. No doubt he applied his full brain power to that 70-30 calculation. But the big picture eludes him. If the captain of the Titanic followed the Greenspan model, he could claim he was on course at least 70 percent of the time too. Frank Rich, The New York Times columnist April 11, 2010 see disclaimer on last page
H. Wood Brock, “Solutions to the Portfolio Problem,” Strategic Economic Decisions, September 2004
At the beginning of the twentieth century, much of what being published by leading physicists in leading journals was, in retrospect, nonsensical...A comparable meltdown is now occurring within financial economics. Whether it is the latest “quantum mechanical theory of market volatility,” or the latest conference on “portable alpha,” arrant nonsense is being heard everywhere. Once useful concepts like alpha and beta have been stretched to the breaking point.
hen engaging with the unknown and working with speculative ideas, I find it comforting to recall that the discovery of fundamental structure has always come as a surprise and been met with skepticism and resistance. Oddly enough, not just the general populace, but sometimes even the very people who suggest underlying structures have been reluctant to believe them at first.
Morton Investment Doctrine A transitioner’s guide to transitions summitVIEW 2 May 2010
Pondering the future of global economic activity is not for the faint of heart as many outcomes seem viable as the world recovers from the Great Recession. One school of thought believes the United States will rebound from the doldrums of the Great Recession to continue its twentieth century position as the global superpower. Another school of thought considers the post Great Recession era the beginning of the end of the United States as the global superpower. Considering the amount of debt accumulated by the public and private sectors of the United States, the former scenario appears unlikely.
The Economist summarized a McKinsey study titled Debt and Deleveraging: The global credit bubble and its economic consequences in January by saying the following: [T]here are several reasons why today’s mess could be more protracted than previous episodes. First, the scale of indebtedness is higher. The highest debt ratio in the report’s group of belt-tighteners was 286%, in Britain after the second world war. Today more than half the rich countries in the McKinsey sample have debt totaling more than 300% of GDP. Second, the number of countries afflicted simultaneously means that rapid expansions of exports, which have supported output in the past, are harder to achieve. Third, big increases in public debt, while cushioning demand in the short term, increase the overall debt reduction that will eventually be needed. Once private deleveraging is done, the public sector will
need to cut back. In theory that sounds simple. In practice it will be fiendishly hard to get the balance right. Investors may worry about the sustainability of public debt long before private-debt reduction is over, forcing a lot of belts to be tightened at once. The most painful bits of deleveraging could well lie ahead.
The above quote addresses the fundamental question regarding long term, global, economic growth: what will be done with all the debt? As the US consumer fueled the growth of export driven Asian economies, word of the Asian economic decoupling from the US economic engine became gospel. The simultaneous crash of all global markets in 2008 removed speculation of decoupling of Asian economies from the US economy. At this juncture in the global recovery, the US consumer continues to tighten its spending, whether due to job loss, the threat of job loss, or an increasing belief that former, prior to the economic crisis, spending habits were profligate.
Although the US consumer remains still the driver of global consumption, the process of changing spending habits, from the US consumer saving more to the Chinese consumer spending more, will not be straight line. Without developed, internal demand markets, emerging economies will continue to rely on foreign consumption of domestically produced goods. As consumption ebbs over the next number of years in the developed world, returning to a level in line with long term averages, what happens to the emerging
As H. Wood Brock states, “when stationarity prevails, all investors will be able to predict the correct probability of all future events from the historical data alone. In this sense, no investor will make ‘mistakes’ in his probabilistic forecasts.” All who are participants in the markets know that all investors make mistakes in estimating, forecasting, or foretelling what the markets will do. The result of MPT is the belief the investor should maintain an asset allocation (appropriate for the investor’s risk profile, of course) that will withstand and benefit from various economic cycles. Tactical adjustments are made to the allocation through such measures as rebalancing to prior determined allocation percentages or by using constructs such as “portable
The above comments about the inherent fallacies in MPT are not to be interpreted as extending to the fundamental MPT assertion that investment returns are best achieved through asset diversification. As it is through portfolio diversification that an investor can achieve returns commensurate with his risk aversion level. Where MPT breaks down is in its application, where the investor has one optimal portfolio allocation. MPT is grounded in the belief that all investors have all the facts, as reflected in asset prices, and cannot make mistakes.
