tag:blogger.com,1999:blog-83165910699023962812024-03-20T03:41:10.519-04:00Gestaltge⋅stalt [guh-shtahlt, -shtawlt, -stahlt, -stawlt]
–noun, plural -stalts, -stal⋅ten (sometimes initial capital letter) Psychology.
1. a configuration, pattern, or organized field having specific properties that cannot be derived from the summation of its component parts; a unified whole.
2. an instance or example of such a unified whole.
Origin:
1920–25; < G: figure, form, structureGestaltUhttp://www.blogger.com/profile/15636551868375563464noreply@blogger.comBlogger25125tag:blogger.com,1999:blog-8316591069902396281.post-88029827789677598752012-06-10T09:42:00.003-04:002012-06-10T09:42:31.369-04:00Adaptive Asset Allocation for a Regime Agnostic 'Balanced Fund"<br />
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<span style="font-family: Verdana,sans-serif; font-size: large;">Investors
are looking for robust, adaptive investment solutions to manage
indelible liabilities like funding objectives or retirements.
Traditional SAA and endowment model 60/40 portfolios are vulnerable to
long-term shifts in return, volatility and correlation regimes across
asset classes. Risk Parity addresses some of the issues of traditional allocation frameworks, but it can be especially vulnerable to long-term structural changes in interest-rate regimes.</span></div>
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<span style="font-family: Verdana,sans-serif; font-size: large;"><br /></span></div>
<span style="font-family: Verdana,sans-serif; font-size: large;">The
Adaptive Asset Allocation framework described below offers a working solution for
investors that provides strong returns with managed risk, a combination
that substantially and positively skews the probability of success for
investors. Further, the introduction of adaptive estimates for returns, volatility and correlation immunizes the AAA approach from the impact of dynamic long-term asset class regimes.</span><br />
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<span style="text-align: left;"><span style="font-family: Verdana,sans-serif; font-size: x-large;">Risk Parity: Past its Prime</span></span><br />
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<span style="text-align: left;"><span style="font-family: Verdana,sans-serif; font-size: large;">Our <a href="http://advisorperspectives.com/dshort/guest/BP-120606-Adaptive-Risk-Parity.php" target="_blank">last article</a> described an Adaptive Risk Parity (ARP) framework for a stock/bond balanced allocation, and discussed the advantages and risks relative to traditional 60/40 approach. While ARP makes intuitive, logical and empirical sense as an allocation framework, there are long-term risks to this approach related to the existence of asset class regimes.</span></span><br />
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<span style="text-align: left;"><span style="font-family: Verdana,sans-serif; font-size: large;">Stocks, bonds and other asset classes generally move through long periods of high total return followed by long-periods of low total return. While there is more contention about where we are in the long-term stock cycle, there can be little debate about whether we are closer to the end or the beginning of the long-term interest rate cycle.</span></span><br />
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<span style="text-align: left;"><span style="font-family: Verdana,sans-serif; font-size: large;">The chart below from Mebane Faber's <a href="http://www.mebanefaber.com/2012/03/22/risk-parity-vs-endowment-model-vs-permanent-portfolio/" target="_blank">great new(ish) series on Risk Parity</a> demonstrates the long-term efficacy of a static version of the approach for a portfolio of stocks and bonds using long-term relative stock and bond volatility for allocations, and targeting the same </span></span><span style="text-align: left;"><span style="font-family: Verdana,sans-serif; font-size: large;">long-term </span></span><span style="text-align: left;"><span style="font-family: Verdana,sans-serif; font-size: large;">volatility as the 60/40 portfolio (10.44%). Notice that to achieve the same level of risk as a 60/40 portfolio, the risk parity portfolio must be levered by 160%.</span></span><br />
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<i><b><span style="text-align: left;"><span style="font-family: Verdana,sans-serif; font-size: large;">Chart 1. Long-term risk parity with S&P 500 and 10-Year Treasuries, 1972 - 2012 </span></span></b></i><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjzADu-IwckNJUemdSYox2gPk-6_lP-ggNxn2pLjOMTQ-7tKDjyf4Hr_wIHTWXmxHQLMm0pcy7J21OzYp-28PpKHhls_qUgRI_pCDr0C73Ec3nfG0isaND_LAIMJ-a4XCr9p8EHPKgK48s/s1600/Faber_LT_Risk_Parity_Stock+Bonds.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="480" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjzADu-IwckNJUemdSYox2gPk-6_lP-ggNxn2pLjOMTQ-7tKDjyf4Hr_wIHTWXmxHQLMm0pcy7J21OzYp-28PpKHhls_qUgRI_pCDr0C73Ec3nfG0isaND_LAIMJ-a4XCr9p8EHPKgK48s/s640/Faber_LT_Risk_Parity_Stock+Bonds.png" width="640" /></a></div>
<span style="text-align: left;"><span style="font-family: Verdana,sans-serif; font-size: large;">Source: Mabane Faber, 2012</span></span><br />
<span style="text-align: left;"><span style="font-family: Verdana,sans-serif; font-size: large;"><br /></span></span><br />
<span style="text-align: left;"><span style="font-family: Verdana,sans-serif; font-size: large;">While the performance of the static risk parity approach is better over the full period, Faber points out that the relative out-performance is sensitive to the start and end dates of the observation period. If we go back in time to mid 2000 and observe the relative performance over the first 28 years, we may have drawn a different conclusion.</span></span><br />
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<i><b><span style="text-align: left;"><span style="font-family: Verdana,sans-serif; font-size: large;">Chart 2. </span></span><span style="text-align: left;"><span style="font-family: Verdana,sans-serif; font-size: large;">Long-term risk parity with S&P 500 and 10-Year Treasuries, 1972 - 2000 </span></span></b></i><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgD7-llN8KBcqKfNlD7vTaW0eyKsWx_jUeWnDScNM0QX3P5GMKOdCnQpi64oLocSPVIAdncykGfspUL0OpzHZoJGykx9bFz6du6Z7LXqfw4PWctBFTRxTOjlAcodCRoOx2zWYjnWcmqE08/s1600/Faber_LT_Risk_Parity_Stock+Bonds_to_1999.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="480" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgD7-llN8KBcqKfNlD7vTaW0eyKsWx_jUeWnDScNM0QX3P5GMKOdCnQpi64oLocSPVIAdncykGfspUL0OpzHZoJGykx9bFz6du6Z7LXqfw4PWctBFTRxTOjlAcodCRoOx2zWYjnWcmqE08/s640/Faber_LT_Risk_Parity_Stock+Bonds_to_1999.png" width="640" /></a></div>
<span style="text-align: left;"><span style="font-family: Verdana,sans-serif; font-size: large;">Source: Mabane Faber, 2012</span></span><br />
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<span style="text-align: left;"><span style="font-family: Verdana,sans-serif; font-size: large;">So what happened during the last decade to create such a massive disparity in returns? The next chart offers a clue: it plots the progression of interest rates since 2000.</span></span><br />
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<i><b><span style="text-align: left;"><span style="font-family: Verdana,sans-serif; font-size: large;">Chart 3. 10-Year Treasury yield, 2000 - 2012 </span></span></b></i><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEho_9YwCY5Ip8QxsOHv0WgfzGylXctMIxZ2Tf5axTuzeXPJ8zkLOYqR5vr52P9Nbgjerd3-KnQMytkABUjuB62oARbLbr_u2SNWl_6Lr0pZPWCK0oMgLyVHyQDr9G1bKLQPJcyERnu2dJc/s1600/Treasuries_2000-2012.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="384" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEho_9YwCY5Ip8QxsOHv0WgfzGylXctMIxZ2Tf5axTuzeXPJ8zkLOYqR5vr52P9Nbgjerd3-KnQMytkABUjuB62oARbLbr_u2SNWl_6Lr0pZPWCK0oMgLyVHyQDr9G1bKLQPJcyERnu2dJc/s640/Treasuries_2000-2012.png" width="640" /></a></div>
<span style="text-align: left;"><span style="font-family: Verdana,sans-serif; font-size: large;"> Source: FRED database</span></span><br />
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<span style="text-align: left;"><span style="font-family: Verdana,sans-serif; font-size: large;">Clearly this has been an exceptional period for interest rates, as they have dropped by over 70% over the past 12 years, delivering almost 7.6% in total returns per year, compared with 0.80% per year for stocks.</span></span><br />
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<span style="text-align: left;"><span style="font-family: Verdana,sans-serif; font-size: large;">The question is, with interest rates at or very near historic lows, and the relative return differential between risk parity and more traditional approaches at an all-time high, should we expect this approach to continue to dominate other approaches going forward? Or should we acknowledge that he best days for risk parity are probably behind us, and adapt?</span></span><br />
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<span style="text-align: left;"><span style="font-family: Verdana,sans-serif; font-size: large;"><span style="font-size: x-large;">Adaptive Asset Allocation</span></span></span><br />
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<span style="text-align: left;"><span style="font-family: Verdana,sans-serif; font-size: large;">In this article we will apply the integrated AAA approach described in our <a href="http://www.macquarieprivatewealth.ca/specialist/darwin/strategies" target="_blank">whitepaper</a> to create a resilient balanced portfolio that is not vulnerable to the interest rate bias that represents the Achilles Heel of risk parity.</span></span><br />
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<span style="text-align: left;"><span style="font-family: Verdana,sans-serif; font-size: large;">AAA uses estimates of returns, volatility and correlation for assets in a portfolio based on recently observed measures of these parameters, rather than long-term averages. These estimates are then integrated using a robust mean-variance optimization algorithm analogous to the equations described under the banner of Modern Portfolio Theory.</span></span><br />
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<span style="font-family: Verdana,sans-serif; font-size: large;"><span style="text-align: left;">Estimates for returns and correlations are drawn from time series for each asset over a 6-month look-back horizon, while volatility is measured over a shorter 60 day horizon. Further, portfolio level volatility at each rebalance period is managed to a 10% target. Depending on the measured volatility of the assets, and the correlation between them, at each rebalance period, cash or leverage may be required to reach the volatility target. N</span>o yield on cash or cost of leverage is included for this illustration.</span><br />
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<span style="text-align: left;"><b><i><span style="font-family: Verdana,sans-serif; font-size: large;">Chart 4. Adaptive Asset Allocation balanced portfolio, rebalanced monthly, 1995 - May 31, 2012</span></i></b></span><br />
<span style="text-align: left;"><b><i><span style="font-family: Verdana,sans-serif; font-size: large;">Max 200% exposure</span></i></b></span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEheh5aFqti0WpBPO_gmex-kdx3JJ1pqT5KzK9p3mws4-1sKaB2R-jbN2n39PnSn4K4l1LI7ygdUCEsKNSZT-C0M3MFxX74epS_8EY6BOMNGsD8VFIfKd2alPXOlLi-eN3AuLtDFhdwLukE/s1600/SPY_TLT_AAA_Max200_basic.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: Verdana,sans-serif; font-size: large;"><img border="0" height="438" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEheh5aFqti0WpBPO_gmex-kdx3JJ1pqT5KzK9p3mws4-1sKaB2R-jbN2n39PnSn4K4l1LI7ygdUCEsKNSZT-C0M3MFxX74epS_8EY6BOMNGsD8VFIfKd2alPXOlLi-eN3AuLtDFhdwLukE/s640/SPY_TLT_AAA_Max200_basic.png" width="640" /></span></a></div>
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<span style="font-family: Verdana,sans-serif; font-size: large;">Source: Data from Yahoo Finance</span></div>
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<span style="font-family: Verdana,sans-serif; font-size: large;">For those with no tolerance for leverage or margin, here is a version of the AAA approach with a maximum 100% portfolio exposure.</span></div>
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<span style="text-align: left;"><b><i><span style="font-family: Verdana,sans-serif; font-size: large;">Chart 5. Adaptive Asset Allocation balanced portfolio, rebalanced monthly, 1995 - May 31, 2012</span></i></b></span></div>
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<span style="text-align: left;"><b><i><span style="font-family: Verdana,sans-serif; font-size: large;">Max 100% exposure</span></i></b></span></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiDqkcGQHKZMGiAIsOfC2YBUpreL6yMNKpdBodLTRy-SVpToDE32hHjSPvcTikd8bVb3VWua3jVPJuMvhS-NkH-CQNul3Am96arL9CwllJL3Q6WaKn-ajcnSNaPzKYAvMD78Y1v_OfGmCU/s1600/SPY_TLT_AAA_Max100_basic.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: Verdana,sans-serif; font-size: large;"><img border="0" height="436" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiDqkcGQHKZMGiAIsOfC2YBUpreL6yMNKpdBodLTRy-SVpToDE32hHjSPvcTikd8bVb3VWua3jVPJuMvhS-NkH-CQNul3Am96arL9CwllJL3Q6WaKn-ajcnSNaPzKYAvMD78Y1v_OfGmCU/s640/SPY_TLT_AAA_Max100_basic.png" width="640" /></span></a></div>
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<span style="text-align: left;"><span style="font-family: Verdana,sans-serif; font-size: large;">Source: Data from Yahoo Finance</span></span></div>
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<span style="font-family: Verdana,sans-serif; font-size: large;">You can see that the Adaptive Asset Allocation framework described in our <a href="https://docs.google.com/open?id=0B99l1MQvi29WRllFSUpyQzJKZzA" target="_blank">whitepaper</a> applies quite well to a typical balanced portfolio of stocks and bonds. The diagram below illustrates how the portfolio adapts its allocations over time based on changing momentum, volatility and correlation dynamics.</span></div>
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<b><i><span style="font-family: Verdana,sans-serif; font-size: large;">Chart 6. Adaptive Asset Allocation balanced portfolio, historical allocations, Aug 31, 2011 - May 31, 1012. Max 100% exposure.</span></i></b></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgk9dmnUQtDfJ-aDnghkIDHIFlNY3lk7oI74Z9dGeGLUl_YruFVqYclX-Evhy4HCuXgtPU0lsxafna-wukcClDgz12h-OD-qz7pnAMCo8wSgh1vwvgiJk0olXLV5CHPNpwDGbkC8wolZwk/s1600/SPY_TLT_AAA_Max100_History.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: Verdana,sans-serif; font-size: large;"><img border="0" height="640" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgk9dmnUQtDfJ-aDnghkIDHIFlNY3lk7oI74Z9dGeGLUl_YruFVqYclX-Evhy4HCuXgtPU0lsxafna-wukcClDgz12h-OD-qz7pnAMCo8wSgh1vwvgiJk0olXLV5CHPNpwDGbkC8wolZwk/s640/SPY_TLT_AAA_Max100_History.png" width="618" /></span></a></div>
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<span style="font-family: Verdana,sans-serif; font-size: large;">Source: Data from Yahoo Finance</span></div>
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<span style="font-family: Verdana,sans-serif; font-size: large;">Notice how during late 2011's extreme market behaviour, the AAA balanced portfolio dramatically reduced exposure to both stocks and bonds, lowering equity allocation to 11% and Treasury allocations to 39% at the end of September, with the balance in a 50% cash allocation. This was necessary to maintain the target 10% portfolio volatility during a period where the observed volatility was much too high. </span></div>
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<span style="font-family: Verdana,sans-serif; font-size: large;">Also notice that, for the most part, the allocations do not stray too far from the Investment Policy Statement guidelines for a typical balanced investor. Where allocations do diverge, they typically err on the side of holding too much cash, and the dispersion rarely lasts more than a month or two except in very extreme situations like 2008.</span><br />
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<span style="font-family: Verdana,sans-serif; font-size: large;">Many IPSs have, or should have, policy flexibility built into the wording of the statement to allow deviations over periods of up to 3 months from policy benchmarks without official notice, and longer deviations after documented consultation with clients. As a result, the AAA framework is an attractive and viable alternative for traditional balanced clients.</span></div>
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<span style="font-family: Verdana,sans-serif; font-size: x-large;">Conclusion</span></div>
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<span style="font-family: Verdana,sans-serif; font-size: large;"><br /></span></div>
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<span style="font-family: Verdana,sans-serif; font-size: large;">The November article <a href="http://gestaltu.blogspot.ca/2011/11/rebalancing-resurrected.html" target="_blank">'Rebalancing Resurrected'</a> introduced the concept of weighting portfolio allocations based on relative volatility rather than as a set portion of capital. It was shown that relative volatility sizing delivered a substantial improvement to risk-adjusted returns without sacrificing absolute returns.</span></div>
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<span style="font-family: Verdana,sans-serif; font-size: large;">The <a href="http://advisorperspectives.com/dshort/guest/BP-120606-Adaptive-Risk-Parity.php" target="_blank">prior article on Adaptive Risk Parity</a> was a natural extension to a volatility sizing approach because it applies the same math to allocate between the assets based on volatility, but then overlays a risk budget at the portfolio level. The ARP approach further improved risk adjusted performance with consistent absolute performance.</span><br />
<br />
<span style="font-family: Verdana,sans-serif; font-size: large;">Further, by allowing the portfolio to take on a limited amount of leverage at times of low asset level volatility and/or very low asset correlations in order to achieve the target risk budget, the ARP portfolio delivered a 27% improvement in absolute returns with the same level of portfolio volatility as the traditional balanced portfolio.</span></div>
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<span style="font-family: Verdana,sans-serif; font-size: large;">Finally, in acknowledgment of the primary flaw in the risk parity approach, the structural overweight to fixed income, we applied an <a href="https://docs.google.com/open?id=0B99l1MQvi29WRllFSUpyQzJKZzA" target="_blank">Adaptive Asset Allocation</a> framework that accounted for estimates of return, volatility and correlation. This framework delivered performance consistent with the ARP approach, but because it is guided by asset class momentum as well as relative volatility and correlations, it is robust to structural shifts in interest rate regimes.</span></div>
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<span style="font-family: Verdana,sans-serif; font-size: large;">Investors are looking for robust, adaptive investment solutions to manage indelible liabilities like funding objectives or retirements. Traditional SAA and endowment model 60/40 portfolios are vulnerable to long-term shifts in return, volatility and correlation regimes across asset classes. This risk is especially acute with interest rates at historic lows.</span></div>
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<span style="font-family: Verdana,sans-serif; font-size: large;"><br /></span></div>
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<span style="font-family: Verdana,sans-serif; font-size: large;">The Adaptive Asset Allocation framework offers a working solution for investors that provides strong returns with managed risk, a combination that substantially and positively skews the probability of success for investors, regardless of market outcomes.</span><br />
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</div>GestaltUhttp://www.blogger.com/profile/15636551868375563464noreply@blogger.com1tag:blogger.com,1999:blog-8316591069902396281.post-35229371539120482772012-06-03T15:38:00.001-04:002012-06-05T10:17:09.630-04:00Evolved Risk Parity for a Better 'Balanced Fund'<span style="font-family: Verdana, sans-serif; font-size: x-large;">Rebalancing Revisited</span><br />
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<span style="font-family: Verdana, sans-serif; font-size: large;">Back in November of 2011 we wrote our first article on <a href="http://gestaltu.blogspot.ca/2011/11/rebalancing-resurrected.html" target="_blank">Rebalancing Resurrected</a>, where we introduced the notion of a balanced portfolio of stocks and bonds in what we termed a 'Volatility Weighting' framework. This article will revisit this novel balanced portfolio, and compare it to a new balanced portfolio approach - Active Risk Parity - and reflect on the strengths and weaknesses of each.</span><br />
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<span style="font-family: Verdana, sans-serif; font-size: large;">Recall that the difference between the </span><span style="font-family: Verdana, sans-serif; font-size: large;">previously described </span><span style="font-family: Verdana, sans-serif; font-size: large;">volatility weighted approach and a typical balanced approach, is that rather than allocating equal portions of </span><i style="font-family: Verdana, sans-serif; font-size: x-large;">capital</i><span style="font-family: Verdana, sans-serif; font-size: large;"> to assets in a portfolio, the volatility weighted portfolio allocates equal portions of risk, as measured by recently observed volatility.</span><br />
<span style="font-family: Verdana, sans-serif; font-size: large;"><br /></span><br />
<span style="font-family: Verdana, sans-serif; font-size: large;">To illustrate this concept consider the following chart, which captures the relative contribution of portfolio volatility from stocks versus bonds in a typical 60/40 balanced portfolio.</span><br />
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<b><i><span style="font-family: Verdana, sans-serif; font-size: large;">Chart 1. Marginal risk contribution: 60/40 portfolio of U.S. stocks vs. Treasuries, 1995 - 2012</span></i></b><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEifVqi8Wa7gMlwnpwhs3ZgU3VJPLgA1p7uR2mA3QS5D8Yf7TpVDQUJDxHBoLSHSHxmlRvpGV-yK6_X-EMY-UQ7V6Ysos-GtMJNtyKIF29tuoTcLk81Okk4vQfhsZEn09E-xxAdTHV8s4yI/s1600/SPY_IEF_Volatility_Contribution.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: Verdana, sans-serif; font-size: large;"><img border="0" height="402" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEifVqi8Wa7gMlwnpwhs3ZgU3VJPLgA1p7uR2mA3QS5D8Yf7TpVDQUJDxHBoLSHSHxmlRvpGV-yK6_X-EMY-UQ7V6Ysos-GtMJNtyKIF29tuoTcLk81Okk4vQfhsZEn09E-xxAdTHV8s4yI/s640/SPY_IEF_Volatility_Contribution.png" width="640" /></span></a></div>
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<span style="font-family: Verdana, sans-serif; font-size: large;">Source: Data from Yahoo Finance</span></div>
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<span style="font-family: Verdana, sans-serif; font-size: large;">The blue area reflects the proportion of portfolio volatility attributable to the 60% stock allocation, while the red area indicates the proportion contributed by the 40% Treasury allocation. Note that while the capital is allocated 60/40 to stocks and bonds respectively, the risk is actually allocated about 80/20. This reality is lost on most investors, including most investment managers, despite the hard lessons learned during recent bear market periods.</span></div>
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<span style="font-family: Verdana, sans-serif; font-size: large;">The volatility weighting framework allocates capital to assets at each rebalance period such that each asset class contributes an equal amount of <i>risk</i> to the portfolio rather than a set proportion of <i>capital</i>. In our November article we compared the performance of a traditional 50/50 capital allocated approach to the performance of a volatility weighted approach using data for stocks and Treasuries going back to 1995. The following charts update the performance of these two mandates through the close of trading on May 31, 2012.</span></div>
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<b><i><span style="font-family: Verdana, sans-serif; font-size: large;">Chart 2. Equal weight portfolio of stocks and bonds, rebalanced quarterly, Jan 1995 - May 2012</span></i></b></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh5-p4MxJIvX5jZFyMozMvGuRina53mzu270VjD2q3ZGovZQuCAhJaeiEhlF0Ws5hpdZJCHf2fKPxNrRR-0XFsz6B5IIsAIBO5kYaiow0C3U16I0uOXpXvzW_BJb1HqCk6MkrIyjxACSlU/s1600/SPY_TLT_EW_Quarterly_Rebalance.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: Verdana, sans-serif; font-size: large;"><img border="0" height="438" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh5-p4MxJIvX5jZFyMozMvGuRina53mzu270VjD2q3ZGovZQuCAhJaeiEhlF0Ws5hpdZJCHf2fKPxNrRR-0XFsz6B5IIsAIBO5kYaiow0C3U16I0uOXpXvzW_BJb1HqCk6MkrIyjxACSlU/s640/SPY_TLT_EW_Quarterly_Rebalance.png" width="640" /></span></a></div>
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<span style="font-family: Verdana, sans-serif; font-size: large;">Source: Data from Yahoo Finance</span></div>
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<b><i><span style="font-family: Verdana, sans-serif; font-size: large;">Chart 3. Equal volatility weighted portfolio of stocks and bonds, rebalanced quarterly, Jan 1995 - May 2012</span></i></b></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi0mqdXLEwTY9BjqKYgU0AxEfkBrf5AanBZukx8YF-PyXrQGypacK1QQtYW2hC-KM8Uo28iofDYWDDhIqXsMRiV4n9twVe_nuTxOGKz6QzLJpws5I-HaP_vrxdFdOs4NPq4Fv1ti11jzRY/s1600/SPY_TLT_EWR_Quarterly_Rebalance.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: Verdana, sans-serif; font-size: large;"><img border="0" height="540" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi0mqdXLEwTY9BjqKYgU0AxEfkBrf5AanBZukx8YF-PyXrQGypacK1QQtYW2hC-KM8Uo28iofDYWDDhIqXsMRiV4n9twVe_nuTxOGKz6QzLJpws5I-HaP_vrxdFdOs4NPq4Fv1ti11jzRY/s640/SPY_TLT_EWR_Quarterly_Rebalance.png" width="640" /></span></a></div>
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<span style="font-family: Verdana, sans-serif; font-size: large;">Source: Data from Yahoo Finance</span></div>
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<span style="font-family: Verdana, sans-serif; font-size: large;">The relative volatility weighted portfolio delivers better risk adjusted, and absolute, performance than the traditional 50/50 portfolio. Further, in two other prior articles we demonstrated that this approach to asset allocation is equally robust for <a href="http://gestaltu.blogspot.ca/2011/12/rebalancing-canada.html" target="_blank">Canadian</a> and <a href="http://gestaltu.blogspot.ca/2011/12/rebalancing-japan.html" target="_blank">Japanese</a> balanced portfolios as well.</span></div>
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<span style="font-family: Verdana, sans-serif; font-size: large;">Given that asset allocation is improved by focusing on proportional risk rather than proportional capital, we are ready to explore a more robust application of this concept.</span></div>
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<span style="font-family: Verdana, sans-serif; font-size: x-large;">Active Risk Parity</span></div>
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<span style="font-family: Verdana, sans-serif; font-size: large;">The volatility weighting approach described above ensures that the volatility contributions of stocks and bonds are equal <i><b>in a fully invested portfolio</b></i>. While this approach promises a much more stable return distribution than the traditional 50/50 capital allocation framework, it is still vulnerable to short- and intermediate-term changes in asset correlations which impacts total risk at the portfolio level.</span><br />
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<span style="font-family: Verdana, sans-serif; font-size: large;">Recall that portfolio volatility is impacted by the volatilities of the individual assets AND the correlation between those assets. For example, if we assume two assets have the same volatility, then the following chart quantifies the change in portfolio level volatility as a function of the change in correlation between the assets based on Markowitz' famous equation.</span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjQwV2Oc9-gFlfF0BsUWEXDf2fJ9cs1NcVTV7ku2IsHJ1ScnEICfNbuIpStAnlWZn3u2rrDtFSHigBL22_y84R_Ew7UqIPXnsQiwR9NBpHm8mKi3azCvWDaa4A5_oEzuw72xZtyY1wuXp8/s1600/Risk_Reduction_from_Correlation.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: Verdana, sans-serif; font-size: large;"><img border="0" height="320" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjQwV2Oc9-gFlfF0BsUWEXDf2fJ9cs1NcVTV7ku2IsHJ1ScnEICfNbuIpStAnlWZn3u2rrDtFSHigBL22_y84R_Ew7UqIPXnsQiwR9NBpHm8mKi3azCvWDaa4A5_oEzuw72xZtyY1wuXp8/s320/Risk_Reduction_from_Correlation.png" width="154" /></span></a></div>
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<span style="font-family: Verdana, sans-serif; font-size: large;">In contrast, in a Risk Parity framework once the assets have been risk-weighted within the portfolio, the portfolio itself is then levered or de-levered to achieve a desired target for portfolio volatility. The math for volatility targeting is simply: </span><br />
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<span style="font-family: Verdana, sans-serif; font-size: large;"><u>target volatility</u></span></div>
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<span style="font-family: Verdana, sans-serif; font-size: large;">observed volatility</span></div>
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<span style="font-family: Verdana, sans-serif; font-size: large;">For example, a Risk Parity investor targeting a 10% risk budget for a portfolio with observed volatility of 8% would allocate 10% / 8% = 125% to the portfolio, which would require 25% leverage. </span><br />
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<span style="font-family: Verdana, sans-serif; font-size: large;">Typically, Risk Parity suffers from the same issues as Strategic Asset Allocation related to the fact that the guiding assumptions for the volatility and correlation inputs to the portfolio optimization are derived from long-term average values. We have published several research pieces (<a href="http://www.macquarieprivatewealth.ca/dafiles/Internet/mgl/ca/en/advice/specialist/darwin/documents/darwin-volatility-analysis.pdf" target="_blank">here</a>, <a href="http://www.macquarieprivatewealth.ca/dafiles/Internet/mgl/ca/en/advice/specialist/darwin/documents/darwin-correlation-analysis.pdf" target="_blank">here</a>, <a href="http://www.macquarieprivatewealth.ca/dafiles/Internet/mgl/ca/en/advice/specialist/darwin/documents/darwin-momentum-analysis.pdf" target="_blank">here</a>, and <a href="https://docs.google.com/open?id=0B99l1MQvi29WRllFSUpyQzJKZzA" target="_blank">here</a>) discussing the dangers of using long-term average values for portfolio inputs, so we will avoid that error here. Rather, we will use 60 day rolling measures of volatility and correlation for allocation decisions at each rebalance period. </span><br />
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<span style="font-family: Verdana, sans-serif; font-size: large;">For the purpose of this article we have coined a new term, Active Risk Parity (ARP), which captures the risk parity concept but applies better portfolio optimization estimates based on near-term observed values. The following ARP performance chart uses a 60 day trailing observation period to allocate at each rebalance period, and to also target a 10% portfolio volatility, rebalanced quarterly. In an effort to keep leverage to manageable levels, maximum portfolio exposure has been limited to 200%, which is practical for typical margin accounts. Note that we have assumed no yield on cash nor costs associated with the use of leverage for this illustration.</span><br />
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<b><i><span style="font-family: Verdana, sans-serif; font-size: large;">Chart 4. Active Risk Parity balanced portfolio, rebalanced quarterly, 1995 - May 31, 2012</span></i></b><br />
<b><i><span style="font-family: Verdana, sans-serif; font-size: large;">Max 200% exposure</span></i></b><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh6gScQ10kj5RFcxF8brXsi9qEFQrHk98GQZgaOCdZ5MU8wAaVSBq_cHNWoZ8pE0YbhPkmAo8W4_uPFa2TrEAmF6w3am9JLHMsDy49FhnzWNuc6XRqvyyupJbH-keGASa14octWE21nqnk/s1600/SPY_TLT_ARP_Max200.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: Verdana, sans-serif; font-size: large;"><img border="0" height="438" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh6gScQ10kj5RFcxF8brXsi9qEFQrHk98GQZgaOCdZ5MU8wAaVSBq_cHNWoZ8pE0YbhPkmAo8W4_uPFa2TrEAmF6w3am9JLHMsDy49FhnzWNuc6XRqvyyupJbH-keGASa14octWE21nqnk/s640/SPY_TLT_ARP_Max200.png" width="640" /></span></a></div>
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<span style="font-family: Verdana, sans-serif; font-size: large;">Source: Data from Yahoo Finance</span></div>
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<span style="font-family: Verdana, sans-serif; font-size: large;">For investors with no tolerance for margin or leverage, the following chart updates the ARP portfolio assuming a maximum of 100% exposure.</span></div>
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<b><i><span style="font-family: Verdana, sans-serif; font-size: large;">Chart 5. Active Risk Parity balanced portfolio, rebalanced quarterly, 1995 - May 31, 2012</span></i></b></div>
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<b><i><span style="font-family: Verdana, sans-serif; font-size: large;">Max 100% exposure</span></i></b></div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg9oSaX5tehVA3YsTOGEEMBauOFiT-kf9kK4ISDa29G8kaYWOcwatEr6GL4yn9iLNOF-XIWsLGLLjyqSG_5jUeRYO1X2QrTun54I-nMAigwi4dvh2BD2xf0bpOOIfT-3oi4m6-h6jR96Qs/s1600/SPY_TLT_ARP_Max100.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: Verdana, sans-serif; font-size: large;"><img border="0" height="436" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg9oSaX5tehVA3YsTOGEEMBauOFiT-kf9kK4ISDa29G8kaYWOcwatEr6GL4yn9iLNOF-XIWsLGLLjyqSG_5jUeRYO1X2QrTun54I-nMAigwi4dvh2BD2xf0bpOOIfT-3oi4m6-h6jR96Qs/s640/SPY_TLT_ARP_Max100.png" width="640" /></span></a></div>
<span style="text-align: left;"><span style="font-family: Verdana, sans-serif; font-size: large;">Source: Data from Yahoo Finance</span></span><br />
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<span style="font-family: Verdana, sans-serif; font-size: large; text-align: left;">Risk Parity, and ARP in particular have significant advantages over a typical asset allocation framework. Obviously, risk adjusted performance is improved substantially in terms of both average portfolio volatility and drawdowns. In addition, absolute performance is consistent with no leverage, and about 27% higher with leverage, at a similar average level of volatility.</span><br />
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<span style="font-family: Verdana, sans-serif; font-size: large;">However, Risk Parity skeptics have long complained that the success of the approach can largely be attributed to the much higher relative allocation to fixed income over a testing period where interest rates have steadily declined. Bonds are structurally much less volatile than stocks, and so command a much higher allocation in a Risk Parity framework on average relative to a typical balanced approach. Obviously during a period of steadily declining rates a risk parity portfolio will have an advantage.</span></div>
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<span style="font-family: Verdana, sans-serif; font-size: large;">But what happens to a risk parity approach when, inevitably, rates start to rise again. Should bonds continue to maintain such a perpetually overweighted position in portfolios when long-term Treasuries promise yields of less than 3% for the next 30 years?</span><br />
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<span style="font-family: Verdana, sans-serif; font-size: large;">We feel this is a valid point. Obviously, return estimates need to be factored into the portfolio optimization somehow. However, we don't accept that this argument suggests that investors should move away from risk parity back toward the traditional Strategic Asset Allocation approach.</span><br />
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<span style="font-family: Verdana, sans-serif; font-size: large;">The next article will apply our Adaptive Asset Allocation framework to improve on the ARP approach by introducing a return estimate. This will short-circuit the fixed income conundrum so that balanced investors have a chance to capture a larger proportion of returns to stocks as rates normalize.</span></div>GestaltUhttp://www.blogger.com/profile/15636551868375563464noreply@blogger.com0tag:blogger.com,1999:blog-8316591069902396281.post-13370895451392663422010-03-22T15:09:00.002-04:002010-03-22T15:09:32.498-04:00Why Now Is Not The Time For Buy And Hold<div style="font-family: Verdana,sans-serif;">The most common question I get from clients is, 'Is now a good time to invest in stocks?' What clients are really asking is, 'If I invest now, will stocks take me where I want to go, on my timeline?' Most advisors answer this question by referring to long-term average returns. Some reference the last 20 years, others the last 30 years, and a small few know average returns over the last 100 years or more. Advisors quote these average returns as though investors are actually likely to achieve this growth regardless of when they invest.</div><div style="font-family: Verdana,sans-serif;"><br />
</div><div style="font-family: Verdana,sans-serif;"><b><span style="color: #b45f06;">It Matters When You Invest</span></b><br />
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In reality, the timing of your decision to put your money to work in the stock market has an enormous impact on your likely future returns. For example, if you chose to invest your money in stocks in September of 1929, your portfolio would have achieved growth of -2.34% per year over the next decade. In contrast, if you invested in July of 1932, your portfolio would have grown at over 8% per year over the next 10 years. Investing in August 1972 would have shown investors -3% a year over the next decade, but putting your money to work exactly 10 years later would have netted an investor 10.6% per year after inflation!<br />
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Given that timing matters, one is left to wonder if there is something about those dates that would have given investors a clue about what to expect from stocks over the following 10 year period. It turns out that by analyzing Yale Professor Robert Shiller's publicly available database of stock market information going back to 1870, clear patterns emerge that can help investors set expectations about future returns. That's the good news. The bad news is that future returns from here are likely to leave buy and hold investors in the dust.<br />
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<b><span style="color: #b45f06;">Are Markets Cheap or Expensive</span></b><br />
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Most investors are familiar with the commonly cited Price to Earnings Ratio, or PE ratio. This is simply the current price of a stock divided by its last year's earnings, and it is frequently to describe , very loosely, whether a stock is cheap or expensive. Interestingly, though the PE ratio is the most commonly cited statistic in finance, it provides very little useful information when picking stocks. A stock with a high PE may be growing very quickly in a market with little competition, high margins and high barriers to entry, so that the price is justified. Alternatively, a low PE stock may be lagging its competitors in terms of growth or profitability, and so the low price is justified.<br />
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The same ratio can be used to describe the stock market in aggregate. The market's PE ratio is just the current level of the index divided by the combined earnings of all its constituent companies. However, when analyzing the stock market in aggregate it makes sense to adjust the ratio by using stock market earnings over the past 10 years, adjusted for inflation, rather than just the previous year's earnings. This method was first proposed by Warren Buffet's mentor and value investment guru Benjamin Graham. He wanted a ratio that reflected the long-term trend of corporate earning potential in the economy, adjusted over one full business cycle. The Cyclically Adjusted PE, or CAPE, helps investors avoid the the misconception that markets are cheap just because the economy is at the peak in the current business cycle.<br />
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It turns out that, at the aggregate market level, the PE ratio does provide information that is useful to investors. Over time, investors are likely to receive above average returns by investing when markets are cheap (low PE), and below average returns by investing when markets are expensive (high PE). One can see from Chart 1. below that over the last 140 years, markets have traded in a PE range of about 5%(1921, 1932, 1982) through 45% (2000).<br />
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Chart 1.<br />
<img height="411" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjf1a_Plcp_25vTKEw_YROdXrLDS5mFLD7PheLd3q_EPkUY1H-7zXAncD4yZBd68FjwX9XEwfQQuAx5978Ujf6xGvthKmKVOHUEi8n1z1IFOZTMFf7RHw6hmM5XETeK9jNiJFwmYEQXCl0/s640/100322_Shiller_LT_CAPE_PE_Chart.jpeg" width="640" /><br />
Source: Robert Shiller<br />
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<b><span style="color: #b45f06;">Do Cheap Markets Deliver Better Future Returns?</span></b><br />
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In Chart 2. below, one can clearly see the relationship between the PE of the market and future returns. Starting PE and future returns are inversely related, so low PE = high future returns and high PE = low future returns. In order to illustrate this relationship, I have inverted the PE ratio to show the market's earnings yield (10-year average earnings divided by current price), so the blue line on the following chart is the inverse of the blue line in Chart 1. When the market is expensive, the blue line in Chart 2. is closer to the bottom, not the top. The red line shows the returns to an investor who invested on each date over the subsequent 10-year period, after inflation and including dividends.<br />
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Chart 2.<br />
<img height="312" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEglAlVhM38ApsFW24bpJTj0x4YFd9V5BT0YVduEPjMTYe-GfFPgjWeMeAUSrcA-DkmRfFhlx7gus55Bron87tUTAw4aiOOM9exvQEm0wrQksSFKqpFDjhpvA1ShvNPUeINnhotWf1Cuw_Y/s640/100318_PE_vs_Real_Returns_Chart.jpeg" width="640" /><br />
Source: Robert Shiller, Butler|Philbrick & Associates<br />
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It is plain to the eye that the 10-year forward returns (red line) very closely track the market's long-term earnings yield ratio (red line). A cheap market (low PE, high earnings yield) usually results in high long-term returns, while an expensive market (high PE, low earnings yield), usually results in low long-term returns.<br />
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It is worth noting at this point that the predictive value of the CAPE ratio is less robust when markets are neither very cheap nor very expensive. For the purpose of the analysis below, we assume the market is cheap when it trades in the 1st quartile of all CAPE ratios over the 140 year time period; it is expensive when it trades in the 4th quartile. When the market is priced in the 2nd or 3rd quartiles, it is neither cheap nor expensive.<br />
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Chart 3. is a scatter plot of all monthly CAPE ratios and the corresponding future 10-year returns, for all months where the market is either cheap (1st quartile), or expensive (4th quartile). The chart also shows the best fit line for the plot, as well as the least-squares linear approximation formula and R-square value. I then calculated the model's expected future returns from the formula using the current market CAPE ratio (20.63). An R-square value above 0.5 suggests a very strong relationship, so the market's current CAPE ratio does an excellent job of explaining future returns.<br />
