December 2009 Economic Update

We assume that under normal conditions, the "base case" or "policy" asset allocations employed by our readers are sufficient to achieve their long-term goals within acceptable risk limits. Given this assumption, the main threat our readers' face is a substantial downside loss that breaches these risk limits, and substantially reduces the probability they will achieve their long-term goals. The goal of our economic updates is to provide timely warning about dangerous overvaluations that could lead to such losses in one or more asset classes. Our main focus is on what is known as "strategic warning"- "the what and the why", with a lesser focus on "operational warning" - "the how". Our objective is not to provide tactical warnings - "who, when and where" - that are more commonly known as "trading tips" intended to increase short term returns.

Our economic analysis methodology is based on a technique known as "analysis of competing hypotheses", or "ACH." Human beings normally seek to collect information that supports a hypothesis. However, since a piece of information may be consistent with more than one hypothesis, this method is inefficient. In contrast, ACH focused on disproving hypotheses, and values information on this basis. For example, a piece of evidence that has a very low probability of being observed under a given hypothesis is more valuable than a piece of evidence that is consistent with multiple hypotheses.

Our economic hypotheses take the form of two alternative scenarios. When it becomes apparent that one of them is much more consistent with the accumulated evidence, we generate two new ones. Our two current scenarios are based on traditional behavior patterns for complex social systems operating in far from equilibrium conditions. The first is enhanced cooperation and the second is higher levels of conflict. Realization of the cooperative scenario should result in a higher level of stability and predictability in the system's operations, while development of the conflict scenario will prolong and quite possibly worsen the system's instability. These scenarios are described in more detail in our previous issues, which (as you go back in time), also describe the scenarios that preceded them.

We further assume that financial market returns reflect the complex interplay between political and economic conditions, which in turn reflect the actions of key groups (i.e., networks), which in turn are comprised of individuals whose behavior is based on an evolving mix of cognitive, informational, emotional and social factors. In our analysis, we use both bottom up and top down approaches to develop our scenarios and guide our search for information that provides insight about which of them is developing.

The assumptions we make in our analyses, and the conclusions we reach, are inescapably uncertain. We believe it is extremely important for the reader of any estimate or assessment to clearly understand the analyst's confidence in the conclusions he or she presents. How best to accomplish this has been the subject of an increasing amount of research (see, for example, "Communicating Uncertainty in Intelligence Analysis" by Steven Rieber; "Verbal Probability Expressions in National Intelligence Estimates" by Rachel Kesselman, "Verbal Uncertainty Expressions: Literature Review" by Marek Druzdzel, and "What Do Words of Estimative Probability Mean?" by Kristan Wheaton). In our analyses, we are standardizing on the use of a three level verbal scale to express our confidence level in our estimates. "Possible" represents a relatively low level of confidence (e.g., 25% – 33%, or a 1 in 4 to 1 in 3 chance of being right), "likely" a moderate level of confidence (e.g., 50%, or a 1 in 2 chance of being right), and "probable" a high level of confidence (e.g., 67% to 75%, or a 2 in 3 to 3 in 4 chance of being right). We do not use a quantitative scale, because we believe that would give a false sense of accuracy to judgments that are inherently approximate.

With respect to the situation we face today, we believe three critical issues must be resolved in order for the world economy to return to a period of sustained growth and relatively normal conditions in financial markets - (1) high levels of household debt across much of the Anglosphere; (2) a deeply weakened world financial system; and (3) unsustainable structural imbalances in the economies of the United States and China, and in these countries' current account balances. We further believe that the actions of three groups - middle class Americans, Chinese peasants, and Iranian youth, are linchpins that could have an outsized impact on the future evolution of political and economic events, and, through them, on the resolution of the three critical issues we face and future asset class returns.

