Is misery back?

The misery index is an interesting economic indicator, courtesy of Arthur Okin, a famous American economist. The idea behind it was a sort of early attempt to capture or measure the misery that one would supposedly experience when the economy was not doing too well. It is basically a combination of the unemployment rate and the rate of inflation combined into a single measure. The graph above plots the misery index for the U.S. over the past four decades with the blue bar representing unemployment and the red bar the rate of inflation. From its peak levels in the 70's and early 80's (high inflation and unemployment), the misery index has been steadily dropping with the occasional short period spikes in unemployment (91-93). Inflation has been far more tamed when compared to the late 70's and early 80's. On the other hand, we note a sharp rise in the unemployment rate, according to the most up to date figures (09), a somewhat worrying observation in the context of dire economic conditions!

The impact of compounding...

Compounding (reinvesting investment gains) can have a wondrous effect on your wealth over the long term. Assume that you invest $1 million that grows by 5% annually for a period of 30 years. If everything goes according to plan, you should actually end up with a whopping $4,322,000 which over the entire period is an appreciation of 322%.

But what happens if you include fees in the equation? Assuming in the above example a 3% all in fee per annum, the final amount shrinks to $1,733,000, for a total gain of 73% over the 30 years and a startling difference of $2,589,000 when compared to the "no fee" version. If we cut the fees to 1.5% per annum, we arrive to a total of $2,746,000, for a gain over the period of 174% which brings the difference with the "no fee" version to $1,576,000.

To conclude, compounding has a substantial effect on the rate of growth of an investment. Because the effect is so significant, chipping into it also has a materially negative impact on the long term growth rate. In other words, if you wish to achieve a reasonable growth rate for your investments over the long term, it is not only important to be aware of the total amount of fees that you are paying, but also to ensure that these fees are reasonable and competitive for the services that you are obtaining.

Finally, the graph below illustrates these exact same concepts but in a more realistic setting: investing into the S&P 500 over the past 30 years. The results are no less startling!

Investing in emerging markets...

The slower economic growth prospects for both the U.S. and Europe have been prompting a growing number of investors to focus a larger share of the investment allocations to emerging markets where a healthier economic environment and sounder policies ensure that growth rates will remain above average for some time to come.

Whilst there is no denying the relative attractiveness of emerging markets at this particular point in time, there is the traditional tradeoff of greater volatility or risk in return for the expectations of higher returns.

There is, however, an additional risk factor that should not be overlooked. The price / earnings ratio (P/E) of developing markets tend to be higher than those of developed markets and right now the difference is rather important given the growing enthusiasm for emerging market investing. The graph above shows the difference in P/E ratios between the U.S. and China. Trouble with high and expanding P/E ratios is that it may be signaling bubble territory which means that there may be a real risk of a sharp correction sometime down the road.

Considering the degree of globalization and integration of economic markets across the globe, a more effective and less volatile way of investing into emerging markets may be through developed market stocks. Given their lower relative P/E ratios, longer history, corporate culture and growing exposure to emerging markets, a number of developed market firms may in fact provide a more effective manner of gaining exposure to emerging markets at a lower volatility to comparable firms in the region. Food for thought.

Rebalancing relative to market values...

