Product and Strategy Notes: "The $100 Billion Question" by Andrew Haldane; Confirmation of Diversification in Portfolios; Growing Concerns of Credit Quality; Inflation Risk and the Inflation Risk Premium; Windham Capital's Mark Kritzman - Principla Components as a Measure of Systemic Risk; Timber; and Algorithmic Trading Programs - the Crash

If you are looking for just one paper to read to understand the arguments behind different approaches to fixing the global financial system, read Andrew Haldane's new paper: "The $100 Billion Question." It is outstanding -- incisive, and not loaded up with fancy equations and Greek notation. It is a paper that advisors can send to their more sophisticated clients who are interested in this issue.
Since the 2007/2008 crisis, much has been written about whether diversification works. In the past, we have noted our conclusion that it does, and the fault lies not with the theory but rather with the models that were used to implement it. Specifically, we are strong believers in the value of regime switching models. Another paper in this line of research which recently caught our eye was "Is the Potential for International Diversification Disappearing?" by Christofferson, Errunza, Jacobs and Jin. They compare returns on emerging and developed market equities between 1973 and 2009, and find that, under a normal regime correlations both within these two asset classes and between them have been increasing (which is what you would expect, given globalization, and in contrast to the recently popularized "decoupling" theory). However, the authors also highlight that this upward trend in correlations has not been the case during extreme market events ("tail events"). They conclude that "the diversification benefits from adding emerging markets to a portfolio still appear to be significant."
With growing concerns about the credit quality of sovereign debt, Giesecke, Longstaff, Schaefer, and Strebulaev have published an excellent paper new paper: "Corporate Bond Default Risk: A 150 Year Perspective." They find that between 1866 and 2008, the corporate bond market "has repeatedly suffered clustered default events much worse than those experienced during the Great Depression" and that "default events are only weakly correlated with economic downturns." In addition, "over the long term, credit spreads have averaged 153 basis points over the sample period, about twice the estimate default rate. This yields a realized premium of about 80 basis points for bearing default risk over the 1866 -- 2008 period." They also note that there is "little or no evidence that credit spreads respond to current or lagged default rates...which supports the view that they are driven largely by factors such as illiquidity."
We have previously summarized the findings of an IMF working paper, "Inflation Hedging for Long Term Investors" by Attie and Roach (May, 2009 issue). A new paper has substantially confirmed their findings. In "Inflation Risk and the Inflation Risk Premium", Bekaert and Wang find that foreign bonds and gold both provide some degree of hedging against unexpected inflation and do a better job than commercial property. However, none of these asset classes provide as good of a hedge as inflation indexed (real return) bonds. They also find that, for nominal return bonds, "the inflation risk premium is sizeable and substantially varies over time."
As regular readers know, we are strong admirers of the folks at Windham Capital, who we regard as among the leading global thinkers on asset allocation. Mark Kritzman, the chairman of the firm, has just published an interesting new paper, along with co-authors Yuanzhen Li, Sebastien Page, and Roberto Rigobon. In "Principla Components as a Measure of Systemic Risk", the authors explore a subject near and dear to our hearts -- the early identification of periods of heighted financial market fragility, when the probability of extreme market moves is highest. The essence of their approach is the association of heightened fragility with periods during which a fixed number of principal components explain the highest proportion of the change in equity market returns. They conclude that it is not the case that "a spike in the absorption ration [the metric they use to summarize the results of their principal components analysis] reliably leads to a significant drawdown in stock prices. In many instances, stocks performed well following a spike in the absorption ratio...On average, however, significant increases in the absorption ratio are followed by significant market losses, while significant decreases in the absorption ratio are followed by significant gains...We would be correct to conclude though, that a spike in the absorption ratio is a near necessary condition for a significant drawdown, just no a sufficient condition. Again, a high absorption ratio is an indication of market fragility." Going forward, we will begin to use this approach to track asset class fragility, in parallel with the approach we already publish each month in our Investor Herding Risk Analysis. If the Windham methodology proves to be insightful at the asset class level, we will begin to regularly publish our results.
We are always on the lookout for good articles about the asset classes we use in our model portfolios. Two pieces about timber recently caught our eye. In "Wealth Investors Discover Timberland", (The Wall Street Journal, 1May10), Jeff Opdyke presents a good summary of timber investing issues, and concludes that "for small investors keen on buying timberland now, the best option might be a timber real-estate investment trust, such as Potlatch, Plum Creek Timber, or Rayonier." The second article was by Reuters "Forestry to Have Big Role in U.S. Carbon Plan" (7Apr10). Quoting Barclays Capital, the article notes that "domestic deals to convert bare lands into forests and keep tree stands healthy could supply 60 percent of available offsets in any U.S. cap and trade plan to limit greenhouse gas emissions."
Finally, we note the continuing investigation into just what caused the sudden crash and equally sudden recovery in US stock prices on May 6th. More and more, the investigation points to the interaction of various algorithmic trading programs as the culprit. The increase in market fragility that the deployment of these programs has created is one we have made repeatedly. Needless to say, we are very interested to see where this investigation leads.