Over the last five decades MPT has become the theoretical foundation for asset allocation, providing investors a framework to build an optimal portfolio commensurate with the investor’s risk profile. The theory’s foundations stem from the false premise that the returns of assets classes are each identically and independently distributed (as like a coin flip where the prior flip as no affect on the result of the next flip). The idea that asset returns are identically and independently distributed also feeds into the random walk theory of market returns, where one cannot predict future returns based on past performance. Further, MPT is grounded in the assumption that the inputs into the model can change but the model itself does not change, known as stationarity.
MPT’s theoretical foundations are based on assumptions that do not reflect the real world, as in the belief that asset class returns are derived independently of one another and that returns are identically distributed, that is the return distribution of one asset class is mirrored in another. Theories concerning the “knowledge” of the market, where all pertinent information is reflected in the current price, utilize the assumptions of MPT as its basis. What is real is that the market can and does often fail to represent all that is real, all that is or should be affecting the asset price. See the price performance of assets during 2007 - 2008 for an example of prices not reflecting all available data.
Periods of transition, historically, while common, are often disruptive. With the aforementioned in mind the US investor is faced with the challenge of positioning portfolios to protect against financial market volatility as cycles of consumption, economic growth, and debt reduction play out over the next ten years. How does one position a portfolio of assets to realize wealth preservation in addition to achieving growth during these transition years? Considering the inadequacy of Modern Portfolio Theory (MPT) to facilitate proper portfolio construction relative to one’s risk profile, the investor’s challenge to construct the most suitable asset allocation is as formidable as ever.
alpha.” For the investor, each has a unique risk profile, or risk aversion, that determines one’s asset allocation as per the Capital Asset Pricing Model (CAPM) and Modern Portfolio Theory. Once the appropriate asset allocation is determined, the investor is expected to maintain that asset allocation, assuming of course, the extenuating circumstances or inputs used to derive the allocation remain constant.
economies? When will domestic consumption increase sufficiently to capture a significant piece of the goods produced domestically? As infrastructure development continues, what happens to the emerging economies if capacity utilization rates drop and layoffs occur?
An investor in financial markets has to be proactive in developing asset allocation models that better capture economic and market realities (or states) and that reflect the investor’s risk aversion. One cannot rely on the belief that an asset allocation that worked in the past will work in the future as asset class performance over various periods of time has been irregular. The mantra of an asset manager should always be “first, do no harm.” With the mantra in mind how does one advise clients and allocate assets so as to minimize risk and maximize return?
4 May 2010
For an investor, the question of most pertinence is, did the value of the assets grow or did it decline. To an investor the growth of the wealth, not the relative performance of the various asset classes, matters most. With the aforementioned thinking in mind, how does one develop an asset allocation that best meets the investor’s risk profile?
The following questions are relevant to developing a suitable asset allocation for investors: • What kind of return distributions do markets have? • What distributions do asset classes have if not independent and identical? • How does an investor respond to shifts in the relative returns of asset classes? • What factors best indicate an asset class’ future performance? • To what extent does investor sentiment effect total return outcome? • Does investment optimism or pessimism effect return beyond economic and financial fundamentals?
