As policymakers struggle in their attempt at restoring market confidence, the probability that we may be facing a protracted recession becomes more likely. A casual observation of the various interventions that have occurred to date suggest that the various institutions are near clueless as to the most effective approach in tackling the crisis. This should come as no surprise considering that the distinguishing characteristic of the current downturn, differentiating it from previous ones has to do with its multilayered nature. The first wave began with the collapse of the housing bubble, followed rapidly with a second wave in the form of a ravaging credit crunch. This in turn triggered a significant contraction in consumer spending as household wealth began to shrink (negative equity, stock market corrections, tighter lending standards). Business contraction seem to be the next wave in line as firms begin to cut production and curb capital expenditures in light of weaker demand and diminished access to credit.
What all this basically means is that to tackle this particular crisis will require a multipronged approach given that there is more than just one malaise that needs fixing. It also means that the duration of the recession is likely to lengthen considering that the various layers are unlikely to be fully resolved at the same time.
27 November, 2008
17 November, 2008
Sector rotation in action...
Although there remains a couple of weeks before year end, it is interesting to see how the various sectors have fared in such a difficult climate.
The graph above depicts the year to date performances of the various global sectors with the "World" bar measuring the capitalization weighted performance of all sectors combined.
The first striking (although clearly not surprising) observation is that none of the sectors have returned a positive performance (to date). The second would be that financials have suffered the most amongst sectors (again, not surprising considering the central role of financials in the current crisis).
Notice also the striking performance disparity between cyclical and defensive sectors. As we enter what seems to be a protracted global recession, the cyclical sectors which include commodities, information technology and luxury goods are suffering the most as they are pricing the impact of the slump whilst the defensive sectors, which include consumer staples, healthcare and utilities, have shown greater resilience to the downturn. This is somewhat reassuring in an environment where most investment concepts have gone haywire (see previous blog).
In conclusion, with hindsight of course, if one was bearish and expecting a recession at the beginning of the year, a sector rotation strategy would seem to have paid off, although we should emphasize the important caveat that one should never jump to conclusions before the period of measure (in this case one year) is through. We do, after all, live in a world of uncertainty (this year proving to be more so than ever) and so we should rightfully expect that anything can happen.
The graph above depicts the year to date performances of the various global sectors with the "World" bar measuring the capitalization weighted performance of all sectors combined.
The first striking (although clearly not surprising) observation is that none of the sectors have returned a positive performance (to date). The second would be that financials have suffered the most amongst sectors (again, not surprising considering the central role of financials in the current crisis).
Notice also the striking performance disparity between cyclical and defensive sectors. As we enter what seems to be a protracted global recession, the cyclical sectors which include commodities, information technology and luxury goods are suffering the most as they are pricing the impact of the slump whilst the defensive sectors, which include consumer staples, healthcare and utilities, have shown greater resilience to the downturn. This is somewhat reassuring in an environment where most investment concepts have gone haywire (see previous blog).
In conclusion, with hindsight of course, if one was bearish and expecting a recession at the beginning of the year, a sector rotation strategy would seem to have paid off, although we should emphasize the important caveat that one should never jump to conclusions before the period of measure (in this case one year) is through. We do, after all, live in a world of uncertainty (this year proving to be more so than ever) and so we should rightfully expect that anything can happen.
13 November, 2008
Shaken to the core...
As we approach the end of what is shaping out to be one of the most disastrous years in financial market history, challenging even the most fundamental concepts of modern portfolio theory, we are left to ponder if the industry will have to reinvent itself.
Fundamental concepts and measures such as Value at Risk (VAR), standard deviation, the normal distribution, correlation or even diversification are being questioned in light of the way this crisis has unfolded.
For example the foundation of modern portfolio theory lies on the premise that diversification in a portfolio contributes to enhancing returns and reducing risk. Well if we apply it over the past year and a half we can firmly conclude that it has failed miserably. In fact we could argue in the case of equity markets that in certain situations, diversification has actually magnified losses. A U.S. or European investor, for example, was much worse off with exposure to emerging markets.