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Chart 3.<br />
<img height="310" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj2rFZY9obzufGiAAu2kajUGKSCWgP5ata_qfUl4x9F-LnyNOo3Zmr_tQxiiwXiIMtg81fNDkzTQKD_ueu2DLlgEsNp4pq7_8m-qM2Unfa4K2oAxexHR7lkOKxGtCFhSlwf2tKbmPeIEEw/s640/100318_PE_vs_Real_Returns_Scatterplot.jpeg" width="640" /><br />
Source: Robert Shiller, Butler|Philbrick & Associates<br />
<br />
Chart 4. attempts to illustrate the relationship between the market's CAPE ratio and future returns by showing the distributions of future returns for both cheap (1st quartile CAPE) and expensive (4th quartile CAPE) markets. You can see that the median 10-year real return to stocks when markets are cheap is 9% per year, while the return to stocks when markets are expensive is 3% per year. Chart 3. shows that the modeled return to stocks when markets are priced at a CAPE of 20.63 is approximately 3.8% per year.<br />
<br />
Chart 4.<br />
<img height="313" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhzQhHCUWB9yDD1_lW63k0SXBMDCKkG2zuYhotw2MnJq74JuwwUtDz8bOROG_0xPhBY9OjISuXD9Bg6gNK_TedMQpOVXqMzKIOb7KOBZ8-GxivblLkzBUdgR5attaZyUzlond5tGRGTacM/s640/100318_PE_vs_Real_Returns_Histogram.jpeg" width="640" /><br />
Source: Robert Shiller, Butler|Philbrick & Associates</div><div style="font-family: Verdana,sans-serif;"><br />
<b><span style="color: #b45f06;">Lower Expectations or Pursue Alternatives to Buy and Hold </span></b></div><div style="font-family: Verdana,sans-serif;"><br />
</div><div style="font-family: Verdana,sans-serif;">Many advisors will argue that a 3.8% expected return may be poor, but it is much better than what an investor can expect from bonds or cash. On this basis, an investor should allocate a larger portion of his or her portfolio to stocks. While this logic may be sound if several other conditions are met, it is peripheral to the main conclusion of this analysis. The primary take-away is that investors should set lower expectations for future returns from here, and build these lower returns into financial and retirement planning models. While most planning software uses future nominal returns of 8% per year (every year!), investors are unlikely to see these returns in practice, especially after fees.</div><div style="font-family: Verdana,sans-serif;"><br />
</div><div style="font-family: Verdana,sans-serif;">Alternatively, accredited investors may wish to pursue alternative strategies that have demonstrated an ability to deliver robust real returns in good markets and bad. I will spend more time on these strategies going forward, but for an excellent example, look no further than last week's post. </div>GestaltUhttp://www.blogger.com/profile/15636551868375563464noreply@blogger.com0tag:blogger.com,1999:blog-8316591069902396281.post-55333606000756679952010-03-15T14:48:00.001-04:002010-03-15T15:00:53.232-04:00A Cure for Investor Depression<div style="font-family: Verdana,sans-serif;">The previous post hinted at a future piece on systematic trading. In this author's humble opinion, well tested systematic investment strategies are the antidote to the poison of expert predictions. These strategies embrace the probabilistic nature of investment markets by applying hard and fast rules for investment decisions based on actual empirical evidence. In other words, these systems do not rely on an elegant theory that is not supported by actual data (like Modern Portfolio Theory, CAPM, or the Efficient Markets Hypothesis), or on the confident views of market experts, but instead rely on rigorously tested systems developed from mountains of actual data. </div><div style="font-family: Verdana,sans-serif;"><br />
</div><div style="font-family: Verdana,sans-serif;">These systems demonstrate an ability to do well in bad and good markets across securities, asset classes, geographies, and time frames. But don't take it from me. Take it from one of the most experienced and successful systematic trading teams in Canada, Jason Russel and Nicholas Markos at Acorn Global Investments. See their recent paper below.</div><div style="font-family: Verdana,sans-serif;"><br />
</div><a href="http://www.scribd.com/doc/28409380/Acorn-Investments-Systematic-Trading" style="display: block; font-family: Helvetica,Arial,Sans-serif; font-size-adjust: none; font-size: 14px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 12px auto 6px; text-decoration: underline;" title="View Acorn Investments - Systematic Trading on Scribd">Acorn Investments - Systematic Trading</a> <object data="http://d1.scribdassets.com/ScribdViewer.swf" height="600" id="doc_428584573875176" name="doc_428584573875176" style="outline-color: -moz-use-text-color; outline-style: none; outline-width: medium;" type="application/x-shockwave-flash" width="100%"> <param name="movie" value="http://d1.scribdassets.com/ScribdViewer.swf"><param name="wmode" value="opaque"><param name="bgcolor" value="#ffffff"><param name="allowFullScreen" value="true"><param name="allowScriptAccess" value="always"><param name="FlashVars" value="document_id=28409380&access_key=key-1z64dor2qnw40x3yas61&page=1&viewMode=list"><embed id="doc_428584573875176" name="doc_428584573875176" src="http://d1.scribdassets.com/ScribdViewer.swf?document_id=28409380&access_key=key-1z64dor2qnw40x3yas61&page=1&viewMode=list" type="application/x-shockwave-flash" allowscriptaccess="always" allowfullscreen="true" height="600" width="100%" wmode="opaque" bgcolor="#ffffff"></embed> </object><br />
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</div><div style="font-family: Verdana,sans-serif;">For more information about systematic trading or Acorn's systems, go to their <a href="http://www.acorn.ca/">home on the Web</a>.</div>GestaltUhttp://www.blogger.com/profile/15636551868375563464noreply@blogger.com0tag:blogger.com,1999:blog-8316591069902396281.post-56198629847127839292010-03-15T12:57:00.001-04:002010-03-15T12:58:11.730-04:00And What About Financial Experts?<div style="font-family: Verdana,sans-serif;">As this blog purports to focus on topics relevant to investing, not just behavioral psychology, I will present some evidence that investment strategists, economists and analysts are particularly awful at predicting the future for the economy, stock prices, earnings, or any other series relevant to investor success. Further, these financial prognosticators are vastly overconfident and resistant to data that runs counter to their views.</div><div style="font-family: Verdana,sans-serif;"><br />
</div><div style="font-family: Verdana,sans-serif;">Before presenting the ugly details, I want to emphasize that investors should not feel disheartened by the evidence that financial marketing and media is dominated by loud, overconfident shills and mountebanks. On the contrary, investors should feel liberated to pursue other interests rather than reading or watching business news. For those that enjoy the cognitive 'sport' of investing from the standpoint of strategy and game theory, feel free to explore the various scenarios with your colleagues and friends as fun dinner conversation. Just don't orient your portfolio on the basis of your conclusions, or the conclusions of other thinkers. You are all bound to be wrong far more often than you are right.</div><div style="font-family: Verdana,sans-serif;"><br />
</div><div style="font-family: Verdana,sans-serif;">Now, here is the evidence. These charts are sourced from James Montier's book <u><b>Behavioural Investing</b></u> (2007):</div><div style="font-family: Verdana,sans-serif;"><br />
</div><div style="font-family: Verdana,sans-serif;">Chart 1. Consensus bond yields forecasts 1 year out vs. actual</div><div class="separator" style="clear: both; font-family: Verdana,sans-serif; text-align: center;"></div><div class="separator" style="clear: both; font-family: Verdana,sans-serif; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjt-hGbcGo60kKjTYQf7eG1Mk3diTi9Xjye44GEGbLMC8K5xTx4yK8E6hWfiSpEmfI1u3SxdO936ckuMC61kVHx8UqW8yx5RsNnOfRFl-SQDVgz0xhreu1uwci__OFfBT4pdzQQVq9tWqg/s1600-h/100315_Concensus_Bond_Yield_Forecasts_vs_Reality.jpeg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="195" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjt-hGbcGo60kKjTYQf7eG1Mk3diTi9Xjye44GEGbLMC8K5xTx4yK8E6hWfiSpEmfI1u3SxdO936ckuMC61kVHx8UqW8yx5RsNnOfRFl-SQDVgz0xhreu1uwci__OFfBT4pdzQQVq9tWqg/s400/100315_Concensus_Bond_Yield_Forecasts_vs_Reality.jpeg" width="400" /></a></div><div style="font-family: Verdana,sans-serif;"><br />
</div><div style="font-family: Verdana,sans-serif;">Chart 2. Consensus S&P500 level 1 year forecasts vs. actual</div><div class="separator" style="clear: both; font-family: Verdana,sans-serif; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjJQbVYe6oCwbVzXys9hT5VSfPODW8yXC-K7zJVUwMSlndKFtV53dee3Mv-sjc65HHDUc0SwKS_VnueIcnaDSGBi0nivONjS5VQ_W07DxCST6My2Cw8vJ6X1vceda0IgdZ_lX83ZXaQWnE/s1600-h/100315_Concensus_SPX_Forecasts_vs_Reality.jpeg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="190" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjJQbVYe6oCwbVzXys9hT5VSfPODW8yXC-K7zJVUwMSlndKFtV53dee3Mv-sjc65HHDUc0SwKS_VnueIcnaDSGBi0nivONjS5VQ_W07DxCST6My2Cw8vJ6X1vceda0IgdZ_lX83ZXaQWnE/s400/100315_Concensus_SPX_Forecasts_vs_Reality.jpeg" width="400" /></a></div><div style="font-family: Verdana,sans-serif;"><br />
</div><div style="font-family: Verdana,sans-serif;">Chart 3. Consensus S&P500 aggregate earnings 1 year forecasts vs. actual</div><div class="separator" style="clear: both; font-family: Verdana,sans-serif; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgOUOP0K9Mok2W8InyiqCzGWRdNOVZaAtdSyvuOEnoYck3VRZXu3oYohdH6U0WaaSDBrhynNhsozXLtaciDMxr9QIg3rfCJfqSdKEURO-aDk9yLDkopX24LoSFSfg6UZYTup9Cc2YpuYdo/s1600-h/100315_Concensus_Earnings_Forecasts_vs_Reality.jpeg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="188" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgOUOP0K9Mok2W8InyiqCzGWRdNOVZaAtdSyvuOEnoYck3VRZXu3oYohdH6U0WaaSDBrhynNhsozXLtaciDMxr9QIg3rfCJfqSdKEURO-aDk9yLDkopX24LoSFSfg6UZYTup9Cc2YpuYdo/s400/100315_Concensus_Earnings_Forecasts_vs_Reality.jpeg" width="400" /></a></div><div style="font-family: Verdana,sans-serif;"><br />
</div><div style="font-family: Verdana,sans-serif;">Note that in all cases, strategists, analysts and economists do an excellent job of describing what <i>happened</i> or is currently <i>happening</i>, that is they do an excellent job of observing the obvious. Unfortunately, they demonstrate no predictive ability whatsoever, as their forecast series for likely levels one year out appear to be <i>lagging</i> indicators, not leading ones.</div><div style="font-family: Verdana,sans-serif;"><br />
</div><div class="separator" style="clear: both; font-family: Verdana,sans-serif; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhWm4Vd0XhAOwFTmLOVgW__RZOeqWzMlKCehLnYFsf_Om9YlI8wZZuCTo8hFP7OxGsqvBVrQMnv6V60Hu47jlHcl7q5UW7IB8GA8LnVfvs39fcCZqiMSV8s2NUZbNW85HDhSxqo-zbdvMQ/s1600-h/100315_economics_poster_science_explaining_today.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="280" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhWm4Vd0XhAOwFTmLOVgW__RZOeqWzMlKCehLnYFsf_Om9YlI8wZZuCTo8hFP7OxGsqvBVrQMnv6V60Hu47jlHcl7q5UW7IB8GA8LnVfvs39fcCZqiMSV8s2NUZbNW85HDhSxqo-zbdvMQ/s400/100315_economics_poster_science_explaining_today.jpg" width="400" /></a></div><div style="font-family: Verdana,sans-serif;">Source: Despair.com<br />
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</div><div style="font-family: Verdana,sans-serif;">Still not convinced? The following chart shows the percentage error of analyst earnings forecasts from 24 months prior to an earnings announcement through to the date of the announcement, using data from 1986 - 2000. Not surprisingly, analysts demonstrate significant over-optimism in their earnings forecasts from two years out, while their forecasts narrow toward the actual number by around 2 months prior to earnings. The average error at 1 year is approximately 10%, and by a month prior they are slightly pessimistic. Of course this slight pessimism then allows the companies they cover to beat estimates slightly, which often results in a price jump.</div><div style="font-family: Verdana,sans-serif;"><br />
</div><div style="font-family: Verdana,sans-serif;">Chart 4. The walk down to beatable earnings.</div><div class="separator" style="clear: both; font-family: Verdana,sans-serif; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjhcXpIijsYbaaxZXvDfyt4Gr3Ka8ILTpCHQnpMn28e7pvmpn7NZfYxtDI4Si0YKHBBMTo33rvZLYoaz82IfjiYGx57YcF0UpJRcvrrlRAbUF68tuk-kMzxDWLSqSq9BIU5PJNaXUY37z4/s1600-h/100315_walk_down_to_beatable_earnings.jpeg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="201" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjhcXpIijsYbaaxZXvDfyt4Gr3Ka8ILTpCHQnpMn28e7pvmpn7NZfYxtDI4Si0YKHBBMTo33rvZLYoaz82IfjiYGx57YcF0UpJRcvrrlRAbUF68tuk-kMzxDWLSqSq9BIU5PJNaXUY37z4/s400/100315_walk_down_to_beatable_earnings.jpeg" width="400" /></a></div><div style="font-family: Verdana,sans-serif;">Source: Dresdner Kleinwort Wasserstein Macro Research</div><div style="font-family: Verdana,sans-serif;"><br />
</div><div style="font-family: Verdana,sans-serif;">The error rate would not be so worrisome if it weren't for the high level of confidence that investment professionals imbue on their predictions. This effect is perhaps best illustrated using the results of a study by Torngern and Montgomery (2004). The study set laypeople (psychology undergraduates, the perennial guinea pigs) against investment professionals in a competition to select the stock that they thought would outperform over the next month from pairs of stocks. All the stocks were well known companies, but participants were given information such as the industry and prior 12-month performance for each stock as well. Participants were asked to choose the best performer from the pair, and to provide their level of confidence in their choice.</div><div style="font-family: Verdana,sans-serif;"><br />
</div><div style="font-family: Verdana,sans-serif;">Over many picks, one might hope that when participants were 50% confident that their choice was right, they were accurate about half the time, and when they were 90% confident they were right almost all the time. In fact, as you can see from the chart below, a person's confidence level was largely irrelevant to their accuracy over time. In other words, having greater confidence in a choice did not lead to higher accuracy levels. In fact, at extreme levels of confidence (>80%), professionals were actually <i>less likely</i> to get it right. At a 90% level of confidence, professional investors actually got it right only 15% of the time, while at a 55% - 75% level of confidence they achieved about 40% accuracy.</div><div style="font-family: Verdana,sans-serif;"><br />
</div><div style="font-family: Verdana,sans-serif;">Chart 4: Accuracy and confidence on a stock selection task</div><div class="separator" style="clear: both; font-family: Verdana,sans-serif; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgoz9JPw5YZxy-H83PeS9DrThZaHhSsHGD8Es73fu4jwQxeYmtAso-ADcQr98ANZ-w1Bha85TDEkwwyfOT1G0IGy-ZciGhoOkmZbeZCp2gkJMdIYSj9udjfhvwpmMlhXgioClwuqOxqnpA/s1600-h/100315_Stock_Picking_Calibration.jpeg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="192" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgoz9JPw5YZxy-H83PeS9DrThZaHhSsHGD8Es73fu4jwQxeYmtAso-ADcQr98ANZ-w1Bha85TDEkwwyfOT1G0IGy-ZciGhoOkmZbeZCp2gkJMdIYSj9udjfhvwpmMlhXgioClwuqOxqnpA/s400/100315_Stock_Picking_Calibration.jpeg" width="400" /></a></div><div style="font-family: Verdana,sans-serif;">Source: Torngren and Montgomery (2004)</div><div style="font-family: Verdana,sans-serif;"><br />
</div><div style="font-family: Verdana,sans-serif;">It is important to remember that over a 1-month time horizon the results of these stock choices are almost random, so we are not out to skewer professionals on the basis of their accuracy in this test. Instead, we are left to wonder why anyone expressed such high levels of confidence in their choices. When asked this question, laypeople admitted that they were mostly guessing, but also placed some emphasis on the previous month's returns. In contrast, almost no professionals admitted to guessing; instead, they attributed their choices to 'Other knowledge' about the stocks, and 'Intuition'. Incidentally, the only factor with any predictive power in this example, however small, is the previous month's results. It has been well demonstrated that there is a strong mean-reversion tendency in stocks over a 1 month time frame, so participants may have had a slight advantage if they chose stocks with poor previous 1 month returns to outperform over the next month.</div><div style="font-family: Verdana,sans-serif;"><br />
</div><div style="font-family: Verdana,sans-serif;">Chart 5. Average rating of decision input importance</div><div class="separator" style="clear: both; font-family: Verdana,sans-serif; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjJm_V1D7tq3KMSS6jcSs5Iy6zTBTKDmDj2pErd3li7CILB-5SWftRl-W2xUDEThSmGr0cPlaymYEDweEzs4NSGN2vAZ6fw6PWWW9vsMrwKb7P7Yr3rVAyS5aB2Nlmn6Fqr3CqpkS7Sv8E/s1600-h/100315_Stock_Picking_Calibration_Input_Importance.jpeg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="182" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjJm_V1D7tq3KMSS6jcSs5Iy6zTBTKDmDj2pErd3li7CILB-5SWftRl-W2xUDEThSmGr0cPlaymYEDweEzs4NSGN2vAZ6fw6PWWW9vsMrwKb7P7Yr3rVAyS5aB2Nlmn6Fqr3CqpkS7Sv8E/s400/100315_Stock_Picking_Calibration_Input_Importance.jpeg" width="400" /></a></div><div style="font-family: Verdana,sans-serif;">Source: Torngren and Montgomery (2004)</div><div style="font-family: Verdana,sans-serif;"><br />
</div><div style="font-family: Verdana,sans-serif;">The quantum leap in thinking that I want to convey with this post is that there is indisputable empirical evidence that the world is too complex to enable accurate forecasting. Axiomatically, people should consider expert forecasts as no more than entertaining narratives - brain candy to stimulate the imagination. Even complex mathematical models are relatively poor predictors of the future beyond a certain time threshold. The best we can hope for is an assessment that a dynamic or trend is likely to stay on a certain course, or alternatively that the course is changing. Forecasting the direction or the magnitude of the change in trend is empirically impossible. We will be spending much more time on trend-following strategies going forward.</div>GestaltUhttp://www.blogger.com/profile/15636551868375563464noreply@blogger.com0tag:blogger.com,1999:blog-8316591069902396281.post-30123512456397471582010-03-12T16:44:00.003-05:002010-03-12T16:51:47.171-05:00Beware of Confident Experts Bearing Forecasts<div style="font-family: Verdana,sans-serif;">Among all forms of mistake, prophecy is the most gratuitous. – GEORGE ELIOT</div><div style="font-family: Verdana,sans-serif;"><br />
</div><div style="font-family: Verdana,sans-serif;">We have spent a great deal of time offering evidence that experts are poor predictors of the future. This post will describe the results of the most comprehensive and compelling study of expert fallibility to date, and offer lessons from the study that we can use to make better use (or not!) of expert opinions in future decisions. </div><div style="font-family: Verdana,sans-serif;"><span style="font-size: small;"> <br style="font-family: Verdana,sans-serif;" /><span style="font-family: Verdana,sans-serif;"> Of course, we – the consumers of expert pronouncements – will continue to be in thrall to experts for the same reasons that our ancestors submitted to shamans and oracles: our uncontrollable need to believe in a controllable world and our flawed understanding of the laws of chance. We generally lack the willpower and good sense to resist the snake oil products on offer. Who wants to believe that, on the big questions, we could do as well tossing a coin as by consulting accredited experts.</span></span><br />
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<span style="font-size: small;">Philip Tetlock spent over 20 years asking some of the top experts in their fields to make predictions about the future. The idea for the experiment took shape in the two or three year period prior to 1984 during the early years of the Reagan administration. Many of you will recall that this was a time of great anxiety and tension as the Soviets and the Americans seemed to move closer to nuclear Armageddon each day. Tetlock served on a committee charged with observing and forming opinions on American/Soviet relations. At that time in late 1983 the Bulletin of Nuclear Scientists had moved their Doomsday clock closer to midnight than at any other time since the Cuban Missile Crisis. It was widely believed by liberals that Reagan was leading the country on the road to nuclear apocalypse. Conservatives meanwhile believed that the best realistic outcome was for it to adopt a neo-Stalinist mode and retreat. Generally, the dominant view on both sides of the political aisle was that nothing good was going to happen. <br />
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While on this committee, which consisted of many well known political and military strategists at the time, it was widely noted that Gorbachev was rising through the political ranks in the Kremlin. Tetlock observed that no one at the time, however, believed that Gorbachev was likely to assume a leadership role in the Politboro. Further, it was commonly held that Gorbachev was secretly a neo-Stalinist in disguise. No one of any credibility thought that Gorbachev would execute a liberal revolution which would lead to the dissolution of the Soviet Union, and eventually the collapse of the Berlin wall and the reunification of Germany. <br />
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Of course, that’s just what Gorbachev went on to do. Interestingly, once Gorbachev had executed his coup, strategists of all stripes were eager to claim credit for having predicted just this outcome. Tetlock knew that in fact no one had predicted this outcome. This convinced Tetlock that there really would be great value if someone tried systematically to keep score on political experts. And that is just what he proceeded to do. From 1984 through 2001 Tetlock solicited frequent predictions from 284 experts in international affairs, economics, political strategy, and other complex fields. The experts consisted of a mixture of academics, journalists, intelligence analysts and people in various think-tanks, with an average of roughly 12 years of work experience each. No political view was over or underrepresented. Each expert made approximately 100 predictions, resulting in about 28,000 predictions in total. This allowed Tetlock to put the law of large numbers to good use. Experts were asked to make predictions on such topics as economic growth, inflation, unemployment, policy priorities, defense spending, leadership changes, border conflicts, entry-exit from international agreements, etc. <br />
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The results from the study are broad reaching and complex. Generally the results support the view that it is the way one thinks, not the depth of knowledge about a certain topic or theory, which matters most in tests of complex prediction. Tetlock expounds on the spectrum of cognitive reasoning techniques bounded by foxes at one end of the spectrum and hedgehogs on the other. (Un)fortunately, this distinction is beyond the scope of this essay. We are more interested specifically in how well experts delivered accurate predictions over time, especially as it relates to experts’ confidence in their own predictions. <br />
</span></div><div style="font-family: Verdana,sans-serif;"><span style="font-size: small;">Here is a summary of the important lessons from the study: <br />
</span></div><ol style="font-family: Verdana,sans-serif;"><li><span style="font-size: small;">Experts are no better at predicting the future than the rest of us. In fact they are less accurate than a large group of dart-throwing monkeys </span></li>
<li><span style="font-size: small;">Experts (like everyone else) are unlikely to admit when they are wrong, or to revise their beliefs in the face of conflicting evidence </span></li>
<li><span style="font-size: small;">Those who know a lot about a subject are more likely to predict extreme outcomes (which rarely happen), and are more overconfident in their forecasts </span></li>
<li><span style="font-size: small;">Specialists are no more reliable than non-specialists in forecasting outcomes in their own domain of study </span></li>
<li><span style="font-size: small;">Experts who hedge their views, are self critical and consider alternative outcomes are more likely to be right </span></li>
<li><span style="font-size: small;">Those experts who are better known and more frequently quoted are less likely to be right. Frightfully, these experts also make entertaining media guests </span></li>
<li><span style="font-size: small;">Experts are no better at forecasting than basic trend-following systems such as ‘no change’ or ‘continue with the same rate of change’ </span></li>
<li><span style="font-size: small;">Of the 284 experts who offered predictions over 18 years, not one expert demonstrated a superior forecasting ability</span></li>
</ol><div style="font-family: Verdana,sans-serif;"><span style="font-size: small;">In a review of Tetlock’s book, Louise Menand at The New Yorker magazine tells how Tetlock witnessed a shocking experiment during his student days at Yale. According to Tetlock, </span> </div><blockquote style="font-family: Verdana,sans-serif;"><span style="font-size: small;">“A rat was placed in a T-shaped maze. Food was placed in either the right or the left transept of the T in a random sequence such that, over the long run, the food was on the left sixty per cent of the time and on the right forty per cent. Neither the students nor (needless to say) the rat was told these frequencies. The students were asked to predict on which side of the T the food would appear each time. The rat eventually figured out that the food was on the left side more often than the right, and it therefore nearly always went to the left, scoring roughly sixty per cent—D, but a passing grade. The students looked for patterns of left-right placement, and ended up scoring only fifty-two per cent, an F. The rat, having no reputation to begin with, was not embarrassed about being wrong two out of every five tries. But Yale students, who do have reputations, searched for a hidden order in the sequence. They couldn’t deal with forty-per-cent error, so they ended up with almost fifty-per-cent error.” </span></blockquote><div style="font-family: Verdana,sans-serif;"><span style="font-size: small;">Amos Tversky, the eminent behavioral economist, was fond of saying that human beings can only distinguish between three probabilistic outcomes: something is sure to happen; something is sure not to happen; and maybe. Quantitative economists and other forecasters can likely distinguish probabilities at a much higher level of granularity, but the experts that subscribe to these models are likely susceptible to the same overconfidence, and are thus not particularly reliable. The reality is that we live in a probabilistic world, not a deterministic one. On this basis, a decision making style that is predicated on adaptation rather than forecasting makes the most sense. Endeavour to not mistake a compelling narrative about future events with a strong likelihood of accuracy. In fact, one would do well to ignore loud exponents of fancy theories altogther, especially where those theories are used to make confident forecasts. By making many smaller bets with less confidence rather than few large bets with great confidence, you are likely to meet with greater success over time. </span></div><div style="font-family: Verdana,sans-serif;"><br />
</div><div style="font-family: Verdana,sans-serif;"><span style="font-size: small;">For more information on Tetlock’s study and his results, I urge you to watch a presentation of his results at this link: <a href="http://fora.tv/2007/01/26/Why_Foxes_Are_Better_Forecasters_Than_Hedgehogs#fullprogram">http://fora.tv/2007/01/26/Why_Foxes_Are_Better_Forecasters_Than_Hedgehogs#fullprogram</a><br />
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Also, the full New Yorker article is worth reading. You will find it at <a href="http://www.newyorker.com/archive/2005/12/05/051205crbo_books1?currentPage=2">http://www.newyorker.com/archive/2005/12/05/051205crbo_books1?currentPage=2</a><br />
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Purchase Philip Tetlock’s book at <a href="http://www.amazon.ca/Expert-Political-Judgment-Good-Know/dp/0691123020">Amazon</a>. <br />
</span> </div>GestaltUhttp://www.blogger.com/profile/15636551868375563464noreply@blogger.com0tag:blogger.com,1999:blog-8316591069902396281.post-75530072866984403292010-02-07T16:10:00.005-05:002010-02-07T16:29:32.857-05:00An Interlude to Discuss Education<span class="Apple-style-span" style="font-style: italic; font-weight: bold;"><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"><br />
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<span class="Apple-style-span" style="font-style: italic;"><span class="Apple-style-span" style="font-weight: bold;"><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;">"We must wake up to what our schools really are: laboratories of experimentation on young minds, drill centers for the habits and attitudes that corporate society demands. Mandatory education serves children only incidentally; its real purpose is to turn them into servants." John Taylor Gatto</span></span></span></span><br />
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<span class="Apple-style-span" style="font-size: medium;"><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"></span></span><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;">Your humble blogger had an opportunity to teach math and science to middle-school children in Asia during a two year stay in Bangkok. Though I had as much experience with the education system as any western person, having spent 11 years of my life in Canadian public schools (and one year in a private school for university prep), I had no formal training in education. Further, and with the benefit of hindsight, I have no particular talent for teaching. Truly effective teaching, like most skills, can be refined in school and through practice, but requires a certain predisposition and talent to achieve anything greater than mediocrity. I believe that no amount of training or practice would enable me to become anything but a passable teacher. </span></span><span class="Apple-style-span" style="font-size: medium;"><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"></span></span><br />
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<span class="Apple-style-span" style="font-family: Verdana;"><span class="Apple-style-span" style="font-size: medium;">Like most people, I had not given much thought to peda</span></span><span class="Apple-style-span" style="font-family: Verdana;"><span class="Apple-style-span" style="font-size: medium;">gogical practice or philosophy before my teaching stint. Of course, any thoughtful person thrown into an established discipline will rail against the rules initially, and I was no exception. It took me 5 or 6 weeks to accept my limitations and the limitations of the rules and philosophy of my Bangkok school. Once I overcame these hurdles I enjoyed the process of knowledge transfer, and the mostly constructive interaction with the children. </span></span><br />
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<span class="Apple-style-span" style="font-family: Verdana;"><span class="Apple-style-span" style="font-size: medium;">Of course, true teaching encompasses far more than this, but in my two years at the school I never managed to evolve my skills to inspire, or to coach, and I had a limited ability to alter my lessons to address the various learning styles of the children in my classes. As a visio-auditory learner, I focused on theory and abstraction at the expense of labs and tactile activities. In contrast, gifted teachers are able to project themselves and their material into all major learning domains at once, effortlessly and instinctively. Such gifted masters can encourage, inspire, coach and support even the most corrupted and stubborn of souls.</span></span><br />
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<span class="Apple-style-span" style="font-family: Verdana;"><span class="Apple-style-span" style="font-size: medium;">In Canada, due mostly to the destructive propaganda disseminated by almost every political party at all levels of government, the teaching profession is afflicted with a generalized public disdain. Politicians have transmogrified the otherwise constructive ideal of accountability in our school system into a twisted flail with which the teaching profession is consistently flogged. Naturally, parents have adopted this attitude toward teachers, and many parents serve as primary obstacles to teacher efficacy nationwide. Parents' attitudes are, of course, adopted by their children, and so modern Canadian classrooms are characterized by disrespect, disdain, and often, due to the way information and emotion is twisted in the tortured minds of adolescents, aggression.</span></span><br />
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<span class="Apple-style-span" style="font-family: Verdana;"><span class="Apple-style-span" style="font-size: medium;">At the same time, courts and school boards have severely limited the tools teachers can use to discipline and motivate. I am not advocating a return to corporeal punishment. However, students should at the very least be taught the basic relationship between action and consequence. Instead, current rules prohibit teachers from penalizing students handing in assignments late. In fact, teachers are required to grade high-school assignments without penalty if they are handed in at any time prior to the end of the academic year. It seems unfair to students to teach them that they are not accountable to deliver on a timetable.</span></span><br />
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<span class="Apple-style-span" style="font-family: Verdana;"><span class="Apple-style-span" style="font-size: medium;">The sorry state of education in the west today is all the more distressing when compared with the caliber of students being produced by cultures from the emerging world. It is important to acknowledge the powerful family and cultural drivers, especially in Asia, that reinforce the education focus. Asian families often live with several generations in one household. Each person in each generation has a role, with younger generations supporting elder generations financially, and grandparents helping with homemaking, cooking and childcare. Many families sacrifice substantially to ensure their children have access to quality education, and school-aged children feel the weight of this responsibility. </span></span><br />
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<span class="Apple-style-span" style="font-family: Verdana;"><span class="Apple-style-span" style="font-size: medium;">This tradition crosses geographic boundaries, so children from these cultures tend to be high achievers no matter where they attend school. It was instructive, if anecdotal, to observe an announcement in a newspaper from a small Detroit exurb featuring the pictures of the top 50 academic achievers from local high-schools. Of the 50 pictures featured, fully 38 were of Asian descent with the balance a mix of caucasian, Latin and African. Note that the exurb in question was typical of Detroit. In other words, the ratio of Asians in the population was relatively low.</span></span><br />
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<span class="Apple-style-span" style="font-family: Verdana;"><span class="Apple-style-span" style="font-size: medium;">My children, aged two and 4, take Mandarin lessons every Saturday morning. When asked why, I joke that I want my children to at least qualify to be nannies or gardeners for Asian families. If I really wanted to give them an advantage, I would move to Singapore and force them to compete in the Asian school system. I would also teach them Hindi, but we haven't discovered any readily accessible Hindi schools in our city. Of course, it's just a matter of time.</span></span><br />
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<span class="Apple-style-span" style="font-family: Verdana;"><span class="Apple-style-span" style="font-size: medium;">A few months into my teaching experience, I was fortunate enough to come across an article in Harper's Magazine written by an inspired ex-teacher, John Taylor Gatto. I've included this article in its entirety. It is long but dense with frank talk about schools and teaching from an experienced teacher with an urgent desire to revolutionize western education, and a plan for how to do it.</span></span><br />
<blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;">AGAINST SCHOOL: How public education cripples our kids, and why.</span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;">By John Taylor Gatto</span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> </span></span><span class="Apple-style-span" style="font-style: italic;"><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;">John Taylor Gatto is a former New York State and New York City Teacher of the Year and the author, most recently, of The Underground History of American Education. He was a participant in the Harper's Magazine forum "School on a Hill," which appeared in the September 2001 issue.</span></span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> I taught for thirty years in some of the worst schools in Manhattan, and in some of the best, and during that time I became an expert in boredom. Boredom was everywhere in my world, and if you asked the kids, as I often did, why they felt so bored, they always gave the same answers: They said the work was stupid, that it made no sense, that they already knew it. They said they wanted to be doing something real, not just sitting around. They said teachers didn't seem to know much about their subjects and clearly weren't interested in learning more. And the kids were right: their teachers were every bit as bored as they were. </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> Boredom is the common condition of schoolteachers, and anyone who has spent time in a teachers' lounge can vouch for the low energy, the whining, the dispirited attitudes, to be found there. When asked why they feel bored, the teachers tend to blame the kids, as you might expect. Who wouldn't get bored teaching students who are rude and interested only in grades? If even that. Of course, teachers are themselves products of the same twelve-year compulsory school programs that so thoroughly bore their students, and as school personnel they are trapped inside structures even more rigid than those imposed upon the children. Who, then, is to blame? </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> We all are. My grandfather taught me that. One afternoon when I was seven I complained to him of boredom, and he batted me hard on the head. He told me that I was never to use that term in his presence again, that if I was bored it was my fault and no one else's. The obligation to amuse and instruct myself was entirely my own, and people who didn't know that were childish people, to be avoided if possible. Certainly not to be trusted. That episode cured me of boredom forever, and here and there over the years I was able to pass on the lesson to some remarkable student. For the most part, however, I found it futile to challenge the official notion that boredom and childishness were the natural state of affairs in the classroom. Often I had to defy custom, and even bend the law, to help kids break out of this trap. </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> The empire struck back, of course; childish adults regularly conflate opposition with disloyalty. I once returned from a medical leave to discover that all evidence of my having been granted the leave had been purposely destroyed, that my job had been terminated, and that I no longer possessed even a teaching license. After nine months of tormented effort I was able to retrieve the license when a school secretary testified to witnessing the plot unfold. In the meantime my family suffered more than I care to remember. By the time I finally retired in 1991, 1 had more than enough reason to think of our schools--with their long-term, cell-block-style, forced confinement of both students and teachers--as virtual factories of childishness. Yet I honestly could not see why they had to be that way. My own experience had revealed to me what many other teachers must learn along the way, too, yet keep to themselves for fear of reprisal: if we wanted to we could easily and inexpensively jettison the old, stupid structures and help kids take an education rather than merely receive a schooling. We could encourage the best qualities of youthfulness--curiosity, adventure, resilience, the capacity for surprising insight--simply by being more flexible about time, texts, and tests, by introducing kids to truly competent adults, and by giving each student what autonomy he or she needs in order to take a risk every now and then. </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> But we don't do that. And the more I asked why not, and persisted in thinking about the "problem" of schooling as an engineer might, the more I missed the point: What if there is no "problem" with our schools? What if they are the way they are, so expensively flying in the face of common sense and long experience in how children learn things, not because they are doing something wrong but because they are doing something right? Is it possible that George W. Bush accidentally spoke the truth when he said we would "leave no child behind"? Could it be that our schools are designed to make sure not one of them ever really grows up? </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> Do we really need school? I don't mean education, just forced schooling: six classes a day, five days a week, nine months a year, for twelve years. Is this deadly routine really necessary? And if so, for what? Don't hide behind reading, writing, and arithmetic as a rationale, because 2 million happy homeschoolers have surely put that banal justification to rest. Even if they hadn't, a considerable number of well-known Americans never went through the twelve-year wringer our kids currently go through, and they turned out all right. George Washington, Benjamin Franklin, Thomas Jefferson, Abraham Lincoln? Someone taught them, to be sure, but they were not products of a school system, and not one of them was ever "graduated" from a secondary school. Throughout most of American history, kids generally didn't go to high school, yet the unschooled rose to be admirals, like Farragut; inventors, like Edison; captains of industry, like Carnegie and Rockefeller; writers, like Melville and Twain and Conrad; and even scholars, like Margaret Mead. In fact, until pretty recently people who reached the age of thirteen weren't looked upon as children at all. Ariel Durant, who co-wrote an enormous, and very good, multivolume history of the world with her husband, Will, was happily married at fifteen, and who could reasonably claim that Ariel Durant was an uneducated person? Unschooled, perhaps, but not uneducated. </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> We have been taught (that is, schooled) in this country to think of "success" as synonymous with, or at least dependent upon, "schooling," but historically that isn't true in either an intellectual or a financial sense. And plenty of people throughout the world today find a way to educate themselves without resorting to a system of compulsory secondary schools that all too often resemble prisons. Why, then, do Americans confuse education with just such a system? What exactly is the purpose of our public schools? </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> Mass schooling of a compulsory nature really got its teeth into the United States between 1905 and 1915, though it was conceived of much earlier and pushed for throughout most of the nineteenth century. The reason given for this enormous upheaval of family life and cultural traditions was, roughly