Brock’s work points to the reality that it is the investor’s belief structure (the proportion of investors at a given point in time who hold below average to above average return expectations) that greatly alters the asset return outcome. Recently, Robert J. Schiller, professor of economics and finance at Yale and cofounder and chief economist of MacroMarkets
LLC, echoed the same sentiment in discussing the housing bubble of the United States. Schiller wrote in April 2010 in the New York Times, “In short, a public case began to be built that we really were experiencing a housing bubble. By 2006 a variety of narratives, taken together, appear to have produced a different mind-set for many people - creating a tipping point that stopped the growth in demand for homes in its tracks.” How does an investor develop asset allocations in an environment where qualitative factors have such an impact on return outcome? As a student of history, I believe the behavioral aspects or factors can be derived from an assessment of current political, economic, and social states. For example, in our debt laden society, how will the efforts to reduce household debt affect the long term growth of the US economy and the continued development of the export driven economies that relied heavily on the US consumers’ debt driven consumption over the last ten years? Late last year, while considering investment options for United States citizens over the next ten years, I laid out how one should begin to think about their investment options. Using an aerial view of the current global landscape and factoring in the above thinking, I decided to ground future investment decisions in terms of political thought, specifically the Monroe Doctrine introduced in 1823 by then U.S. President James Monroe. In response to a political policy issued to protect United States interests in the Western Hemisphere in the early 19th century, I have revised the policy to reflect US investor interests in the 21st century. Namely, how does a US investor derive the appropriate risk/reward relationship in his/her particular asset allocation for the future? Specifically, how does one protect and grow their assets?
The Federal government continues to pile on debt to solve an over levered prior state. In an environment of burgeoning bureaucracy and ever increasing debt and entitlement spending, one is forced to contemplate options for protecting and growing wealth: • Does one use blind faith that the US government will be successful developing the processes and methods by which the levered consumer and government are able to reduce debt to a normalized level? • Will the processes and methods developed and deployed by the Federal government return the US economy to a past normal state of growth anytime soon? As a discerning investor one has to weigh probable outcomes of the steps and policies the Federal government is using to correct the highly levered state of the US consumer. As David Rosenberg said in April 2010,
capita GDP expands. As the urban migration continues, infrastructure to meet the needs of the migrating worker will grow. China appears to be poised to experience its own Industrial Revolution with wealth expansion for all classes.
In 2006 The McKinsey Global Institute wrote: The rising economy in China will lift hundreds of millions of households out of poverty. Today 77 percent of urban Chinese households live on less than 25,000 renminbi a year; we estimate that by 2025 that figure will drop to 10 percent. By then, urban households in China
Stepping back and assessing the current state of the global economy, the potential for global growth far outweighs any other time in the recent past. The migration to urban environments will continue for years to come in countries such as China, India, and Brazil. As the People’s Republic of China’s experiment with capitalism has proven, prosperity is a great motivator. As more move up the socioeconomic ladder, demand will continue to grow. Increasing per capita gross domestic product (GDP) is a great indicator of potential product demand, where, for example, more durable goods and higher protein content foods are desired as per
Using the thinking behind the development of the Monroe Doctrine to protect the long term interests of the United States, I have developed the Morton Investment Doctrine (MID). Essentially, the MID relies on both geographic proximity of foreign, investable free markets and countries of common ancestry to facilitate the US investor’s development of appropriate asset allocation models during what are expected to years of financial market volatility. As global consumption declines in the developed worlds and increases in the developing worlds, the transition period likely will be shaped by uncertainty.
To be sure, if you are an Anglo-Saxon country with a stable financial base, limited government intervention and contained deficits along with heavy resource exposure, your currency is in demand – as we have seen of late with the Kiwi, Aussie, and of course, the Loonie. These currencies are overbought and expensive but are retaining a premium for a reason – stability and commodity orientation.
