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With many of our readers laboring over their year-end client letters, our first feature article this month takes an extended look at three critical questions that are probably on their minds:
We conclude that strategy - defined as the ends, ways, and means to achieve long-term goals in the face of uncertainty - in fact has an even more important role to play than in the past. However, we caution that strategy is not synonymous with planning, nor is uncertainty synonymous with risk. Consequently, while effective strategy is more important than ever, many financial services professionals may have to raise their game to deliver it to their clients in 2009. With many of those clients moving beyond their initial shock and now angrily demanding to know why they weren't warned about the ferocious crisis that hit global markets in late 2008, we reject the simplistic excuse that "nobody could see this coming" and examine in depth why so many people were taken by surprise. Our starting point is a model of the processes that drive human beings' behavior: We first allocate our scarce attention to stimuli that seem important, and then our brains then attempt to extract meaning from them while using as little of our scarce cognitive capacity as possible. In broad terms, this processing is intended to produce three outputs: (1) rational and emotional categorization of the information in light of our conscious goals and usually unconscious needs (since processing aggregated categories requires fewer cognitive resources); (2) a set of possible actions (again, to save cognitive resources, we first attempt to use previously learned "condition-action" rules); and (3) a set of expectations about the results of different possible actions (including their emotional outcome). We call the results of these processes our thoughts and feelings. In the next stage of the process, we choose which of the possible actions to execute, based on the range of internal and external, rational, emotional, and social incentives we face. And once again, this decision is not made in a wholly conscious manner (e.g., did you ever hesitate to walk down a street because you just had a "funny feeling" about it?). After we act, uncertainties are resolved, random effects occur (which together we often call "luck") and we evaluate the results of our action using one or more metrics. Sometimes these results trigger conscious or unconscious learning, most often they merely serve as new information inputs as the process enters a new cycle. Echoing findings from studies of surprise attack in the military and intelligence spheres, we find that investors were either taken by surprise, and/or failed to act on the warnings they received, because of failures at all stages of this process. Our conclusions regarding the first two questions frame our answer to the third - the range of adaptations we expect the financial services industry to make in 2009 and beyond. Suffice to say, they are many and important.
Our second feature article is an update to both our assessment of the evolving situation in the world economy and financial markets, and to our analytical methodology. We conclude that if the world pursues cooperative solutions in 2009, the damage to the world economy and investors' portfolios will be far less than if the world heads down the conflict ridden path, either by accident or because of the intentional actions of one or more parties. In the near term, we will be paying close attention to the way critical micro and macro uncertainties are being resolved. At the micro/agent based modeling level, there are two central uncertainties. The first is whether the Obama administration will be able to reduce the insecurities and confusion facing the American middle class, before they metastasize into destructive and unpredictable populist anger. The second is whether growing economic and political frustration in China reaches a tipping point where it can no longer be held in check by increased government spending and higher levels of repression. Both of these micro level issues involve a mix of cognitive and emotional changes at the individual level, and their amplification through social interaction.
At the macro level, the central uncertainties are whether potential South Asian/Middle Eastern conflicts can be held in check and whether a balance can be struck between the United States, China and the Eurozone that enables current account imbalances to reduced over time without a violent disruption of world trade and financial markets. On the first issue, the actions of India and Pakistan, and Israel and Iran, will determine whether current conflicts explode or are held in check. On the second macro issue, the evolution of events in China will be critical. This feature concludes with an assessment of the asset allocation implications of our analysis, as we prepare to enter the Chinese year of the ox, which (accurately, we hope) is characterized by prosperity through fortitude. We believe that some asset classes appear to be quite undervalued today, though we caution that valuations could go lower depending on whether our cooperative or conflict scenario unfolds. On balance, we believe that the most upside is offered by moving into inflation hedges (e.g., real return bonds, commercial property, commodities and timber), as valuations for uncertainty/deflation hedges seems quite rich while those for equities, while tempting in some cases, are still marked by high uncertainty. Finally, as we have since May 2007, we reiterate the importance we attach to maintaining an adequate level of liquid reserves.
This month's product and strategy notes also cover a lot of ground. We begin with a proposal to simultaneously reduce household mortgage burdens while creating new securities that provide investors with access to residential property as an asset class. We then review the lessons of the Madoff scandal, and highlight some examples of great writing that has been inspired by the 2008 crisis. We move on to some interesting returns data that caught our eye (who doesn't like to compare their performance to the Harvard Endowment's?), as well as some thought provoking research that was recently published. Finally, we review a number of new product introductions, including new ways to (more profitably, we hope) invest over the long-term in commodities.
| 2008 Year End Double Issue: Key Points | This Month's Letters to the Editor: Commodies: Supply, Demand and Equilibrium; Construct of DJAIG; Benefits of ENM in Model Portfolios; Liquidity Reserves; and the Purpose of our Monthly Asset Valuation Update | Global Asset Class Returns | Asset Class Valuation Update | What Will We Tell The Clients? | 2008 Year End Situation and Methodology Update | Product and Strategy Notes: How to Deal with Real Debt Burden; Why He Madoff with Their Money; Great Writing Not to be Missed; Interesting Data Returns; Thought Provoking Research; and New Products | 2007-2008 Benchmark Portfolios - All Currencies |