speaking, threefold: </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> 1)</span></span><span class="Apple-tab-span" style="white-space: pre;"><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> </span></span></span><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;">To make good people. </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;">2)</span></span><span class="Apple-tab-span" style="white-space: pre;"><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> </span></span></span><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;">To make good citizens. </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;">3)</span></span><span class="Apple-tab-span" style="white-space: pre;"><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> </span></span></span><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;">To make each person his or her personal best. </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;">These goals are still trotted out today on a regular basis, and most of us accept them in one form or another as a decent definition of public education's mission, however short schools actually fall in achieving them. But we are dead wrong. Compounding our error is the fact that the national literature holds numerous and surprisingly consistent statements of compulsory schooling's true purpose. We have, for example, the great H. L. Mencken, who wrote in The American Mercury for April 1924 that the aim of public education is not </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> to fill the young of the species with knowledge and awaken their intelligence. ... Nothing could be further from the truth. The aim ... is simply to reduce as many individuals as possible to the same safe level, to breed and train a standardized citizenry, to put down dissent and originality. That is its aim in the United States... and that is its aim everywhere else. </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> Because of Mencken's reputation as a satirist, we might be tempted to dismiss this passage as a bit of hyperbolic sarcasm. His article, however, goes on to trace the template for our own educational system back to the now vanished, though never to be forgotten, military state of Prussia. And although he was certainly aware of the irony that we had recently been at war with Germany, the heir to Prussian thought and culture, Mencken was being perfectly serious here. Our educational system really is Prussian in origin, and that really is cause for concern. </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> The odd fact of a Prussian provenance for our schools pops up again and again once you know to look for it. William James alluded to it many times at the turn of the century. Orestes Brownson, the hero of Christopher Lasch's 1991 book, The True and Only Heaven, was publicly denouncing the Prussianization of American schools back in the 1840s. Horace Mann's "Seventh Annual Report" to the Massachusetts State Board of Education in 1843 is essentially a paean to the land of Frederick the Great and a call for its schooling to be brought here. That Prussian culture loomed large in America is hardly surprising, given our early association with that utopian state. A Prussian served as Washington's aide during the Revolutionary War, and so many German-speaking people had settled here by 1795 that Congress considered publishing a German-language edition of the federal laws. But what shocks is that we should so eagerly have adopted one of the very worst aspects of Prussian culture: an educational system deliberately designed to produce mediocre intellects, to hamstring the inner life, to deny students appreciable leadership skills, and to ensure docile and incomplete citizens in order to render the populace "manageable." </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> It was from James Bryant Conant--president of Harvard for twenty years, WWI poison-gas specialist, WWII executive on the atomic-bomb project, high commissioner of the American zone in Germany after WWII, and truly one of the most influential figures of the twentieth century--that I first got wind of the real purposes of American schooling. Without Conant, we would probably not have the same style and degree of standardized testing that we enjoy today, nor would we be blessed with gargantuan high schools that warehouse 2,000 to 4,000 students at a time, like the famous Columbine High in Littleton, Colorado. Shortly after I retired from teaching I picked up Conant's 1959 book-length essay, The Child, the Parent and the State, and was more than a little intrigued to see him mention in passing that the modem schools we attend were the result of a "revolution" engineered between 1905 and 1930. A revolution? He declines to elaborate, but he does direct the curious and the uninformed to Alexander Inglis's 1918 book, Principles of Secondary Education, in which "one saw this revolution through the eyes of a revolutionary." </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> Inglis, for whom a lecture in education at Harvard is named, makes it perfectly clear that compulsory schooling on this continent was intended to be just what it had been for Prussia in the 1820s: a fifth column into the burgeoning democratic movement that threatened to give the peasants and the proletarians a voice at the bargaining table. Modern, industrialized, compulsory schooling was to make a sort of surgical incision into the prospective unity of these underclasses. Divide children by subject, by age-grading, by constant rankings on tests, and by many other more subtle means, and it was unlikely that the ignorant mass of mankind, separated in childhood, would ever re-integrate into a dangerous whole. </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> Inglis breaks down the purpose--the actual purpose--of modem schooling into six basic functions, any one of which is enough to curl the hair of those innocent enough to believe the three traditional goals listed earlier: </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> 1)</span></span><span class="Apple-tab-span" style="white-space: pre;"><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> </span></span></span><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;">The adjustive or adaptive function. Schools are to establish fixed habits of reaction to authority. This, of course, precludes critical judgment completely. It also pretty much destroys the idea that useful or interesting material should be taught, because you can't test for reflexive obedience until you know whether you can make kids learn, and do, foolish and boring things. </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;">2)</span></span><span class="Apple-tab-span" style="white-space: pre;"><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> </span></span></span><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;">The integrating function. This might well be called "the conformity function," because its intention is to make children as alike as possible. People who conform are predictable, and this is of great use to those who wish to harness and manipulate a large labor force. </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;">3)</span></span><span class="Apple-tab-span" style="white-space: pre;"><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> </span></span></span><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;">The diagnostic and directive function. School is meant to determine each student's proper social role. This is done by logging evidence mathematically and anecdotally on cumulative records. As in "your permanent record." Yes, you do have one. </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;">4)</span></span><span class="Apple-tab-span" style="white-space: pre;"><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> </span></span></span><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;">The differentiating function. Once their social role has been "diagnosed," children are to be sorted by role and trained only so far as their destination in the social machine merits--and not one step further. So much for making kids their personal best. </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;">5)</span></span><span class="Apple-tab-span" style="white-space: pre;"><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> </span></span></span><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;">The selective function. This refers not to human choice at all but to Darwin's theory of natural selection as applied to what he called "the favored races." In short, the idea is to help things along by consciously attempting to improve the breeding stock. Schools are meant to tag the unfit--with poor grades, remedial placement, and other punishments--clearly enough that their peers will accept them as inferior and effectively bar them from the reproductive sweepstakes. That's what all those little humiliations from first grade onward were intended to do: wash the dirt down the drain. </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;">6)</span></span><span class="Apple-tab-span" style="white-space: pre;"><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> </span></span></span><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;">The propaedeutic function. The societal system implied by these rules will require an elite group of caretakers. To that end, a small fraction of the kids will quietly be taught how to manage this continuing project, how to watch over and control a population deliberately dumbed down and declawed in order that government might proceed unchallenged and corporations might never want for obedient labor. </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> That, unfortunately, is the purpose of mandatory public education in this country. And lest you take Inglis for an isolated crank with a rather too cynical take on the educational enterprise, you should know that he was hardly alone in championing these ideas. Conant himself, building on the ideas of Horace Mann and others, campaigned tirelessly for an American school system designed along the same lines. Men like George Peabody, who funded the cause of mandatory schooling throughout the South, surely understood that the Prussian system was useful in creating not only a harmless electorate and a servile labor force but also a virtual herd of mindless consumers. In time a great number of industrial titans came to recognize the enormous profits to be had by cultivating and tending just such a herd via public education, among them Andrew Carnegie and John D. Rockefeller. </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> There you have it. Now you know. We don't need Karl Marx's conception of a grand warfare between the classes to see that it is in the interest of complex management, economic or political, to dumb people down, to demoralize them, to divide them from one another, and to discard them if they don't conform. Class may frame the proposition, as when Woodrow Wilson, then president of Princeton University, said the following to the New York City School Teachers Association in 1909: "We want one class of persons to have a liberal education, and we want another class of persons, a very much larger class, of necessity, in every society, to forgo the privileges of a liberal education and fit themselves to perform specific difficult manual tasks." But the motives behind the disgusting decisions that bring about these ends need not be class-based at all. They can stem purely from fear, or from the by now familiar belief that "efficiency" is the paramount virtue, rather than love, liberty, laughter, or hope. Above all, they can stem from simple greed. </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> There were vast fortunes to be made, after all, in an economy based on mass production and organized to favor the large corporation rather than the small business or the family farm. But mass production required mass consumption, and at the turn of the twentieth century most Americans considered it both unnatural and unwise to buy things they didn't actually need. Mandatory schooling was a godsend on that count. School didn't have to train kids in any direct sense to think they should consume nonstop, because it did something even better: it encouraged them not to think at all. And that left them sitting ducks for another great invention of the modem era--marketing. </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> Now, you needn't have studied marketing to know that there are two groups of people who can always be convinced to consume more than they need to: addicts and children. School has done a pretty good job of turning our children into addicts, but it has done a spectacular job of turning our children into children. Again, this is no accident. Theorists from Plato to Rousseau to our own Dr. Inglis knew that if children could be cloistered with other children, stripped of responsibility and independence, encouraged to develop only the trivializing emotions of greed, envy, jealousy, and fear, they would grow older but never truly grow up. In the 1934 edition of his once well-known book Public Education in the United States, Ellwood P. Cubberley detailed and praised the way the strategy of successive school enlargements had extended childhood by two to six years, and forced schooling was at that point still quite new. This same Cubberley--who was dean of Stanford's School of Education, a textbook editor at Houghton Mifflin, and Conant's friend and correspondent at Harvard--had written the following in the 1922 edition of his book Public School Administration: "Our schools are ... factories in which the raw products (children) are to be shaped and fashioned .... And it is the business of the school to build its pupils according to the specifications laid down." </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;"> It's perfectly obvious from our society today what those specifications were. Maturity has by now been banished from nearly every aspect of our lives. Easy divorce laws have removed the need to work at relationships; easy credit has removed the need for fiscal self-control; easy entertainment has removed the need to learn to entertain oneself; easy answers have removed the need to ask questions. We have become a nation of children, happy to surrender our judgments and our wills to political exhortations and commercial blandishments that would insult actual adults. We buy televisions, and then we buy the things we see on the television. We buy computers, and then we buy the things we see on the computer. We buy $150 sneakers whether we need them or not, and when they fall apart too soon we buy another pair. We drive SUVs and believe the lie that they constitute a kind of life insurance, even when we're upside-down in them. And, worst of all, we don't bat an eye when Ari Fleischer tells us to "be careful what you say," even if we remember having been told somewhere back in school that America is the land of the free. We simply buy that one too. Our schooling, as intended, has seen to it. </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;">Now for the good news. Once you understand the logic behind modern schooling, its tricks and traps are fairly easy to avoid. School trains children to be employees and consumers; teach your own to be leaders and adventurers. School trains children to obey reflexively; teach your own to think critically and independently. Well-schooled kids have a low threshold for boredom; help your own to develop an inner life so that they'll never be bored. Urge them to take on the serious material, the grown-up material, in history, literature, philosophy, music, art, economics, theology--all the stuff schoolteachers know well enough to avoid. Challenge your kids with plenty of solitude so that they can learn to enjoy their own company, to conduct inner dialogues. Well-schooled people are conditioned to dread being alone, and they seek constant companionship through the TV, the computer, the cell phone, and through shallow friendships quickly acquired and quickly abandoned. Your children should have a more meaningful life, and they can. </span></span></blockquote><blockquote><span class="Apple-style-span" style="font-family: Verdana, sans-serif;"><span class="Apple-style-span" style="font-size: medium;">First, though, we must wake up to what our schools really are: laboratories of experimentation on young minds, drill centers for the habits and attitudes that corporate society demands. Mandatory education serves children only incidentally; its real purpose is to turn them into servants. Don't let your own have their childhoods extended, not even for a day. If David Farragut could take command of a captured British warship as a pre-teen, if Thomas Edison could publish a broadsheet at the age of twelve, if Ben Franklin could apprentice himself to a printer at the same age (then put himself through a course of study that would choke a Yale senior today), there's no telling what your own kids could do. After a long life, and thirty years in the public school trenches, I've concluded that genius is as common as dirt. We suppress our genius only because we haven't yet figured out how to manage a population of educated men and women. The solution, I think, is simple and glorious. Let them manage themselves. </span></span></blockquote><div><br />
</div></blockquote>GestaltUhttp://www.blogger.com/profile/15636551868375563464noreply@blogger.com0tag:blogger.com,1999:blog-8316591069902396281.post-54765711333612139152010-01-26T20:22:00.008-05:002010-03-15T13:21:21.891-04:00On Market Timing<div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px; min-height: 16px;"><span style="letter-spacing: 0px;"></span></div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px;"><span style="letter-spacing: 0px;">It is a common refrain from mutual fund and investment management marketing material that investors should assume that it is impossible to time the market. In reality, with a fairly simple toolbox small investors can take steps to largely avoid major bear markets while enjoying the bulk of large, multi-year bull markets.</span></div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px; min-height: 16px;"><span style="letter-spacing: 0px;"></span></div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px;"><span style="letter-spacing: 0px;">One might wonder, if this is possible, why everyone does not follow such a system. There is a different answer to this question for each major type of investor.</span></div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px; min-height: 16px;"><span style="letter-spacing: 0px;"></span></div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px;"><span style="letter-spacing: 0px;">Large investors like pension funds, mutual funds and institutional portfolio managers can not react quickly enough to take advantage of the signals. It takes several weeks, often months, for very large investors to enter and exit stock and bond positions. A rapid exit would have a dramatic effect on the stocks being purchased or sold, and in the case of very large investors, on the markets themselves. For these investors, ‘Buy and Hold’ is the only option, so this is the message they preach in their marketing materials. Further, investors who can not sell do not invest in the development of market timing strategies.</span></div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px; min-height: 16px;"><span style="letter-spacing: 0px;"></span></div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px;"><span style="letter-spacing: 0px;">Small investors who own stocks or mutual funds often deal with an Advisor with a large number of clients. Under regulations in Canada and the U.S., most Advisors must call each client for approval to buy or sell securities in their portfolios. An average Advisor with 200 clients to call may take a week or more to contact everybody. Often, these Advisors choose not to act rather than undertake the Herculean effort to reorient their clients’ accounts for changing market conditions. Further, market timing signals usually require quick action. As these Advisors can not act quickly to reallocate all their clients’ funds, they do not invest in the development of market timing systems.</span></div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px; min-height: 16px;"><span style="letter-spacing: 0px;"></span></div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px;"><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj3eWHGqBY3xm7qyOBnh1_NLXUc5dbJ-wJW1Owldi9O-4b30mw4TwuQE37IgOb05HhRXSLiZV0TeHihedIVIRnBSnxX0KIMP9M5bBhgS0ih9n6FxWW8zSp-ljXbrIPx1rbJWuTLI4kEuIU/s1600-h/090924_Your_Strengths.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="312" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj3eWHGqBY3xm7qyOBnh1_NLXUc5dbJ-wJW1Owldi9O-4b30mw4TwuQE37IgOb05HhRXSLiZV0TeHihedIVIRnBSnxX0KIMP9M5bBhgS0ih9n6FxWW8zSp-ljXbrIPx1rbJWuTLI4kEuIU/s640/090924_Your_Strengths.jpg" width="640" /></a></div><br />
<div style="margin: 0px;"><span style="letter-spacing: 0px;">Source: Butler|Philbrick & Associates</span></div><div style="margin: 0px;"><div style="margin: 0px;">Click for larger version.</div></div><br />
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<span style="letter-spacing: 0px;">A small proportion of Advisors are licensed to make changes to all their clients’ portfolios at once without having to call. These Advisors usually have special qualifications, such as a CFA or a CIM, and significant experience such that regulators grant them permission to manage client portfolios with discretion. In Canada, professionals who service individual clients, and who possess a discretionary license, are designated Associate Portfolio Managers or Portfolio Managers. Often these Advisors manage small amounts of capital, usually less than $1 billion. Their discretionary license enables them to act quickly and decisively to protect or deploy their clients’ assets.</span></div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px; min-height: 16px;"><span style="letter-spacing: 0px;"></span></div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px;"><span style="letter-spacing: 0px;">Associate Portfolio Managers and Portfolio Managers usually have the training, experience, and regulatory ability to take advantage of high quality market timing systems. However, very few invest the time and money to develop and test trading and timing systems that they can apply confidently to client portfolios. Perhaps they have misplaced faith in the Modern Portfolio Theory they learned in school. Perhaps they haven’t heard about Behavioral Economics, or tested the assumptions of MPT with real data.</span></div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px; min-height: 16px;"><span style="letter-spacing: 0px;"></span></div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px;"><span style="letter-spacing: 0px;">Whatever the reason, this is unfortunate, as the payoff to those who take the time to research, develop and rigorously back-test trading and timing systems can be enormous.</span><br />
<br />
<span style="letter-spacing: 0px;">Consider a simple timing system for a stock market index with a single signal line based purely on historical stock market index price data. If the market index closes above the signal line, an investor would purchase stocks. If the market index closes below the signal line, an investor would sell his stocks. The following chart illustrates this approach using the Dow Jones Industrial Average from 1966 through 1983. The stock market index is the blue line, and the signal line is red. If the blue line crosses below the red line, sell stocks. If the blue line crosses back above the red line, buy stocks.</span></div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px;"><br />
</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEghqY33UmcXVUfteJ2_peve-NJHvm5wUkEYepMgv9OTPRr_x89eoMKqvFxdvPcyLdYy2l60t1NDy7YCZux6ND0yYijkijLjJ6QrrKkmuL1FxpcFrFbzRlnMR-yVPOMg69zjT29Cbu-Vleg/s1600-h/090505_Chart_DJIA_1966-1982_10-Month_MA.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="422" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEghqY33UmcXVUfteJ2_peve-NJHvm5wUkEYepMgv9OTPRr_x89eoMKqvFxdvPcyLdYy2l60t1NDy7YCZux6ND0yYijkijLjJ6QrrKkmuL1FxpcFrFbzRlnMR-yVPOMg69zjT29Cbu-Vleg/s640/090505_Chart_DJIA_1966-1982_10-Month_MA.jpg" width="640" /></a></div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px;">Source: Butler|Philbrick & Associates<br />
Click for larger version.</div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px;"><br />
</div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px;"><span style="letter-spacing: 0px;">At certain levels of granularity (for example, using monthly closing data rather than daily or weekly), such a simple system yields significant results. By broadening the system to include more asset classes (i.e. commodities, foreign stocks, etc.), and simply allocating an equal portion of portfolios to each asset class, one is able to generate impressive results indeed.</span></div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px; min-height: 16px;"><span style="letter-spacing: 0px;"></span></div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px;"><span style="letter-spacing: 0px;">The following chart illustrates a system that discretionary managers can easily apply to client accounts. Since 1973, this system has delivered substantially better results than stocks, and at a fraction of the market risk. The system’s worst year was 2009, with a 0.01% loss on the year. Further, the system has delivered positive returns in 92% of all 12-month periods.</span></div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px;"><br />
</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhK2cc_Bgn1WCEqvL6zkWFIKmykI9OTE3WNZCn49BhaYHPFFejJONwZ8xPvmH-eRB5M_DEhZtttzd1jVTCubVzo2KJpY1VmUm5jKam6_sezPMN1GAquF6vhiYnzqXFz5Gcxe5diMCWZ1O8/s1600-h/100126_TAA_Returns_Table_and_Chart.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="508" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhK2cc_Bgn1WCEqvL6zkWFIKmykI9OTE3WNZCn49BhaYHPFFejJONwZ8xPvmH-eRB5M_DEhZtttzd1jVTCubVzo2KJpY1VmUm5jKam6_sezPMN1GAquF6vhiYnzqXFz5Gcxe5diMCWZ1O8/s640/100126_TAA_Returns_Table_and_Chart.jpg" width="640" /></a></div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px;">Source: Faber (2009), Butler|Philbrick & Associates<br />
Click for larger version.</div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px; min-height: 16px;"><span style="letter-spacing: 0px;"></span></div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px;"><span style="letter-spacing: 0px;">A corollary myth in the market timing domain relates to the assertion by many buy-and-hold advocates that an investor must be in the market at all times to enjoy long-term growth. These misinformed ‘experts’ often cite statistics that show returns to a portfolio that was out of the market for the best 10-months out of the last 10, 25, 50, or 100 years. Obviously, the returns to a portfolio that missed the best 10 months of market returns will do substantially worse than a buy-and-hold investor. What the expert fails to mention is that the best months of returns in stocks usually follow or precede the worst months of returns in stocks. Further, these best and worst months usually occur during periods where a market timing model would have parked money in cash. In fact, over the past 138 years, 7 of the worst 10 months, and 8 of the best 10 months occurred during the Great Depression!</span></div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px; min-height: 16px;"><span style="letter-spacing: 0px;"></span></div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px;"><span style="letter-spacing: 0px;">The following chart illustrates the returns to four portfolios. The blue line shows returns to a portfolio that managed to miss the 10 worst months. The red line shows returns to a portfolio that missed the 10 best months. The green line shows returns to a portfolio that missed both the best and the worst 10 months, while the purple line shows returns to a buy-and-hold investor.</span></div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px;"><br />
</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgCbmAFnTeU39wkaxbSDvl73goam2x_op0UwY7Ma8UEQkYNMXzaWpYF3j9TSQY28PMQn4ytiw5OohQR7Q8zTr4biqbb_0XEZkEp-L7QZkNXSQD49K7kcMw_HZfsjhnHOhSDGhHXwJqqhps/s1600-h/091024_S&P_Excluding_Worst_&_Best_Months.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="436" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgCbmAFnTeU39wkaxbSDvl73goam2x_op0UwY7Ma8UEQkYNMXzaWpYF3j9TSQY28PMQn4ytiw5OohQR7Q8zTr4biqbb_0XEZkEp-L7QZkNXSQD49K7kcMw_HZfsjhnHOhSDGhHXwJqqhps/s640/091024_S&P_Excluding_Worst_&_Best_Months.jpg" width="640" /></a></div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px;">Source: Butler|Philbrick & Associates<br />
Click for larger version.</div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px; min-height: 16px;"><span style="letter-spacing: 0px;"></span></div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px;"><span style="letter-spacing: 0px;">Observe that, quite obviously, investors who avoided big losses did better than investors that missed big gains. More interestingly, investors who avoided both large monthly gains and large monthly losses experienced approximately the same return over 138 years as an investor who held stocks from start to finish.</span></div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px; min-height: 16px;"><span style="letter-spacing: 0px;"></span></div><div style="font-family: Verdana; font-size-adjust: none; font-size: 13px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: 20px; margin: 0px;"><span style="letter-spacing: 0px;">In conclusion, individual investors have an opportunity to commit the necessary time and effort to find a qualified, licensed portfolio manager who has invested in the development and testing of trading and timing systems to best protect and grow wealth. You are likely to pay more for the services of such a team, but the value you receive in return may deliver multiples of your costs.</span></div>GestaltUhttp://www.blogger.com/profile/15636551868375563464noreply@blogger.com1tag:blogger.com,1999:blog-8316591069902396281.post-42154234500505046292010-01-26T13:52:00.017-05:002010-03-15T13:20:49.972-04:00On Monkey Brains<div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: medium;"><br />
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<span style="font-family: Verdana,sans-serif;"><span style="font-size: small;">It is prudent periodically to upset the apple cart in order to see what sort of rot and grime are sitting at the bottom. This series, which will include four or five posts over the next few days, will explore some common myths about investing and the investment industry.</span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;"><br />
</span> <span style="font-size: small;"> </span><span style="font-size: small;"> </span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="letter-spacing: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;">The modern investment industry is highly motivated to conceal the realities that I intend to expose. The fat margins investment firms enjoy are predicated on the assumption that the professionals at these firms possess knowledge and information that is not available to the masses. This may be true in some cases, but large, traditional firms are handicapped in ways that more than offset this value.</span></span></span><br />
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<span style="letter-spacing: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;">The single most important take-away from this series is this: almost no one in the investment industry is motivated to take you out of the market when the risk is high. Because of this, almost no one in the investment industry is motivated to create systems and tools that signal when to get out.</span></span></span><br />
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<span style="letter-spacing: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;">Imagine for example that Fidelity, with $1.57 trillion of assets under managment, instructs their managers to pull their funds entirely out of the market. This would cause quite a dislocation. So what did they do? As necessity is the mother of invention, large money managers invented 'buy and hold'.</span></span></span><br />
<div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;"><br />
</span> <span style="font-size: small;"> </span><span style="font-size: small;"> </span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="letter-spacing: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;">In this context, it makes sense to begin with a short primer on a a relatively new investment theory called ‘<a href="http://en.wikipedia.org/wiki/Behavioral_economics">Behavioral Economics</a>’ which is rapidly gaining in credibility, even among investment traditionalists. This theory addresses experimentally the many ways that Modern Portfolio Theory, the most widely adopted model in finance, fails to usefully describe reality.</span></span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;"><br />
</span> <span style="font-size: small;"> </span><span style="font-size: small;"> </span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="letter-spacing: 0px;"><span style="letter-spacing: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;">An anecdote from the book </span></span></span><span style="letter-spacing: 0px; text-decoration: underline;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;"><a href="http://www.superfreakonomicsbook.com/">SuperFreakonomics</a></span></span></span><span style="letter-spacing: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;"> (2009) by Steven Levitt and Stephen Dubner illustrates the power of emotional biases to short-circuit rational behavior. The book describes an experiment orchestrated by Dr. Keith Chen where monkeys are conditioned to understand the utility of money as a way to acquire treats.</span></span></span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;"><br />
</span> <span style="font-size: small;"> </span><span style="font-size: small;"> </span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="letter-spacing: 0px;"><span style="letter-spacing: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;">Once the monkeys learned they could trade a certain number of coins for different treats, the experimenters introduced ‘price shocks’ to test the monkeys’ rational adherence to the basic rules of supply and demand. When researchers ‘charged’ substantially more for one treat over another, monkeys bought less of the more ‘expensive’ treat and more of the less expensive. The demand curve slopes downward for monkeys as it does for humans.</span></span></span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;"><br />
</span> <span style="font-size: small;"> </span><span style="font-size: small;"> </span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="letter-spacing: 0px;"><span style="letter-spacing: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;">To test for irrational behavior, the experimenters introduced two gambling games. This is where things really get interesting.</span></span></span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;"><br />
</span> <span style="font-size: small;"> </span><span style="font-size: small;"> </span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="letter-spacing: 0px;"><span style="letter-spacing: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;">In the first game, a monkey was shown one grape and, depending on a coin toss, either received just the one grape, or a ‘bonus’ grape as well. In the second game, the monkey was presented with two grapes to start. When the coin was flipped against him, the researcher took away one grape and the monkey received the other.</span></span></span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;"><br />
</span> <span style="font-size: small;"> </span><span style="font-size: small;"> </span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="letter-spacing: 0px;"><span style="letter-spacing: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;">Note that in both games the monkeys got the same number of grapes on average. However, in the first game the grape is framed as a potential gain, whereas in the second game it is framed as a potential loss.</span></span></span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;"><br />
</span> <span style="font-size: small;"> </span><span style="font-size: small;"> </span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="letter-spacing: 0px;"><span style="letter-spacing: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;">How did the monkeys react? From the book:</span></span></span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;"><br />
</span> <span style="font-size: small;"> </span><span style="font-size: small;"> </span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="letter-spacing: 0px;"><span style="letter-spacing: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;"><i><b>“Once the monkeys figured out that the two-grape researcher sometimes withheld the second grape and that the one grape researcher sometimes added a bonus grape, the monkeys strongly preferred the one-grape researcher.</b></i></span></span></span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;"><i><b><br />
</b> </i><b> </b></span><i><b> </b></i><span style="font-size: small;"><i><b> </b></i></span><span style="font-size: small;"><i><b> </b></i></span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="letter-spacing: 0px;"><span style="letter-spacing: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;"><i><b>A rational monkey would not have cared, but these irrational monkeys suffered from what psychologists call loss aversion. They behaved as if the pain of losing a grape was greater than the pleasure of gaining one.</b></i></span></span></span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;"><i><b><br />
</b> </i><b> </b></span><i><b> </b></i><span style="font-size: small;"><i><b> </b></i></span><span style="font-size: small;"><i><b> </b></i></span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="letter-spacing: 0px;"><span style="letter-spacing: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;"><i><b>Up until now, the monkeys appeared to be as rational as humans in their use of money, but surely this last experiment showed the vast gulf that lay between monkey and man.</b></i></span></span></span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;"><i><b><br />
</b> </i><b> </b></span><i><b> </b></i><span style="font-size: small;"><i><b> </b></i></span><span style="font-size: small;"><i><b> </b></i></span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="letter-spacing: 0px;"><span style="letter-spacing: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;"><i><b>Or did it?</b></i></span></span></span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;"><i><b><br />
</b> </i><b> </b></span><i><b> </b></i><span style="font-size: small;"><i><b> </b></i></span><span style="font-size: small;"><i><b> </b></i></span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="letter-spacing: 0px;"><span style="letter-spacing: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;"><i><b>The fact is that similar experiments with human beings, investors, have found that people make the same kind of irrational decisions and at a nearly identical rate. The data generated by the capuchin monkeys, Chen says, make them statistically indistinguishable from most key market investors. So the parallels between human beings and these tiny-brained food/sex monkeys remain intact.”</b></i></span></span></span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;"><br />
</span> <span style="font-size: small;"> </span><span style="font-size: small;"> </span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="letter-spacing: 0px;"><span style="letter-spacing: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;">Loss aversion is one of the central principles of behavioral economics. The behavioral literature is consistent in observing that people are about twice as sensitive to losses as they are to gains. Investors manifest this behavior by holding on to losing positions for far too long in order to defer realizing a loss. On the flip side, investors sell their winning positions too soon in order to avoid ‘losing’ their gains. </span></span></span></span><br />
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<span style="letter-spacing: 0px;"><span style="letter-spacing: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;">For evidence that you or your Advisor may be a slave to the loss aversion instinct, look no further than your portfolio. If there are many positions with large losses that have been on the books for several months or years, loss aversion is a likely culprit. Successful investors sell their losing trades quickly while letting their winning trades run.</span></span></span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;"><br />
</span> <span style="font-size: small;"> </span><span style="font-size: small;"> </span></span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="letter-spacing: 0px;"><span style="letter-spacing: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;">Loss aversion is just one facet of a broader theory of investor behavior called ‘Prospect Theory’. Behavioral Economics is much broader still, and fills many of the dangerous gaps that are not adequately addressed by Modern Portfolio Theory. Some other important behavioral vulnerabilities are outlined in the diagram below (click image for larger version).</span></span></span></span><br />
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</span> <span style="font-size: small;"> </span><span style="font-size: small;"> </span></span></div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjF2h4RfRgjUxTydHIL7EDqRNJW3_Y3htMbXvcMYr9Lx0jvhVXf3dVScuHN4snFcDq8-ihqKep3-4fduoeFc2wVeRXt5ao8IOyZOIHCIYXHrCZkjQmcnpv2QyUnH_qojRxJ5kWQwoHB1fQ/s1600-h/90924_Behavioral_Vulnerabilities.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-size: small;"><img height="262" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjF2h4RfRgjUxTydHIL7EDqRNJW3_Y3htMbXvcMYr9Lx0jvhVXf3dVScuHN4snFcDq8-ihqKep3-4fduoeFc2wVeRXt5ao8IOyZOIHCIYXHrCZkjQmcnpv2QyUnH_qojRxJ5kWQwoHB1fQ/s640/90924_Behavioral_Vulnerabilities.jpg" width="640" /></span></a></div><div class="separator" style="clear: both; text-align: center;"><span style="font-size: small;"><br />
</span></div><div class="separator" style="clear: both; text-align: left;"><span style="font-family: Verdana,sans-serif; font-size: small;">Source: Butler|Philbrick & Associates</span></div><div class="separator" style="clear: both; text-align: left;"><span style="font-family: Verdana,sans-serif;"><br />