Rebalancing a portfolio can be perceived as a contrarian approach to investing and rightly so because what you are effectively doing is selling the asset that is performing well and buying the one that is not. This strategy can be highly effective in a directionless market and much less so if markets are heading in one direction all the time (as they did between 2003 and 2007).
How less effective it is also depends on a number of factors, one of which is the width of the rebalancing bands that the portfolio manager has defined. If they are too narrow and therefore trigger frequent rebalancing in a directional market environment, the portfolio will be less effective in capturing positive returns than say a portfolio with more generous bands or a buy and hold strategy.
On the other hand, if the markets are directionless (i.e. trendless), a rebalancing strategy is bound to be substantially more effective than a buy and hold strategy.
When constructing a portfolio, one of the main tasks is to define the asset allocation for the various asset classes. The main building blocks of an optimal asset allocation portfolio include historical data for the asset classes, the objectives and constraints of the investor, the impact of economic policy and current market values of assets. Among these variables, only one happens to be backward looking (historical data).
Most of these variables can be plugged into an optimizer to generate an efficient frontier on which an optimal portfolio can be devised as a function of the risk/reward appetite of the investor.
Once the portfolio is fully invested, in order to preserve its "optimal" risk profile, it needs to occasionally be rebalanced . A major drawback with this traditional approach to portfolio construction is that it totally fails to take into account the collective market perception of risk. The market values of the various assets in effect reflect the collective market perception as to the riskiness of those assets. By not taking this into consideration, the portfolio manager may in effect be taking greater or less risk than what was originally planned.
As an example, following the severe stock market correction of 2008, managers that followed a stict rebalancing regimen may have inadvertently increased the risk profile of their portfolios. In other words the portfolio may be overweight stocks relative to the markets.
So what are the lessons to be drawn from all this? If we want to ensure that risk profiles are preserved more effectively, we need to somehow find ways to reflect market values in the portfolio. At a strict minimum one should keep track of the market values of the various asset classes and compare their change through time to the same asset classes in the portfolios.

Stealthy inflation...

The Fed seems to have changed its discourse of late and the markets seem to be pricing this in. Bernanke's rhetoric has shifted from coming to the rescue in the event of a slowdown to intervention even if there is no slowdown, and part of the problem may reside with an over reliance on core inflation figures, an indicator that may not be showing the full picture with regards to inflation. Over the past decade, for example, headline inflation, which includes both food and energy, remained substantially above core inflation. Had the bull period continued for a while longer, core inflation may have headed in the same direction as headline and there were already signs of this happening just before the sub prime market blew up.

The Fed's argument for relying on core figures is twofold. They not only see both food and energy as just noise but they also don't feel there is much that can be done to control them in any case. Currently both food and energy prices have been soaring which begs the question as to whether inflation may be around the corner and that it may be just a question of time before it rears its ugly head to an unprepared Fed.

Stuck in a quicksand...

Intervention is sometimes a necessary evil, particular in situations where doing nothing can risk creating a major meltdown in the financial systems. This was exactly the consequences of the "laissez-faire" approach that preceded the great depression of the 1930's. In a similar way, when the sub-prime market collapsed, it didn't take long to realize that the stakes where just too large to do nothing or very little about it. The longer term costs of maintaining the financial system on life support is manifold. For one, it will undoubtedly raise the risk of "moral hazard", particularly with regards to the "too big to fail" group and there is no real solution to this. Another risk that is more specific to the current crisis, however, is the long term negative impact on growth. The amount of liquidity injection and debt accumulation by the various government agencies across developed markets are unprecedented but what really seems to make the situation somewhat unique with respect to comparable situations in the past is that there doesn’t seem to be any effective exit strategies in sight. Confidence is low, unemployment is high, savings are virtually non-existent and leverage is still sky high. To make matters worse, most of the new debt is in relatively short term maturities (3 to 5 years) which kills any prospect of a vigorous fiscal stimulus plan taking hold.
Emerging markets that are structurally in much better shape may offer some degree of hope but this is very limited. At best we could hope for a partial decoupling from the toxicity of developed markets, it is hard to imagine anything else let alone how a market of roughly 2 trillion dollars in consumption (China and India combined) could possibly pull a market of 10 trillion dollars (U.S.) out of its current slump.
So although the latest economic figures are signalling growth, the economies of developed markets find themselves in a sort of quicksand where time is of essence. But this is quicksand and it is a delicate fine tuning balance between doing too much (fostering an environment that is conducive to organic "rotting") and not enough (raising the risks of a double dip recession). In either case, things could turn ugly.

At crossroads (again)?

Inflation? deflation? double dip? protracted recession? The directionless markets are symptomatic of a general malaise facing investors who are increasingly at a loss about how best to position their portfolios in an environment where visibility remains poor.