As a hectic year winds down, recent weeks have been relatively quiet on the new developments front. In Iran, there has been renewed rioting on university campuses as protects against the Ahmadinejad regime turned violent. However, there is no sign that these protests are spreading beyond the student core, and the regime does not appear to be in imminent danger from within. That might not be the case on the external front, however, with Israel providing clear signals that its patience has run out with Iran's continued stalling in talks with the west over the future of its nuclear program. In China, while the government's recently concluded annual economic review struck all the right notes about its intended policy (e.g., increasing domestic consumption), the continuation of heavy investment in export industries and industrial capacity, as well as undervaluation of the Renminbi paint a far less reassuring picture of what lies ahead. More important, this view is gradually becoming the conventional wisdom, as evidenced by the recent publication of two excellent reports on rising Sino-American tensions: "The End of Chimerica" by Niall Ferguson and Moritz Scholarick, and Michael Pettis' "Sharing the Pain: The Global Struggle Over Savings." We strongly recommend both of them. Finally, we note that at the just opened Copenhagen climate talks, China has taken an aggressive stance vis-a-vis the U.S. and the west, demanding much higher levels of technology transfer and financing to support climate change efforts in emerging markets. At a time when these governments' financing capacity is fully dedicated (and then some) to shoring up the world financial system and maintaining aggregate demand, it is hard not to see this as further evidence that China's main intent is to press its national advantage rather than acting, as many had hoped, as a responsible supporter of the international system that has facilitated its rapid economic development over the past decade.

In the United States, the Environmental Protection Agency announced its finding that greenhouse gas emissions are dangerous to human health, setting the stage for more aggressive regulatory efforts in this area if the U.S. Congress fails to pass energy and environmental legislation. We continue to view this as a two edged sword - in the short term, more aggressive environmental regulations will raise energy costs for some and serve as a brake on economic growth. In the medium term, however, these regulations should stimulate higher levels of business investment. The Obama administration also began a campaign for a second round of stimulus spending, this time focused on job creation as high levels of unemployment, and the uncertainty created by fear of job loss continue to restrict consumer spending (and, indirectly, business investment). However, preliminary evidence also emerged that the administration's mortgage modification program was meeting with little success, while other stories noted worsening conditions in commercial property markets and, by implication, in the condition of many smaller and medium size banks with heavy exposure to construction and development loans. Credit market confidence also received additional negative shocks from Dubai's default and the downgrading of Greece's sovereign credit. Finally, there was no indication that major Wall Street banks had retreated from their plans to pay extremely large (and politically incendiary) bonuses this year, though the British government announced plans to heavily tax them. That said, criticism of the banking industry continued to mount, with Paul Volker questioning whether a decade of alleged "financial innovation" contributed anything to real economic, while GE's Jeffrey Immelt, in a speech at the U.S. Military Academy at West Point, announced his intention to shrink the size of GE Capital, stating that in recent years "rewards became perverted. The richest people made the most mistakes with the least accountability." In sum, over the past few weeks, the world seems to have continued its march toward our conflict scenario, and much more challenging and uncertain conditions in 2010. In light of this conclusion, and with substantial apparent overvaluation many equity markets, we believe that investors should reduce their equity exposures and either move to higher cash holdings (we believe that 12 - 24 months of expenses is now more prudent than the traditional recommendation of 3 - 6 months) or to increased exposure to undervalued asset classes (see our Asset Class Valuation Update for more detail).

| Overview of Our Valuation Methodology | Global Asset Class Valuation Updates Detail | Uncorrelated Alpha Strategies Detail | Global Asset Class Valuation Updates Detail | Global Asset Class Returns | Table: Market Implied Regime Expectations and Three Year Return Forecast | Feature Article: End of 2009 Review: Learning From the Past, Anticipating the Future, and Adapting Quickly in the Present | This Month's Letters to the Editor: Followup on Luck, How Does One Get Lucky?; Deloitte's Study - Skill versus Luck; Vanguard's New ETFs | Table: Fundamental Asset Class Valuation and Recent Return Momentum | Product and Strategy Notes: Four Gift Book Ideas, Muni Market Update; Commodity Futures vs. Direct Oil and Gas Investments; New Research on Alpha/Beta Allocation; and Highlights from Research Studies | December 2009 Issue: Key Points | Investor Herding Risk Analysis | A Year-End Overview of Major Asset Class Valuation Drivers and Best Regimes | December 2009 Economic Update |