</span></div><div style="font-family: Helvetica; font-size-adjust: none; font-size: 12px; font-stretch: normal; font-style: normal; font-variant: normal; font-weight: normal; line-height: normal; margin: 0px;"><span style="letter-spacing: 0px;"><span style="letter-spacing: 0px;"><span style="font-family: Verdana,sans-serif;"><span style="font-size: small;">The next post in this series will deal with timing the market. It turns out that there are tried and true rules to distinguish between markets that are likely to trend higher and markets that are in jeopardy of steep drops and volatility. It is the development of, confidence in, and above all adherence to these rules that distinguish successful investors from their poorer peers.</span></span></span></span></div></div>GestaltUhttp://www.blogger.com/profile/15636551868375563464noreply@blogger.com1tag:blogger.com,1999:blog-8316591069902396281.post-73703333724818895192009-12-21T11:18:00.000-05:002009-12-21T11:18:02.181-05:00Astrology, Voodoo, Tarot Cards and Economics<span style="font-size: small;"><span style="font-family: Verdana,sans-serif;">From a recent <a href="http://www.counterpunch.org/hudson12142009.html">piece by Michael Hudson</a> (h/t Leo Kolivakis), economist and author of ‘Trade, Development and Foreign Debt’:</span><br style="font-family: Verdana,sans-serif;" /><br style="font-family: Verdana,sans-serif;" /><i><span style="font-family: Verdana,sans-serif;">Bad economic content starts with bad methodology. Ever since John Stuart Mill in the 1840s, economics has been described as a deductive discipline of axiomatic assumptions. Nobel Prize winners from Paul Samuelson to Bill Vickery have described the criterion for economic excellence to be the consistency of its assumptions, not their realism. Typical of this approach is Nobel Prizewinner Paul Samuelson's conclusion in his famous 1939 article on "The Gains from International Trade":</span><br style="font-family: Verdana,sans-serif;" /><br style="font-family: Verdana,sans-serif;" /><span style="font-family: Verdana,sans-serif;">“<b>In pointing out the consequences of a set of abstract assumptions, one need not be committed unduly as to the relation between reality and these assumptions.</b>”</span><br style="font-family: Verdana,sans-serif;" /><br style="font-family: Verdana,sans-serif;" /><span style="font-family: Verdana,sans-serif;">This attitude did not deter him from drawing policy conclusions affecting the material world in which real people live. These conclusions are diametrically opposed to the empirically successful protectionism by which Britain, the United States and Germany rose to industrial supremacy.</span><br style="font-family: Verdana,sans-serif;" /><br style="font-family: Verdana,sans-serif;" /><span style="font-family: Verdana,sans-serif;">Typical of this now widespread attitude is the textbook Microeconomics by William Vickery, winner of the 1997 Nobel Economics Prize:</span><br style="font-family: Verdana,sans-serif;" /><span style="font-family: Verdana,sans-serif;">Economic theory proper, indeed, is nothing more than a system of logical relations between certain sets of assumptions and the conclusions derived from them ...</span><br style="font-family: Verdana,sans-serif;" /><br style="font-family: Verdana,sans-serif;" /><span style="font-family: Verdana,sans-serif;">“</span><b><span style="font-family: Verdana,sans-serif;">The validity of a theory proper does not depend on the correspondence or lack of it between the assumptions of the theory or its conclusions and observations in the real world. A theory as an internally consistent system is valid if the conclusions follow logically from its premises, and the fact that neither the premises nor the conclusions correspond to reality may show that the theory is not very useful, but does not invalidate it. In any pure theory, all propositions are essentially tautological, in the sense that the results are implicit in the assumptions made.</span></b></i><i><span style="font-family: Verdana,sans-serif;">”</span><br style="font-family: Verdana,sans-serif;" /><br style="font-family: Verdana,sans-serif;" /><span style="font-family: Verdana,sans-serif;">Such disdain for empirical verification is not found in the physical sciences. Its popularity in the social sciences is sponsored by vested interests. There is always self-interest behind methodological madness.</span><br style="font-family: Verdana,sans-serif;" /><br style="font-family: Verdana,sans-serif;" /><span style="font-family: Verdana,sans-serif;">That is because success requires heavy subsidies from special interests who benefit from an erroneous, misleading or deceptive economic logic. Why promote unrealistic abstractions, after all, if not to distract attention from reforms aimed at creating rules that oblige people actually to earn their income rather than simply extracting it from the rest of the economy?</span><br style="font-family: Verdana,sans-serif;" /></i><br style="font-family: Verdana,sans-serif;" /><span style="font-family: Verdana,sans-serif;">Essentially, Michael is highlighting statements from some of the pioneers of modern economics in which they assert that the quality of an economic theory is independent of the theory’s ability to describe reality. Instead they suggest that economic theory is valid if it is supported by a series of logical constructs that begin with sound premises.</span><br style="font-family: Verdana,sans-serif;" /><br style="font-family: Verdana,sans-serif;" /><span style="font-family: Verdana,sans-serif;">The economics profession has thus denounced its own usefulness, and relegated itself to the same epistemological bucket as astrology, voodoo and tarot card reading.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Verdana,sans-serif;">Hudson goes on to attribute the ubiquitous acceptance of modern ecnomics as sound 'science' to the special interests who stand to benefit from a perpetuation of the status quo.</span></span><br />
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<span style="font-size: small;"><span style="font-family: Verdana,sans-serif;">Investors and policy-makers take note. Forewarned is forearmed.</span><span style="font-family: Verdana,sans-serif;"></span><br style="font-family: Verdana,sans-serif;" /><br style="font-family: Verdana,sans-serif;" /></span>GestaltUhttp://www.blogger.com/profile/15636551868375563464noreply@blogger.com0tag:blogger.com,1999:blog-8316591069902396281.post-75268215375577309962009-12-09T15:24:00.007-05:002010-02-01T13:16:25.872-05:00Quantifying the Debt Drag<span style="font-family: Verdana, sans-serif; font-size: small;"></span><br />
<div style="font-family: Verdana,sans-serif;"><span style="font-size: small;">Most economists and analysts do a poor job of capturing the juxtaposition between normal cyclical recovery expectations and long-term headwinds from structural consumer over-indebtedness. Those who argue for a perpetuation of the consumer credit cycle that began post WWII and accelerated exponentially starting in 1982, with a steepening in 1994, must implicitly believe that household debt can grow to the sky.</span></div><div style="font-family: Verdana,sans-serif;"><br />
</div><div class="separator" style="clear: both; font-family: Verdana,sans-serif; text-align: center;"><span style="font-size: small;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjMJndkr3Gu8VYmApZGjGpLrsQKtXi1VeeNdI5IKHqPiiGN0HCN-ANxXt5LiwHwRdXzIM3ammYFLU3Ymk6F0PHwO9b11iKC45cADxAuzR7OZJo3S9UBzwSLMA6Xg9WDcgtf9VIMjMgxfDo/s1600-h/090701_Prechter_US_Credit_Market_Debt_To_GDP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjMJndkr3Gu8VYmApZGjGpLrsQKtXi1VeeNdI5IKHqPiiGN0HCN-ANxXt5LiwHwRdXzIM3ammYFLU3Ymk6F0PHwO9b11iKC45cADxAuzR7OZJo3S9UBzwSLMA6Xg9WDcgtf9VIMjMgxfDo/s640/090701_Prechter_US_Credit_Market_Debt_To_GDP.jpg" /></a></span></div><div style="font-family: Verdana,sans-serif;"><br />
</div><div style="font-family: Verdana,sans-serif;"><span style="font-size: small;">If instead we acknowledge that households have accumulated new debt equal to 50% of rolling GDP since 1980 (chart below), thereby doubling aggregate household debt outstanding to ~102%, this implies a 2.4% p.a. boost to aggregate consumer spending over that time period. Assuming average consumer spending as a proportion of GDP was 65% over this horizon, this amounted to a boost of ~1.6% p.a. to U.S. GDP.</span></div><div style="font-family: Verdana,sans-serif;"><br />
</div><div class="separator" style="clear: both; font-family: Verdana,sans-serif; text-align: center;"><span style="font-size: small;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg2l6XbBWO27ySsgbDDgGw5Lkz5jAIuza0rwcipvSKLX9xUQfQixJ8ROgdZs1Gsv7RboydgDR4mtCE6t9dRXdqqU2h0nSeCPyYpmB0RNT7QZlhZjbicIisa4mhRDxzU26OMZfxKoXzzoOc/s1600-h/090810_Household_Debt_to_GDP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg2l6XbBWO27ySsgbDDgGw5Lkz5jAIuza0rwcipvSKLX9xUQfQixJ8ROgdZs1Gsv7RboydgDR4mtCE6t9dRXdqqU2h0nSeCPyYpmB0RNT7QZlhZjbicIisa4mhRDxzU26OMZfxKoXzzoOc/s640/090810_Household_Debt_to_GDP.jpg" /></a></span></div><div style="font-family: Verdana,sans-serif;"><br />
</div><div style="font-family: Verdana,sans-serif;"><span style="font-size: small;">This analysis is upwardly biased by mortgage debt, which only flows through to GDP in the form of rents, new home construction and sales, and consumption funded by 2<sup>nd</sup> mortgages or home equity lines of credit. If we just take the increase in consumer credit (revolving and non-revolving) since 1980 (chart below), which has increased from 12.93% of GDP to 17.988% of GDP, our analysis yields a boost of 1.15% p.a. as a result of this new consumer debt. With consumer spending at 65% of GDP this would have resulted in a boost of 0.75% p.a. from unsecured lines of credit, credit card debt, and car loans alone.</span></div><div style="font-family: Verdana,sans-serif;"><span style="font-size: small;"><br />
</span></div><div class="separator" style="clear: both; font-family: Verdana,sans-serif; text-align: center;"><span style="font-size: small;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhDPSlsAidGMsDQJv8_9fdmknr1zGBo81lc9V4znk6j59aYD_T85yDsAv-TOy60ieS-2Z4AT8vkuttTZxO7fYuEV0FfDtjAyVXjo2tBwGhCVo4giG6b0riJ-Cy8tXH2XPDR5e3WihL7u0M/s1600-h/091209_US_Consumer_Debt_to_GDP_Revolving+Non_Revolving.jpeg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhDPSlsAidGMsDQJv8_9fdmknr1zGBo81lc9V4znk6j59aYD_T85yDsAv-TOy60ieS-2Z4AT8vkuttTZxO7fYuEV0FfDtjAyVXjo2tBwGhCVo4giG6b0riJ-Cy8tXH2XPDR5e3WihL7u0M/s640/091209_US_Consumer_Debt_to_GDP_Revolving+Non_Revolving.jpeg" /></a></span></div><div style="font-family: Verdana,sans-serif;"><span style="font-size: small;"><br />
</span></div><div style="font-family: Verdana,sans-serif;"><span style="font-size: small;">It is difficult to know to what degree mortgages to purchase existing homes biased the first analysis higher, or to what degree not accounting for home equity lines of credit and second mortgages biased the second analysis lower. I think it is safe to say, however, that the annual boost to U.S. GDP from the expansion in consumer debt is between 1% and 1.25% per annum between 1980 and 2009.</span><br />
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<span style="font-size: small;">Importantly, if consumer debt somehow remains constant at current nosebleed levels going forward, U.S. GDP will grow at a rate 1% - 1.25% below average growth rates since 1980. If however consumers pay-down debt at the same pace that they accumulated it from 1980 - 2008, GDP growth will drop by a further 1% - 1.25%. This would then shave a total of 2% - 2.5% from GDP growth potential, which puts likely growth rates for U.S. GDP between 1% and 2% p.a. for the foreseeable future, barring the creation of another consumer credit cycle.</span><br />
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Interestingly, Japanese GDP growth averaged 1.9% during its 'Lost Decade' from 1990 - 2000 after posting 10+ years of 3 - 4% growth leading up to the Nikkei's 1989 peak. Despite aggressive policies by the BOJ to bring rates to zero and a massive buildup in Japanese government debt to offset corporate and household balance sheet rebuilding, Japanese GDP was exceedingly volatile through the 1990s and share prices dropped by 65% over the decade. Of course, they are almost 75% below their 1989 peak today.<br />
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<span style="font-size: small;">Given this anemic consumption scenario, and the Japanese template for a debt deflation scenario, investors should be asking to what degree the market is discounting a long period of slower economic growth. With consumers retrenching, boomers retiring, and government indebtedness likely to necessitate higher corporate and personal taxes in the future, is it likely that stock market valuations will continue to hold at 1980 - 2008 levels relative to the size of the economy? Or is it possible that they may revert to levels that dominated for most of the last century.</span><br />
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<div style="text-align: center;">Chart: Ratio of U.S. Stock Market Capitalization to U.S. GDP</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi9cmQnQE-eakzU7hDIEZKqCie09Xa6AlLMnidRvsusBtEa1LOyvW2w_RpEkkyOF9_-sZCMQrlMlATKNyUxU_MYy1_xgT5ByfEmJAkZKGCs8Wy0X25N-pn6n2pr02D-yeT5A6BDLVyXjkQ/s1600-h/090922_NYSE_Market_Cap_Ratio_GDP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi9cmQnQE-eakzU7hDIEZKqCie09Xa6AlLMnidRvsusBtEa1LOyvW2w_RpEkkyOF9_-sZCMQrlMlATKNyUxU_MYy1_xgT5ByfEmJAkZKGCs8Wy0X25N-pn6n2pr02D-yeT5A6BDLVyXjkQ/s640/090922_NYSE_Market_Cap_Ratio_GDP.jpg" /></a></div><span style="font-size: small;">Source: Ned Davis Research </span></div>GestaltUhttp://www.blogger.com/profile/15636551868375563464noreply@blogger.com1tag:blogger.com,1999:blog-8316591069902396281.post-23329643398322293372009-12-01T08:57:00.000-05:002009-12-01T08:57:32.266-05:00Hussman: We face two possible states of the world.<span style="font-family: Verdana, sans-serif;">John Hussman manages the eponymous Hussman Funds. Hussman was among the few who both forecast the 2008/2009 credit crisis, and also had the fortitude to position his clients' defensively in advance. Returns this year have lagged global stocks, but Hussman is largely unrepentant. Like us, he lacks faith in the sustainability of the current rally, and rails against the unconstitutional actions of the Fed in supporting the bondholders of egregiously mismanaged banks.</span><br />
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<span style="font-family: Verdana, sans-serif;">Dr. Hussman writes a weekly column at his web site, which I strongly encourage everyone to read. This is his latest piece.</span><br />
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<span style="color: #2f8b9e; font-weight: 700;"><b><i><span style="font-family: Verdana, sans-serif;">November 30, 2009</span></i><span style="font-family: Verdana, sans-serif;"><i></i></span></b></span><span style="font-family: Verdana, sans-serif;"><b></b></span><br />
<div style="color: black;"><b><i><span style="color: #000099; font-weight: 700;"><b><i><span style="font-family: Verdana, sans-serif;">Reckless Myopia<br />
</span></i></b></span></i></b><b><i><span style="font-family: Verdana, sans-serif;"><br />
</span></i></b><i class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">John P. Hussman, Ph.D.<br />
All rights reserved and actively enforced.</span></i><br />
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</span></i><span style="color: black;"><a href="http://www.hussmanfunds.com/html/reprints.htm" onclick="popup = window.open('http://www.hussman.net/html/reprints.htm', 'Reprints', 'height=300,width=750,scrollbars=yes,resizable=yes'); return false" style="color: #000099; font-weight: 500; text-decoration: underline;" target="_blank"><span style="font-family: Verdana, sans-serif;">Reprint Policy</span></a></span><br />
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</div><div style="color: black;"><span style="color: black;"><span style="font-family: Verdana, sans-serif;">I was wrong.</span></span><br />
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</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">Not about the implosion of the credit markets, which I urgently warned about in 2007 and early 2008. Not about the recession, which we shifted to anticipating in November 2007. Not about the plunge in the stock market, which erased the entire 2002-2007 market gain, which was no surprise. Not about the “ebb and flow” of short-term data, which I frequently noted could produce a powerful (though perhaps abruptly terminated) market advance even in the face of dangerous longer-term cross-currents. I expect not even about the “surprising” second wave of credit distress that we can expect as we move into 2010.</span><br />
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</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">From a long-term perspective, my record is very comfortable. But clearly, I was wrong about the </span><em><span style="font-family: Verdana, sans-serif;">extent </span></em><span style="font-family: Verdana, sans-serif;">to which Wall Street would respond to the ebb-and-flow in the economic data – particularly the obvious and temporary lull in the mortgage reset schedule between March and November 2009 – and drive stocks to the point where they are not only overvalued again, but strikingly dependent on a sustained economic recovery and the achievement and maintenance of record profit margins in the years ahead.</span><br />
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</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">I should have assumed that Wall Street's tendency toward reckless myopia – ingrained over the past decade – would return at the first sign of even temporary stability. The eagerness of investors to chase prevailing trends, and their unwillingness to concern themselves with </span><em><span style="font-family: Verdana, sans-serif;">predictable </span></em><span style="font-family: Verdana, sans-serif;">longer-term risks, drove a successive series of speculative advances and crashes during the past decade – the dot-com bubble, the tech bubble, the mortgage bubble, the private-equity bubble, and the commodities bubble. </span><br />
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</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">And here we are again.</span><br />
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</div><div class="largeText" style="color: black;"><i><span style="font-family: Verdana, sans-serif;"><b>We face two possible states of the world. One is a world in which our economic problems are largely solved, profits are on the mend, and things will soon be back to normal, except for a lot of unemployed people whose fate is, let's face it, of no concern to Wall Street. The other is a world that has enjoyed a brief intermission prior to a terrific second act in which an even larger share of credit losses will be taken, and in which the range of policy choices will be more restricted because we've already issued more government liabilities than a banana republic, and will steeply debase our currency if we do it again. It is not at all clear that the recent data have removed any uncertainty as to which world we are in.</b></span></i><br />
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</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">Taking the weighted average </span><span style="font-family: Verdana, sans-serif;">outcome </span><span style="font-family: Verdana, sans-serif;">for the two states of the world still produces a poor average return/risk tradeoff. Taking the weighted average </span><span style="font-family: Verdana, sans-serif;">investment position </span><span style="font-family: Verdana, sans-serif;">for the two states of the world is somewhat more constructive. As I noted several weeks ago, I have adapted our weightings accordingly. As a result, we have been trading around a modest positive net exposure, increasing it slightly on market weakness, and clipping it on strength, as is our discipline. Currently, the Strategic Growth Fund has a net exposure to market fluctuations of less than 10%, but enough “curvature” (through index options) that our exposure to market risk will automatically become more muted on market weakness and more positive on market advances, allowing us to buy weakness and sell strength without material concern about the (increasing) risk of a market collapse.</span><br />
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</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">There is no chance, even in hindsight (“could have, would have, should have” stuff) that I would have responded to the existing evidence in recent months with more than a moderate exposure to market risk during some portion of the advance since March. But our year-to-date returns might now be into a second digit had I recognized that investors have learned utterly nothing from the bubbles and collapses of the past decade. That recognition might have encouraged a greater weight on trend-following measures versus fundamentals, valuations, price-volume sponsorship, and other factors.</span><br />
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</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">Still, our stock selections continue to perform well relative to the market, our risks remain well-managed through a substantial (though not full) hedge, and our investment approach has nicely outperformed the S&P 500 over complete market cycles, with substantially less downside risk than a passive investment approach. We have implemented some modest changes to improve our potential to benefit from (even ill-advised) speculative runs, but we've done fine nonetheless, and we can sleep nights.</span><br />
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</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">Whether or not I have focused too much on probable “second-wave” credit risks is something we will find out in the quarters ahead – my record of economic analysis is strong enough that a “miss” on that front would be an outlier. What I do think is that over the past decade, investors (including people who hold themselves out as investment professionals) have become far more susceptible to reckless myopia than I would have liked to believe. They have become speculators up to the point of disaster.</span><br />
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</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">Frankly, I've come to believe that the markets are no longer reliable or sound discounting mechanisms. The repeated cycle of bubbles and </span><em><span style="font-family: Verdana, sans-serif;">predictable </span></em><span style="font-family: Verdana, sans-serif;">crashes over the recent decade makes that clear. Rather, investors appear to respond to emerging risks no more than about three months ahead of time. Worse, far too many analysts and strategists appear to discount the future only in the most pedestrian way, by taking year-ahead earnings estimates at face value, and mindlessly applying some arbitrary and historically inconsistent multiple to them.</span><br />
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</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">This is utterly different from true discounting – which </span><em><span style="font-family: Verdana, sans-serif;">does not </span></em><span style="font-family: Verdana, sans-serif;">rely on multiples, but instead carefully traces out the likely path of future revenues, profit margins, cash flows and earnings over time, and explicitly discounts expected payouts and probable terminal values back at an appropriate rate of return. That's what we actually do here. Talking in terms of multiples can make the process easier to explain, and can be a reasonable approach to the market as a whole if earnings are normalized properly, but ultimately, an investment security is a claim to a </span><em><span style="font-family: Verdana, sans-serif;">long-term stream </span></em><span style="font-family: Verdana, sans-serif;">of cash flows. It is not simply a blind multiple to the latest analyst estimate.</span><br />
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</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">Fortunately, the evidence suggests that the long-term returns to a careful discounting approach tend to be strong even if investors repeatedly behave in speculative and short-sighted ways. This is because </span><em><span style="font-family: Verdana, sans-serif;">long-term </span></em><span style="font-family: Verdana, sans-serif;">returns are </span><em><span style="font-family: Verdana, sans-serif;">fully determined </span></em><span style="font-family: Verdana, sans-serif;">by the stream of cash flows actually received by investors over time, and because inappropriate valuations ultimately tend to mean-revert. In the face of speculative noise, the long-term returns from a proper discounting approach may not capture as much speculative return as might be possible, but over time, many of those speculative swings tend to wash out anyway.</span><br />
</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">In part, the market's increasing propensity toward speculation reflects the increasing lack of fiscal and monetary discipline from our leaders. Policy makers who seek quick fixes and could care less about long-term consequences undoubtedly encourage investors to embrace the same value system. Paul Volcker was the last Fed Chairman to have any sense that discipline and the acceptance of temporary discomfort was good for the nation.</span><br />
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</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">Our current Fed Chairman's voice literally quivers in response to the phrase “bank failure,” even though in the present context, a bank failure implies none of the disorganized outcomes that characterized the Great Depression. It simply means that the bondholders take a loss and the remaining part of the institution survives intact as a “whole bank” entity (and can be sold or re-issued back to public ownership, less the debt to bondholders, as such). The same outcome would have been possible with Lehman had the FDIC been granted authority from Congress to take conservatorship of a non-bank financial entity.</span><br />
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</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">In my estimation, there is still close to an 80% probability (Bayes' Rule) that a second market plunge and economic downturn will unfold during the coming year. This is not certainty, but the evidence that we've observed in the equity market, labor market, and credit markets to-date is simply much more consistent with the recent advance being a component of a more drawn-out and painful deleveraging cycle. Meanwhile, valuations are clearly unfavorable here, and even under the “typical post-war recovery” scenario, we are observing an increasing number of internal divergences and non-confirmations in market action.</span><br />
</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;"><br />
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</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">As Gluskin Sheff chief economist David Rosenberg noted last week, “Even if the recession is over, the historical record shows that downturns induced by asset deflation and credit contraction are different than a garden-variety recession induced by Fed tightening and excessive manufacturing inventories since the former typically induce a secular shift in behavior and attitudes towards debt, asset allocation, savings, discretionary spending and homeownership. The latter fades more quickly.</span><br />
</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">“This is why people didn't figure out that it was the Great Depression until two years after the worst point in the crisis in the 1930s; and why it took decades, not months, quarters or even years, for the complete transition to the next sustainable economic expansion and bull market.</span><br />
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</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">“Mortgage applications for new home purchases hit a 12-year low in the middle of November (down 22% in the past month!), fully two weeks after the Administration said it was going to not only extend but expand the program to include higher-income trade-up buyers. Once again, there is minimal demand for autos and housing, and that is partly because the market is still saturated with both of these credit-sensitive big-ticket items after an unprecedented credit and consumer bubble that went absolutely parabolic in the seven years prior to the collapse in the financial markets an asset values. We are probably not even one-third of the way through this deleveraging cycle. Tread carefully.”</span><br />
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</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">Andrew Smithers, one of the few other analysts who foresaw the credit implosion and remains a credible voice now, concurred last week in an interview with my friend Kate Welling (a former Barrons' editor now at Weeden & Company): “The good news so far is that the stock market got down to pretty much fair value or even, possibly, a tickle below it, at its March bottom. But now it has gone up… we probably have a market which is, roughly, 40% overpriced. In order to assess value, it is necessary either to calculate the level at which the EPS would be if profits were neither depressed nor elevated, or to use a metric of value which does not depend on profits. The cyclically adjusted P/E (CAPE) normalizes EPS by averaging them over 10 years. It thus follows the first of those two possible methods. Using even longer time periods has advantages, particularly as EPS have been exceptionally volatile in recent years - and using longer time periods raises the current measured degree of overvaluation. The other methodology we use measures stock market value without reference to profits: the q ratio. It compares the market capitalization of companies with their net worth, also adjusted to current prices. The validity of both of these approaches can be tested and is robust under testing - and they produce results that agree. Currently, both q and CAPE are saying that the U.S. stock market is about 40% overvalued.”</span><br />
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</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">In the chart below, the current data point would be about 0.4, not as extreme as we observed in 1929, 2000, or 2007 of course, but equal to or beyond what we've observed at virtually every other market peak in history. This aligns well with our own analysis, where as I've noted in recent weeks, the S&P 500 is priced to deliver one of the weakest 10-year total returns in history except for the (ultimately disappointing) period since the mid-1990's.</span><br />
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</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;"><img height="370" src="http://www.hussmanfunds.com/wmc/wmc091130.gif" width="543" /></span><br />
</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;"><br />
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</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">One of the fascinating aspects of the past few months is the lack of equilibrium thinking with respect to what happened to the trillions of dollars in government money that has been spent to defend the bondholders of mismanaged financial companies. Almost by definition, money given to corporations will show up most quickly as improvements in corporate earnings, and then slightly later, as executive compensation. A few pieces came across my desk last week, hailing the ability of the corporate sector to bounce back from the recent economic downturn even though revenues have continued to suffer and employment has been steeply cut. Why is this a surprise? Where else could the money have gone? Labor compensation? It is truly mind-numbing that a moment after a temporary surge of </span><em><span style="font-family: Verdana, sans-serif;">trillions </span></em><span style="font-family: Verdana, sans-serif;">of dollars, borrowed and tossed out of a helicopter (though to specific corporations and private beneficiaries), analysts would hail a subsequent improvement in corporate results as evidence of “resilience.”</span><br />
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</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">What matters is sustainability, and unfortunately, it is clear that credit continues to collapse. Banks are contracting their loan portfolios at a record rate, according to the latest FDIC Quarterly Banking Profile. Even so, new delinquencies continue to accelerate faster than loan loss reserves. Tier 1 capital looked quite good last quarter, as one would expect from the combination of a large new issuance of bank securities, combined with an easing of accounting rules to allow “substantial discretion” with respect to credit losses. The list of problem institutions is still rising exponentially. Overall, earnings and capital ratios have enjoyed a reprieve in the past couple of quarters, but delinquencies have not, and all evidence points to an acceleration as we move into 2010.</span><br />
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</div><div class="blueArticleHeadline" style="color: #000099; font-weight: 700;"><span style="font-family: Verdana, sans-serif;">Urgent Policy Implications</span><br />
</div><div class="blueArticleHeadline" style="color: #000099; font-weight: 700;"><span style="font-family: Verdana, sans-serif;"><br />
</span><br />
</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">From a policy standpoint, it is effectively too late to forestall further foreclosures absent explicit losses to creditors. The best policy option now is to make sure that the second wave does not result in a debasement of the U.S. dollar. The way to do that is to require three things:</span><br />
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</span><br />
</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">First, the FDIC should be given regulatory authority to take non-bank financials into conservatorship the way they should have been able to do with Bear Stearns and Lehman. If this authority had existed in 2008, Bear's bondholders would not now stand to get 100% of their money back, with interest, as they presently do, and Lehman's disorganized liquidation would have been completely unnecessary. As I've noted before, the problem with Lehman was not that it went bankrupt, but that it went bankrupt in a </span><em><span style="font-family: Verdana, sans-serif;">disorganized </span></em><span style="font-family: Verdana, sans-serif;">way. If the FDIC had authority over insolvent non-bank financials and bank holding companies, it could wipe out equity and an appropriate amount of bondholder capital, and sell the fully-functioning residual to an acquirer, as is typically done with failing banks, without any loss to depositors or customers.</span><br />
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</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">Second, bank capital requirements should be altered to require a substantial portion of bank debt to be of a form that </span><em><span style="font-family: Verdana, sans-serif;">automatically converts </span></em><span style="font-family: Verdana, sans-serif;">to equity in the event of capital inadequacy. This would force losses onto bondholders, rather than onto taxpayers. This policy adjustment is urgent – we have perhaps a few months to get this right.</span><br />
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</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">Finally, Congress should be clear that government funds will be available only to protect the interests of depositors, not bondholders. Specifically, any funds provided by the government should be contingent on the ability to exert a senior claim to bondholders in the event of subsequent bankruptcy, even if a category is created to allow those funds to be counted as “capital” for purposes of satisfying capital requirements prior to such bankruptcy. Government-provided capital should be subordinate </span><em><span style="font-family: Verdana, sans-serif;">only</span></em><span style="font-family: Verdana, sans-serif;"> to depositor claims, if equity and bondholder capital ultimately proves insufficient to meet those obligations.</span><br />
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</div><div class="largeText" style="color: black;"><b><i><span style="font-family: Verdana, sans-serif;">Since early 2008, beginning with the provision of non-recourse funding in the Bear Stearns debacle, the Federal Reserve and the Treasury have repeatedly allocated or implicitly obligated public funds to defend the bondholders of mismanaged financial companies. This has included the outright and non-recourse purchase of nearly a trillion dollars in mortgage securities that have no explicit guarantee by the U.S. government. By purchasing these securities outright (rather than through a well-defined repurchase agreement), the Fed is effectively obligating the U.S. government to either guarantee them or to absorb any future losses.</span></i></b><br />
</div><div class="largeText" style="color: black;"><b><i><span style="font-family: Verdana, sans-serif;"><br />
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</div><div class="largeText" style="color: black;"><b><i><span style="font-family: Verdana, sans-serif;">Aside from the fraction of bailout funding that was specifically allocated by Congress through legislation, these actions represent an unconstitutional breach into enumerated spending powers that are the domain of the elected members of Congress alone. The issue here is not whether the Fed should be independent from political influence. The issue is the constitutionality of the Fed's actions. The discretion that it has exerted over the past two years crosses the line into prerogatives reserved for Congress. That line needs to be clarified sooner rather than later.</span></i></b><br />
</div><div class="largeText" style="color: black;"><b><i><span style="font-family: Verdana, sans-serif;"><br />
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</div><div class="largeText" style="color: black;"><b><i><span style="font-family: Verdana, sans-serif;">Emphatically, the trillions of dollars spent over the past year were </span></i></b><b><i><span style="font-family: Verdana, sans-serif;">not</span></i></b><b><i><span style="font-family: Verdana, sans-serif;"> in the interest of protecting bank depositors or the general public. They went to protect bank bondholders. Instead of taking appropriate losses on those bonds (which financed reckless mortgage lending), those bonds are happily priced near their face value, for the benefit of private individuals, thanks to an equivalent issuance of U.S. Treasury debt. But that's not enough. Outside of a very narrow set of institutions that are subject to compensation limits, just watch how much of the public's money – which benefitted several major investment banks following a very direct route – gets allocated to Wall Street bonuses in the next few weeks.</span></i></b><br />
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</div><div class="blueArticleHeadline" style="color: #000099; font-weight: 700;"><span style="font-family: Verdana, sans-serif;">Market Climate</span><br />
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</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and mixed market action. The market remains significantly overbought on an intermediate-term basis, and we've seen increasing divergences from breadth, small and mid-cap stocks, trading volume, and other internals, which have lagged the most recent advance in the S&P 500 and other cap-weighted indices.</span><br />
</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">The prospect of a debt-repayment “standstill” from Dubai prompted some weakness in foreign markets that spilled over to the U.S. on Friday. This was interesting given that David Faber reported the issue on CNBC on Wednesday, to no reaction. Importantly, the payment difficulties do not stem from oil revenues, but largely from tourism and financial activity, as those are Dubai's chief industries (Dubai is home to the tallest building and the largest man-made islands in the world, for example). From that standpoint, it is difficult to imagine much in the way of contagion as a result of Dubai's difficulties.</span><br />
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</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">Whatever shock the market will get from left field is likely to come from larger financial or geopolitical risks. The market for credit default swaps bears watching, but thus far we haven't observed spikes to indicate that something major is imminent. Unfortunately, as I noted earlier, investors have earned an “F” for vigilance in recent years, so our lead time on new difficulties may be shorter than we might like.</span><br />
</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">In any event, I'm pleased with the overall behavior of our stock holdings, and I expect that we'll have plenty of opportunity to increase our exposure to market fluctuations at more appropriate valuations. Presently, we've got a small amount of exposure to market fluctuations, but not enough to cause any material difficulties if the market experiences some trouble. The largest source of day-to-day fluctuations remains the difference in performance between the stocks we hold long and the indices we use to hedge. That source of risk has also been the primary contributor to returns over the life of the Fund.</span><br />
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</div><div class="largeText" style="color: black;"><span style="font-family: Verdana, sans-serif;">In bonds, the Market Climate was characterized last week by moderately unfavorable yield levels and generally favorable yield pressures. We saw a good example of how the market is inclined to respond to fresh credit concerns last week, with upward pressure on the U.S. dollar and U.S. Treasuries, and downward pressure on foreign currencies and commodities. While I continue to believe that the dollar faces substantial risk of further erosion in its exchange value, as well as a near doubling of the CPI over the coming decade or so (both reflecting the massive increase in U.S. government liabilities in recent years), those prospects are not likely to emerge until risk-aversion about credit default materially abates. Credit concerns typically create a spike in demand for default-free assets such as U.S. government liabilities, so even though there is a much larger float than is likely to be sustained over time without inflation as the ultimate outcome, credit concerns tend to support the value of these liabilities and hence mutes immediate inflation pressures (essentially, monetary velocity declines as these liabilities are sought as a default-free store of value).</span><br />
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</div><div style="color: black;"><span style="color: black;"><span style="font-family: Verdana, sans-serif;">The Strategic Total Return Fund currently has an overall duration slightly over 3 years, primarily in straight Treasuries, with a small 1% exposure to precious metals shares and about 4% of assets in utility shares.</span></span><br />
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</div>GestaltUhttp://www.blogger.com/profile/15636551868375563464noreply@blogger.com0tag:blogger.com,1999:blog-8316591069902396281.post-73099801841080924362009-09-11T11:14:00.001-04:002010-02-01T13:18:12.339-05:00Welcome to the Liquidity SurgeI've been trying to reconcile the apparent mixed signals in credit markets relative to stock markets in the past 2 months.<br />
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Inflation expectations implied by the 10-Year TIPS breakeven rate broke an intermediate-term downtrend on Monday, suggesting that investors are not overly concerned with <i>deflation</i> at the moment. However, a broken downtrend is not the same as an up-trend.<br />
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<div style="text-align: center;">10-Year TIPS Breakeven Rate (Implied Inflation Expectations) </div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi59F1285DuvMkBDGDw9vX_mlMgH03Oxcv9eVRX4R3nA8mWbDizm21dFLZhBm-FkZYzfCXvj5C168iPWRm6xyJPCQGmmaDAJ7Z9vfkKHx8V14hPPbO8coJO7Q8AsghTxOlz4qCvaajSS8E/s1600-h/090911_TIPS_BE_Annotated.jpeg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi59F1285DuvMkBDGDw9vX_mlMgH03Oxcv9eVRX4R3nA8mWbDizm21dFLZhBm-FkZYzfCXvj5C168iPWRm6xyJPCQGmmaDAJ7Z9vfkKHx8V14hPPbO8coJO7Q8AsghTxOlz4qCvaajSS8E/s400/090911_TIPS_BE_Annotated.jpeg" /></a></div><div class="separator" style="clear: both; text-align: left;">Source: Bloomberg</div><div class="separator" style="clear: both; text-align: center;"><br />
</div>Meanwhile, rates have declined substantially all along the curve, signaling that bond market investors have no fear of inflation anywhere.2-year rates are breaking down around the world.<br />
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<div style="text-align: center;"> Global 2-Year Government Bond Yields</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhk3q7XPHK_nPrc0tpDKWs1JcKk-RZDuy0URRJRtrscvme12dmwTQ2gywVW3Ilo_suKlHXxQRYEzOxoRAiFO1uNKf1SrJGjUAJH4TlWgtdoyw5W0_7Mj1vaZ_qWY4i0CgaeXFbNjG6HscE/s1600-h/090911_Global_2_yr_yields.jpeg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhk3q7XPHK_nPrc0tpDKWs1JcKk-RZDuy0URRJRtrscvme12dmwTQ2gywVW3Ilo_suKlHXxQRYEzOxoRAiFO1uNKf1SrJGjUAJH4TlWgtdoyw5W0_7Mj1vaZ_qWY4i0CgaeXFbNjG6HscE/s400/090911_Global_2_yr_yields.jpeg" /></a></div><div style="text-align: center;"><div style="text-align: left;">Source: BMO CM Research </div><span class="Apple-style-span" style="font-size: x-small;"><br />