Pundits have been warning for a while that the long term bond rally has truly ended but bond yields have proven otherwise. They have in fact dropped to such an extent that a number of dividend paying stocks have become more attractive investments when compared to their bond counterparts.

The dangers of an uncertain environment is the risk of getting swayed by a particular strategy. Anticipating a double dip scenario, for example, may lead one to structure a more defensive portfolio that is likely to suffer if, instead, a surprise market rally kicks in. Same goes for targeting inflation/deflation strategies. If the opposite scenario materializes, the portfolio will undoubtedly suffer.
So how does one navigate the choppy seas? The most important point is to avoid getting swayed by emotions, especially when market turmoil is the norm. This can be accomplished by defining clear investment guidelines and ensuring that they are followed at all times. Asset classes should have a mid or "neutral" weight with defined bands around which one can tactically maneuver. By sticking to them, we avoid irrational behavior taking hold of our investments.
Markets move in cycles and attempting to time them can be a very dangerous endeavor. Sticking to reasonable guidelines ensures that we avoid the cyclical traps and instead concentrate the portfolio on the more important longer term secular trends that are more likely to ensure that we attain our investment goals.

The Alpha delusion

Does the systematic outperformance of fund managers relative to their benchmark over a long enough period reflect skill or luck? This is a debate that has been raging on ever since the proponents of the efficient market hypothesis entered the scene. If even the weak form of the efficient market hypothesis holds true, most of the outperformance could very well be attributed to just plain luck. The reasoning goes something like this: at a micro level, even if a gifted manager is able to identify industry trends, it is impossible to anticipate powerful random events such as unanticipated changes in government regulation or even natural events. In other words, there is a significant random component that can creep into and distort the earnings of a company.

This isn’t to say that skill doesn't play any role, it certainly does but the danger is that actual skill may be overestimated. Take the following example:
A hundred people are invited into a hall and asked to perform the simple task of flipping a coin. Those that obtain “tails” are kindly asked to leave the hall whilst the remaining persons are asked to repeat the coin flipping exercise. This experiment is continued until one person, the winner, is left. In terms of statistics, the probability of obtaining “heads” is 50%. Each draw is independent from the other, which means that the probability for each draw are not influenced by any other draw. Taking this into consideration, we can expect about 50 persons leaving the hall after the first draw, another 25 after the second and about 12 after the third etc. After about 6 draws there should remain only one person. Now if we forget about this experiment and try to visualize these results in terms of the performance of a particular fund manager, we could easily get carried away into thinking it was due to skill. As the experiment has shown us, the exceptional results could be a result of just plain old luck but the observers are totally blind to this. They are much likely to attribute the way better than average results to the manager's particular skills. That particular manager will be revered and a large amount of money will flow into the fund but if the results were more luck than skill, it will turn out to be a very bad investment.

In the midst of a deflation conundrum...

Sovereign issuer default risk scare apart, the deflationary bears are once again taking center stage as worries grow over the longer term impact of the mountainous debt that governments of the troubled economies have accumulated over a very short time span. If this actually translates into a protracted period of anemic growth, it could trigger a deflationary spiral with real consequences on an already troubled economy. The recent substantial rally in U.S. treasuries are partly symptomatic of this fear. Recall that an out of control deflation causes damage to the economy by shifting longer term expectations for both producers and consumers. As businesses face the prospect of downward spiraling prices they anticipate this by laying off a growing number of workers. Consumers feed into the frenzy by postponing consumption to a future date not only in anticipation of almost certain lower prices but also because of the growing job insecurity as unemployment inflates. All this bodes very badly for stocks which are likely to experience shrinking margins in such a scenario. Same goes for commodities that are a proxy for economic activity. Sovereign debt, on the other hand, tend to shine (which it is already doing) when deflation rears its ugly head as investors flock to it in search for greater security and income that becomes more valuable as prices take a nose dive.

What makes this downturn interesting is that we don't really know how investors are going to behave if real deflation takes hold. Will they be willing to park their hard earned cash into troubled sovereign debt which has lost its traditional "risk free" status or will they go elsewhere? I guess time will tell.