As previously discussed, Modern Portfolio Theory has failed to provide proper guidance to investors due to inherent flaws in the theory. Therefore, what are the steps one has to take to ensure proper asset allocation commensurate with one’s risk tolerance? As I considered the amount of debt in the US, held both publicly and privately, substantially accumulated over the last couple of decades, I reflected on historical examples of empires gone bust due to colonialism or imperialism, coupled with excessive expansion of credit (e.g. the Roman Empire and the British Commonwealth). Albeit, the US does not continue to expand its borders geographically.
summitVIEW 6 May 2010
will make up one of the largest consumer markets in the world, spending about 20 trillion renminbi annually — almost as much as all Japanese households spend today. (note: as of April 2010, 25,000 renminbi is approximately 3,660 US dollars)
How does a US investor position resources to benefit from the long term trends in global, socioeconomic development? Investing directly in China and India is difficult and restricted; difficult in that the local markets are not as developed as the liquid, open markets found in the United States, United Kingdom, or Hong Kong, for example. In addition, in India and China there exist restrictions on foreign direct investment (FDI). In Brazil, FDI is not so much restricted as it is taxed. The Morton Investment Doctrine proffers to investors a thinking by which one can develop a suitable asset allocation based on their particular risk profile. By allocating assets to the neighboring economies of Canada, Brazil (and other Latin American countries), and to Australia (although not a neighbor, Australia is a developed country with similar ancestry and legal structures), an investor gains both systematic and economic diversification. By allocating assets outside United States borders, a U.S. based investor gains diversification into growing economies that have considerable less private and public debt, have stable, transparent governments run by elected officials, and are directly exposed to the middle class development of 40 percent of the world’s population in India and China.
The challenge to investors is not so much “achieving alpha” as it is allocating resources
into markets where risk/reward parameters are suitable. Considering the aging population, the high ratio of retirees and non-workers to workers, increasing entitlement spending by the Federal government, growing public debt burdens, leaders unwilling to lead, no long term energy policy, little to no regard for infrastructure improvement, and a public unwilling to force politicians to make responsible decisions, at what point does the primary economic trend change? The U.S. economy will continue to grow, just not at a pace at which most are accustomed. So, what are the implications of lower economic growth coupled with higher and higher debt loads? High systematic risk and little economic reward. Again, Woody Brock offers insights into the current economic state of the United States:
The failure of President Obama’s policy of “engagement” to achieve any bargaining concessions by Russia, by China, or by Iran is fully consistent with this analysis of declining US power. Finally, as the US evolves over the next two decades into yet another ageing welfare state where fiscal expenditures shift from defense to social welfare expenditures, its loss in overall power will increase still further. If the US’s looming “fiscal red hole” evolves as predicted over coming decades, the nation is likely to disarm while China arms.
One might as well look beyond US borders to achieve the investment returns one expects and needs, regardless of where one fits on a risk aversion scale. Once an analysis of one’s future liabilities (be they retirement income, education tuition or some other future, quality of life
expectation) and current assets is complete, coupled with expected future income flows, the proper allocation to fulfill those obligations can be developed.
As Americans we have become accustomed to driving the world’s economy for the last fifty years, especially in the last twenty-one years since the Berlin Wall fell. Consequently, adjusting one’s perspective to reflect new global realities is not easily accomplished. Viewing Brazil, and other Latin American countries (pick one: Mexico, Colombia, Argentina), through a lens tainted by past experience will bring one to surmise the risks are too great given each countries’ former systemic problems. Will hyper inflation consume Latin American economies? Will civil unrest rise, endangering investment capital? Is the sovereign risk too high; could a currency default ripple through the global economy?
A rose tinted view of United States history will do little to ensure a future as prosperous as the past. In When Markets Collide, Mohamed El-Erian wrote, Inevitably, the particulars of the individual action plan involve revisiting elements of conventional wisdom. Some imply a change in mindset; other a retooling of institutional and organizational parameters. As such, they are not easy to implement. And they involve risks. But these difficulties pale in comparison to the consequences of not adjusting.
In assessing the current state of the United States economy one can easily return to prior history and assume, all things being equal, that the past is prologue for the fate of the United States. Two things are important to consider in the prior sentence. One, will things continue to be equal? Are the circumstances that fueled United States growth and success over the last century the same as the circumstances of the country now? Two, which past is prologue? One should consider the paths of other
Understanding the truth of the United States’ economic reality will facilitate thriving in future economic regimes, and by embracing change the US investor can position assets to benefit from this transitional period in which we exist. As William Faulkner said, “Facts and truth
really don’t have much to do with each other.”