</span></div><div style="text-align: left;"></div><div style="text-align: left;">Longer-term rates broke their intermediate-term downtrend line in August, but have broken back above their short-term downtrend. A break of 3.265% on the US Ten-Year would signal a new intermediate-term downtrend. This might give equity investors pause, but in light of the relentless, mindless bullishness currently extant, lets not hold our breath.</div><div style="text-align: left;"></div><div style="text-align: center;">Ten-Year Treasury Bond Yield</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgMXqjxX_jsQU_6e8dBkKyukzcdla5V6QuJtNggwW49UIgZEuDntHQMNtYmI50M4mfOaVBqwlEB4NmyW2PMrgO0rKBSDYzZ7wgXs1oupLQeETZ-NkbOCTgiAhCpA5JCYviwyZb6hhe-Mn4/s1600-h/090911_10_yr_Treasury_Yield_Annotated.jpeg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgMXqjxX_jsQU_6e8dBkKyukzcdla5V6QuJtNggwW49UIgZEuDntHQMNtYmI50M4mfOaVBqwlEB4NmyW2PMrgO0rKBSDYzZ7wgXs1oupLQeETZ-NkbOCTgiAhCpA5JCYviwyZb6hhe-Mn4/s400/090911_10_yr_Treasury_Yield_Annotated.jpeg" /></a></div><div class="separator" style="clear: both; text-align: left;">Source: Stockcharts.com</div><div class="separator" style="clear: both; text-align: left;"><br />
</div><div style="text-align: left;"></div> Stocks, copper and gold have moved to new bull market highs, with oil close behind. <br />
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<div style="text-align: center;">streetTRACKS Gold Trust ETF</div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjQopZI-W-t3gYvs4V3W9NczkkBycReQBLlEIc17Rvrh1CjHuCITqzsCO0v4rYeaGqw3d64wqjKdeyXPNKBl-EF4u7R411g5r_K4n6aUqg8Y74RTq_w9pZ7ZdHt6rt4zNsYeLmhIhcErSo/s1600-h/090911_GLD_Annotated.jpeg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjQopZI-W-t3gYvs4V3W9NczkkBycReQBLlEIc17Rvrh1CjHuCITqzsCO0v4rYeaGqw3d64wqjKdeyXPNKBl-EF4u7R411g5r_K4n6aUqg8Y74RTq_w9pZ7ZdHt6rt4zNsYeLmhIhcErSo/s400/090911_GLD_Annotated.jpeg" /></a></div><div class="separator" style="clear: both; text-align: left;">Source: Stockcharts.com</div><div style="text-align: center;"></div><br />
The only explanation that seems to make sense is that this is the beginning of the next liquidity surge as the banks start to make use of those reserves at the Fed. They are moving out the curve (from zero duration) and driving risk capital out the risk spectrum. Even 88bps in the 2-year is better than 25 bps or less for funds on deposit at the Fed.<br />
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<div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj296yW_V75p3_sF7tAExplKzpAW__DAqXJksJNuX3DmtTGXLZdLA2JZVrPHJL95LK1k4NiunNmIjU88pXMc2IBFo2SEEtKwBwcTLCZjcXfrYp7lKZ3VjNlEyJaLV9mZlaoE9epykCZX7A/s1600-h/090911_Excess_Reserves_at_Fed.jpeg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj296yW_V75p3_sF7tAExplKzpAW__DAqXJksJNuX3DmtTGXLZdLA2JZVrPHJL95LK1k4NiunNmIjU88pXMc2IBFo2SEEtKwBwcTLCZjcXfrYp7lKZ3VjNlEyJaLV9mZlaoE9epykCZX7A/s400/090911_Excess_Reserves_at_Fed.jpeg" /></a></div><div class="separator" style="clear: both; text-align: left;">Source: FRB</div><br />
As the banks move into notes they will drive 2-year yields down. Investors will then move out the curve looking for yield, which will push longer maturity bond prices higher. This is the only explanation I can come up with for the coincident rally in bonds, stocks, copper and gold.<br />
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We’ll drive stock multiples back into the stratosphere, as the economy is clearly not supportive of the assumed risk premia.<br />
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Watch the TIPS BE rate (USGGBE10:IND in Bloomberg) for a signal of trend reversal. Until then, we are firing on all cylinders.<br />
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Welcome to the liquidity surge. <span style="color: #1f497d; font-family: Calibri, sans-serif; font-size: 11pt;"><o:p></o:p></span>GestaltUhttp://www.blogger.com/profile/15636551868375563464noreply@blogger.com0tag:blogger.com,1999:blog-8316591069902396281.post-22781525920993781352009-09-04T16:02:00.003-04:002009-09-04T16:04:28.117-04:001930's Redux<span style="font-family: Georgia, 'Times New Roman', serif;"><span style="font-size: small;">David Rosenberg quoted from a September 1930 Wall Street Journal editorial in this morning's 'Breakfast with Dave'. With </span></span><i><span style="font-family: Georgia, 'Times New Roman', serif;"><span style="font-size: small;">Spiritus Animus</span></span></i><span style="font-family: Georgia, 'Times New Roman', serif;"><span style="font-size: small;"> bubbling to the surface today, wise investors would be well served to keep things in perspective. The following piece should put even the most bullish data and comments in context:</span></span><br />
<span style="font-family: Georgia, 'Times New Roman', serif;"><span style="font-size: small;"><br />
</span> </span><span style="font-family: Georgia, 'Times New Roman', serif;"><span style="font-size: small;">August 28, 1930: </span></span><br />
<span style="font-family: Georgia, 'Times New Roman', serif;"><span style="font-size: small;"></span></span><br />
<blockquote><span style="font-family: Georgia, 'Times New Roman', serif;"><i><span style="font-size: small;">"There’s a large amount of money on the sidelines waiting for investment opportunities; this should be felt in market when “cheerful sentiment is more firmly entrenched.” Economists point out that banks and insurance companies “never before had so much money lying idle.”</span></i><span style="font-size: small;"> </span></span></blockquote><span style="font-family: Georgia, 'Times New Roman', serif;"><i><span style="font-size: small;">September 3, 1930: </span></i></span><span style="font-family: Times;"><span style="font-family: Georgia, 'Times New Roman', serif;"><i><span style="font-size: small;"><br />
</span> </i></span></span><br />
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<span style="font-family: Times;"><blockquote><span style="font-family: Georgia, 'Times New Roman', serif;"><i><span style="font-size: small;">"Market has now reached [the] resistance level where it ran out of steam on July 18 (240.57) and July 28 (240.81). Breaking through this level would be considered a highly bullish signal. General confidence that this will happen based on recent market action; many leading stocks have already surpassed July highs. Further positive technicals seen in recent volume pattern (higher on rallies and lower on pullbacks), and in continued large short interest. </span></i></span></blockquote><blockquote><span style="font-family: Georgia, 'Times New Roman', serif;"><i><span style="font-size: small;">Some wariness based on recent good rally recovering all of drought-related break; some observers advise taking profits on at least part of long positions, to be in position to rebuy on good pullbacks. </span></i></span></blockquote><blockquote><span style="font-family: Georgia, 'Times New Roman', serif;"><i><span style="font-size: small;">Most economists agree business upturn is close; peak in business was reached July 1929, so depression has lasted about 14 months. “Those who have faith and confidence in the country and its ability to come back will profit by their foresight. This has also been the case over the past half century.” </span></i></span></blockquote><blockquote><span style="font-family: Georgia, 'Times New Roman', serif;"><i><span style="font-size: small;">Harvard Economic Society points to steady rise in bond prices as favorable for stocks. Says there is “every prospect that the [business] recovery ... will not long be delayed,” although fall period may not be strong as expected. Notes worldwide decline in business, but 1922 recovery demonstrates U.S. due to “great size, natural advantages, and diversity of conditions ... can lift itself out of depression without the stimulus of improved foreign demand.”</span></i></span></blockquote></span><span style="font-family: Times;"><span style="font-family: Georgia, 'Times New Roman', serif;"><span style="font-size: small;">Rosenberg concludes with the ominous, "</span></span><b><span style="font-family: Georgia, 'Times New Roman', serif;"><span style="font-size: small;">We only know now with perfect hindsight what these pundits did not know back then — that there was another 80% of downside left in the bear market."</span></span></b></span>GestaltUhttp://www.blogger.com/profile/15636551868375563464noreply@blogger.com0tag:blogger.com,1999:blog-8316591069902396281.post-74358737027063313042009-09-03T21:12:00.017-04:002010-02-01T13:19:30.937-05:00Low Quality Rally<div class="separator" style="clear: both; text-align: auto;"><span style="font-family: Georgia, 'Times New Roman', serif;"><span style="font-size: small;">Many Advisors and fund managers have been complaining about how difficult it has been to beat their stock market benchmarks since the March 9th bottom. It turns out that, for active managers with a rigorous process for selecting the highest quality stocks, it has been quantifiably frustrating. This post will shed some light on this topic, to the delight of disciplined stock-pickers everywhere.</span></span></div><div class="separator" style="clear: both; text-align: auto;"><span style="font-family: Georgia, 'Times New Roman', serif;"><span style="font-size: small;"><br />
</span></span></div><div class="separator" style="clear: both; text-align: auto;"><span style="font-family: Georgia, 'Times New Roman', serif;"><span style="font-size: small;">Over long periods (> 2 years) 'high-quality' stocks outperform 'low-quality' stocks by a substantial margin. A stock's 'quality' in this sense is defined by its relative standing among factors such as earnings growth and momentum, earnings stability, debt-to-equity, trading liquidity, return-on-equity, credit rating, analyst earnings estimate revisions, price level and price momentum, etc. However, since March 9th, an investor who stuck to a discipline of choosing only 'high-quality' stocks for portfolios would have substantially underperformed North American benchmarks.</span></span></div><span style="font-family: Georgia, 'Times New Roman', serif;"><br />
<span style="font-family: Georgia, 'Times New Roman', serif;"><span style="font-size: small;">It may seem intuitive that stocks that dropped the most during the bear market (worst momentum, smallest market cap at the bottom, lowest price at the bottom) have shown some of the greatest returns off the bottom. This intuition is faulty however, for several reasons. First, those who own the stocks that dropped the most - owned the stocks that dropped the most. Very few investors were able to time the purchase of these cataclysmic names, like Citigroup, Bank of America, and AIG so that they avoided the bloodbath before experiencing the ecstasy of rebirth. Even the bravest value investors like Bill Miller, whose Legg Mason Value Trust had one of the strongest 10-year track records of any mutual fund until late 2007, saw his fund value drop from $85 to $22, a drop of 74% (!!) before seeing his fund rebound by almost 100% since March 9th. His fund is still down over 50% from its peak.</span></span><br />
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</span></span> <span style="font-family: Georgia, 'Times New Roman', serif;"><span style="font-size: small;">Another reason why it makes little sense to try to buy the stocks that have dropped the most during bear markets is that these stocks usually underperform over the duration of the subsequent bull market. The 2000 - 2003 bear market is a great example. The stocks that went down the most in the bear market - JDS Uniphase, Nortel Networks, Mindspring, Cisco, etc. were very weak performers from 2003 - 2007. The strongest performers throughout the 2000 - 2003 bear market - energy, materials, and gold companies - were enormous winners during the following bull market. This is the rule, not the exception.</span></span><br />
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<span style="font-family: Georgia, 'Times New Roman', serif;"><span style="font-size: small;">Myles Zyblock, Chief Institutional Strategist for RBC Capital Markets wrote the following in his September 1st note to clients:</span></span><br />
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<span style="font-family: Georgia, 'Times New Roman', serif;"><blockquote><span style="font-family: Georgia, 'Times New Roman', serif;"><i>"North American stock-specific leadership, regardless of sector membership, has been characterized by a type of constituency that most analysts refer to as “low quality”. This has been a rather unnerving shift for managers who follow a discipline that emphasizes particular attributes such as earnings quality or profitability. Many mandates have not allowed managers to enter this low-quality style box, to the detriment of relative performance. Strict adherence to a process more often than not leads to investment success, but the market can and often does move against a winning long-term strategy for brief time periods. Keep in mind that low quality cycles, even in up markets, tend to be relatively short-lived and our best guess is that there are only another 1-2 quarters of life left in this one.</i></span><br />
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<span style="font-family: Georgia, 'Times New Roman', serif;"><i>One way to get a sense of what the low quality rally has been all about is to view the performance of stocks since the March low sorted by a few simple metrics that isolate the impact of quality factors including size/liquidity, valuations and profitability. Based on this methodology, it’s pretty clear that the smaller, less liquid, relatively inexpensive and more fundamentally broken companies have been the big outperformers over the past five months. " (See Table 1.)</i></span></blockquote><span style="font-family: Times;"></span><br />
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<span style="font-family: Times;"><div style="text-align: center;">Table 1. S&P 500 Returns Since March 9th By Decile Rank</div></span></span><br />
<div style="text-align: center;"><span style="font-size: small;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjhm21KMmmbmh4ctM9ynSyfxoW9GxdK_5rQzD5TKVQL-_trXd-WU9PnfFagRoNNsufFV6Vq0-Gah80ty62yzJpyNPXAVEZM0Kqv2XRFG_84to5zgfYg-7nX1vOdvMZy5hydPC_Olr9Z60E/s1600-h/090903_S&P500_Returns_Factor_Matrix.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="216" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjhm21KMmmbmh4ctM9ynSyfxoW9GxdK_5rQzD5TKVQL-_trXd-WU9PnfFagRoNNsufFV6Vq0-Gah80ty62yzJpyNPXAVEZM0Kqv2XRFG_84to5zgfYg-7nX1vOdvMZy5hydPC_Olr9Z60E/s400/090903_S&P500_Returns_Factor_Matrix.jpg" width="400" /></a></span><br />
<div style="text-align: left;">Source: RBC</div></div><br />
The next chart shows the performance of North American stocks, with S&P performance on the left, and TSX performance on the right. The grey bars represent the performance of highest quality stocks in each of the four major investment styles - Momentum, Predictability, Growth, and Value - while the blue bars show the performance of the lowest quality stocks. All performance is from the March 9th bottom.<br />
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<div style="text-align: center;"><div style="text-align: auto;"><span style="font-size: small;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhzYNLTaDbmOIkB7FEdxJvBuYGCQsmuAey_oE4MXBZQMyZUG5sLJx0-ZT7FXcG7moRwoXha3W0ypoS-D_yARRG4XrxqWfaeaHFbulR9fvXOdSgxJ1fQDzh_2AHDwg_uEeZqwQS8peg1z0A/s1600-h/090903_Low_Quality_Stocks_Outperformance_Bar_Chart.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhzYNLTaDbmOIkB7FEdxJvBuYGCQsmuAey_oE4MXBZQMyZUG5sLJx0-ZT7FXcG7moRwoXha3W0ypoS-D_yARRG4XrxqWfaeaHFbulR9fvXOdSgxJ1fQDzh_2AHDwg_uEeZqwQS8peg1z0A/s400/090903_Low_Quality_Stocks_Outperformance_Bar_Chart.jpg" /></a></span><br />
<div style="text-align: left;">Source: RBC</div></div></div><div><span style="font-size: small;"><br />
</span> </div><div>High quality U.S. stocks underperformed low-quality stocks in every category, though the outperformance in the Value category is minor. This makes sense, as at the bottom many of the low quality stocks were priced well below book value, on the assumption that many would be liquidated as non-viable businesses. Of course, without unprecedented government intervention, many of the worst performing stocks would have collapsed, and these numbers would look quite different. </div><div><span style="font-size: small;"><br />
</span></div><div><span style="font-size: small;">In Canada, high-quality outperformed low-quality Value stocks quite substantially. Canadian Value managers have had the most prospective stock-picking environment in generations, while growth and momentum managers have dramatically underperformed.</span></div><div><span style="font-size: small;"><br />
</span></div><div><span style="font-size: small;">Overall, the above charts show that rapidly declining companies with highly unpredictable financials and significant earnings contraction as of March 9th very significantly outperformed stocks with predictable financials, strong earnings growth, and which were already in positive price trends.</span></div><div><span style="font-size: small;"><br />
</span></div><div><span style="font-size: small;">History shows that this dynamic is not that unusual in frequency, but that it doesn't last for very long. According to RBS research, low-quality stocks have outperformed high-quality stocks during 8 periods in the past 30 years, and this performance advantage tends to persist for about 6 to 9 months. So low quality stocks may continue to dominate for another three months or so.</span></div><div><span style="font-size: small;"><br />
</span></div><div><span style="font-size: small;">To further illustrate the point of low-quality dominance, I have included two tables below describing the performance of several style models from Canada's Computerized Portfolio Management Services (CPMS). The top table shows U.S. models, and the bottom table shows Canadian models. </span></div><div><span style="font-size: small;"><br />
</span></div><div><span style="font-size: small;">Each style model (Asset Value, Earnings Value, Earnings Momentum, etc.) tracks a portfolio of stocks chosen using different high-powered factors, such as earnings momentum, earnings predicability, analyst estimate revisions, price-to-book value, price momentum, etc. The 'Dangerous' model in each table tracks the performance of a portfolio of stocks which the system suggests would make good short candidates. These are the lowest quality stocks, with poor earning growth and quality, negative analyst estimate revisions, high debt levels relative to equity, etc. </span></div><div><span style="font-size: small;"><br />
</span></div><div><span style="font-size: small;">Note that over the past year the 'Dangerous' models have outperformed every model except the Canadian 'Earnings Value' model. This makes sense, as the Dangerous portfolio closely approximates a low-quality value portfolio, while the 'Earnings Value' model replicates a high-quality Value portfolio.</span></div><div><span style="font-size: small;"><br />
</span></div><div><span style="font-size: small;">The Momentum portfolio in Canada, and the Earnings and Price Momentum portfolios in the U.S. have demonstrated the best performance since inception (1985 and 1993 for the Canadian and U.S. models respectively) by a wide margin (see far right column). However, these models have been terrible under-performers since the beginning of this year.</span></div><div><span style="font-size: small;"><br />
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</span></div><div class="separator" style="clear: both; text-align: center;"><span style="font-size: small;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgZWWA2I3b2TEQyOdvPVBbehpeLZD1OYqpGDMw6n6cBXyBnkavHSILdvbNfhCRkdevQEKGtDlVMxQLNfZXJUmGTE0IyHRoNG5B3KBpqBcqv5pFN1P5p80HY2HIWQ2VCBZ78HcoiEeJDKzE/s1600-h/090903_CPMS_Models_US.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgZWWA2I3b2TEQyOdvPVBbehpeLZD1OYqpGDMw6n6cBXyBnkavHSILdvbNfhCRkdevQEKGtDlVMxQLNfZXJUmGTE0IyHRoNG5B3KBpqBcqv5pFN1P5p80HY2HIWQ2VCBZ78HcoiEeJDKzE/s400/090903_CPMS_Models_US.jpg" /></a></span></div><div class="separator" style="clear: both; text-align: left;">Source: CPMS</div><div><span style="font-size: small;"><br />
</span></div><div class="separator" style="clear: both; text-align: center;"><span style="font-size: small;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhWICUicXvvr2L_KT_8q9vPvM6JRyncsP4m8C4yNozYLCpRMiTuYTRZN22ej6tFq9JbZBuV4sI-PJQAXi0fJt1dwc1QdLNLDpBiN1UoPEEH9cbw2nd0dHaknm0RGqGsFCI735Ubpe7dEJk/s1600-h/090903_CPMS_Models_Canada.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhWICUicXvvr2L_KT_8q9vPvM6JRyncsP4m8C4yNozYLCpRMiTuYTRZN22ej6tFq9JbZBuV4sI-PJQAXi0fJt1dwc1QdLNLDpBiN1UoPEEH9cbw2nd0dHaknm0RGqGsFCI735Ubpe7dEJk/s400/090903_CPMS_Models_Canada.jpg" /></a></span></div><div class="separator" style="clear: both; text-align: left;">Source: CPMS</div><div><span style="font-size: small;"><br />
</span></div><div><span style="font-size: small;">Fortunately, we can be confident that the low-quality rally won't last forever. If this rally provides us with another leg up, disciplined adherents to high-quality stock picking strategies will almost certainly get their day in the sun.</span></div><div class="separator" style="clear: both; text-align: left;"></div>GestaltUhttp://www.blogger.com/profile/15636551868375563464noreply@blogger.com0tag:blogger.com,1999:blog-8316591069902396281.post-58526447628983334312009-09-03T15:58:00.008-04:002010-02-01T13:20:21.885-05:00The Statistics of Prediction<span style="font-size: small;"><span style="font-family: Georgia, 'Times New Roman', serif;">Given the high level of ambiguity in the economy and markets at the moment (both gold and Treasuries rallying?), I thought it might be useful to revisit the concept of forecast error. Economic forecasters, even (perhaps especially?) the top, highest paid Wall Street celebrity economists, are egregiously poor predictors of stock market levels or direction over any meaningful time frame.</span></span><br />
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</span> <span style="font-family: Georgia, 'Times New Roman', serif;"> </span><span style="font-family: Georgia, 'Times New Roman', serif;"> </span></span></div><div><span style="font-size: small;"><span style="font-family: Georgia, 'Times New Roman', serif;">Robert Prechter does an excellent job of describing the logical fallacy about economists:<br />
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</span> <span style="font-family: Georgia, 'Times New Roman', serif;"> </span><span style="font-family: Georgia, 'Times New Roman', serif;"> </span></span><b><span style="font-size: small;"><span style="font-family: Georgia, 'Times New Roman', serif;">From Elliott Wave Theorist, May 2009</span></span></b><span style="font-size: small;"><span style="font-family: Georgia, 'Times New Roman', serif;"><br />
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<blockquote><i><span style="font-family: Georgia, 'Times New Roman', serif;">"Although it has suddenly become fashionable to bash economists, I would like to point out that economists are very valuable when they stick to economics. They can explain, for example, why and individual's pursuit of self interest is beneficial to others, why prices fall when technology improves, why competition breeds cooperation, why political action is harmful, and why fiat money is destructive. Such knowledge is crucial to the survival of economies.</span><span style="font-style: normal;"><span style="font-family: Georgia, 'Times New Roman', serif;"> </span></span></i></blockquote><blockquote><i><span style="font-family: Georgia, 'Times New Roman', serif;">Economic theory pertains to economics, but not to finance and so-called macro-economics. Socionomic theory pertains to social mood and its consequences, which manifest in the fields of finance and macro-economics.</span><span style="font-style: normal;"><span style="font-family: Georgia, 'Times New Roman', serif;"> </span></span></i></blockquote><blockquote><i><span style="font-family: Georgia, 'Times New Roman', serif;">If you want someone to explain why minimum wage laws hurt the poor, talk to an economist. But if you want someone to predict the path of the stock market, talk to a socionomist.</span><span style="font-style: normal;"><span style="font-family: Georgia, 'Times New Roman', serif;"> </span></span></i></blockquote><blockquote><i><span style="font-family: Georgia, 'Times New Roman', serif;">The two fields are utterly different, yet economists don't know it.</span><span style="font-style: normal;"><span style="font-family: Georgia, 'Times New Roman', serif;"> </span></span></i></blockquote><blockquote><i><span style="font-weight: bold;"><span style="font-family: Georgia, 'Times New Roman', serif;">How Correct are Economists Who Forecast Macro-Economic Trends? </span></span></i></blockquote><blockquote><i><span style="font-family: Georgia, 'Times New Roman', serif;">The Economy is usually in expansion mode. It contracts occasionally, sometimes mildly, sometimes severely. Economists generally stay bullish on the macro-economy. In most environments, this is an excellent career tactic. The economy expands most of the time, so economists can claim they are right, say, 80 percent of the time, while missing every turn toward recession and depression. </span></i></blockquote><blockquote><i><span style="font-family: Georgia, 'Times New Roman', serif;">Now, suppose a market analyst actually has some ability to warn of downturns. He detects signs of a downturn ten times, catching all four recessions that actually occur but issuing false warnings six times. He, a statistician might say, is right only about 40 percent of the time, just half as much as most economists; therefore the economist is more valuable. But these statistics are only as good as the premises behind them. </span></i></blockquote><blockquote><i><span style="font-family: Georgia, 'Times New Roman', serif;">Suppose you eat at an outdoor cafe daily, but it happens that on average once every 100 days a terrorist will drive by and shoot all the customers. The economist has no tools to predict these occurrences, so he simply 'stays bullish' and tells you to continue lunching there. He's right 99 percent of the time. He is wrong 1% of the time. In that one instance, you are dead. </span></i></blockquote><blockquote><i><span style="font-family: Georgia, 'Times New Roman', serif;">But the market analyst has some useful tools. he can predict probabilistically when the terrorist will attack, but his tools involve substantial error, to the point that he will have to choose on average 11 days out of 100 on which you must be absent from the cafe in order to avoid the day on which the attack will occur. This analyst is therefore wrong 10% of the time, which is ten times the error rate of the economist. But you don't die. </span></i></blockquote><blockquote><i><span style="font-family: Georgia, 'Times New Roman', serif;">How can the economist be mostly right yet worthless and the analyst be mostly wrong yet invaluable? The statistics are clear - aren't they? </span></i></blockquote><blockquote><i><span style="font-family: Georgia, 'Times New Roman', serif;">The true statistics, the ones that matter, are utterly different from those quoted above. When one defines the task as keeping the customer alive, the economist is 0% successful, and the analyst is 100% successful. </span></i></blockquote><blockquote><i><span style="font-family: Georgia, 'Times New Roman', serif;">When consequences really matter, difference in statistical inference can be a life and death issue. In the real world, business people need timely warnings, and realize that economists miss most downturns entirely. Would you rather suffer several false alarms, or would you rather get caught in expansion mode at the wrong time and go bankrupt? </span></i></blockquote><blockquote><i><span style="font-family: Georgia, 'Times New Roman', serif;">Focus on irrelevant statistics is one reason why economists have been improperly revered, and some analysts have been unfairly pilloried, during long-term bull markets. But economists' latest miss was so harmful to their clients that their reputation for forecasting isn't surviving it."</span></i></blockquote><span style="font-family: Georgia, 'Times New Roman', serif;">The following table offers a stark example of forecaster fallibility. Every December, Barron's financial journal gathers the top analysts from Wall Street, names most investors are familiar with, and asks them to forecast the value of the S&P500 on December 31st of the following year. Granted, this is an impossible task; a probable range might be more reasonable. But more importantly, it is also useless because markets can travel an infinite variety of paths to get from A to B, and the paths are important to anyone with an active view on the markets. Regardless, these analysts were off by such a large factor that it can legitimately be claimed that they offer no predictive value, whatsoever.</span></div><b></b><br />
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</span> <span style="font-family: Georgia, 'Times New Roman', serif;"> </span><span style="font-family: Georgia, 'Times New Roman', serif;"> </span></span><span style="font-family: Georgia, 'Times New Roman', serif;"> </span></span></div><div class="separator" style="clear: both; text-align: center;"><span style="font-size: small;"><span style="font-weight: normal;"><span style="font-family: Georgia, 'Times New Roman', serif;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg9peQFShpGd-Lc86hKJRE4tZI6WHT-N9uRyBVRByIES6IN3yUvBZwr4zNvvdSC68eHNsCb-zGBYCTwnEj-vo1dRg3y1kOzDh9wL29U9STbqKJaKIGMaLaZ_qmXEMTR1DBhM3PiNmWgLso/s1600-h/090903_Economist_Forecast_Error_Table_2007.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg9peQFShpGd-Lc86hKJRE4tZI6WHT-N9uRyBVRByIES6IN3yUvBZwr4zNvvdSC68eHNsCb-zGBYCTwnEj-vo1dRg3y1kOzDh9wL29U9STbqKJaKIGMaLaZ_qmXEMTR1DBhM3PiNmWgLso/s400/090903_Economist_Forecast_Error_Table_2007.jpg" /></a></span></span></span></div><div class="separator" style="clear: both; text-align: left;"><span class="Apple-style-span" style="font-family: Georgia, 'Times New Roman', serif;"><span class="Apple-style-span" style="font-weight: normal;">Source: Bloomberg, Butler|Philbrick & Associates</span></span></div><div><span style="font-size: small;"><span style="font-weight: normal;"><span style="font-family: Georgia, 'Times New Roman', serif;"><br />
</span> <span style="font-family: Georgia, 'Times New Roman', serif;"> </span><span style="font-family: Georgia, 'Times New Roman', serif;"> </span></span><span style="font-family: Georgia, 'Times New Roman', serif;"> </span></span></div><div><span style="font-size: small;"><span style="font-weight: normal;"><span style="font-family: Georgia, 'Times New Roman', serif;">Note that the average estimate of 1650 from these 12 Chief Economists was </span></span></span><span style="font-size: small;"><span style="font-weight: normal;"><span style="font-family: Georgia, 'Times New Roman', serif;">82% </span></span></span><span style="font-size: small;"><span style="font-weight: normal;"><span style="font-family: Georgia, 'Times New Roman', serif;">above</span></span></span><span style="font-size: small;"><span style="font-weight: normal;"><span style="font-family: Georgia, 'Times New Roman', serif;"> the actual closing value on December 31st.<br />
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A recent study by James Montier of Societe Generale suggests that stock strategists at Wall Street’s biggest banks -- including Citigroup Inc., MorganStanley and Goldman Sachs Group Inc. -- have failed to predict returns for the Standard & Poor’s 500 Index every year this decade except 2005. Their forecasts were w</span> <span style="font-family: Georgia, 'Times New Roman', serif;"> </span><span style="font-family: Georgia, 'Times New Roman', serif;"> </span></span><span style="font-family: Georgia, 'Times New Roman', serif;"> </span></span><span style="font-size: small;"><span style="font-weight: normal;"><span style="font-family: Georgia, 'Times New Roman', serif;">rong by an average of 18 percentage points</span></span></span><span style="font-size: small;"><span style="font-weight: normal;"><span style="font-family: Georgia, 'Times New Roman', serif;">, according to data compiled by Bloomberg.</span></span></span></div><div><span style="font-size: small;"><span style="font-weight: normal;"><span style="font-family: Georgia, 'Times New Roman', serif;"><br />
</span> <span style="font-family: Georgia, 'Times New Roman', serif;"> </span><span style="font-family: Georgia, 'Times New Roman', serif;"> </span></span><span style="font-family: Georgia, 'Times New Roman', serif;"> </span></span></div><div><span style="font-size: small;"><span style="font-weight: normal;"><span style="font-family: Georgia, 'Times New Roman', serif;">There is a mountain of evidence supporting the view that economist forecasts are statistically no more accurate than random guesses around a long-term trend. Yet most, if not all, Advisors eagerly follow the views of their favorite economist closely, and generally adhere to their recommendations. What is the definition of 'deranged'? Repeating the same mistake over and over while expecting a different result.</span></span></span></div><div><span style="font-family: Georgia, 'Times New Roman', serif;"><span style="font-size: small;"><br />
</span></span></div></div></b>GestaltUhttp://www.blogger.com/profile/15636551868375563464noreply@blogger.com0tag:blogger.com,1999:blog-8316591069902396281.post-27464440365056893842009-08-31T16:21:00.007-04:002010-02-01T13:22:40.938-05:00Macro Indicator Summary<span style="font-size: small;"></span><br />
<div style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">I am impressed with markets' resilience in the face of China's 6.7% sell-off overnight. Aside from Hong-Kong, global equity markets have shrugged-off the new Chinese bear market with a disinterested grunt. Here in Canada, banks are mostly higher on the day despite a 1.5% drop in the index, while the U.S. banking sector continues to consolidate sideways, off just 0.75% today.</span><br />
<br />
<span style="font-size: small;"><b>4:30pm update:</b> Volume was lower across the board, so institutions are sitting on their hands. </span><br />
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<b>9:30pm update: </b>After-hours volume pushed end-of-day numbers well above yesterday's levels, registering a 'distribution day'.<br />
<span style="font-size: small;"> <br />
</span></div><div style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">Note: Please click on any and all charts for a larger image. <br />
</span></div><div style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;"><br />
</span></div><div style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">The clear losers from the China sell-off are commodities, with oil down $3 to below $70, and copper off 12 cents at 2.83. Oil is at critical support from a trend-line going back to late April (see chart of DBO below), while copper has reversed off important resistance at the 61.8% Fibonacci retracement level of $3.00 (See copper Fibs below). <br />
</span></div><div style="font-family: Georgia,"Times New Roman",serif; text-align: center;"><span style="font-size: small;">DBO Oil Fund ETF<br />
</span></div><div class="separator" style="clear: both; font-family: Georgia,"Times New Roman",serif; text-align: center;"><span style="font-size: small;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg7B3DcMgUSdmMoaItWqT_shEtN7FmltMXZa54064N1M8NbFuO5qkzuFDa4VTSQ8078wlB3_nD5laDxnW2KihEYO3mnNDmv_Hz3g3r4qSZ7WaJ2eHeB9h55SXehXvh9HOoK_gOlCIkUVOQ/s1600-h/090830_DBO_breakdown.jpeg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg7B3DcMgUSdmMoaItWqT_shEtN7FmltMXZa54064N1M8NbFuO5qkzuFDa4VTSQ8078wlB3_nD5laDxnW2KihEYO3mnNDmv_Hz3g3r4qSZ7WaJ2eHeB9h55SXehXvh9HOoK_gOlCIkUVOQ/s400/090830_DBO_breakdown.jpeg" /></a></span></div><div class="separator" style="clear: both; font-family: Georgia, 'Times New Roman', serif; text-align: left;">Source: Stockcharts.com</div><div style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;"><br />
</span></div><div style="font-family: Georgia,"Times New Roman",serif; text-align: center;"><span style="font-size: small;">Copper Market with Fibonacci Levels<br />
</span></div><div class="separator" style="clear: both; font-family: Georgia,"Times New Roman",serif; text-align: center;"><span style="font-size: small;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg7hnsBDB7JJJSZcIg3bjtcr5GIje_rvaKG5qpnGU6SGw7YkhKBhIDPiItTgqrB__ddfME1eDm3tmv5Z1wambjFa6aKZnXyZtIJ0qeWI6WFe0kUW79cLl5o0luQlohiwSoK0KNq7qXPaSg/s1600-h/090830_Copper_Fibs.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg7hnsBDB7JJJSZcIg3bjtcr5GIje_rvaKG5qpnGU6SGw7YkhKBhIDPiItTgqrB__ddfME1eDm3tmv5Z1wambjFa6aKZnXyZtIJ0qeWI6WFe0kUW79cLl5o0luQlohiwSoK0KNq7qXPaSg/s400/090830_Copper_Fibs.jpg" /></a></span></div><div class="separator" style="clear: both; font-family: Georgia, 'Times New Roman', serif; text-align: left;">Source: Stockcharts.com</div><div style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;"><br />
</span></div><div style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">Commodity currencies, like the CAD and AUD sold off substantially earlier in the day but have since rebounded, especially against the Yen. The CAD/USD found support from its 50 day moving average slightly below 90 in the morning, and is likely to test its multi-week trend-line (currently at ~89) before finding further direction.<br />
</span></div><div style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;"><br />
</span></div><div style="font-family: Georgia,"Times New Roman",serif; text-align: center;"><span style="font-size: small;">Canadian Dollar ETF<br />
</span></div><div class="separator" style="clear: both; font-family: Georgia,"Times New Roman",serif; text-align: center;"><span style="font-size: small;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh2cMhyphenhyphenDswkesCGfz0vfBC1JlywRLT5K3MZg588L4oJiUgK_BvEVqZwluJZqnpnxccrCjpkSZFhFEJuDT_QUEjTgw54qEbYCrHqFT7eg8f0sRv6lKAjtSewI8ROEtiFL5ASW3nvMSJ3b54/s1600-h/090830_FXC_breakdown.jpeg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh2cMhyphenhyphenDswkesCGfz0vfBC1JlywRLT5K3MZg588L4oJiUgK_BvEVqZwluJZqnpnxccrCjpkSZFhFEJuDT_QUEjTgw54qEbYCrHqFT7eg8f0sRv6lKAjtSewI8ROEtiFL5ASW3nvMSJ3b54/s400/090830_FXC_breakdown.jpeg" /></a></span></div><div class="separator" style="clear: both; font-family: Georgia, 'Times New Roman', serif; text-align: left;">Source: Stockcharts.com</div><div style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;"><br />
</span></div><div style="font-family: Georgia,"Times New Roman",serif; text-align: center;"><span style="font-size: small;">Canadian Dollar ETF / Japanese Yen ETF Ratio<br />
</span></div><div class="separator" style="clear: both; font-family: Georgia,"Times New Roman",serif; text-align: center;"><span style="font-size: small;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgV6nrslHBWQnGl4ScubS7vB9O9Ko2qz69T16Vtu1yi5uHVGUuGTSjIABgYNdQJHpEDE7l5e-UhAa-EKh0CDs5_BEUS9QlBMU9OI94dm0zQeyV_Vm5sNqn_RvSm1TMKA_35rzVVlkJyTL4/s1600-h/090830_FXCvsFXY_support.jpeg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgV6nrslHBWQnGl4ScubS7vB9O9Ko2qz69T16Vtu1yi5uHVGUuGTSjIABgYNdQJHpEDE7l5e-UhAa-EKh0CDs5_BEUS9QlBMU9OI94dm0zQeyV_Vm5sNqn_RvSm1TMKA_35rzVVlkJyTL4/s400/090830_FXCvsFXY_support.jpeg" /></a></span></div><div class="separator" style="clear: both; font-family: Georgia, 'Times New Roman', serif; text-align: left;">Souce: Stockcharts.com</div><div class="separator" style="clear: both; font-family: Georgia,"Times New Roman",serif; text-align: center;"><br />
</div><div style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">We monitor the Asian Dollar Index for macroeconomic strength in that region. The index has been consolidating for several weeks in a pennant formation which is likely to break up or down in the next few days. Given the ADXY's strength in the face of China's panic sell-off overnight, an upside breakout is more likely.</span><span style="font-size: small;"> On an upward break-out, there is resistance at the previous high (~109) which, if broken, would signal further emerging market strength, led by Asia. </span></div><div style="font-family: Georgia,"Times New Roman",serif; text-align: center;"><span style="font-size: small;">Asian Dollar Index <br />
</span></div><div class="separator" style="clear: both; font-family: Georgia,"Times New Roman",serif; text-align: center;"><span style="font-size: small;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhx6bsH1EmNhePocstEtHsioTb6IKvM1BVz5wCmFF1ouwJUA4EY4FPtqO4ssKwGMTju2ra-ou9bA5-Xp95H6he7HXAdtPO4Q4TDABnvUJQ5hVMuQk45cNeiXKXXaen8x2d_-gX-YBU0O9Q/s1600-h/090830_ADXY_Pennant.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhx6bsH1EmNhePocstEtHsioTb6IKvM1BVz5wCmFF1ouwJUA4EY4FPtqO4ssKwGMTju2ra-ou9bA5-Xp95H6he7HXAdtPO4Q4TDABnvUJQ5hVMuQk45cNeiXKXXaen8x2d_-gX-YBU0O9Q/s400/090830_ADXY_Pennant.jpg" /></a></span></div><div class="separator" style="clear: both; font-family: Georgia, 'Times New Roman', serif; text-align: left;">Source: Bloomberg</div><div style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;"><br />
</span></div><div style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">Bonds are confirming the bearish story in commodities, with long-term Treasuries rallying to resistance for the second time in 2 days. </span></div><div style="font-family: Georgia,"Times New Roman",serif; text-align: center;"><span style="font-size: small;"> 20+ Year US Treasury Bond ETF<br />
</span></div><div class="separator" style="clear: both; font-family: Georgia,"Times New Roman",serif; text-align: center;"><span style="font-size: small;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEikXFgFU16k3jzbJb_7lXt3-gRg5VmmLq25spmK1k4iKNF0lNAeo5lnpqN7NgpEY9of-Gf0EuGgyWbNTGNqFP1viTJJmSaw3uMptBiGWNvZSK0O3M_DeufnT3AYB7kKqE-CGx4Pntzw0tE/s1600-h/090830_TLT_breakout.jpeg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEikXFgFU16k3jzbJb_7lXt3-gRg5VmmLq25spmK1k4iKNF0lNAeo5lnpqN7NgpEY9of-Gf0EuGgyWbNTGNqFP1viTJJmSaw3uMptBiGWNvZSK0O3M_DeufnT3AYB7kKqE-CGx4Pntzw0tE/s400/090830_TLT_breakout.jpeg" /></a></span></div><div class="separator" style="clear: both; font-family: Georgia, 'Times New Roman', serif; text-align: left;">Source: Stockcharts.com</div><div class="separator" style="clear: both; font-family: Georgia,"Times New Roman",serif; text-align: center;"><br />
</div><div style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">The 10-year TIPS breakeven rate, a measure of bond traders' future inflation expectations, is testing key support today, suggesting that traders are skeptical of current commodity strength.</span></div><div style="font-family: Georgia,"Times New Roman",serif; text-align: center;"><span style="font-size: small;">10-Year TIPS Breakeven Rate<br />
</span></div><div class="separator" style="clear: both; font-family: Georgia,"Times New Roman",serif; text-align: center;"><span style="font-size: small;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhcheL4gaiSIDpRSjrG10YygNhm4Of0n-OnZBO3CNuZz3pxebPfr_-RkB3DOZ8_8axZLHrxska1Xw2DXsze4Q77jhZVVrFYJpx4B3B9KQIelpeT5cC91z3qpuFfsRz9tyKs9FH8loEjII8/s1600-h/090830_US_10_yr_Breakeven.jpeg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhcheL4gaiSIDpRSjrG10YygNhm4Of0n-OnZBO3CNuZz3pxebPfr_-RkB3DOZ8_8axZLHrxska1Xw2DXsze4Q77jhZVVrFYJpx4B3B9KQIelpeT5cC91z3qpuFfsRz9tyKs9FH8loEjII8/s400/090830_US_10_yr_Breakeven.jpeg" /></a></span></div><div class="separator" style="clear: both; font-family: Georgia, 'Times New Roman', serif; text-align: left;">Source: Bloomberg</div><div style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;"><br />
</span></div><div style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">10-year yields have also been consolidating in a pennant formation; a break of 3.25% would indicate a major change in the trend of 10-year rates, at which point equity bulls would necessarily be put on the defensive.</span></div><div style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;"><br />
</span></div><div style="font-family: Georgia,"Times New Roman",serif; text-align: center;"><span style="font-size: small;">10-Year US Bond Yield<br />
</span></div><div class="separator" style="clear: both; font-family: Georgia,"Times New Roman",serif; text-align: center;"><span style="font-size: small;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgDzdmSUuyHLVBUkqihbBnRGplLkGl8uTXSQWv7k9j6yhkjFR-bTgW0rDG2jmbzW73STKeSp_pA_KTj8BA4S49fgaYV3uZoGjWm5U9hatWHstArl_16nrXRS7X1Z_8oVlKX2YDeaSdMhwU/s1600-h/090830_US_10_yr_yield.jpeg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgDzdmSUuyHLVBUkqihbBnRGplLkGl8uTXSQWv7k9j6yhkjFR-bTgW0rDG2jmbzW73STKeSp_pA_KTj8BA4S49fgaYV3uZoGjWm5U9hatWHstArl_16nrXRS7X1Z_8oVlKX2YDeaSdMhwU/s400/090830_US_10_yr_yield.jpeg" /></a></span></div><div class="separator" style="clear: both; font-family: Georgia, 'Times New Roman', serif; text-align: left;">Source: Bloomberg</div><div style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;"><br />