Deep in a crisis...

We are still in a crisis, it doesnt take much to figure that out but it is also most clearly evident when looking at equity market performance figures (see above). If we take the period from the end of July '07 to date, it is striking to note from the graph above that not only the broad equity market index is negative but this is also the case for all sectors (red bars) without exception! I would also add that there is a wide disparity in performances amongst the sectors and that a large number of sectors still have some way to go before they become positive again.

By far, and not surprisingly so, the largest loss comes from the financials sector that is still reeling from the 2008 blowup. It is also interesting to note that materials and energy are in better shape (relatively speaking of course) mainly as a result of the emerging market factor, information technology because of product cycles (firms are replacing their aged computers), and healthcare and consumer staples mainly because these are traditionally defensive sectors that tend to perform well when the economy is limping.

As the economy steadily improves (we expect this process to take some time), growth sectors such as consumer discretionary, IT, Telecom, Energy, Materials and maybe Financials (if they can get their act together) are likely to outperform the rest.

Paul the Oracle...

Now that the World Cup is over, there is growing intrigue on the impressive "psychic" abilities of Paul the Octopus. For those that have no clue what I am referring to, Paul happens to be an octopus that lives in a marine life center in Germany that was summoned by its owners to choose the winners for all seven matches in which the German team participated and the very last match of the World Cup in where he was asked to pick the ultimate winner of the World Cup.
Surprisingly, he was able to pick the winner in every single one of the eight events. I say surprising because from a purely probabilistic perspective, the chances of being 100% correct is pretty low.
With 8 events in total, assuming that each event is completely independent from the other, there is a total of 2^8 (2 to the power of 8) or 256 possible sequences of outcomes. The actual probability of getting it right in all 8 events is in fact 0.5^8 (0.5 to the power of 8) which comes to a total probability of 0.39%! That is incredibly low and to assume that it is purely due to chance is difficult to believe.
So...if Paul truly does have a gift, who knows what his psychic abilities could do to the business of forecasting the markets! Hedge fund managers would finally be able to claim with all honesty that their "black box" strategy is truly a black box, even to them.

Still in troubled waters...

The sheer scale of deficit for a growing number of Euro zone members makes it almost impossible for them to escape the debt trap without going through an eventual restructuring. This is despite the 750 billion Euro collateral put aside for those that may need to tap into it, which in reality serves as a temporary "band aid" to buy some additional time. The governments should not expect to be able to resolve their debt woes by simply becoming more frugal with their spending as a tightening of the belt will have the dangerous side effect of weakening consumption at a time when its needed most. In fact, it is not far fetched to think that belt tightening at this stage could trigger a protracted recession/depression. The G20 summit conclusions are therefore very worrying given that the consensus worry seems to be the risk of a surge in inflation which would mean that they are attaching less importance than would be warranted to the debt driven recession.

As the graph on Greek debt CDS spreads above shows, the problem is far from being resolved, and, in some ways may actually be getting worse.

Seeking growth...

It is hard enough to find investments that can provide capital gains, let alone on a continuous basis, as a growing base of capital continues to chase after limited resources, compressing future expected returns. Although this is an observation that can be generalized, there is growing evidence that emerging economies are in a far more attractive situation both structurally and politically. As property rights in developing nations continue to evolve, so does the wealth and sophistication of its inhabitants which reinforces the economic strength of the countries involved. The future world engine of growth or demand is increasingly coming from emerging economies, in stark contrast to the past when most if not all demand came from western nations. Probably the most damning evidence in favor of emerging markets comes from recent trends in debt to GDP. The graph above says it all, the level of debt in developed markets have exploded. If we combine this with the increasingly ageing populations of the countries involved, the future doesn't bode well at all for developed markets.

Challenging times...

Anxieties are rising as the market turmoil enters a new phase of uncertainty. The palpable market nervousness is understandable because, as blatantly observed in 2008, a sharp rise in volatility translates into a sharp rise in correlations which is the equivalent of modern portfolio theory's worst nightmare as it results in a breakdown of what would otherwise be a robust theory of how to ensure stable returns in an environment of controlled risk over the long term.