When asked by Charlie Rose what investments Batista had in the United States, the answer was none.
In May 2008 Parag Khanna said, “I believe that Latin America will emerge as the solution to the problem of the United States’ future competitiveness. The answer doesn’t lie in worrying about China or expanding influence in the Middle East or restoring transatlantic ties. The answer lies in our own backyard. Literally.” I couldn’t agree more.
It’s the highway between Brazil and China that the world should start paying attention to, because it’s fabulous. Most things that the Chinese need we have in abundance, and we can export, and there’s an entrance market on the other side within, because what does the world [need] in an economy, you need pent-up demand. China has an endless pent-up demand for these products, oil, food, and iron ore.
countries and empires to provide perspective. Who is to say the country cannot succumb to the same fate of the British Commonwealth? Perhaps the immediate circumstances are not exactly the same, but similarities persist. Based on the current path of the United States, its long term, primary trend, is one of declining global influence. The path can change, but change is slow in a democratic society.
Earlier this year in February 2010, Brazil’s wealthiest person, Erik Batista, was on Charlie Rose. Discussing Brazil’s prospects for the global economic future, Batista, the CEO of OGX said of Brazil,
Bremmer, Ian and Preston Keats, “The Fat Tail: The Power of Political Knowledge for Strategic Investing”, Oxford University Press, January 2009 Brainard, Lael and Leonardo Martinez-Diaz, editors, “Brazil as an Economic Superpower? Understanding Brazil’s Changing Role in the Global Economy”, Brookings Institution Press, Washington D.C., 2009 Brock, H. Wood, “Solutions to the Portfolio Problem” Profile, Strategic Economic Decisions, Inc., September 2004
Brock, H. Wood, Profile, Number 74, Strategic Economic Decisions, Inc., February 2005
Brock, H. Wood, Profile, Number 85, Strategic Economic Decisions, Inc., June 2008 Brock, H. Wood, “The Rise of the East, and the Decline of the West - A Clarification of What this Really Means” Profile, Strategic Economic Decisions, Inc., March 2010 Capra, Fritjof, “The Tao of Physics: An Exploration of the Parallels between Modern Physics and Eastern Mysticism” (25th Anniversary Edition), Shambhala Publications, Inc., 4th edition, Boston, MA, January 2000 Economist, The, “Digging out of Debt”, January 14, 2010 El-Erian, Mohamed, “When Markets Collide: Investment Strategies for the Age of Global Economic Change”, McGrawHill, 1-edition, May 2008 Farrell, Diana and Ulrich A. Gersch and Elizabeth Stephenson, “The value of China’s emerging middle class”, McKinsey Global Institute, McKinsey & Co., June 2006 Khanna, Parag, “The Second World: Empires and Influence in the New Global Order”, Allen Lane, January 2008 Lewis, Michael, “The Big Short: Inside the Doomsday Machine”, W.W. Norton & Company, New York, March 2010 McKinsey Global Institute, “Debt and deleveraging: The global credit bubble and its economic consequences”, McKinsey & Co., January 2010 Randall, Lisa, “Warped Passages: Unraveling Mysteries of Universe’s Hidden Dimensions”, HarperCollins , January 2005 Rich, Frank, “No One Is to Blame for Anything”, New York Times, April 11, 2010
Disclaimer: All material presented herein is believed to be reliable but we cannot attest to its accuracy. Neither the information nor any opinion expressed constitutes a solicitation by us for the purchase or sale of any securities.
Rosenberg, David, “Breakfast With Dave”, Gluskin Sheff + Associates, Inc., April 15, 2010 Schiller, Robert , “Don’t Bet on a Long Housing Recovery”, New York Times, April 11, 2010