</span></div><div style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;">Gold continues to consolidate in its intermediate-term pennant structure forming the right shoulder of what looks like a huge inverse head and shoulders formation. This structure suggests higher prices lie ahead. However, there are two clear resistance levels that must be breached before we can celebrate gold's new up-trend. Using the GLD ETF chart, the first resistance line sits at ~$94.25, with the longer-term line at ~$95.50. These are important levels to watch. A breach of the upper resistance line would suggest a re-test of the previous highs near $99, with potential for a test of it's all-time high of $100.44.</span><br />
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</div><div style="font-family: Georgia,"Times New Roman",serif; text-align: center;"><span style="font-size: small;">GLD US Gold ETF<br />
</span></div><div class="separator" style="clear: both; font-family: Georgia,"Times New Roman",serif; text-align: center;"><span style="font-size: small;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi2CbEKuaXtpd-Sg4GUZpPjvoRNb-pJLahTWRf5cgZ8_iU7mIA6rVV-NhVvGLUSflQMGNaP63XK17YPoV5wKxCRUVPuMlRonUfPl57cVDgOtpCGDQ85Y-kGp0vXyldJNEtrsIhCd6_-hAs/s1600-h/090830_GLD_pennant.jpeg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi2CbEKuaXtpd-Sg4GUZpPjvoRNb-pJLahTWRf5cgZ8_iU7mIA6rVV-NhVvGLUSflQMGNaP63XK17YPoV5wKxCRUVPuMlRonUfPl57cVDgOtpCGDQ85Y-kGp0vXyldJNEtrsIhCd6_-hAs/s400/090830_GLD_pennant.jpeg" /></a> </span></div><div class="separator" style="clear: both; font-family: Georgia, 'Times New Roman', serif; text-align: left;">Source: Stockcharts</div><div class="separator" style="clear: both; font-family: Georgia,"Times New Roman",serif; text-align: left;"><span style="font-size: small;"><br />
</span></div><div class="separator" style="clear: both; font-family: Georgia,"Times New Roman",serif; text-align: left;"><span style="font-size: small;">Meanwhile, credit spreads seem impervious to the macro fragility implied by the charts above. CDS spreads in Europe and the U.S. continue to consolidate near their intermediate-term lows.</span></div><div class="separator" style="clear: both; font-family: Georgia,"Times New Roman",serif; text-align: left;"></div><div class="separator" style="clear: both; font-family: Georgia,"Times New Roman",serif; text-align: center;"><span style="font-size: small;">US and European CDS Indices <br />
</span></div><div style="font-family: Georgia,"Times New Roman",serif; text-align: center;"><span style="font-size: small;"> <a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiui-e8CnXFGeoalg9-nMgAu0Qfc_jdVdpys9Pq0Jh3SB53tW21nJcamjGRl8jZmTmcDm5OhEtrxJyYQUNuM2WiW0UQJa81ksgCeFir6p9cxwsRNEwUchE_jWM-x2rJDlwOV6TRO8xqnr4/s1600-h/090830_CDS_Spreads.jpeg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiui-e8CnXFGeoalg9-nMgAu0Qfc_jdVdpys9Pq0Jh3SB53tW21nJcamjGRl8jZmTmcDm5OhEtrxJyYQUNuM2WiW0UQJa81ksgCeFir6p9cxwsRNEwUchE_jWM-x2rJDlwOV6TRO8xqnr4/s400/090830_CDS_Spreads.jpeg" /></a></span><br />
<div style="text-align: left;">Source: BMO CM Research</div></div><div class="separator" style="clear: both; font-family: Georgia,"Times New Roman",serif; text-align: left;"><span style="font-size: small;"><br />
</span></div><div class="separator" style="clear: both; font-family: Georgia,"Times New Roman",serif; text-align: left;"><span style="font-size: small;">In conclusion, several important macro indicators are testing important resistance and support levels, but the pennant-shaped consolidation patterns suggest trend-continuation at this time. As such, stock markets are likely to move sideways in the short-term, with the potential for a short-term correction driven by commodity weakness. The most likely intermediate-term direction for stocks is up, with the potential for the S&P to move as high as 1200 before we begin wave 3 down. Should 980 be taken out on the S&P, we would look for a more immediate, steeper decline to ensue.</span></div><div class="separator" style="clear: both; font-family: Georgia,"Times New Roman",serif; text-align: left;"><span style="font-size: small;">For longer-term context, I leave you with Doug Short's most recent chart of the Three Mega Bear Markets.</span></div><div class="separator" style="clear: both; font-family: Georgia,"Times New Roman",serif; text-align: left;"><span style="font-size: small;"><br />
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</span></div><div style="font-family: Georgia,"Times New Roman",serif; text-align: center;"><span style="font-size: small;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEix9c6MaD4TFY66PwE0RokEdmz9V5oTBYev6tYWZLePzLPN56lD24lzXlzAcEOq3kPIX-laKr-uizytYc7Tnvmw2DBxgeOpPZEdAmYut5xdIDBrs3uCL6C2sXyRJFuPd0IQV1D5Xnw4tWE/s1600-h/090830_Doug_Short_Three_Mega_Bears.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEix9c6MaD4TFY66PwE0RokEdmz9V5oTBYev6tYWZLePzLPN56lD24lzXlzAcEOq3kPIX-laKr-uizytYc7Tnvmw2DBxgeOpPZEdAmYut5xdIDBrs3uCL6C2sXyRJFuPd0IQV1D5Xnw4tWE/s400/090830_Doug_Short_Three_Mega_Bears.jpg" /></a></span><br />
<div style="text-align: left;">Source: Dshort.com</div></div><div style="font-family: Georgia,"Times New Roman",serif;"><span style="font-size: small;"><br />
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</span></div>GestaltUhttp://www.blogger.com/profile/15636551868375563464noreply@blogger.com0tag:blogger.com,1999:blog-8316591069902396281.post-55524121606276926312009-08-23T10:44:00.007-04:002010-06-24T09:34:38.473-04:00Sirens in the Distance<div class="separator" style="clear: both; text-align: left;"><span style="font: 12px Garamond; letter-spacing: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">"</span></span></span><span style="letter-spacing: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">The American Republic will endure until the day Congress discovers how to bribe the public with the public's money</span></span></span><span style="font: 12px Garamond; letter-spacing: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">."</span></span></span></div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><span style="letter-spacing: 0px;"></span><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px;"><span style="letter-spacing: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">- Alexander Fraser Tytler</span></span></span></div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><span style="letter-spacing: 0px;"></span><br />
</span></span> </div><div style="font: 18px Garamond; margin: 0px;"><span style="font: 12px Garamond; letter-spacing: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">"</span></span></span><span style="letter-spacing: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">The hardest thing to explain is the glaringly evident which everybody has decided not to see.</span></span></span><span style="font: 12px Garamond; letter-spacing: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">"</span></span></span></div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><span style="letter-spacing: 0px;"></span><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px;"><span style="letter-spacing: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">- Ayn Rand</span></span></span></div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><span style="letter-spacing: 0px;"></span><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px;"><span style="letter-spacing: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">Never in modern history has a voting majority confiscated so much from its children, by incurring so much debt to preserve its own excesses. Debt is simply a form of deferred payment which accrues geometrically compounding costs in the form of interest. Given the response of governments to the current economic downturn, and the acquiescence of voters to unprecedented government deficits, one is compelled to question the values and motives of contemporary citizens. </span></span></span></div><div style="font: 12px Garamond; margin: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><br />
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</span></span> </div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhwTiWxw-3EqTRvMUuOR_8VL_ZkkZEpG68zMCptRShomT4uzOiHl3P-mKTRzbXKZg6lCJMOrYTUXzXpqH4Pr-dz5mZ_BqUfE3avYZn_kdiBX_U5lpfyDCAzEjmRim_YBdkE_TtL8yc4DaI/s1600-h/090822_CBO_US_Budget_Balance_Projections.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><img border="0" height="396" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhwTiWxw-3EqTRvMUuOR_8VL_ZkkZEpG68zMCptRShomT4uzOiHl3P-mKTRzbXKZg6lCJMOrYTUXzXpqH4Pr-dz5mZ_BqUfE3avYZn_kdiBX_U5lpfyDCAzEjmRim_YBdkE_TtL8yc4DaI/s640/090822_CBO_US_Budget_Balance_Projections.jpg" width="640" /></span></span></a></div><div style="font: 12px Garamond; margin: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">In fact, there are only three possible explanations. One involves a form of pervasive, illusory expectation in which this debt is somehow repaid during the voting public's remaining lifespan out of current meager savings. A second possibility is that voters are convinced that bailouts and record deficits are a better legacy for future generations than a period of retrenchment. Thirdly, existing voters may be ambivalent to the fate of future generations when faced with the alternative of thrift. </span></span></div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><span style="letter-spacing: 0px;"></span><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px;"><span style="letter-spacing: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">I will draw on simple math and personal experience to illustrate an important facet of the existing conundrum. It is well known in the financial planning community that, under optimistic assumptions, one's savings at retirement must be at least 20 times one's expected retirement income when adjusted for inflation. For example, a couple retiring at age 65 that requires a consistent $100,000 pre-tax purchasing power in retirement must have at least $2 million in savings. A $150,000 pre-tax retirement income, adjusted for annual inflation, requires $3 million in savings.</span></span></span></div><div style="font: 12px Garamond; margin: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><br />
</span></span> </div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEif0s8YRZZl0IdocsK3P-eFJDNFbCV8IokwkPTDOcXvAS8T-qwGdi_SvXusKpGxCN_GQ6SMQCNPkbk2trtuH0lhQoLE6EOf1NT2atzn0OQWzLR5OHscVQSCmApY-H-YLNs3kq0A2hLi1P8/s1600-h/090613_Extraction_Rate_S&P500_Distribution_Chart.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><img border="0" height="412" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEif0s8YRZZl0IdocsK3P-eFJDNFbCV8IokwkPTDOcXvAS8T-qwGdi_SvXusKpGxCN_GQ6SMQCNPkbk2trtuH0lhQoLE6EOf1NT2atzn0OQWzLR5OHscVQSCmApY-H-YLNs3kq0A2hLi1P8/s640/090613_Extraction_Rate_S&P500_Distribution_Chart.jpg" width="640" /></span></span></a></div><div style="font: 12px Garamond; margin: 0px; text-align: center;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">Source: Butler|Philbrick & Associates</span></span></div><div style="font: 12px Garamond; margin: 0px; text-align: center;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">Click image for larger version</span></span></div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><span style="letter-spacing: 0px;"></span><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px;"><span style="letter-spacing: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">The data suggests that just a small fraction of non-pensioned families have enough savings to support their lifestyle objectives in retirement. Many are ill-equipped to fund even a basic retirement under current lifespan assumptions. What proportion of people you know that are nearing retirement have an appropriate level of savings according to the above model?</span></span></span></div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><span style="letter-spacing: 0px;"></span><br />
</span></span> </div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi4Iyk5xf8PUBMK5iHlwcWxm2dvufDJT-wsB9BPf-eyLbPZleELoUInHRIFdDaEu9wJgWJ5hvrlIuWX_1tkJrSX7E5LidgIkCtNnjI0w4Z2dfh4DrKBjwUr3Hp1Nyr5HzDhtRVq3DSUSt0/s1600-h/090822_McKinsey_Boomer_Retirement_Preparation_Gap.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><img border="0" height="494" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi4Iyk5xf8PUBMK5iHlwcWxm2dvufDJT-wsB9BPf-eyLbPZleELoUInHRIFdDaEu9wJgWJ5hvrlIuWX_1tkJrSX7E5LidgIkCtNnjI0w4Z2dfh4DrKBjwUr3Hp1Nyr5HzDhtRVq3DSUSt0/s640/090822_McKinsey_Boomer_Retirement_Preparation_Gap.jpg" width="640" /></span></span></a></div><div style="font: 12px Garamond; margin: 0px; min-height: 13px; text-align: center;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">Click image for larger version</span></span></div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px;"><span style="letter-spacing: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">In the public and private pension worlds, data suggests the situation is not much better. A majority of pensions, both private and public, were underfunded even before the current global bear-market. Companies, municipalities, and provincial and federal governments have deferred pension contributions for many years to avoid tax hikes or program cuts or, in the case of private companies, to enhance current earnings. This deferral serves the goals of politicians and company managers who are rewarded in the short-term for program and earnings largesse. These same people are unlikely to face the consequences of these actions during their terms. Worse, when stock and bond markets fail to meet performance expectations, as in 2000-2003 and 2008, politicians alter the rules to allow even greater deferrals to preserve corporate earnings or avoid raising taxes during challenging economic periods. The misguided hope is, of course, that an even more stressed and over-leveraged economy will provide such a boost to asset prices that managers can grow their way out of deficits. For many reasons, this is less likely now than ever.</span></span></span></div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><span style="letter-spacing: 0px;"></span><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px;"><span style="letter-spacing: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">One reason this is unlikely is that insufficient savings will produce one of two outcomes: higher savings in the years before retirement, or lower spending in retirement. Given that consumer spending represents around 60% - 70% of Gross Domestic Product in developed economies, a reduction in consumer spending due to higher savings rates and/or lower retirement incomes will surely cause much slower economic growth over the next several years. Further, the U.S. consumer is responsible for no less than 16.6% of total global GDP, followed by Japan (8.1%), China (7.3%), and Germany (6.0%). </span></span></span></div><div style="font: 12px Garamond; margin: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><br />
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</span></span> </div><div class="separator" style="clear: both; text-align: center;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEixcs3yg_ed0WiD-bFNGeg17_fdFd4NqGLhEzogseRzWtkT1C-0jjkJNcNhsVK5sClvWwDjOcTj41AbAD5ykoy6HV5TUvMow0QUoSsq64X3z7BHHqgtDgOoUPnZaB2-A1KkqY4tP-v9uFI/s1600-h/090822_US_Consumer_Spending_%25_GDP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="398" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEixcs3yg_ed0WiD-bFNGeg17_fdFd4NqGLhEzogseRzWtkT1C-0jjkJNcNhsVK5sClvWwDjOcTj41AbAD5ykoy6HV5TUvMow0QUoSsq64X3z7BHHqgtDgOoUPnZaB2-A1KkqY4tP-v9uFI/s640/090822_US_Consumer_Spending_%25_GDP.jpg" width="640" /></a></span></span></div><div style="font: 12px Garamond; margin: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><br />
</span></span> </div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgjDyhWNKKJ-uTICDQG0sEQ6T5Puj-3FspAl02tLH1ZUTyEvFBqS45sVARQrLWyWqrg2INSbfVyUkoyqDI9-pwhD6ZfFF9lFWP36hgwKRGMU4Bf3opMm-iViV4fZe9rAeNUDRBzVVgD7Nk/s1600-h/090822_US_Consumer_%25_Global_GDP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><img border="0" height="396" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgjDyhWNKKJ-uTICDQG0sEQ6T5Puj-3FspAl02tLH1ZUTyEvFBqS45sVARQrLWyWqrg2INSbfVyUkoyqDI9-pwhD6ZfFF9lFWP36hgwKRGMU4Bf3opMm-iViV4fZe9rAeNUDRBzVVgD7Nk/s640/090822_US_Consumer_%25_Global_GDP.jpg" width="640" /></span></span></a></div><div class="separator" style="clear: both; text-align: center;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><br />
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</span></span> </div><div class="separator" style="clear: both; text-align: left;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">Many people point to growth in relatively young emerging economies as a reason for optimism. Indeed, growth in these economies, under more likely global financial trajectories, may buffer the impact of lower spending in developed nations. However, there are significant hurdles that will limit the impact of emerging market growth. The first is the mercantilist structure of these economies. Growth in emerging markets has largely resulted from the migration of Western domestic manufacturing to lower cost jurisdictions. This migration, which is a mutually beneficial arrangement under the right (Schumpeterian) circumstances, is the first step in the evolution of any young economy into a mature capitalist democracy. The 'Asian Tigers', which include Taiwan, Singapore, South Korea and Hong-Kong, managed very rapid growth from the early 1960s through the 1990s by successfully leveraging this export-driven model to become mature capitalist states. China, and to a lesser degree India, have also adopted this model to support their aggressive growth ambitions. Unfortunately, demographic and secular forces have likely conspired to delay the best laid plans of Indian and Chinese central policy makers. They are unlikely to achieve the same level of prosperity on the same timeline, or using the same methods as the Asian Tigers.</span></span></div><div style="font: 12px Garamond; margin: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">Productivity is the degree to which a labour force can achieve higher output with a constant level of inputs. There are two ways to drive productivity growth: leverage and innovation. Innovation is a sustainable resource, limited exclusively by the creativity and courage of humanity. It is a function of risk-taking, which depends on a society's tolerance for failure. Leverage is the degree to which a society embraces debt to amplify growth. All economies can accommodate a degree of leverage, but the sustainable leverage ratio in an economy depends on economic productivity, flexibility, workforce mobility, ratio of services to goods, and other factors. This ratio is constantly changing, but the ratio should fluctuate in a slowly increasing range; it should not grow exponentially. The drawback to leverage is that it also amplifies the volatility of economic growth, with higher leverage leading to a higher degree of economic fluctuation.</span></span></div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><br />
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</span></span> </div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi0DDgHIvZqlJIurV-hgkoxMFQLDx1BiyqR9-W9w9Jujfe8ZrcA7LSMi_K5pe27pui0weg2pFKB1ik_ryPgDRE0n_TYn5EgFkD-6R0VHuimhvKdl-2xVWt6Sd5StnMhODCK6rQ9BxI4PV0/s1600-h/090701_Prechter_US_Credit_Market_Debt_To_GDP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><img border="0" height="484" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi0DDgHIvZqlJIurV-hgkoxMFQLDx1BiyqR9-W9w9Jujfe8ZrcA7LSMi_K5pe27pui0weg2pFKB1ik_ryPgDRE0n_TYn5EgFkD-6R0VHuimhvKdl-2xVWt6Sd5StnMhODCK6rQ9BxI4PV0/s640/090701_Prechter_US_Credit_Market_Debt_To_GDP.jpg" width="640" /></span></span></a></div><div class="separator" style="clear: both; text-align: center;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">Click image for larger version</span></span></div><div style="font: 12px Garamond; margin: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><br />
</span></span> </div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjhEMuAq83IAM83LUIBWzb590utWcemptFJxprVFjNjWG7gpXaHFF1aE12w3RIR6fRprBkoMuyNqwSDbNbXnEmZsyk8dU8dyRjfu_AhhuTJZQxnUwt0zacqMWY3uVzveih_aZ7gG2Bs1dA/s1600-h/090810_Household_Debt_to_GDP.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><img border="0" height="472" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjhEMuAq83IAM83LUIBWzb590utWcemptFJxprVFjNjWG7gpXaHFF1aE12w3RIR6fRprBkoMuyNqwSDbNbXnEmZsyk8dU8dyRjfu_AhhuTJZQxnUwt0zacqMWY3uVzveih_aZ7gG2Bs1dA/s640/090810_Household_Debt_to_GDP.jpg" width="640" /></span></span></a></div><div style="font: 12px Garamond; margin: 0px; text-align: center;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">Click image for larger version</span></span></div><div style="font: 12px Garamond; margin: 0px; text-align: center;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><br />
</span></span> </div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiWZh1z2DzGFN2WE7U41iaUTBpZawRVzd30hhE-L01V6RCFav9Q8u_iwrLDMhxXL46Rnv3Sy3IGEOuKAehTyulkMdPEqNiOdAVzRsmN4n4Oy8WEPwWjVUFfhynYi3co6iZeU-N_eMt1XSs/s1600-h/090810_Household_Debt_to_Personal_Income.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><img border="0" height="144" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiWZh1z2DzGFN2WE7U41iaUTBpZawRVzd30hhE-L01V6RCFav9Q8u_iwrLDMhxXL46Rnv3Sy3IGEOuKAehTyulkMdPEqNiOdAVzRsmN4n4Oy8WEPwWjVUFfhynYi3co6iZeU-N_eMt1XSs/s640/090810_Household_Debt_to_Personal_Income.jpg" width="640" /></span></span></a></div><div class="separator" style="clear: both; text-align: center;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">Click image for larger version</span></span></div><div style="font: 12px Garamond; margin: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">Demographic forces related to the average age of a population largely influence the flexibility, creativity and productivity of economies. Leap-frog innovation generally occurs when the bulk of a population is in their early twenties and thirties. This is a point of maximum risk-taking, and risk is a necessary input to innovation. One must be willing to fail many times in the pursuit of a better mousetrap, and people in their twenties can more easily start over. People in their thirties and forties are focused on raising a family and accumulating domestic necessities such as shelter, transportation and early schooling for children. This necessitates a more conservative approach to life and career. As people move through their forties and fifties, post-graduate education for children becomes the priority, and lifestyle and retirement considerations enter the picture. These priorities limit risk-taking, which in turn limit innovation.</span></span></div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><br />
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</span></span> </div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEglzz7aPIN8WALhQEaO9nQJtj7s9pHUhV8in2vvn2KREpi1mVdu4YVdgP6scXBqbf23oAUH5R3bEqD6i6XZW5x5XVd6V726nLCG7X1JRYkpWxaM_3r31xZcmj-wZoRJdDnWiIgrtTgUB34/s1600-h/090822_US_Spending_Wave_Births_Lagged_for_Peak_Spending.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><img border="0" height="388" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEglzz7aPIN8WALhQEaO9nQJtj7s9pHUhV8in2vvn2KREpi1mVdu4YVdgP6scXBqbf23oAUH5R3bEqD6i6XZW5x5XVd6V726nLCG7X1JRYkpWxaM_3r31xZcmj-wZoRJdDnWiIgrtTgUB34/s640/090822_US_Spending_Wave_Births_Lagged_for_Peak_Spending.jpg" width="640" /></span></span></a></div><div class="separator" style="clear: both; text-align: center;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">Source: Harry S. Dent, </span></span><i><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">The Great Depression Ahead, </span></span></i><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">2009</span></span></div><div class="separator" style="clear: both; text-align: center;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">Click image for larger version</span></span></div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">The 'Baby Boomer' demographic cohort is generally considered to encompass the generation born between 1946 and 1964. Thus, the first Boomers entered their prime innovation years during the early 1970s, and innovation likely peaked around 1980. The Boomers rode the information technology innovation wave, which was pioneered by 5 people born between the years 1954 and 1956: Bill Gates (Microsoft), Steve Jobs (Apple), Steve Ballmer (Microsoft), Scott McNealy (Sun Microsystems) and Eric Schmidt (Sun Microsystems, Novell). The innovations developed and commercialized by these creative Boomers generated enormous productivity gains throughout the 1980s and early 1990s.</span></span></div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><span style="letter-spacing: 0px;"></span><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px;"><span style="letter-spacing: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">Another innovation wave that occurred during the 1960s and impacted the economy through the early 1990s was the rise of feminism and the migration of women from the home into the paid workforce. GDP growth is simply the product of the growth of GDP per capita (productivity) and the growth in the working population. The migration of women from the home expanded the pool of paid workers, as homemaking was not, and unfortunately still is not, recognized as productive labour in GDP calculations. This magnified the gains from the information technology innovation wave, and significantly contributed to Western GDP growth during this period.</span></span></span></div><div style="font: 12px Garamond; margin: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><br />
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</span></span> </div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj4_fufp68KP5YdN7ixxJZaIV8TCvqV3V1qUWZvcSHHHPYvwkTb_hjkW1AknZtntypdOzkeEbZcVy4iYXOq6vDayhDIAgC7Cfhi_z76aqnyStRp9vy_sbicaHGuJqEdWsfQqlT7kZmo6DU/s1600-h/090822_Labour_Force_Participation_By_Gender.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><img border="0" height="470" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj4_fufp68KP5YdN7ixxJZaIV8TCvqV3V1qUWZvcSHHHPYvwkTb_hjkW1AknZtntypdOzkeEbZcVy4iYXOq6vDayhDIAgC7Cfhi_z76aqnyStRp9vy_sbicaHGuJqEdWsfQqlT7kZmo6DU/s640/090822_Labour_Force_Participation_By_Gender.jpg" width="640" /></span></span></a></div><div class="separator" style="clear: both; text-align: center;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">Source: Bureau of Labour Statistics, Mckinsey Global Institute</span></span></div><div class="separator" style="clear: both; text-align: center;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">Click image for larger version.</span></span></div><div style="font: 12px Garamond; margin: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">The Asian Tigers capitalized on this innovation wave by developing their economies around domestic high-tech engineering, and manufacturing for export to a prosperous and fast-growing Western population which was rapidly adopting microcomputers and networking. They were further fed by the maturation of the Japanese consumption wave and credit bubble, which peaked in 1989. Without these massive external demand stimuli, Asian Tiger economic prosperity would have never gotten off the ground. They benefitted from thirty-five to forty years of growing Western demand while an entire generation of ‘Tigers’ was educated, entered the workforce, and gained middle-class levels of prosperity. This pervasive middle-class prosperity is one of the key defining characteristics of a mature capitalist democracy.</span></span></div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><span style="letter-spacing: 0px;"></span><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px;"><span style="letter-spacing: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">Despite over a decade of 7%+ GDP growth, China and India are still a very long way from achieving the same level of economic prosperity as the Asian Tigers. Further, their domestic economies are still highly reliant on exports for economic growth. This combination makes them especially vulnerable to a slowdown in demand from mature Western economies.</span></span></span></div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><span style="letter-spacing: 0px;"></span><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px;"><span style="letter-spacing: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">China and India captured very little of the information technology innovation wave that crested in the early 1990s because their rapid economic growth did not begin until the early 1990s. Instead, these countries have relied on, and to a large degree financed, the phase of Western growth from the mid-1990s through 2007 that was based largely on an increase in leverage. In the period from 1993 through 2005, U.S. households went from saving 8% of disposable personal income to spending almost 1% </span></span><i><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">in excess of</span></span></i><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"> disposable income. In the same period, U.S total debt to GDP, a measure of aggregate economic leverage, rose from 230% to over 350%. For context, the total leverage at the peak of the roaring 20s, before the 1929 stock crash, was 265%. It was 110% of GDP just prior to WWII, and rose to 143% at the peak during the war. This magnitude of debt creation is unprecedented in modern history, and is the legacy we leave to our children.</span></span></span></div><div style="font: 12px Garamond; margin: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><br />
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</span></span> </div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhaL11jRdGwzoTPM8xTTmkAiGnr8qGTIhh61pb-ZbDmy3f_LiSWnQlQK2kheXEHZDqJjr3HJGr6tl658Cj-rAfI6cVLOYiWq7n6rgCjMd9saoBaQ2nv61qE93SyH855fiLFsCY7AcoozhA/s1600-h/090822_Savings_Rate_Annotated.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><img border="0" height="396" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhaL11jRdGwzoTPM8xTTmkAiGnr8qGTIhh61pb-ZbDmy3f_LiSWnQlQK2kheXEHZDqJjr3HJGr6tl658Cj-rAfI6cVLOYiWq7n6rgCjMd9saoBaQ2nv61qE93SyH855fiLFsCY7AcoozhA/s640/090822_Savings_Rate_Annotated.jpg" width="640" /></span></span></a></div><div class="separator" style="clear: both; text-align: center;"><span class="Apple-style-span" style="font-family: Georgia,'Times New Roman',serif;">Source: CalculatedRiskBlog, Butler|Philbrick & Associates</span></div><div class="separator" style="clear: both; text-align: center;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">Click image for larger version.</span></span></div><div style="font: 12px Garamond; margin: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><span style="letter-spacing: 0px;"></span><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px;"><span style="letter-spacing: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">China and India, and to a lesser extent other developing nations in Asia, South and Central America, have relied on Western profligacy to sustain their economic ‘miracle’. The productivity benefits of innovation in Western countries peaked in the 1980s and early 1990s. Productivity gains experienced from the early 1990s through 2005 were largely, if not completely due to an expansion of debt ratios in developed economies.</span></span></span></div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><span style="letter-spacing: 0px;"></span><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px;"><span style="letter-spacing: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">If Westerners accrued so much debt, it is natural to ask, ‘who lent us all this money?’. The answer is that the export-driven economies of China, India, and Japan loaned Western economies money so that they could continue buying their exported goods. Chinese, Indians, and Japanese are excellent savers. The Chinese save almost 40% of their disposable income. Income earned from exports goes directly into savings, and this savings is lent to Western consumers so that they can continue to spend. This global vendor-financing arrangement suited everyone until Western consumers ran out of borrowing capacity.</span></span></span></div><div style="font: 12px Garamond; margin: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><br />
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</span></span> </div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi8m8lfP5bLVUy7LDhu0d18C0BHWWgRDIMrrY2T5V1hMwKVojVc6YQottPvJUgVKXLN-F9wVZElwHQdrBMYRSHne2T8i2tRV95HVPYeaWQhgkwta4UXeSZuAArUqc9rbmH-vSrZUPzZ_10/s1600-h/090822_Chinese_Holdings_Treasuries.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><img border="0" height="496" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi8m8lfP5bLVUy7LDhu0d18C0BHWWgRDIMrrY2T5V1hMwKVojVc6YQottPvJUgVKXLN-F9wVZElwHQdrBMYRSHne2T8i2tRV95HVPYeaWQhgkwta4UXeSZuAArUqc9rbmH-vSrZUPzZ_10/s640/090822_Chinese_Holdings_Treasuries.jpg" width="640" /></span></span></a></div><div class="separator" style="clear: both; text-align: center;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">Source: Brad Setser, Council on Foreign Relations</span></span></div><div class="separator" style="clear: both; text-align: center;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><br />
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</span></span> </div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">Western consumers felt comfortable spending more than they earned so long as their assets, in the form of homes and stock portfolios, were growing faster than their liabilities. Why should one save an extra $5,000 per year when the savings are dwarfed by the increase in the value of one’s home? If the value of one’s assets are increasing by $20,000 per year, why not spend the extra $5,000 on a vacation? Better yet, why not borrow $10,000 against the $20,000 increase in the value of the home to finance a down-payment on a car lease?</span></span></div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><span style="letter-spacing: 0px;"></span><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px;"><span style="letter-spacing: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">Homeowners extracted record amounts of equity from their homes over the past few years to finance lifestyles beyond their means. Thirty years ago, those Americans with mortgages owned 50% of the equity in their houses. Now they own less than 20%. At the peak in 2005, home equity withdrawals directly financed almost 10% of GDP! For many people, their home is their principal asset, and they relied on constant appreciation in the price of this asset to fund their retirement. With U.S. home prices down 25 or more percent from their peak, a record number of homeowners now owe more on their mortgages than their house is worth. This has had a devastating impact on people’s sense of wealth and stability.</span></span></span></div><div style="font: 12px Garamond; margin: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><br />
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</span></span> </div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiTyzp_RT2QpVtzfAXkXHagTEfUfAZXU3x2Rrb8lb7S9WPoTEdrwUQfacsl2k2jdUY1glN55QUi09J-VCfAWHh6a8OMVu8WBKd_Iarx6VbGrpr8VeEJRvG8ZN17DT8-yXF0TZ7TfJHW2Xk/s1600-h/090822_MEW_%25_Disposable_Income.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><img border="0" height="448" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiTyzp_RT2QpVtzfAXkXHagTEfUfAZXU3x2Rrb8lb7S9WPoTEdrwUQfacsl2k2jdUY1glN55QUi09J-VCfAWHh6a8OMVu8WBKd_Iarx6VbGrpr8VeEJRvG8ZN17DT8-yXF0TZ7TfJHW2Xk/s640/090822_MEW_%25_Disposable_Income.jpg" width="640" /></span></span></a></div><div class="separator" style="clear: both; text-align: center;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">Click image for a larger version.</span></span></div><div class="separator" style="clear: both; text-align: center;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><br />
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</span></span> <a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiCAdYt4-3wLzkcpOs1jpqYMLZREWN_ss0V-hWoUS1uF5lg5Pgp4vDIYtonUAsHCUQBhWH_ROtGTL2yrrB1ly-aJ2RfGNM-hi0Iez8sPvYRTvINFWn3Us8_J3eY8pLRGW81OgnmQDEc830/s1600-h/090822_%25_Homeowners_Underwater.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><img border="0" height="420" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiCAdYt4-3wLzkcpOs1jpqYMLZREWN_ss0V-hWoUS1uF5lg5Pgp4vDIYtonUAsHCUQBhWH_ROtGTL2yrrB1ly-aJ2RfGNM-hi0Iez8sPvYRTvINFWn3Us8_J3eY8pLRGW81OgnmQDEc830/s640/090822_%25_Homeowners_Underwater.jpg" width="640" /></span></span></a></div><div class="separator" style="clear: both; text-align: center;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">Click image for larger version.</span></span></div><div style="font: 12px Garamond; margin: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><span style="letter-spacing: 0px;"></span><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">This same dynamic is at play across the globe, with property values down precipitously in many parts of Europe, the Middle-East, and Asia. Commercial properties, such as hotels, condominiums, and malls, are experiencing massive drops in value.</span></span></div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><span style="letter-spacing: 0px;"></span><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px;"><span style="letter-spacing: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">With consumers unable to increase their spending, governments around the world have stepped-in to fill the void. U.S. government deficit spending this year is a whopping 15% of GDP. Chinese spending and loan growth amounts to nearly 35% of GDP. U.K. and Japanese deficit spending is at record levels. Yet even with this record stimulus, GDP is likely to contract this year in all of the above countries save China. Put another way, government is stimulating the economy to the tune of 15% of GDP, but the economy is not growing. How much must the rest of the economy be contracting so that a 15% adrenaline shot can not kick-start growth?</span></span></span></div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><span style="letter-spacing: 0px;"></span><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px;"><span style="letter-spacing: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">It is important to recognize that deficit spending is nothing more than the government attempting to bribe its citizens with their children’s money. Deficit spending during times of economic weakness was first advocated by Keynes in the early 20th century. Keynes suggested that governments might attenuate normal boom and bust cycles in the economy by increasing spending during recessions to replace slack demand. Deficits incurred during these periods would then be paid back when the economy recovered.</span></span></span></div><div style="font: 12px Garamond; margin: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">Unfortunately, the 4 year political election cycle works against Keynes’ policy recommendations. When times are tough, politicians generally have no problem loosening the purse strings. However, when the economy is growing, politicians find reasons to cut taxes and expand programs rather than paying down deficits. Thus, Western democracies have spent over 80% of years since Keynes’ policies were first introduced incurring deficits despite the fact that the economy has been in growth mode more than 90% of the time.</span></span></div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><span style="letter-spacing: 0px;"></span><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px;"><span style="letter-spacing: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">At this point, one is likely asking, ‘So what is the solution?’ In this age of flu shots, antibiotics, high-fructose corn syrup, on-demand video, Rock-Star energy drinks, Ultimate Fighting, and 24 hour business news, it may come as a shock to discover that the answer can not be summarized in a 140 character ‘Tweet’ a la Twitter.</span></span></span></div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><span style="letter-spacing: 0px;"></span><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px;"><span style="letter-spacing: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">The inescapable truth is that the only sustainable solution to the current crisis is a prolonged period of retrenchment and slower growth around the world. Boomers will have to work longer to afford less robust retirement lifestyles. Unemployment will remain elevated for many years as producers adjust to a period of significantly lower aggregate demand. Enormous overcapacity in manufacturing and real-estate will result in low inflation and, for a while, deflation in the price of goods. People that lived beyond their means for many years will spend many years living below their level of disposable income as they use more of this income to pay off debt. Families will lose their homes and will end-up renting or living with family members. Income levels will fall across the spectrum, but incomes in the highest brackets, such as those of bankers and tort lawyers, stand to fall the most. People will travel less, camp more, golf less, and spend more time with their families. People in large cities will finally meet their neighbors, but they will gather for barbecued hot-dogs instead of Kobe strip-loins. Families may start raising their own children instead of outsourcing to day-cares and nanny services. Married children will be more likely to settle close to their parents to raise their families.</span></span></span></div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><span style="letter-spacing: 0px;"></span><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px;"><span style="letter-spacing: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">Notice that some of the above outcomes do not sound all that bad. In fact, during periods of economic retrenchment, cultures tend to get back in touch with core beliefs and values. Obesity levels and the incidence of stroke and heart-disease are reduced. Divorce is less frequent as individuals are less likely to perceive that the grass is greener elsewhere. This is bad news for ubiquitous divorce lawyers, but great news for community attachment, which in turn lowers levels of juvenile delinquency, and drug and alcohol addiction.</span></span></span></div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><span style="letter-spacing: 0px;"></span><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px;"><span style="letter-spacing: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">What does this mean for stock and bond portfolios? It almost certainly means that stock and bond prices are likely to drop substantially over the next few years once this rally runs its course in the next few weeks and months. Real return expectations must be lowered, and financial plans must be re-visited. Savings must replace portfolio growth as the means to financial independence. ‘Buy and Hold’ or, more accurately, ‘Buy and Hope’ strategies will prove disastrous for a while. Investors must position themselves to take advantage of large market swings rather than a long period of rising prices. Trading is in, investing is out.</span></span></span></div><div style="font: 12px Garamond; margin: 0px; min-height: 13px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;"><span style="letter-spacing: 0px;"></span><br />