The keyword here is "long term" because, thankfully, volatility spikes tend to occur over relatively short periods of time and therefore, it is hoped, cancel out their negative impact over the longer term.

So how does the theory stack up in the real world? Our next newsletter will attempt to answer that question but, in the meantime, the intriguing graph above, known as a "radar" graph, summarizes our thoughts regarding the various asset classes. Reading it is relatively straight forward. Each point in this heptagonal shape refers to an asset class or a sub asset class. Each asset class is given a sentiment score of one to three with one being bearish, two, neutral, and three, bullish. An asset and/or sub asset class with a bearish outlook would be marked at the center of the heptagon whilst one with a bullish outlook would be marked at the outer boundary.

A pledge with teeth?

The element of surprise is what tends to move markets or break trends. Stocks, for example, move as part of market movements, the so called beta factor, but the largest movements occur when earnings results come out way above or below consensus, because the market is caught by surprise which means that the intrinsic value of the stock needs to be re-adjusted to take into consideration new information.
The European turmoil of the last couple of days illustrates well the effect of surprise. When it became clear that the half hearted rescue effort of Greece was not going to work, raising the risk of contagion by the day, the Euro zone members decided to shock the markets by pledging an astronomical 750 billion Euros on the table. This figure was so above expectations (it turns out to be even more than what the U.S. government pledged in 2008) that it had the intended effect of putting a firm stop to the hemorrhaging. The other surprising effect is that with this pledge, the member states effectively surrender a large portion of their independence, an independence that caused the crisis in the first place. So basically Europe is in unchartered waters so to speak, they are making history and it took a crisis to make it happen.
Irrespective of how the political structure is likely to evolve from here, it should be made clear that this mega rescue plan is not a fix but more like a temporary patch. A good analogy would be a deep sea diver running out of oxygen who suddenly stumbles across a discarded oxygen tank. The tank will buy the diver some precious time, but the real question should be: will the amount of additional time bought be enough for the diver to return safely back to surface?
Countries like Portugal and Spain desperately need the pledge in order to borrow at reasonable rates, with the hope being that the additional time provided will allow them to put their respective houses in order. Problem is that their houses are in such disarray that it is difficult to phantom how they will achieve this without enjoying total independence. Time will tell, but the Euro project is on shaky ground and as the rescue plan euphoria dies out and reality begins to sink in, we could be in for other and maybe more exotic surprises on the horizon.

Asset Allocation facts and fallacies

• A large number of studies using time series over differing periods demonstrate that the markets and asset allocation together have an R-squared value hovering around 0.8 (i.e. markets and asset allocation account for around 80% of the variability in returns of a portfolio comprised of asset classes), with the remaining variability explained by active management (timing, selection, tactical allocation).


• Combining asset classes with low correlation to one another improves the portfolio risk/return characteristics. Returns are more stable as the overall volatility is smoothened. Although the return calculation is the sum of the weighted returns of the constituents of the portfolio, the volatility calculation includes a correlation factor in its formula which is determined by the covariance values of the constituents.
  
• Time horizon is key when evaluating the performance of an asset allocation portfolio. The weight allocation to the various asset classes determine the risk profile of the portfolio and hence the time horizon of the investments. Evaluating performances over periods that are substantially shorter than the time horizon can be extremely misleading and damaging to performance over the longer term, as it subjects the decision making process to random noise.


• Correlations amongst asset classes can spike during periods of systemic risk (as in 2008) which can lead to a temporary breakdown in the risk/return characteristics of the underlying portfolio. It should be noted that such events tend to occur over relatively short periods as markets adjust themselves to new valuations that more closely reflect their respective intrinsic values, for example following the burst of a financial bubble.


• An asset class is defined as a group of investment instruments that share similar traits in terms of their structure and their risk and return characteristics. In order to constitute an asset class, it should be possible to calculate the intrinsic value of its members. For stocks, for example, the dividend discount model is used to calculate the present value of the expected future stream of cash flows of the company. Although commodities are typically treated as a separate asset class, it is impossible to calculate its intrinsic value as no future cash flow stream is involved. Price is determined by the forces of demand/supply.