Related to this is the concept of correlation whereby a weaker correlation between two investments contributes to enhancing the risk/return tradeoff of a portfolio. But all this becomes hogwash or even worse when those same correlations suddenly jump up to a level close to 1.
So where does this leave us? Do we just abandon the very core foundations of modern portfolio theory and search elsewhere for answers or do we just stick to them and ride this crisis out?
History, in this case, does provide clues since it is not the first time that the core concepts have been challenged like this. The main lesson we can draw from the past is that these concepts only function in normal market environments. In other words they are prone to failure when markets are either in a bubble or when they are experiencing a crash, and since a crash is arguably (arguably because they too can be exploited) the least desirable environment to be in and thankfully don’t last too long, it makes no sense to abandon these core concepts if things will eventually return to normal.
Warren Buffet recently stated that the biggest losers in this crisis are going to be those that are currently sitting on cash. That is because by the time you know that things are improving, it will be too late to do anything about it. This particular market correction has two parts to it, one related to a reversion to the mean effect (reflecting the fundamentals) and another that is emotionally driven and that tends to exaggerate things both on the downside and the upside. The first part will take time to fix as the world is entering what could become a protracted recession. The second part, however, will resolve itself as soon as all the bad news is out in the open. When that happens, however, it will be too late to do anything about it.
Fundamental concepts and measures such as Value at Risk (VAR), standard deviation, the normal distribution, correlation or even diversification are being questioned in light of the way this crisis has unfolded.
For example the foundation of modern portfolio theory lies on the premise that diversification in a portfolio contributes to enhancing returns and reducing risk. Well if we apply it over the past year and a half we can firmly conclude that it has failed miserably. In fact we could argue in the case of equity markets that in certain situations, diversification has actually magnified losses. A U.S. or European investor, for example, was much worse off with exposure to emerging markets.
Related to this is the concept of correlation whereby a weaker correlation between two investments contributes to enhancing the risk/return tradeoff of a portfolio. But all this becomes hogwash or even worse when those same correlations suddenly jump up to a level close to 1.
So where does this leave us? Do we just abandon the very core foundations of modern portfolio theory and search elsewhere for answers or do we just stick to them and ride this crisis out?
History, in this case, does provide clues since it is not the first time that the core concepts have been challenged like this. The main lesson we can draw from the past is that these concepts only function in normal market environments. In other words they are prone to failure when markets are either in a bubble or when they are experiencing a crash, and since a crash is arguably (arguably because they too can be exploited) the least desirable environment to be in and thankfully don’t last too long, it makes no sense to abandon these core concepts if things will eventually return to normal.
Warren Buffet recently stated that the biggest losers in this crisis are going to be those that are currently sitting on cash. That is because by the time you know that things are improving, it will be too late to do anything about it. This particular market correction has two parts to it, one related to a reversion to the mean effect (reflecting the fundamentals) and another that is emotionally driven and that tends to exaggerate things both on the downside and the upside. The first part will take time to fix as the world is entering what could become a protracted recession. The second part, however, will resolve itself as soon as all the bad news is out in the open. When that happens, however, it will be too late to do anything about it.
05 November, 2008
A truly historic moment...
After a long and arduous battle between two rivals with very contrasting opinions on how to run the country, Barack Obama was chosen to become the 44th president of the United States, marking the beginning of a new era in American politics. By electing Obama, Americans have decided to turn a page in U.S. history, effectively dismantling one of the remaining barriers of the racial divide. They have also joined the world chorus in demanding a radical change in policies after 8 years of republican rule, wrought with strategic blunders both at the home front and abroad.
Obama undoubtedly faces formidable challenges in the form of a severe economic crisis, serious geopolitical issues and a significantly tarnished image abroad, to name a few. They won't be easy to fix but if his track record is any indication, we may be in for some pleasant surprises!
In any case we congratulate him for his election and wish him the very best of luck as the next president of the United States.
Obama undoubtedly faces formidable challenges in the form of a severe economic crisis, serious geopolitical issues and a significantly tarnished image abroad, to name a few. They won't be easy to fix but if his track record is any indication, we may be in for some pleasant surprises!
In any case we congratulate him for his election and wish him the very best of luck as the next president of the United States.
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