</span></span> </div><div style="font: 12px Garamond; margin: 0px;"><span style="letter-spacing: 0px;"><span class="Apple-style-span" style="font-size: small;"><span style="font-family: Georgia,'Times New Roman',serif;">In summary, global citizens have enjoyed an almost unprecedented period of economic prosperity and peace. This period was a natural consequence of several positive trends catalyzed by post WWII euphoria. Boomers drove an innovation wave in technology, and women around the world joined the workforce to drive a wave of GDP growth and productivity from the late 1960s through the early 1990s. Once innovation and the feminist movement crested in the early 1990s, Western citizens refused to curtail extravagant lifestyles born of prior innovation waves. Like an alcoholic who drinks coffee to keep the party going, Westerners turned to debt to sustain their excessive spending habits. But coffee can only delay the hangover for so long. One can hear the sirens in the distance. And when they raid the house of ill repute, even the good girls and the piano player go to jail. </span></span></span></div>GestaltUhttp://www.blogger.com/profile/15636551868375563464noreply@blogger.comtag:blogger.com,1999:blog-8316591069902396281.post-89376955093822393282009-08-23T07:14:00.018-04:002009-09-03T10:38:46.886-04:00The Fallacy of Cash on the Sidelines<div style="text-align: center;"></div><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhZ2qOU5OoecZcNyuOPMMyKYeHIss_jWkz73d_EaeisFUQSL5MpxpzIVTLMSpg0JZQA5f_hyGQMfCWSFQkNOQ6579q0QN-ki7RtYxK_lHFXQuicJs8fKrm-sZkQldwsxvjLRKAAe-9x3v4/s1600-h/090820_PD_Liquidity.jpg" onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}"></a><br />
<div style="text-align: center;"></div><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhwTjKX-aIhtdxzEa5NvjBFPBl4UxVkVNYjAvqScTpPlAmnRP349cfe0IeKcJ42RiQkFTX62cDx6Ivqb7lDatLC-xqtSu2uAOnGfC7MzfQhdVRw_9sw-ezD8b2vPN-Tqs1jBk-12pdhqDk/s1600-h/090820_CP_and_Money_Market_Funds_annotated.jpg" onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}"></a><span style="font-family: georgia;"><span style="font-size: small;">Merrill Lynch posted the results of its most recent Survey of Fund Managers for August this morning. The survey covered 204 fund managers in 80 countries who control $554 billion in assets, and the data dispels the myth of excess cash on the sidelines.<br />
<br />
Barry Ritholtz at ritholtz.com summarized the findings. Note that U.S. markets peaked in September 2007:<br />
<br />
• Cash balances plunge to 3.5%, lowest since July'07;<br />
<br />
• Highest equity allocation (34% from 7%) since Oct'07;<br />
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• Bond allocation (-28% from -12%) lowest since April'07;<br />
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• Tech (28%) is the most favored sector everywhere.<br />
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Barry concluded, 'While I keep hearing about cash on the sidelines, the professionals seem to be "All In."'<br />
<br />
As an addendum to the Merrill Lynch survey (full release pasted below), please see the attached chart of US commercial paper and Money Market assets. The chart was originally posted by WallStreetExaminer.com using US Federal Reserve data. Annotations in red are my own.</span></span><br />
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</span><br />
<div></div><div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi73X_A8sFVNxoWW49XPXJe0HjLS_wosZYQvKQ3iMeMYMtDN15h4wFo55-rK6llQGyL_K3uR6f7WjNqjHTnetZHxHJaliuhrapVTYhpaPgXiYMaOxtSIl3uaSc0lN1V2tVoQDqC34pWUjw/s1600-h/090820_CP_and_Money_Market_Funds_annotated.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi73X_A8sFVNxoWW49XPXJe0HjLS_wosZYQvKQ3iMeMYMtDN15h4wFo55-rK6llQGyL_K3uR6f7WjNqjHTnetZHxHJaliuhrapVTYhpaPgXiYMaOxtSIl3uaSc0lN1V2tVoQDqC34pWUjw/s320/090820_CP_and_Money_Market_Funds_annotated.jpg" /></a></div><div class="separator" style="clear: both; text-align: center;"><span style="font-size: x-small;">Click image for larger version</span></div><div class="separator" style="clear: both; text-align: center;"></div><div class="separator" style="clear: both; text-align: center;"></div><div class="separator" style="clear: both; text-align: center;"></div><div class="separator" style="clear: both; text-align: center;"></div></div><div><span style="-webkit-text-decorations-in-effect: underline; color: #0000ee;"></span></div><div><div><div><span style="font-family: georgia;"><br />
</span><br />
<span style="font-family: georgia;">Conclusion: Investable Money Market fund assets are no higher than at the peak of markets in September 2007. Retail holdings of MM funds have now retraced to the levels of Sept 2007. The spike in Institutional MM assets from Sept 2007 is exactly equivalent to the drop in CP assets over the same time period, offering compelling evidence that companies have simply moved treasury working capital out of CP and into IMM funds. This is NOT parked investment capital, and is unlikely to find its way into stocks.</span><br />
<span style="font-family: georgia;"><span style="font-size: small;"> <br />
Investors appear to be exactly as fully invested as they were in September 2007, at the peak of the bull market. This dovetails nicely with the Merrill survey.<br />
<br />
That said, the Primary Dealers are swimming in reserves. Liquidity parked in Securities Open Market Accounts at Primary Dealers is also back at September 2007 levels (See PD Liquidity Chart). If the money-centre banks decided to leverage these reserves into the system, they could single-handedly push stocks, commodities and corporate bonds higher. It remains to be seen whether banks will hold these as reserves against 'Level III' assets on their balance sheets or put it to work speculating.</span></span><br />
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</span></span></div><div><div class="separator" style="clear: both; text-align: center;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgMLnYjt9NX1Up6ehItTxP4c8bFg1PguAWM77CObXzgV21RB6J5jvKtRlpCpgSeCOatRiBVXesE3cpfAs0bskQ254GQ4R4RTSJN3zqeoUGk_ZiPW-PTXv341gkyN206ds5muQp9wNkcItI/s1600-h/090820_PD_Liquidity.jpg" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgMLnYjt9NX1Up6ehItTxP4c8bFg1PguAWM77CObXzgV21RB6J5jvKtRlpCpgSeCOatRiBVXesE3cpfAs0bskQ254GQ4R4RTSJN3zqeoUGk_ZiPW-PTXv341gkyN206ds5muQp9wNkcItI/s320/090820_PD_Liquidity.jpg" /></a></div></div><div><span style="-webkit-text-decorations-in-effect: underline; color: #0000ee;"></span></div><div><div style="text-align: center;"><span style="font-family: georgia;"><span style="font-family: Times;"><span style="font-size: x-small;">Click image for larger version</span> </span></span></div></div><div><span style="font-family: georgia;"><span style="font-size: small;">Original Press Release</span></span></div><div><span style="font-family: georgia;"><span style="font-size: small;">----------------------------------------------------<br />
</span></span><a href="https://webmail.gmponline.com/owa/redir.aspx?C=e96e49d5fb96406395768645c4d69cfa&URL=http%3a%2f%2fnews.prnewswire.com%2fDisplayReleaseContent.aspx%3fACCT%3d104%26STORY%3d%2fwww%2fstory%2f08-19-2009%2f0005079889%26EDATE%3d" target="_blank"><span style="font-family: georgia;"><span style="font-size: small;">http://news.prnewswire.com/DisplayReleaseContent.aspx?ACCT=104&STORY=/www/story/08-19-2009/0005079889&EDATE=</span></span></a><span style="font-family: georgia;"><span style="font-size: small;"><br />
<br />
NEW YORK, NY UNITED STATES<br />
<br />
Questions over Imbalances in Early Stages of Recovery<br />
NEW YORK and LONDON, Aug. 19 /PRNewswire/ -- Investor optimism about the global economy has soared to its highest level in nearly six years, with portfolio managers putting their cash back into equity markets, according to the Merrill Lynch Survey of Fund Managers for August.<br />
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A net 75 percent of survey respondents believe the world economy will strengthen in the coming 12 months, the highest reading since November 2003 and up from 63 percent in July. Confidence about corporate health is at its highest since January 2004. A net 70 percent of the panel respondents expect global corporate profits to rise in the coming year, up from 51 percent last month.<br />
<br />
August's survey shows that investors are matching their sentiment with action, by putting cash to work. Average cash balances have fallen to 3.5 percent from 4.7 percent in July, their lowest level since July 2007. Equity allocations have risen sharply month-over-month with a net 34 percent of respondents overweight the asset class, up from a net 7 percent in July. Merrill Lynch's Risk and Liquidity Indicator, a measure of risk appetite, has risen to 41, the highest in two years.<br />
<br />
"Strong optimism in August represents a big turnaround from the apocalyptic bearishness of March. And yet with four out of five investors predicting below trend growth for the year ahead, a nagging lack of conviction about the durability of the recovery remains," said Michael Hartnett, chief global equities strategist at Banc of America Securities-Merrill Lynch Research. "The equity rally has been narrowly led by China and tech stocks. We have yet to see investors fully embrace cyclical regions such as Japan or Europe, or Western bank stocks."<br />
<br />
Lasting recovery requires greater balance<br />
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Global emerging markets, led by China, and technology stocks are the strongest engines behind the early recovery. Investors would rather be overweight emerging markets than any other region, and by some distance. A net 33 percent of the panel prefers to overweight emerging markets while investor consensus is to remain underweight the U.S., the eurozone, the U.K. and Japan.<br />
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Technology remains the number one sector, with 28 percent of the global panel overweight the industry. Industrials and Materials lag with global fund managers holding 11 percent and 12 percent overweight positions respectively.<br />
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Further behind are Banks. Global fund managers remain concerned about the sector, holding a 10 percent underweight position. In contrast, investors within emerging markets are positive about Banks with a net 17 percent of fund managers in the regional survey overweight bank stocks.<br />
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Some of these sectoral and regional imbalances are starting to erode, however. Global fund managers have scaled back their underweight positions in bank stocks from 20 percent in July. Industrials and Materials have recovered from underweight positions one month ago. Emerging markets are less popular than in July when 48 percent of the panel most wanted to overweight the region. And Europe is a lot less unpopular. In July, a net 30 percent of respondents wanted to underweight the eurozone. That figure has dropped to just 2 percent in August.<br />
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Improved outlook for Europe, but investors drag their feet<br />
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Within Europe, fund managers appear as excited about the outlook as their global colleagues. A net 66 percent of respondents to the regional survey expect the European economy to improve in the coming year, up from a net 34 percent in July.<br />
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The net percentage expecting earnings per share to rise nearly trebled, reaching 62 compared with a net 23 percent a month ago. Investors in the region took an overweight position in Basic Resources, a cyclical sector, and radically scaled back their overweight position in Pharmaceuticals, a defensive sector.<br />
<br />
In contrast to global respondents, those in Europe have failed to inject new money. "European growth optimism has finally caught up with other regions, but fund managers have yet to fully act on this and cash levels have actually increased and overall sector conviction is near record lows," said Patrik Schowitz, European equity strategist at Banc of America Securities-Merrill Lynch Research.<br />
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Survey of Fund Managers<br />
<br />
A total of 204 fund managers, managing a total of US$554 billion, participated in the global survey from 7 August to 12 August. A total of 177 managers, managing US$370 billion, participated in the regional surveys. The survey was conducted by Banc of America Securities - Merrill Lynch Research with the help of market research company TNS. Through its international network in more than 50 countries, TNS provides market information services in over 80 countries to national and multi-national organizations. It is ranked as the fourth-largest market information group in the world.<br />
----------------------------------------------------</span></span> </div></div></div>GestaltUhttp://www.blogger.com/profile/15636551868375563464noreply@blogger.com0tag:blogger.com,1999:blog-8316591069902396281.post-60289100325907818492009-08-22T10:31:00.009-04:002010-02-01T13:25:57.599-05:00Forever Blowing Bubbles<div style="text-align: center;"><br />
</div><div class="MsoNormal">Those tortured souls who have thus far clung faithfully to the rules of capitalism, finance and economics they learned in business school have surely been disillusioned by the markets' most recent break to new highs. Like children who have finally relinquished the corporeal reality of Santa Claus, these poor souls may be searching for new rules and theories to legitimize their discipline. After all, we can't all be technical analysts, can we? Someone has to take the first step, buy the first shares in order to break a stock to new highs and trigger the technical feeding frenzy!</div><div class="MsoNormal"><br />
</div><div class="MsoNormal">Those looking for new meaning in the markets may have already discovered the refreshing empiricism of behavioral economics to fill the theoretical void left from the now incontrovertible refutation of the efficient markets hypothesis and CAPM. Surely everyone now realizes that the only factors that impact asset prices are liquidity and sentiment. The former is measurable, though definitions vary considerably. Volume, cash on the sidelines, monetary growth and velocity, reserves held at Primary Dealers and foreign capital flows all contribute to a predictive measurement of liquidity. Sentiment is more esoteric, but can still be measured using surveys and studies of actual trader commitments. Of course, sentiment is only really predictive of market direction when it reaches extreme levels; extreme levels of bullish sentiment often signal important market tops (who is left on to buy more stock?), while extreme bearishness often signals market bottoms (who is left to sell stocks?).</div><div class="MsoNormal"><br />
</div><div class="MsoNormal">James Montier of Societe Generale is perhaps the most widely followed practitioner of behavioral finance (as opposed to researchers and theorists like Thaler, Kahneman, Tversky and Smith). A recent missive of his was particularly interesting, as it described the results of a remarkable experiment in behavioral finance that may have some bearing on the present market environment. </div><div class="MsoNormal"><br />
</div><div class="MsoNormal">From the report:</div><div class="MsoNormal"><br />
</div><div class="MsoNormal">"As the US market is now back at fair value [950 at time of writing], I've been pondering what could drive the market higher. Jeremy Grantham provides some answers in his latest missive to clients. He argues that "the greatest monetary and fiscal stimulus by far in US history" coupled with a "super colossal dose of moral hazard" could generate a stock market rally "far in excess of anything justified by…economic fundamentals". This viewpoint receives support from the latest finding from experimental economics. The evidence from this field shows that even amongst the normally well behaved 'experienced' subjects, a very large liquidity shock can reignite a bubble!"</div><div class="MsoNormal"><div style="text-align: left;"><br />
</div></div><div class="MsoNormal">Mr. Montier then goes on to describe the results of an important study involving experimental markets (in which participants trade an equity-like asset against one another in a simulation), which suggests that experience helps to prevent bubbles - but that it takes more than one experience to change behavior. Explains Montier, "The first time people play the game, they create a massive bubble (like the dot.com bubble). The second time people play the game, they create yet another bubble. However, this seems to be driven by overconfidence that this time they will get out before the top. The third time subjects encounter the game, they generally end up with prices close to fundamental value."</div><div class="MsoNormal"><br />
</div><div class="MsoNormal"><br />
</div><div class="MsoNormal"><img alt="" border="0" id="BLOGGER_PHOTO_ID_5372796849611327426" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiVidtf4wBPwvb0dKt54_qFuBz4qCDTJi5XtFVZGgQcdFnr8lZvycPeyP2Hk9W3_JtdaPiKOpMee3YRZNK4xzqESXoaDxVzGirf_-eoYuN9tG6XDdIut37Z8wtgSPXYODmWmzxo92oIhCE/s400/090821_Bubble_Charts_1&2.jpg" style="cursor: hand; cursor: pointer; display: block; height: 209px; margin: 0px auto 10px; text-align: center; width: 400px;" /></div><div class="MsoNormal"><br />
</div><div class="MsoNormal"><br />
</div><div class="MsoNormal">To reiterate, experimental results indicate that even subjects who have experienced the euphoria and losses from the creation and eventual implosion of one market bubble will almost always go on to create another bubble under similar conditions. When surveyed after the fact to explain why they made the same mistake a second time, subjects overwhelmingly indicated that they were confident they could get out ahead of the crash. When subjects realized after their second failed attempt that they were unlikely to outsmart the bubble, they finally refused to create a bubble on their third encounter with the game.</div><div class="MsoNormal"><br />
</div><div class="MsoNormal"><br />
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhst6gZDA-VsOv5Am9Xh-xbA6ytRe8tJIruFK-JO5JDq97L4thD3wIv-ezhJIGofxiRx7mJlX7OfPyrqfMjBqWFsOj9wDPnou_i00Rmh0nlrYb6ANxZ9NMdgXXi50AakjNg9GYWP94VV7s/s1600-h/090821_Bubble_Chart_Liquidity_Shock.jpg" onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}"><img alt="" border="0" id="BLOGGER_PHOTO_ID_5372797518498685842" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhst6gZDA-VsOv5Am9Xh-xbA6ytRe8tJIruFK-JO5JDq97L4thD3wIv-ezhJIGofxiRx7mJlX7OfPyrqfMjBqWFsOj9wDPnou_i00Rmh0nlrYb6ANxZ9NMdgXXi50AakjNg9GYWP94VV7s/s400/090821_Bubble_Chart_Liquidity_Shock.jpg" style="cursor: hand; cursor: pointer; display: block; height: 209px; margin: 0px auto 10px; text-align: center; width: 400px;" /></a></div><div class="MsoNormal"><br />
</div><div class="MsoNormal">Of particular interest in today's environment, the experimenters took the simulation one step further to discover whether, under the right conditions, they could cause the same experienced participants to create yet another bubble. It turns out that all it takes to re-ignite another bubble among experienced game participants is a massive liquidity injection. To wit, "new research by the godfather of experimental economics, Vernon Smith, shows that it is possible to reignite bubbles even amongst the normally staid and well behaved subjects who have played multiple bubble games. The key to this rekindling is massive liquidity creation. In fact, in his experiments Smith doubled the amount of liquidity available."</div><div class="MsoNormal">Why is this relevant to today's market situation? For starters, the Fed has essentially doubled the monetary base from $850 billion to $1.7 trillion in the past 12 months. Keep in mind that, given the leverage in the system ($~2 trillion in money supplied by the Fed supporting $56 trillion of credit), this has the potential to create a liquidity shock of epic proportions. </div><div class="MsoNormal"><br />
</div><div class="MsoNormal"><br />
</div><div class="MsoNormal"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEivheVTPbnlaPlSSfg6Pjp-9Z4ttUJ92sQt4_6dGVJGAGi0SyQCwk1LLWHSEpC1b5Xdqu7u8erTpVV5RXhfkjmIKS2QXFtodn6Dzn9JLhKrnLXNOzTGTl6YfBONpgfb0GgKjlfhIobFehs/s1600-h/090821_Monetary_Base.jpg" onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}"><img alt="" border="0" id="BLOGGER_PHOTO_ID_5372798739753835058" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEivheVTPbnlaPlSSfg6Pjp-9Z4ttUJ92sQt4_6dGVJGAGi0SyQCwk1LLWHSEpC1b5Xdqu7u8erTpVV5RXhfkjmIKS2QXFtodn6Dzn9JLhKrnLXNOzTGTl6YfBONpgfb0GgKjlfhIobFehs/s400/090821_Monetary_Base.jpg" style="cursor: hand; cursor: pointer; display: block; height: 241px; margin: 0px auto 10px; text-align: center; width: 400px;" /></a><br />
<div style="text-align: center;">Source: FRB</div><div class="MsoNormal"><br />
</div><div class="MsoNormal">However, given the stagnation in the growth of monetary aggregates (M2 and MZM), banks are not currently leveraging these new reserves. In fact, of the $850 billion added to the monetary base by the Fed, $733 billion has been re-deposited at the Fed by the money-centre banks rather than serving as reserves against new credit creation, suggesting that banks are not yet ready to initiate a new credit cycle. I have attached to charts to this email from the St. Louis Fed for illustrative purposes.</div><div class="MsoNormal"><br />
<br />
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgLLkYMogCQkj3_8Pu49vv_QKlA-tWKZWwJD6mY5WTt5IB16I3yGwt_oBWuCDAwIcmu8YLmZfokijlWVIlmVgxJMUn9V8zj1h6ztXV2ZwwwhfPN53JjcxU5xZCYRX-wdNO9EzEhNKuKBg4/s1600-h/090821_Excess_Reserves_on_Deposit.jpg" onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}"><img alt="" border="0" id="BLOGGER_PHOTO_ID_5372799172733783362" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgLLkYMogCQkj3_8Pu49vv_QKlA-tWKZWwJD6mY5WTt5IB16I3yGwt_oBWuCDAwIcmu8YLmZfokijlWVIlmVgxJMUn9V8zj1h6ztXV2ZwwwhfPN53JjcxU5xZCYRX-wdNO9EzEhNKuKBg4/s400/090821_Excess_Reserves_on_Deposit.jpg" style="cursor: hand; cursor: pointer; display: block; height: 241px; margin: 0px auto 10px; text-align: center; width: 400px;" /></a></div><div class="MsoNormal"><div style="text-align: center;">Source: FRB</div><div style="text-align: center;"><br />
</div>In conclusion, the Fed and other central banks (notably the Bank of China) have certainly done everything in their power to create the elements necessary to catalyze another asset bubble powered by a new wave of credit creation by the money-centre banks. It remains to be seen whether markets will fall for the same trick a third time. Should the Fed succeed, and new bubbles form, investors would be wise to heed the lesson learned by participants in the market simulation cited above, and beware the trap of overconfidence. Not every investor can be quick enough to avoid the inevitable burst - are your tools up to the task?</div></div>GestaltUhttp://www.blogger.com/profile/15636551868375563464noreply@blogger.comtag:blogger.com,1999:blog-8316591069902396281.post-41247272435200975782009-04-23T23:05:00.010-04:002009-08-23T07:26:10.503-04:00The Escherization of Bank Profits<span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">Yep, even more bankster chicanery.</span></span><div><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"><br /></span></span></div><div><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">We knew that many of the banks have been taking advantage of the inscrutable fair value accounting rules by channelling reductions in the market values of their outstanding debt through income statements where they show up as earnings. If the value of outstanding liabilities declines while asset values are constant (under the revised fair value accounting rules introduced a few days ago), this can be recognized as an accounting gain.</span></span></div><div><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"><br /></span></span></div><div><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">This practice allows a bank to pad earnings on the basis that the risk implicit in its outstanding credit obligations has i</span></span><span class="Apple-style-span" style="font-style: italic;"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">ncreased</span></span></span><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">, likely due to the bank's deteriorating financial position. (All things equal, as interest rate spreads on a bond increase, the price of the bond (or debt) decreases). The mind-bending implication is that, should the bank's financial situation improve, spreads on its outstanding debt will narrow and the bank will have to book a loss.</span></span></div><div><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"><br /></span></span></div><div><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">Now we discover that, not only are the banks playing strange accounting games with the value of their outstanding liabilities, but many of the banks are actually booking profits from credit insurance written against their own debt! You just can't make this stuff up!</span></span></div><div><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"><br /></span></span></div><div><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">Apparently the CDSs are subject to fair value accounting even though they will ultimately mature with no value unless the company defaults on its own debt. </span></span></div><div><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"><br /></span></span></div><div><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">Don't worry if this didn't make any sense on first pass. It is the accounting equivalent of an M. C. Escher drawing. </span></span></div><div><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"><br /></span></span></div><div><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"><br /></span></span><a href="http://upload.wikimedia.org/wikipedia/en/thumb/6/66/Ascending_and_Descending.jpg/300px-Ascending_and_Descending.jpg"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"><img style="cursor:pointer; cursor:hand;width: 300px; height: 398px;" src="http://upload.wikimedia.org/wikipedia/en/thumb/6/66/Ascending_and_Descending.jpg/300px-Ascending_and_Descending.jpg" border="0" alt="" /></span></span></a><div><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"><br /></span></span></div><div><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"><br /></span></span></div><div><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">******************************************************************</span></span></div><div><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"><br /></span></span><h2 style="color: black; font-weight: normal; padding-top: 0px; padding-right: 0px; padding-bottom: 0px; padding-left: 0px; margin-top: 0px; margin-right: 0px; margin-bottom: 0px; margin-left: 0px; "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">From Financial Times' Alphaville Blog:</span></span></h2><h2 style="color: black; font-weight: normal; padding-top: 0px; padding-right: 0px; padding-bottom: 0px; padding-left: 0px; margin-top: 0px; margin-right: 0px; margin-bottom: 0px; margin-left: 0px; "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"><br /></span></span></h2><h2 style="color: black; font-weight: normal; padding-top: 0px; padding-right: 0px; padding-bottom: 0px; padding-left: 0px; margin-top: 0px; margin-right: 0px; margin-bottom: 0px; margin-left: 0px; "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">Banking credit catch-22 in action?</span></span></h2><span class="byline" style="display: block; margin-bottom: 12px; margin-top: 4px; "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">Posted by </span></span><b><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">Tracy Alloway</span></span></b><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"> on Apr 22 13:56.</span></span></span><div id="thepostcontent" style="color: rgb(51, 51, 51); line-height: 135%; "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"><a href="http://upload.wikimedia.org/wikipedia/en/thumb/6/66/Ascending_and_Descending.jpg/300px-Ascending_and_Descending.jpg"></a></span></span><p style=" color: rgb(51, 51, 51); line-height: 135%; font-family:Georgia, serif;font-size:16px;"><a href="http://upload.wikimedia.org/wikipedia/en/thumb/6/66/Ascending_and_Descending.jpg/300px-Ascending_and_Descending.jpg"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">On Monday we </span></span></a><a href="http://ftalphaville.ft.com/blog/2009/04/20/54865/a-citi-fied-catch-22/"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">wrote</span></span></a><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"> about Citi's Q1 gains on credit value adjustments of its CDS.</span></span></p><p style=" color: rgb(51, 51, 51); line-height: 135%; font-family:Georgia, serif;font-size:16px;"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">We're still not sure whether this is an actual CDS position against itself. Citi's Q1</span></span><a title="Citi Q1 results (PDF)" target="_blank" href="http://www.citigroup.com/citi/fin/data/qer091.pdf?ieNocache=859" style="border-top-style: none; border-right-style: none; border-bottom-style: none; border-left-style: none; border-width: initial; border-color: initial; text-decoration: none; color: rgb(70, 128, 168); "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">statement</span></span></a><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"> has the following:</span></span></p><p style=" color: rgb(51, 51, 51); line-height: 135%; font-family:Georgia, serif;font-size:16px;"><span class="quote" style="display: block; background-color: rgb(224, 209, 190); padding-top: 12px; padding-right: 12px; padding-bottom: 12px; padding-left: 12px; margin-top: 10px; margin-right: 25px; margin-bottom: 10px; margin-left: 25px; font-style: italic; "><span><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">- A net $2.5 billion positive CVA on derivative positions, excluding monolines, mainly due to the widening of Citi's CDS spreads<br /><br />- A net $30 million positive CVA of Citi's liabilities at fair value option</span></span></span></span></p><p style=" color: rgb(51, 51, 51); line-height: 135%; font-family:Georgia, serif;font-size:16px;"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">However, we do note this bit from Morgan Stanley's recently released Q1 </span></span><a target="_blank" title="Morgan Stanley Q1 results" href="http://www.morganstanley.com/about/ir/shareholder/1q2009.pdf" style="border-top-style: none; border-right-style: none; border-bottom-style: none; border-left-style: none; border-width: initial; border-color: initial; text-decoration: none; color: rgb(70, 128, 168); "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">results</span></span></a><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">.</span></span></p><p style=" color: rgb(51, 51, 51); line-height: 135%; font-family:Georgia, serif;font-size:16px;"><span class="quote" style="display: block; background-color: rgb(224, 209, 190); padding-top: 12px; padding-right: 12px; padding-bottom: 12px; padding-left: 12px; margin-top: 10px; margin-right: 25px; margin-bottom: 10px; margin-left: 25px; font-style: italic; "><span><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">In fact, </span></span><strong><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">Morgan Stanley would have been profitable this quarter if not for the dramatic improvement in our credit spreads - which is a significant positive development, but had a near-term negative impact on our revenues.</span></span></strong></span></span></p><p style="color: rgb(51, 51, 51); line-height: 135%; "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">There's a tiny bit more detail in the footnote of on the bank's $1.69bn of Q1 net revenue in Insitutional Securities.</span></span></p><p style="color: rgb(51, 51, 51); line-height: 135%; "><span class="quote" style="display: block; background-color: rgb(224, 209, 190); padding-top: 12px; padding-right: 12px; padding-bottom: 12px; padding-left: 12px; margin-top: 10px; margin-right: 25px; margin-bottom: 10px; margin-left: 25px; font-style: italic; "><span><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">(1) Results for the quarters ended Mar 31, 2008, Dec 31, 2008 and Mar 31, 2009 include positive / (negative) revenues of $1.8 billion, $(5.7) billion and $(1.5) billion, respectively, related to the movement in Morgan Stanley's credit spreads on certain long term debt.</span></span></span></span></p><p style="color: rgb(51, 51, 51); line-height: 135%; "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">The banking </span></span><a title="FT Alphaville - A Citi-fied catch-22" href="http://ftalphaville.ft.com/blog/2009/04/20/54865/a-citi-fied-catch-22/" style="border-top-style: none; border-right-style: none; border-bottom-style: none; border-left-style: none; border-width: initial; border-color: initial; text-decoration: none; color: rgb(70, 128, 168); "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">credit catch-22</span></span></a><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"> in action? We wrote this on Monday in relation to Citi.</span></span></p><p style="color: rgb(51, 51, 51); line-height: 135%; "><span class="quote" style="display: block; background-color: rgb(224, 209, 190); padding-top: 12px; padding-right: 12px; padding-bottom: 12px; padding-left: 12px; margin-top: 10px; margin-right: 25px; margin-bottom: 10px; margin-left: 25px; font-style: italic; "><span><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">If the market thinks Citi is doing well, the bank's shares could rise, its CDS could tighten, its CVA gains could well reverse, hitting its earnings, and vice versa. If the market thinks it's doing badly, Citi's CVA gain will increase, but it could still possibly be in need of more capital.</span></span></span></span></p><p style=" color: rgb(51, 51, 51); line-height: 135%; font-family:Georgia, serif;font-size:16px;"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">Which today, turns into…</span></span></p><p style=" color: rgb(51, 51, 51); line-height: 135%; font-family:Georgia, serif;font-size:16px;"><span class="quote" style="display: block; background-color: rgb(224, 209, 190); padding-top: 12px; padding-right: 12px; padding-bottom: 12px; padding-left: 12px; margin-top: 10px; margin-right: 25px; margin-bottom: 10px; margin-left: 25px; font-style: italic; "><span><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">If the market thinks Morgan Stanley is doing well, the bank's shares could rise, its CDS could tighten, its CVA gains could well reverse, hitting its earnings…</span></span></span></span></p><p style=" color: rgb(51, 51, 51); line-height: 135%; font-family:Georgia, serif;font-size:16px;"><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">This is something of a problem for financials and should serve to highlight the ephemeral nature of certain bank profits in general.</span></span></p><p face="Georgia, serif" size="16px" style=" color: rgb(51, 51, 51); line-height: 135%; "><a title="Holding to Account blog" target="_blank" href="http://holdingtoaccount.blogspot.com/" style="border-top-style: none; border-right-style: none; border-bottom-style: none; border-left-style: none; border-width: initial; border-color: initial; text-decoration: none; color: rgb(70, 128, 168); "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">Holding to Account</span></span></a><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"> blogger </span></span><a target="_blank" title="Not the real Luca Pacioli" href="http://acct.tamu.edu/smith/ethics/pacioli.htm" style="border-top-style: none; border-right-style: none; border-bottom-style: none; border-left-style: none; border-width: initial; border-color: initial; text-decoration: none; color: rgb(70, 128, 168); "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">Luca Pacioli</span></span></a><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"> (H/T reader JN) for instance, also points us in the direction of 2008 CVA gains from banks including Barclays, RBS, HSBC and Bank of America, totalling at least $13bn. In his words:</span></span></p><p face="Georgia, serif" size="16px" style=" color: rgb(51, 51, 51); line-height: 135%; "><span class="quote" style="display: block; background-color: rgb(224, 209, 190); padding-top: 12px; padding-right: 12px; padding-bottom: 12px; padding-left: 12px; margin-top: 10px; margin-right: 25px; margin-bottom: 10px; margin-left: 25px; font-style: italic; "><span><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">Together with Citi, that means approximately $17.9bn will have to be charged back to bank P&Ls. Or </span></span><strong><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">put another way - in the last few months, the above banks have reported $17.9bn of profit they probably will never actually realise</span></span></strong><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"> (this is on top of the general MTM issues on illiquid assets).</span></span></span></span></p><p style="color: rgb(51, 51, 51); line-height: 135%; "><strong><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">Related links:</span></span></strong><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"><br /></span></span><a target="_blank" title="FT Alphaville on Morgan Stanley not in Q1 happy bank club" href="http://ftalphaville.ft.com/blog/2009/04/22/54991/morgan-stanley-not-in-q1-happy-bank-club/" style="border-top-style: none; border-right-style: none; border-bottom-style: none; border-left-style: none; border-width: initial; border-color: initial; text-decoration: none; color: rgb(70, 128, 168); "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">Morgan Stanley not in Q1 happy bank club</span></span></a><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"> - FT Alphaville<br /></span></span><a target="_blank" title="FT Alphaville - A Citi-fied catch-22" href="http://ftalphaville.ft.com/blog/2009/04/20/54865/a-citi-fied-catch-22/" style="border-top-style: none; border-right-style: none; border-bottom-style: none; border-left-style: none; border-width: initial; border-color: initial; text-decoration: none; color: rgb(70, 128, 168); "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">A Citified catch-22</span></span></a><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"> - FT Alphaville<br /></span></span><a title="FT Alphaville - One off gains" target="_blank" href="http://ftalphaville.ft.com/blog/Related%20links:%20Dissecting%20bank%20results%20-%20FT%20Alphaville%20The%20IBs%20of%20March%20-%20FT%20Alphaville%20The%20return%20of%20the%20IB%20capital%20call%20On%20Wells%20Fargo%20and%20banks%27%20well-being%20-%20FT%20Alphaville" style="border-top-style: none; border-right-style: none; border-bottom-style: none; border-left-style: none; border-width: initial; border-color: initial; text-decoration: none; color: rgb(70, 128, 168); "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">One off gains</span></span></a><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;"> - FT Alphaville</span></span></p></div><p class="avpostmetadata" style="color: rgb(51, 51, 51); line-height: 135%; "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">This entry was posted by Tracy Alloway on Wednesday, April 22nd, 2009 at 13:56 and is filed under </span></span><a href="http://ftalphaville.ft.com/blog/category/capital-markets/" title="View all posts in Capital markets" rel="category tag" style="border-top-style: none; border-right-style: none; border-bottom-style: none; border-left-style: none; border-width: initial; border-color: initial; text-decoration: none; color: rgb(70, 128, 168); "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">Capital markets</span></span></a><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">. Tagged with </span></span><a href="http://technorati.com/tag/accounting" rel="tag" style="border-top-style: none; border-right-style: none; border-bottom-style: none; border-left-style: none; border-width: initial; border-color: initial; text-decoration: none; color: rgb(70, 128, 168); "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">accounting</span></span></a><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">, </span></span><a href="http://technorati.com/tag/Banks" rel="tag" style="border-top-style: none; border-right-style: none; border-bottom-style: none; border-left-style: none; border-width: initial; border-color: initial; text-decoration: none; color: rgb(70, 128, 168); "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">Banks</span></span></a><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">, </span></span><a href="http://technorati.com/tag/CDS" rel="tag" style="border-top-style: none; border-right-style: none; border-bottom-style: none; border-left-style: none; border-width: initial; border-color: initial; text-decoration: none; color: rgb(70, 128, 168); "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">CDS</span></span></a><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">, </span></span><a href="http://technorati.com/tag/citi" rel="tag" style="border-top-style: none; border-right-style: none; border-bottom-style: none; border-left-style: none; border-width: initial; border-color: initial; text-decoration: none; color: rgb(70, 128, 168); "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">citi</span></span></a><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">, </span></span><a href="http://technorati.com/tag/morgan+stanley" rel="tag" style="border-top-style: none; border-right-style: none; border-bottom-style: none; border-left-style: none; border-width: initial; border-color: initial; text-decoration: none; color: rgb(70, 128, 168); "><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">morgan stanley</span></span></a><span class="Apple-style-span" style="font-family:georgia;"><span class="Apple-style-span" style="font-size: small;">.</span></span></p><p></p></div></div>GestaltUhttp://www.blogger.com/profile/15636551868375563464noreply@blogger.comtag:blogger.com,1999:blog-8316591069902396281.post-73182362927193014482009-03-15T10:15:00.002-04:002009-03-15T11:06:48.879-04:00The Looting of America's CoffersI am increasingly convinced that the looting of fiscal coffers by the international transactional class is one of the great defining issues of our time. I have observed this phenomenon with increasing frustration since the Bear Stearns intervention in early 2008. This type of looting is not new, of course.<br /><br />We have become a society of looters. The transactional classes feel it is their noble right to perpetuate their status by looting the productive classes. This occurs in three ways:<br /><br />1. The transfer of tax revenues to entities whose only productive effort is lobbying. This is nothing more than a form of graft and is the enemy of democratic society.<br /><br />2. The incursion of sovereign debt, which is a tax on the productivity of future generations, in order to offset the natural loss in wealth of the current transactional classes as a result of capitalistic attrition. This looting occurs via 'bail-outs'. Whenever you hear the term 'bail-out' remember that this is a synonym for 'looting'.<br /><br />3. The continuous creation of fiat money, which dilutes the purchasing power of savers via the hidden tax of inflation. The transactional classes protect themselves from this tax via the ownership of 'assets', the prices of which increase at a rate that exceeds the rate of inflation. It is the fear of asset price deflation that the transactional class fears most of all, and this fear is the motivation for looting.<br /><br />Importantly, the transactional class is distinguished from the productive class in that the transactional class receives income from capital while the productive class receives income from productivity. Note that those who profit disproportionately from the productivity of others, such as a large fraction of corporate CEOs and other executives are also members of the transactional class, and are by definition 'looters'.<br /><br />The <a href="http://www.bloomberg.com/apps/news?pid=20601087&sid=aNHPv4JMlcCo&refer=home">recent announcement</a> of $165 million in bonuses set aside for payment to executives of AIG provides the perfect example of a transfer of wealth from the productive class (taxpayers) to the transactional class (looters). AIG’s fourth-quarter loss of $61.7 billion was the biggest ever recorded for any U.S. company, and taxpayers are on the hook for several hundred billion dollars in 'bail-outs' to AIG.<br /><a href="http://www.nytimes.com/2009/03/11/business/economy/11leonhardt.html?_r=1&pagewanted=print"><blockquote></blockquote>The Looting of America’s Coffers</a><br /><br />By DAVID LEONHARDT<br />Sixteen years ago, two economists published a research paper with a delightfully simple title: “Looting.”<br /><br />The economists were George Akerlof, who would later win a Nobel Prize, and Paul Romer, the renowned expert on economic growth. In the paper, they argued that several financial crises in the 1980s, like the Texas real estate bust, had been the result of private investors taking advantage of the government. The investors had borrowed huge amounts of money, made big profits when times were good and then left the government holding the bag for their eventual (and predictable) losses.