• Diversification amongst asset classes is the only known effective method of countering the inherent randomness of markets. Although it is "future" proof, it is certainly not "fool" proof and therefore can and should be complemented by other techniques such as portfolio insurance to mitigate the sometimes ravaging effects of negative fat tails.

A "Black Swan" week...

During last week two particular events occurred that squarely belong to the "black swan" category.
Iceland's volcanic ashes spread across Europe, shutting down the airspace for most countries, leaving passengers stranded and further exacerbating the recovery of a weak and struggling airline industry. As no one was really prepared for this event and as no one really knows until when the European airspaces will remain closed (it will largely depend on the forces of nature), stocks of major airlines have taken a nose dive over the last couple of days. The repercussions could extend further into the European economy that is already struggling with a major debt crisis.
On a similar note, Friday's news that the U.S. Securities and Exchange Commission would be investigating the "venerable" Goldman Sachs for alleged fraudulent behavior led a major blow to a firm that, until then, had been boasting on its ability to boost the bottom line in any type of market condition. Again, no one was prepared, unless, of course, someone had access to insider information on the matter and decided to trade on it, which, in any case, would constitute fraud in most jurisdictions. The financial sector also took a nose dive with shares of Goldman losing close to 13% over a single day.
Although these two events are perfect examples of "black swans", I would like to emphasize that a "black swan" event can also very well be a positive one (these two examples just happen to be negative events) that would have the effect of lifting markets.
It should also be noted that positive and negative events don't carry the same weight in the human mind. According to studies on behavioral finance, a negative event can carry up to 2.5 times the impact on our psyche that a positive event would. Food for thought.

Degrees of certainty...

When facing speculators, the amount of information disclosed can make the difference between succeeding or blowing up. Take currency pegs as an example. Typically, you have two types of pegs, the "clean" type whereby a declared exchange rate is defended by the government and the more frequent "dirty" type, better known as a "dirty float" where the currency is allowed to fluctuate within a narrow band. The problem with clean pegs are that they are extremely difficult to defend because there is a very small margin for error. The slightest fluctuation in the exchange rate could trigger an onslaught of the speculators who could interpret such information as meaning that the government does not have sufficient reserves to defend the peg.

With a dirty float, on the other hand, certainty is replaced by uncertainty as a slight deviation in the exchange rate could simply be the result of noise and therefore unrelated to the government's capability of defending the peg. Uncertainty in this instance provides a clear advantage in defending a currency peg.

It is interesting to note that these observations are in complete accordance with studies on human psychology. In one famous experiment, students were broken into two groups and subjected to mild electric shocks. The first group received an audio cue which was randomly combined with the electric shock, whilst the second group would receive the shock once every tenth audio cue. The blood pressure and brainwave activities of both groups were measured. Unsurprisingly, the first group were permanently stressed, as they could not figure out when they would receive the next shock, whilst in the case of the second group, the stress level would only start building up after the eighth or ninth audio cue.

The human mind is not very good at coping with uncertainty but, like the currency peg example above, there are instances where uncertainty can be used as a very effective weapon. There are also instances where the contrary is true. Take the Greek debt crisis as an example. The European Union thought that the simple declaration that they would intervene if need be would suffice to keep speculators at bay. Wrong! The markets apparently did not take their word at face value, forcing them into disclosing the exact terms of the bailout. The markets seem to have reacted favorably to this additional "valuable" information but it is still too early to say if it will suffice to salvage what seems to be a sinking ship. The "black swan" adage would argue that just because such a default has never been observed in the past certainly does not mean it will never happen.

You are what you eat?

