November 2009 Issue: Key Points

We view financial markets as a complex adaptive system, in which asset prices are, in the long term, attracted to their fundamental values. Unfortunately, experience has shown that asset class prices usually revert towards their fundamental values only over relatively long periods, and do so in a volatile manner that reflects the fact that fundamental value can only be estimated with some degree of uncertainty. For investors who are pursuing goals over shorter time horizons (e.g., a portfolio manager who is compensated on annual results), analysis of fundamental valuation on its own provides insufficient information for making decisions. They also need ways to forecast short term investor behavior and its impact on asset prices. That is the subject of this month's feature article, which attempts to boil down a large amount of recent research in different areas into a useable framework for thinking about an issue that is very complex, challenging and critical. We describe how collective investor behavior results from five processes. At the individual level, these include conscious and unconscious allocation of our scarce attention, and the processing of various types of information through our mental, emotional and decision models. Individual behavior is then aggregated through an evolving, non-linear process to produce collective investor behavior.

We conclude that forecasting collective investor behavior over the short-term remains a very difficult challenge. Yet it is one that investors ignore at their peril, as sharp downside moves will always be mathematically devastating to investors' ability to achieve their long-term goals. Rather like weather forecasting, identifying turning points in investor behavior requires the ability to integrate multiple indicators that measure the state of the financial markets system, and use them to draw inferences about the probability that severe storms may occur in the near future. And when that probability rises to a high enough level, it requires the willingness to buck conventional wisdom, and issue clear warnings to investors, as we did in May 2007.

With that in mind, we reiterate our belief that conditions are ripe for another sharp shift in investor behavior, that will likely have significantly negative results for asset classes (such as equity and high yield bonds) that do well in normal times, and somewhat less negative results for asset classes which hedge against high inflation (including property, commodities, and real return bonds). In contrast, asset classes which perform best under the high uncertainty regime should do well (including short term domestic and foreign government bonds, volatility and gold). With levels of uncertainty and network connectedness (see our Market Phase Change Analysis section) at high levels, and volatility displaying the signs of a system under high stress (e.g., short sharp increases in the VIX that quickly subside), we believe that professional investors who account for the majority of trading volume are engaged in a high stakes game of "beat the gun", hoping to preserve this year's gains through year end to justify high compensation, while anxiously watching for any sign that their peers have decided to liquidate their risk positions in substantial volume. In the absence of substantial improvements in the state of the political economic environment (which, if anything, seems to be worsening), we expect that failure to resolve the imbalances at the heart of this crisis (over leveraged consumers, weakened financial institutions, and unsustainable current account positions, particularly in China and the United States) will ultimately result in a substantial shock to financial markets, with very unpredictable political consequences.

This month's product and strategy notes summarize disturbing developments on the H1N1 influenza front (which further reinforce our expectation of higher levels of uncertainty in the months ahead), new research on the roles of skill and luck in corporate management (which should make one think twice about active strategies based on superior security selection), new products and interesting new research that provokes a common response: "Who knew?"

| Table: Market Implied Regime Expectations and Three Year Return Forecast | Uncorrelated Alpha Strategies Detail | Global Asset Class Returns | Table: One Year Asset Class Valuation Conclusions and Recent Momentum | Product and Strategy Notes: H1N1 Update, November 2009; Corporate Management Success: Luck Versus Skill; New Products; and Who Knew? | November 2009 Economic Update | Market Phase Change Risk Analysis | November 2009 Issue: Key Points | Feature Article: Predicting Changes in Investor Behavior | This Month's Letters to the Editor: What is Index's Perspective on Risk-based Factor Modeling? and Index Definition of Alpha and Beta | Global Asset Class Valuation Updates Detail |