<br /><br />In a word, the investors looted. Someone trying to make an honest profit, Professors Akerlof and Romer said, would have operated in a completely different manner. The investors displayed a “total disregard for even the most basic principles of lending,” failing to verify standard information about their borrowers or, in some cases, even to ask for that information.<br /><br />The investors “acted as if future losses were somebody else’s problem,” the economists wrote. “They were right.”<br /><br />On Tuesday morning in Washington, Ben Bernanke, the Federal Reserve chairman, gave a speech that read like a sad coda to the “Looting” paper. Because the government is unwilling to let big, interconnected financial firms fail — and because people at those firms knew it — they engaged in what Mr. Bernanke called “excessive risk-taking.” To prevent such problems in the future, he called for tougher regulation.<br /><br />Now, it would have been nice if the Fed had shown some of this regulatory zeal before the worst financial crisis since the Great Depression. But that day has passed. So people are rightly starting to think about building a new, less vulnerable financial system.<br /><br />And “Looting” provides a really useful framework. The paper’s message is that the promise of government bailouts isn’t merely one aspect of the problem. It is the core problem.<br /><br />Promised bailouts mean that anyone lending money to Wall Street — ranging from small-time savers like you and me to the Chinese government — doesn’t have to worry about losing that money. The United States Treasury (which, in the end, is also you and me) will cover the losses. In fact, it has to cover the losses, to prevent a cascade of worldwide losses and panic that would make today’s crisis look tame.<br /><br />But the knowledge among lenders that their money will ultimately be returned, no matter what, clearly brings a terrible downside. It keeps the lenders from asking tough questions about how their money is being used. Looters — savings and loans and Texas developers in the 1980s; the American International Group, Citigroup, Fannie Mae and the rest in this decade — can then act as if their future losses are indeed somebody else’s problem.<br /><br />Do you remember the mea culpa that Alan Greenspan, Mr. Bernanke’s predecessor, delivered on Capitol Hill last fall? He said that he was “in a state of shocked disbelief” that “the self-interest” of Wall Street bankers hadn’t prevented this mess.<br /><br />He shouldn’t have been. The looting theory explains why his laissez-faire theory didn’t hold up. The bankers were acting in their self-interest, after all.<br /><br />The term that’s used to describe this general problem, of course, is <a href="http://www.nytimes.com/2008/03/18/business/18hazard.html">moral hazard</a>. When people are protected from the consequences of risky behavior, they behave in a pretty risky fashion. Bankers can make long-shot investments, knowing that they will keep the profits if they succeed, while the taxpayers will cover the losses.<br /><br />This form of moral hazard — when profits are privatized and losses are socialized — certainly played a role in creating the current mess. But when I spoke with Mr. Romer on Tuesday, he was careful to make a distinction between classic moral hazard and looting. It’s an important distinction.<br /><br />With moral hazard, bankers are making real wagers. If those wagers pay off, the government has no role in the transaction. With looting, the government’s involvement is crucial to the whole enterprise.<br /><br />Think about the so-called liars’ loans from recent years: like those Texas real estate loans from the 1980s, they never had a chance of paying off. Sure, they would deliver big profits for a while, so long as the bubble kept inflating. But when they inevitably imploded, the losses would overwhelm the gains. As Gretchen Morgenson has <a href="http://www.nytimes.com/2009/02/22/business/22pay.html">reported</a>, Merrill Lynch’s losses from the last two years wiped out its profits from the previous decade.<br /><br />What happened? Banks borrowed money from lenders around the world. The bankers then kept a big chunk of that money for themselves, calling it “management fees” or “performance bonuses.” Once the investments were exposed as hopeless, the lenders — ordinary savers, foreign countries, other banks, you name it — were repaid with government bailouts.<br /><br />In effect, the bankers had siphoned off this bailout money in advance, years before the government had spent it.<br /><br />I understand this chain of events sounds a bit like a conspiracy. And in some cases, it surely was. Some A.I.G. employees, to take one example, had to have understood what their credit derivative division in London was doing. But more innocent optimism probably played a role, too. The human mind has a tremendous ability to rationalize, and the possibility of making millions of dollars invites some hard-core rationalization.<br /><br />Either way, the bottom line is the same: given an incentive to loot, Wall Street did so. “If you think of the financial system as a whole,” Mr. Romer said, “it actually has an incentive to trigger the rare occasions in which tens or hundreds of billions of dollars come flowing out of the Treasury.”<br /><br />Unfortunately, we can’t very well stop the flow of that money now. The bankers have already walked away with their profits (though many more of them deserve a subpoena to a Congressional hearing room). Allowing A.I.G. to collapse, out of spite, could cause a financial shock bigger than the one that followed the collapse of Lehman Brothers. Modern economies can’t function without credit, which means the financial system needs to be bailed out.<br /><br />But the future also requires the kind of overhaul that Mr. Bernanke has begun to sketch out. Firms will have to be monitored much more seriously than they were during the Greenspan era. They can’t be allowed to shop around for the regulatory agency that least understands what they’re doing. The biggest Wall Street paydays should be held in escrow until it’s clear they weren’t based on fictional profits.<br /><br />Above all, as Mr. Romer says, the federal government needs the power and the will to take over a firm as soon as its potential losses exceed its assets. Anything short of that is an invitation to loot.<br /><br />Mr. Bernanke actually took a step in this direction on Tuesday. He said the government “needs improved tools to allow the orderly resolution of a systemically important nonbank financial firm.” In layman’s terms, he was asking for a clearer legal path to nationalization.<br /><br />At a time like this, when trust in financial markets is so scant, it may be hard to imagine that looting will ever be a problem again. But it will be. If we don’t get rid of the incentive to loot, the only question is what form the next round of looting will take.<br /><br />Mr. Akerlof and Mr. Romer finished writing their paper in the early 1990s, when the economy was still suffering a hangover from the excesses of the 1980s. But Mr. Akerlof told Mr. Romer — a skeptical Mr. Romer, as he acknowledged with a laugh on Tuesday — that the next candidate for looting already seemed to be taking shape.<br /><br />It was an obscure little market called credit derivatives.<blockquote></blockquote>GestaltUhttp://www.blogger.com/profile/15636551868375563464noreply@blogger.comtag:blogger.com,1999:blog-8316591069902396281.post-52583610905808902982009-03-15T10:05:00.002-04:002009-03-15T10:15:23.193-04:00Heads Banks Win, Tails Taxpayers LoseI know it’s not our place to have an opinion about how U.S. taxpayer dollars are spent. We may however, in the coming weeks and months, be facing similar questions about our ‘visionary’ Canadian banks as commercial property, revolving credit, and potentially residential mortgage loan provisions start eating away at tangible Canadian bank capital.<br /><br />In the meantime, if we must sit on our hands we might as well become better acquainted with what is really going on in the boardrooms and offices of Washington, New York, London, Zurich, etc.: the shameless perpetration of a “hideous public subsidy of the global transactional class, a transfer of wealth from [snip…] taxpayers to the institutional investors who hold the bonds and derivative obligations tied to zombie banks, AIG and the GSEs.” – Institutional Risk Analytics<br /><br />It is important to note that bank bondholders and shareholders have a responsibility to analyze the investments they make. They are entitled to profit from their purchase if their analysis is correct, and they should suffer the consequences if their analysis is wrong. These investors (and the management of these companies) did and would continue to benefit from these investments if the banks were making a profit. Now that the banks are in trouble, investors (and executives) seem to feel they should be able to avoid the negative consequences.<br /><br />I adamantly oppose this perspective.<br /><br />From <a href="https://webmail.gmponline.com/owa/redir.aspx?C=b9b9ba446c154d859bb456a9979bed25&URL=http%3a%2f%2fus1.institutionalriskanalytics.com%2fpub%2fIRAstory.asp%3ftag%3d347">Institutional Risk Analytics</a> (All bold, underline, and capitalization emphases are mine.)<br /><br />_____________________________________________________________________________________<br /><span style="font-size:180%;"><br /><a href="https://webmail.gmponline.com/owa/redir.aspx?C=b9b9ba446c154d859bb456a9979bed25&URL=http%3a%2f%2fus1.institutionalriskanalytics.com%2fpub%2fIRAstory.asp%3ftag%3d347">Stress Test Zombies: Not Too Big To Fail? Tough Tootsies Little Banks!</a></span><br />March 13, 2009<br /><br />There are certain professions in which the collective genius of the American people dominates the field: semiconductor design, fast food product differentiation, fire-control systems for air-to-air combat, and con artistry. That these are not, at the moment, sufficient to earn a current account surplus, is a problem being worked on, not least by the service exporters in the latter occupation.<br /><br />John Dizard<br />Financial Times<br />March 1, 2009<br /><br />Last week, we learned from Fed Chairman Ben Bernanke and Treasury Secretary Tim Geithner that Washington lacks the guts to fix the problems eating away at the US financial system, at least so far. So large are the derivative-fueled losses and so majestic the collective incompetence of the Congress, regulators and the Sell Side dealers on Wall Street in enabling these losses, that the judgment of the single party state called Washington is to simply hide the problem under an ever-widening public TARP.<br /><br />Now, in most parts of the country, a TARP is used to cover unneeded things, usually a pile of stuff nobody wants, far in the back yard. This is essentially the plan articulated by Bernanke and Geithner: Buy the bad assets, invest more capital in the zombie banks, and hope asset prices eventually recover. This is not a plan to do anything but buy time and extend losses. The scary part is that nobody else in the Obama White House seems to know enough about finance to argue the point.<br /><br />As we told the subscribers to IRA's Advisory Service, the Fed and Treasury have created a rule without reason, a ridiculous standard that only ensures the unsoundness and instability of the US financial system. Apparently, banks that fail the <a href="https://webmail.gmponline.com/owa/redir.aspx?C=b9b9ba446c154d859bb456a9979bed25&URL=http%3a%2f%2fwww.fdic.gov%2fnews%2fnews%2fpress%2f2009%2fpr09025a.pdf">Supervisory Capital Assessment Program</a> stress test <span style="font-weight: bold;">will not be broken up as required by law, but instead given more capital at taxpayer expense.</span> This is the solution to the financial crisis embraced by President Barack Obama. <span style="font-weight: bold;">There is no market discipline, no bad results for the bond holders who stupidly funded these giant derivatives-driven, risk-creation machines. </span><br /><br />Below is our best guess as to the identity of the 19 or so banks that are part of the stress test process. We hear in the community that these 19 domestic financials are the de facto "Too Big To Fail" banks, which of course means that all other banks are not part of the group. We should probably add American International Group (NYSE:AIG) and the Depository Trust and Clearing Corp, which owns a Fed member bank, to the TBTF list.<br /><br />Holding Company<br /><br />JPMORGAN CHASE & CO.<br />BANK OF AMERICA CORPORATION<br />CITIGROUP INC.<br />WELLS FARGO & COMPANY<br />MORGAN STANLEY<br />PNC FINANCIAL SERVICES GROUP<br />U.S. BANCORP<br />BANK OF NEW YORK MELLON<br />SUNTRUST BANKS, INC.<br />STATE STREET CORPORATION<br />GOLDMAN SACHS GROUP<br />CAPITAL ONE FINANCIAL CORPORATION<br />BB&T CORPORATION<br />REGIONS FINANCIAL CORPORATION<br />FIFTH THIRD BANCORP<br />AMERICAN EXPRESS<br />KEYCORP<br />NORTHERN TRUST CORPORATION<br />COMERICA INCORPORATED<br /><br />Notice that there are no foreign-owned banks as part of the stress test group. Note too that there are several banks on the list that are rated "F" by the IRA Bank Monitor as of year-end 2008. These negative ratings are driven both by <span style="font-weight: bold;">negative ROEs as well as above-average realized credit losses.</span><br /><br />We see two issues facing Bernanke, Geithner and the Obama Administration when it comes to the cowardly "feed the zombies" approach articulated last week. First, it is not sustainable financially and must eventually be changed because of funding constraints. And two, <span style="font-weight: bold;">the policy of subsidizing the bond holders of the largest banks is unworkable politically and must eventually also be changed to conform with domestic political reality. That's right, at some point the Obama Administration may need to choose between our foreign creditors and American voters.</span><br /><br /><span style="font-weight: bold;">The Bernanke/Geithner approach to not dealing with the financial crisis amounts to a hideous public subsidy of the global transactional class, a transfer of wealth from American taxpayers to the institutional investors who hold the bonds and derivative obligations tied to the zombie banks, AIG and the GSEs. All of these companies will require continuing cash subsidies if they are not resolved in bankruptcy.</span><br /><br />Remember that the maximum probably loss ("MPL") shown in The IRA Bank Monitor for the top US banks with assets above $10 billion, also known as Economic Capital, is a cash number representing the amount of incremental capital the banks may require to absorb the losses from a 3-4 standard deviation economic slump, such as the one we have today. If you include the subsidy required for the GSEs and AIG, <span style="font-weight: bold;">the US Treasury could face a collective funding requirement of $4 trillion through the cycle.</span> Do Ben Bernanke and Tim Geithner really believe that they can sell such a program to the Congress? To put it in perspective, the <span style="font-weight: bold;">$250 billion in the Obama Budget for additional TARP funds will not quite cover Citigroup (NYSE:C)</span>.<br /><br /><span style="font-weight: bold;">Bottom line: The policy decision articulated this week by Bernanke and Geithner represents the largest transfer of wealth in American history, yet no legislation has been passed and no meaningful debate has occurred. The biggest danger facing the markets is that Ben and Tim still do not seem to have a clue what to do about the big banks -- other than to write more checks against the public trust. The conflict over this decision to pass the cost to the taxpayer, between the Fed, Treasury and the Congress, on the one hand, and the Wall Street dealer banks is staggering, yet nothing is said in the Big Media.</span><br /><br />The Fed and Treasury claim that situations like C and AIG cannot be addressed idiosyncratically, to paraphrase our friend David Kotok, but the reality is more complex. <span style="font-weight: bold;">Fact is, the Sell Side dealers have leveraged the real economy via OTC derivatives to such a degree that bailing out toxic waste sites like AIG, several large Euroland banks and the world of structured finance could cost trillions of dollars. That is the true cost of the crisis. The only issue is whether we recognize it directly, via a public resolution, or hide the costs via public subsidies and future inflation.</span><br /><br />If we wish to preserve some semblance of market discipline in the US, an alternative strategy must be found. Until somebody, somehow gets to President Obama and effectively refutes the self-serving argument of the Fed and Treasury that we can't resolve C or AIG, the cost of the zombie dance party can only grow. <span style="font-weight: bold;">The way you end the need for public subsidy is by resolving these firms via a restructuring and forcing the bond and equity holders of the bank's public parent company to absorb the cost of marking assets to market. If we establish a hard rule regarding solvency and break up rather than recapitalize zombie firms, then we have started to apply a real solution.</span><br /><br />Mark to Market Accounting<br /><br />To answer your many questions about our view on mark-to-market accounting, the damage - or adjustment - is done. We opposed the way the return to FVA was handled because it was too much driven by accounting and not enough other issues around business reporting. We need to be cognizant of not just accounting goals and rules, but also business reporting, investor relations, legal and business issues in order to assess this question.<br /><br />We like the idea of more disclosure. We just think that swings in short-term prices observed by M2M need be confirmed by time, then you begin to convince us that the observed average price over a period of time equals value and should affect assets or income.GestaltUhttp://www.blogger.com/profile/15636551868375563464noreply@blogger.comtag:blogger.com,1999:blog-8316591069902396281.post-40889391643279685882008-12-22T10:58:00.013-05:002008-12-22T12:20:01.086-05:00Corporate Bond Opportunities<span style="color: rgb(0, 0, 0);font-family:georgia;font-size:100%;" >Barrons interviewed Rob Arnott for this weekend's edition.<br /><br />From Wikipedia:<br /></span><p style="color: rgb(0, 0, 0);font-family:georgia;"><span style="font-size:100%;"><b>Robert D. Arnott</b> (born 1954) </span><span style="font-style: italic;font-size:100%;" >is an </span><span style="font-size:100%;"><a style="font-style: italic;" href="http://en.wikipedia.org/wiki/United_States" title="United States">American</a></span><span style="font-style: italic;font-size:100%;" > entrepreneur, investor, editor and writer who focuses on articles about quantitative </span><span style="font-size:100%;"><a style="font-style: italic;" href="http://en.wikipedia.org/wiki/Investing" title="Investing" class="mw-redirect">investing</a></span><span style="font-style: italic;font-size:100%;" >. He edited the </span><span style="font-size:100%;"><a style="font-style: italic;" href="http://en.wikipedia.org/wiki/CFA_Institute" title="CFA Institute">CFA Institute</a></span><span style="font-style: italic;font-size:100%;" >'s </span><span style="font-size:100%;"><i style="font-style: italic;">Financial Analysts Journal</i></span><span style="font-style: italic;font-size:100%;" >, as well as three other books on equity and </span><span style="font-size:100%;"><a style="font-style: italic;" href="http://en.wikipedia.org/wiki/Asset_allocation" title="Asset allocation">asset allocation</a></span><span style="font-style: italic;font-size:100%;" > </span><span style="font-style: italic;font-size:100%;" >management.</span><span style="font-size:100%;"><sup style="font-style: italic;" id="cite_ref-NAREIT_0-0" class="reference"><a href="http://en.wikipedia.org/wiki/Robert_D._Arnott#cite_note-NAREIT-0" title=""><span>[</span>1<span>]</span></a></sup></span></p> <p style="font-style: italic; color: rgb(0, 0, 0);font-family:georgia;"><span style="font-size:100%;">Arnott has also served as a Visiting Professor of Finance at the <a href="http://en.wikipedia.org/wiki/UCLA_Anderson_School_of_Management" title="UCLA Anderson School of Management">UCLA Anderson School of Management</a>, on the editorial board of the <a href="http://en.wikipedia.org/w/index.php?title=Journal_of_Portfolio_Management&action=edit&redlink=1" class="new" title="Journal of Portfolio Management (page does not exist)">Journal of Portfolio Management</a>, the product advisory board of the <a href="http://en.wikipedia.org/wiki/Chicago_Mercantile_Exchange" title="Chicago Mercantile Exchange">Chicago Mercantile Exchange</a>, and the <a href="http://en.wikipedia.org/wiki/Chicago_Board_Options_Exchange" title="Chicago Board Options Exchange">Chicago Board Options Exchange</a>.<sup id="cite_ref-NAREIT_0-1" class="reference"><a href="http://en.wikipedia.org/wiki/Robert_D._Arnott#cite_note-NAREIT-0" title=""><span>[</span>1<span>]</span></a></sup> He previously served as Chairman of First Quadrant, LP, as global equity strategist at Salomon (now <a href="http://en.wikipedia.org/wiki/Salomon_Smith_Barney" title="Salomon Smith Barney" class="mw-redirect">Salomon Smith Barney</a>), president of <a href="http://en.wikipedia.org/w/index.php?title=TSA_Capital_Management&action=edit&redlink=1" class="new" title="TSA Capital Management (page does not exist)">TSA Capital Management</a><a href="http://en.wikipedia.org/w/index.php?title=TSA/Analytic&action=edit&redlink=1" class="new" title="TSA/Analytic (page does not exist)">TSA/Analytic</a>), and as vice president at the <a href="http://en.wikipedia.org/w/index.php?title=Boston_Company&action=edit&redlink=1" class="new" title="Boston Company (page does not exist)">Boston Company</a>. He graduated from the <a href="http://en.wikipedia.org/wiki/University_of_California_at_Santa_Barbara" title="University of California at Santa Barbara" class="mw-redirect">University of California at Santa Barbara</a> in 1977. (now </span></p><span style="color: rgb(0, 0, 0);font-family:georgia;font-size:100%;" ><br />Rob has been bearish for several years on both bonds and stocks, but he is starting to see some genuine value in risky assets. In particular, Rob expressed enthusiasm for locally priced emerging market bonds, emerging market stocks, and corporate bonds.<br /><br />Some excerpts:<i><br />------------------------------------------------------------------<br />What's your view now?</i></span> <p style="color: rgb(0, 0, 0);font-family:georgia;" origdisplay="" class="verdana"><span style="font-size:100%;">... [T]his is the richest environment of low-hanging fruit I've seen in my career. And you would have to go back to 1973, 1974 or even, in some markets, to the Great Depression to find markets priced as attractively as now. This is not a time to be hunkering down in the safety and comfort of the Treasury curve. There are tremendous opportunities right now. It is so tempting in a bear market to focus on the glass being half-empty and on how much has been lost. But the glass being half full side is largely ignored.</span></p> <p style="color: rgb(0, 0, 0);font-family:georgia;" origdisplay="" class="verdana"><span style="font-size:100%;"><i>What kind of an asset-allocation mix makes sense to you?</i></span></p> <p style="color: rgb(0, 0, 0);font-family:georgia;" origdisplay="" class="verdana"><span style="font-size:100%;">First of all, most investors think that putting some money in growth stocks, some money in value stocks and some money in international stocks is a well-diversified portfolio. It's not. Diversification means taking on risk in markets that are uncorrelated and that can go up when other markets go down. So a well-diversified portfolio should look at multiple sources of risk, not just in stocks.</span></p><p style="color: rgb(0, 0, 0);font-family:georgia;" origdisplay="" class="verdana"><span style="font-size:100%;"><i>Where do you see opportunities?</i></span></p> <p style="color: rgb(0, 0, 0);font-family:georgia;" origdisplay="" class="verdana"><span style="font-size:100%;">A year from now, investors in convertible bonds are likely to be very pleased with what they [see] in terms of prices and yields. The same holds for emerging-market debt denominated in the local currency, which I prefer to dollar-denominated debt. You get a premium yield for emerging-market debt and an additional premium for investing in the local currency. Tacitly, that's a dollar bet, but I don't see how the dollar can do well on a long-term basis when we have indebtedness that is eight times our national income. Imagine an individual going to a bank and saying, "I owe eight times my income and I would like to borrow more." The reaction would be immediate and drastic: "Give us your credit cards; we will slice them up." But as a nation we still have our credit cards, and we are still using them aggressively.</span></p><p style="color: rgb(0, 0, 0);font-family:georgia;" origdisplay="" class="verdana"><span style="font-size:100%;"><i>You don't sound like you are sold on stocks, Rob, even after this huge selloff.</i></span></p> <p style="color: rgb(0, 0, 0);font-family:georgia;" origdisplay="" class="verdana"><span style="font-size:100%;">The problem I have with stocks -- and it is a very simple problem -- is that while stocks are nicely priced, they aren't attractively priced relative to their own bonds. The savagery of September, October and November was more drastic for bonds than it was for stocks. A 40% drop in stocks is big. A 20% to 30% drop in major categories of bonds is immense. So the take-no-prisoners market actually widened the opportunities on the bond side even more than on the stock side.</span></p> <p style="color: rgb(0, 0, 0);font-family:georgia;" origdisplay="" class="verdana"><span style="font-size:100%;">Investment-grade corporate bonds are a vivid example of that. The yield spreads over stocks is averaging about six [percentage points] right now. If you can get a 3.5% yield on stocks and 9.5% on the same company's bonds, which is going to give you the higher return? The stocks will, if they show earnings and dividend growth faster than 6% -- but historically that's a stretch. So the bonds have been savaged worse than the stocks have, and actually represent the most interesting opportunity.</span></p><p style="color: rgb(0, 0, 0);font-family:georgia;" origdisplay="" class="verdana"><span style="font-size:100%;"><i>So you are talking about investment-grade bonds?</i></span></p> <p style="color: rgb(0, 0, 0);font-family:georgia;" origdisplay="" class="verdana"><span style="font-size:100%;">Yes, investment-grade bonds. But for bonds below investment grade, the spreads are quite extraordinary. By the end of November, spreads had widened out to nearly 20 percentage points above Treasuries and also above the corresponding stock yields. Suppose 40% of those bonds go bust next year. And suppose that you get 50 cents on the dollar back on the bonds that go bust. By that point, you have lost your spread of 20 percentage points.</span></p> <p style="color: rgb(0, 0, 0);font-family:georgia;" origdisplay="" class="verdana"><span style="font-size:100%;">But such a scenario has to happen every year, until the high-yield bonds mature, in order to merely match Treasury returns. A 40% default rate every year for several years would be truly without precedent. So I view 2009 as an "ABT" year -- Anything but Treasuries. The less you hold in Treasuries, the better you are likely to do.</span></p><p style="color: rgb(0, 0, 0);font-family:georgia;" origdisplay="" class="verdana"><span style="font-size:100%;">---------------------------------------------------------------</span></p><p style="color: rgb(0, 0, 0);font-family:georgia;" origdisplay="" class="verdana"><span style="font-size:100%;">Given Rob's views on corporate and emerging market bonds, and his bearish call on Treasuries, I examined the performance of these markets relative to Treasuries of equivalent duration. I used the iShares fixed income ETFs as investable proxies for these bond market sectors as follows (data as of Friday close):</span></p><ul style="color: rgb(0, 0, 0);font-family:georgia;"><li><span style="font-size:100%;">iShares Barclays 7-10 Yr Treasury Bond Fund (<a href="http://us.ishares.com/product_info/fund/overview/IEF.htm">IEF</a>: Effective Duration = 7.00)</span></li><li><span style="font-size:100%;">iShares iBoxx $ Investment Grade Corporate Bond Fund </span><span class="fund_ticker" style="font-size:100%;"> (<a href="http://us.ishares.com/product_info/fund/overview/LQD.htm">LQD</a>: ED = 7.21)</span></li><li><span class="fund_ticker" style="font-size:100%;">iShares </span><span style="font-size:100%;">JPMorgan USD Emerging Markets Bond Fund </span><span class="fund_ticker" style="font-size:100%;"> (<a href="http://us.ishares.com/product_info/fund/overview/EMB.htm">EMB</a>: ED = 6.67)</span></li><li><span class="fund_ticker" style="font-size:100%;">iShares </span><span style="font-size:100%;"> iBoxx $ High Yield Corporate Bond Fund </span><span class="fund_ticker" style="font-size:100%;"> (<a href="http://us.ishares.com/product_info/fund/overview/HYG.htm"><span style="text-decoration: underline;">HYG</span></a>: ED = 6.67)</span></li></ul><span style="color: rgb(0, 0, 0);font-family:georgia;font-size:100%;" >By utilizing the 7-10 Yr Treasury Bond ETF I can effectively neutralize interest rate risk against the other funds, as the funds all have an effective duration at or near 7. This allows the analysis to focus exclusively on spreads to Treasuries.<br /><br /><span style="font-weight: bold;">Chart 1. Emerging Market Bonds vs Treasuries (Cash yield spread = 590 bps)<br /></span><br /><a onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjYGax8DEBUgLRj9C5fPB3_k6V1ZdBKqq_TwdwV90FPkzfpuP-UIJoqPvofas32t4yxhqHn3mT-nZwh6akxuTwHblFC_JwqgkMMsgwsYrBwN-np5N_iWPNIaFG3muEjFXhyp29c6XdslqE/s1600-h/081222_EMBvsIEF.png"><img style="cursor: pointer; width: 382px; height: 400px;" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjYGax8DEBUgLRj9C5fPB3_k6V1ZdBKqq_TwdwV90FPkzfpuP-UIJoqPvofas32t4yxhqHn3mT-nZwh6akxuTwHblFC_JwqgkMMsgwsYrBwN-np5N_iWPNIaFG3muEjFXhyp29c6XdslqE/s400/081222_EMBvsIEF.png" alt="" id="BLOGGER_PHOTO_ID_5282658550006623938" border="0" /></a></span><span style="color: rgb(0, 0, 0);font-size:100%;" ><br /><br /></span><span style="color: rgb(0, 0, 0); font-weight: bold;font-family:georgia;font-size:100%;" >Chart 2. High Grade Bonds versus Treasuries</span><span style="color: rgb(0, 0, 0); font-weight: bold;font-size:100%;" ><span style="font-family:georgia;"> </span></span><span style="color: rgb(0, 0, 0); font-weight: bold;font-family:georgia;font-size:100%;" >(Cash yield spread = 417 bps)</span><span style="color: rgb(0, 0, 0);font-size:100%;" ><br /><br /><a style="font-family: georgia;" onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEigbTjBPIuRWTsZp4Pbb0ssoiqZS4Gi9CDA2p2JcfFDOb96JD2sDaYrnNiSw_DW4ALBWVoJjj9tgn8KrIJoKy7yTQGYtb7oEAXkBH2R5MjWl-1RRIKNYVsGL_iSg6PcfZbH8wDksqZfL5Y/s1600-h/081222_LQDvsIEF.png"><img style="cursor: pointer; width: 382px; height: 400px;" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEigbTjBPIuRWTsZp4Pbb0ssoiqZS4Gi9CDA2p2JcfFDOb96JD2sDaYrnNiSw_DW4ALBWVoJjj9tgn8KrIJoKy7yTQGYtb7oEAXkBH2R5MjWl-1RRIKNYVsGL_iSg6PcfZbH8wDksqZfL5Y/s400/081222_LQDvsIEF.png" alt="" id="BLOGGER_PHOTO_ID_5282659767510616498" border="0" /></a><br /><br /></span><span style="color: rgb(0, 0, 0); font-weight: bold;font-family:georgia;font-size:100%;" >Chart 3. High Yield Bonds versus Treasuries (Cash yield spread = 1504 bps)</span><span style="color: rgb(0, 0, 0);font-size:100%;" ><br /><br /><a style="font-family: georgia;" onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEja-52zJwDTAYIVj4wAXkrQn2eC7QYvozUfPlM5gHwCbzLmrksOHxMyXHf8OBzyHToirG56WbM7BXJkZqVcsvegyihQQoDhMAXyLNcpLvg-Ca1qzwa5Ro2Wqv9KR0K9qHXoxIvZ5_P3fOg/s1600-h/081222_HYGvsIEF.png"><img style="cursor: pointer; width: 382px; height: 400px;" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEja-52zJwDTAYIVj4wAXkrQn2eC7QYvozUfPlM5gHwCbzLmrksOHxMyXHf8OBzyHToirG56WbM7BXJkZqVcsvegyihQQoDhMAXyLNcpLvg-Ca1qzwa5Ro2Wqv9KR0K9qHXoxIvZ5_P3fOg/s400/081222_HYGvsIEF.png" alt="" id="BLOGGER_PHOTO_ID_5282660259561392626" border="0" /></a><br /><br /><span style="font-family:georgia;"><br />Bonds are effectively pricing in the Depression scenario; in order for Treasury yields to continue to decline, and spreads to continue to widen from these levels, the perception of default risk would have to increase beyond the levels of defaults and recoveries actually experienced in either the 30s, the 70s or the 80s by a substantial margin.<br /></span><br /><span style="font-family:georgia;">Although this is a risk, I view it as a small risk that is easily hedged against this trade by utilizing far out of the money put options on the S&P 500 and/or the emerging markets stock ETF (EEM). Even incorporating the premiums for the purchase of these options, the trade still represents a significant positive carry and a high reward to risk ratio.<br /></span><br /><span style="font-family:georgia;">Thus I envision a short Treasury ETF / long credit and emerging market bonds ETF trade to focus on the propensity of yield spreads over Treasuries to narrow over the coming weeks and months. This trade has effectively no interest rate risk as the durations of the ETFs in question all approximate 7.</span><br /><br /></span>GestaltUhttp://www.blogger.com/profile/15636551868375563464noreply@blogger.com0tag:blogger.com,1999:blog-8316591069902396281.post-55822950774562021842008-12-21T08:41:00.012-05:002010-02-01T13:28:42.542-05:00Prudent Capitalism - China Style<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj2QL5fVA5OJk3aSyZgzRRAHUV9wsV9oQ8dlb-5rbfDvcp-Np1SVy0qhPyllAougJuyhFR9CO61GJaB5US51pwdqlxUdo8FNaGzchiInts5Ae1mOWvNCx-loHWjcWwp-FHfYB2pD-gCFO4/s1600-h/081221_FXIvsSPY.png" onblur="try {parent.deselectBloggerImageGracefully();} catch(e) {}" style="color: black;"><img alt="" border="0" id="BLOGGER_PHOTO_ID_5282255518099399586" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj2QL5fVA5OJk3aSyZgzRRAHUV9wsV9oQ8dlb-5rbfDvcp-Np1SVy0qhPyllAougJuyhFR9CO61GJaB5US51pwdqlxUdo8FNaGzchiInts5Ae1mOWvNCx-loHWjcWwp-FHfYB2pD-gCFO4/s320/081221_FXIvsSPY.png" style="cursor: pointer; float: left; height: 320px; margin: 0pt 10px 10px 0pt; width: 306px;" /></a><span class="Apple-style-span" style="color: black; font-size: small;"></span><br />
<span class="Apple-style-span" style="color: black; font-size: small;"></span><br />
<span class="Apple-style-span" style="color: black; font-size: small;"><div><span class="Apple-style-span" style="font-family: georgia;"><span class="Apple-style-span" style="font-size: small;">China is behaving in truly Keynesian fashion by cleaning up bad</span><span class="Apple-style-span" style="font-family: Georgia;"><span class="Apple-style-span" style="font-family: georgia;"><span class="Apple-style-span" style="font-size: small;"> debts on bank balance sheets and demanding prudence and risk management during boom times while forcing banks to expand their bal</span><span class="Apple-style-span" style="font-family: Georgia;"><span class="Apple-style-span" style="font-family: georgia;"><span class="Apple-style-span" style="font-size: small;">ance sheets aggressively during more challenging times in order to move funds into the economy.</span></span></span></span></span></span></div><div><span class="Apple-style-span" style="font-family: georgia;"><span class="Apple-style-span" style="font-size: small;"><br />
Though the author of the article below takes the view that China’s actions within the banking system are inappropriate, I would assert that it is exactly this mechanism for moving funds into the economy that European and North American economies are lacking. </span></span></div><div><span class="Apple-style-span" style="font-size: small;"><br />
</span></div><div><span class="Apple-style-span" style="font-family: georgia;"><span class="Apple-style-span" style="font-size: small;">It is also why China is likely to lead us out of this global slump. Chinese shares have been demonstrating consistent relative strength since </span></span><br />
<span class="Apple-style-span" style="font-family: georgia;"><span class="Apple-style-span" style="font-size: small;">mid-October. Shares in Shanghai and equivalent H-Shares in Hong Kong are making higher highs and higher lows, and they are holding above both short- and longer-term moving averages.</span></span></div><div><span class="Apple-style-span" style="font-size: small;"><br />
</span></div><img alt="" border="0" id="BLOGGER_PHOTO_ID_5282366983740264770" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhQ7y63jXmY2YDWyIYTjA5Wqi7hWUfiRlCxv0_65lT0zJ9x-1Ss0Uu7me-bx01EkyqZ1ovLAjjbGs7-pn6hyTVLLqKNJEoXEuipakyKe5SuRQVN-QG3ukYpA8wOCy0F9WuP_u-WpcDtQVM/s320/081221_EWZvsSPY.png" style="cursor: pointer; float: right; height: 320px; margin: 0pt 0pt 10px 10px; width: 306px;" /><br />
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<div><span class="Apple-style-span" style="font-size: small;">Singapore, Hong Kong and Taiwan appear poised to break out to the upside on the back of the strength in Chinese shares. Brazil and South Africa also look strong and, with both the reais and the rand looking to join the Euro in a surge against the dollar, you may receive a double whammy on the ETFs.</span></div><div><span class="Apple-style-span" style="font-size: small;"><br />
</span></div><div><div><span class="Apple-style-span" style="font-size: small;">Please see the following story from Dow Jones News.<br />
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Chinese Banks' Great Leap Backward<br />
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Around the world, the banks we see today are very different from their former selves of just a few months ago. The transformation has been most pronounced in the U.S. and Europe, where a combination of mergers and government involvement have reshaped the financial sector. But change is afoot elsewhere as well, and it isn't always positive. In particular, Chinese banks are currently under enormous pressure to change their business practices in ways that represent a serious step backward.</span><br />
<span class="Apple-style-span" style="font-size: small;"> <br />
A year ago, many of us were ready to be impressed with China's banking system. To be sure, banks were still mainly state-owned, and the Chinese Communist Party continued to be omnipresent. However, the average bank managers were extremely risk conscious, and regulators from the China Banking Regulatory Commission (CBRC) swooped down on bank branches conducting surprise inspections every so often. Bankers were extremely hesitant to make uncollateralized loans to any firm except for the largest corporations.<br />
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This was an enormous change from just 10 years ago, when bankers doled out large sums at the slightest urging of the local governments and when banks were considered the "second treasury" by central policy makers. At that time, the nonperforming loan ratio was estimated to be nearly half of all loans outstanding. By January 2008, the official NPL ratio was less than 6%. This transformation wasn't cheap or easy -- it required hundreds of billions of dollars from the government to buy bad loans off bank balance sheets and recapitalize the institutions, and also the participation of Western "strategic partners" brought in to lend their expertise in best practices.<br />
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However, risk-prevention institutions built up over the past decade are now under enormous pressure to forgo prudence in the interest of maintaining economic growth. There have been two triggers for this. First, the global recession caused a plunge in demand for Chinese goods -- in November, Chinese exports fell for the first time in nearly a decade. At the same time, the property market continues to shrink in many major Chinese cities.<br />
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Anticipating a declining economy, in November the central government announced a four trillion yuan ($586 billion) stimulus package to be carried out in the next two years. At the same time, the National Development and Reform Commission was ordered to approve fixed asset investment worth 100 billion yuan before the end of the year. As of mid-December, much of the money has been doled out. This forceful injection of funds into the economy will be the dominant method of generating growth in the next two years.<br />
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Banks are trapped in the middle, because they will finance much of the stimulus package. Of the four trillion yuan stimulus, only about a quarter will be financed by the government's central budget. At a time when local governments are strapped for cash due to falling land prices (land sales are a common form of municipal cash-raising), banks are expected to finance much of the remaining three trillion yuan in the package. This isn't a matter of choice. Most banks must follow the government's lead because senior bankers are appointed by the Party.<br />
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It gets worse. Local governments have announced a further 20 trillion yuan in investment to "supplement" the central package. Assuming both Beijing and the local governments stick to these spending targets, banks will be under enormous pressure to finance trillions in state-sponsored projects in the next two years. With so much money to push out the door, risk management will almost inevitably take a back seat. Banks that had made enormous strides toward global best practices were compelled by central pressure to greatly boost credit in the last two months of this year.<br />
Prudence is not completely out the window yet because of continuation of CBRC monitoring, but risk management is increasingly a second priority. The CBRC has sent subtle signals to banks to not worry about profit too much and to exclude more risky loans to small- and medium enterprises from their main balance sheets.<br />
<br />
Partly as a result, banks are increasingly compromising between risk prevention and political pressure by boosting lending through bill financing instead of writing outright loans. In theory this limits risks because bill financing tends to be short-term and can be easily transferred to another bank. Of the 477 billion yuan of new loans made in November, half were in bill financing. The rise of bill financing may increase systemic risks in the future because banks tend to be less careful when they discount these bills due to their transferability. Loans, on the other hand, are stuck on banks' balance sheets.<br />
<br />
Meanwhile, if the economy worsens in the first quarter the government may be tempted to abandon prudent regulation altogether. Beijing could order the CBRC to disregard risk targets or even abolish the CBRC. This would plunge China back into the old days when the only risks that bankers faced were political ones.<br />
<br />
Without a global financial crisis, the global financial community might have criticized such a giant step back toward the planned economy. The criticism might have at least triggered some debate in China. However, with the rest of the world suffering a severe credit crunch that has seen free-market governments bailing out their own financial institutions, there are few people left who can credibly criticize China's actions.<br />
Western central banks have conducted operations that once were monopolized by the Chinese central bank and drew scoffs and snorts from the global banking community. For example, the People's Bank of China, the central bank, used to conduct "relending" operations to inject funds into distressed banks to pay creditors or to write off distressed assets. Now, the Federal Reserve is doing the same by buying or accepting as collateral questionable assets from banks.<br />
<br />
In any event, everyone is too preoccupied with their own losses to comment on Chinese policies. Which is a problem, not least for China itself. With enormous political pressure from the central government to pump money into the economy and silence from the rest of the world, much of the work in the past decade is being undone.<br />
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</div></div></div></span>GestaltUhttp://www.blogger.com/profile/15636551868375563464noreply@blogger.com1