The graph above says it all. It compares the yield spread between a Procter & Gamble corporate bond maturing in 2012 to a comparable treasury bond (same coupon and similar maturity). A positive spread occurs when the yield to maturity of the corporate bond is more than that of the treasury (which is as it should be). Lately, a certain number of corporate bonds have been priced with yields that are inferior to that of treasuries. This is an interesting situation because it means that investors perceive treasuries (backed by the full faith and power of the U.S. government) as being riskier than that of a corporate bond. Mind you, there are many businesses out there that have very clean balance sheets (at least cleaner than that of the Fed) and for some of them (we all know who they are), it is partially thanks to government intervention that they are in better shape.

The perception of risk is clearly shifting for government debt mainly because it has a large (and growing) inventory of the riskier kind of debt that is starting to take over a larger portion of their balance sheet. As the saying goes, you are what you eat!

Asset allocation insights...

We all know that the risk profile of a person changes with time. As a result, the tradeoff in allocation between riskier (equities) and less riskier (high investment grade bonds) assets should also change through time. Riskier assets are basically required so that the portfolio can grow in real terms (faster than inflation) but, over the short term, can prove volatile. Riskless or low risk assets, on the other hand, tend to exhibit far less volatility (much appreciated in down markets) but won't provide you much in terms of growth.

At a younger age, a more "dynamic" risk profile, defined as a portfolio with a larger allocation to "riskier" assets such as equities, is more appropriate mainly because the person in question typically has a job, which provides a steady stream of income into the future. In other words, the human capital in terms of income generation is much larger for a young person. As the person approaches retirement age, however, this steady stream of income is expected to expire as the human capital potential continues to decay steadily. Human capital is similar to a "bullet" type bond in the sense that a steady income is generated until "maturity". If we are to optimize portfolio, we need to adjust it for the human capital potential. Thus, at a young age, the portfolio allocation to equities should be significant, as the income is assured by the human capital. As the person approaches retirement, however, the human capital can no longer assure a steady stream of income and, hence, a larger allocation to fixed income becomes necessary.
It goes without saying that the shift from one risk profile to another should not be abrupt but progressive.

We can take this thought one step further and think of human capital containing an "embedded option" in the form of the individual's ability to change jobs (with potential repercussions on future income streams). Just like the human capital itself, however, the "embedded option" is subject to time decay. As we get older, our ability to change jobs diminishes. This would imply that as we shift to a more conservative risk profile, in addition to a larger allocation to fixed income, we may need to somehow account for the gradual loss of the "embedded option".

A lurking danger...

Bond yields have been steadily rising ever since the stock markets began rallying, right about a year ago. The reversal in trend was a reflection of the growing appetite for risk, following the market turmoil of 2008. The long end of the curve may also reflect anticipation of both inflationary pressure over the longer run and the gradual withdrawal of government support (such as quantitative easing) for the economy.

The problem with rising yields is that maturities on the yield curve are typically used as reference benchmarks to set interest rates for various industries. The mortgage market, for examples, typically looks at the 10 year segment of the curve to set the interest rates that will be charged to the home buyer. With recent economic releases suggesting weakness in housing, employment and consumption, a rise in the yield curve is likely to have an asphyxiating effect on the health and recovery of the economy.

How to interpret the Fed's latest move...

The Fed caught everyone by surprise with their decision to hike the discount rate by 25 basis points right after the U.S. market close last night. Markets reacted negatively, whilst the dollar continued to strengthen.

As a reminder, the discount rate is the rate that the Fed charges banks that want to borrow directly from it. When the crisis began in 2007, the Fed embarked on an aggressive rate cutting process. The discount rate eventually settled at an unusually low 0.5% towards the end of 2008, whilst the target rate (a main tool for setting monetary policy), which is the rate the Fed sets for inter-bank federal funds lending, dropped to a low of 0.25% around the same time. At the time, there was no sense in cutting rates any further as a so called liquidity trap had formed, whereby the stimulus effect of cutting rates any further had effectively become null.

So what is the message behind the move? My interpretation would be that this change marks the beginning of the end of the emergency support to the financial system. I doubt very much that tightening of the target rate will come any time soon. There is still a lot of damage out there and the economy is still a long way away from being able to walk about without government crutches. This move effectively paves the way for additional withdrawals of support. I expect quantitative easing to be one of the next major candidates on the list.

The burden of uncertainty

It is a well known fact that one of humankinds greatest burdens has to do with uncertainty, and just like its distant cousin, infinity, our minds have a difficult time coping with the concept. Countless studies have shown, for example, that we are much happier once something that was uncertain becomes certain, even if it happens to be something unpleasant. Apparently the mere presence of certainty removes a whole layer of tension.
Markets behave in a very similar manner and the degree of uncertainty can easily be measured by the degree of volatility. It is why in times of serious trouble, as in the second half of 2008, volatility levels can rise dramatically.
As uncertainty is perceived to be an unpleasant experience, it acts as a powerful driver that pushes us to come up with solutions to counter it. The insurance business is a perfect example of an industry that has flourished as a direct result of mankind's desire to counter uncertainty. Corporate earnings announcements is another example whereby the time frame between earnings reports have been shortened in order to reduce the degree of uncertainty regarding the health of a business. Such strategies do come at a price, however. By increasing the frequency of earnings results in a given year, the firm may be sacrificing long term objectives for short term gains.
With all this in mind, the EU's willingness to bail out Greece and Abu Dhabi's intervention on Dubai should come as no surprise. In both cases it would seem that the uncertainty of doing nothing is just too large of a burden to cope with.

A fluke or for real?

Last week's announcement that the U.S. economy had expanded in the fourth quarter (the second consecutive expansion) by a greater amount than what the market consensus expected took everyone by surprise, raising the risk that the resulting complacency may lead to a premature withdrawal of some of the more critical stimulus plans in place.

The trouble stems from the nature of the downturn which in this case is structural rather than cyclical. Historically speaking, it takes an economy significantly longer to recover from a structural downturn than a cyclical one. The combination of greater government regulation in an environment of high unemployment and weak consumption can only contribute to extending the period of slump. The stock market rally in 2009 may reflect a disconnect between expectations and the real fundamentals and, as a consequence, stocks may disappoint this year.

The tough road ahead...

According to Ibbotson Associates, a well respected data mining firm, since 1926, U.S. stocks have returned on average 9.8% per annum. This is the compounded annualized total return (i.e. including dividends that are reinvested) of the S&P 500. Over the same period, bonds, which is the other major asset class has returned 5.3%, significantly less than equities. Taking the more recent past such as the last 10 years, however, the results are -2.22% and +6% for equities and bonds respectively, in stark contrast to the longer term where the equity investor was the clear winner. These results tell us that although we can expect average returns in the order of 9.8% over the very long term, we can experience significantly long periods (a decade in this example) where average returns could turn out to be substantially below this figure.
This example illustrates well the importance of diversification amongst asset classes because although even for a diversified portfolio, correlation aberrations over shorter term periods such as in 2008 can lead to significant losses, over the longer term they are likely to be diluted somewhat.
Coming back to the 9.8% return expectations drawn from data that spans over a very long period, it is not very realistic to expect such returns into the future, particularly in an environment of weak consumption, investment and greater fiscal discipline. To make matters worse, the Ibbotson figures happen to be gross of inflation (average 3%), investment expenses (average 1-2%) and taxes (average 1-2%) which means that if we were to calculate the net expected annualized total return for equities, it would add up to between 2.8% (worst case) and 4.8% (best case). You may argue that inflation is a non issue because we haven't seen much of it over the past decade, but the future may turn out to be very different given the quantity of stimulus out there. In any case what is clear from the above is that to be able to generate a decent return over coming year is going to require a lot of skill that only true professionals can provide.

A mirror image of a year earlier?

2009 turned out to be a year in which most asset classes yielded positive returns after a rough beginning. Just about the only asset class that performed negatively were treasury securities (the only asset class that yielded positive returns a year earlier).
Just as in 2008, correlations were generally relatively high but because the move was in the opposite direction there wasn’t much to complain about (unlike in 2008 when pundits were suggesting that diversification was dead). Commodities recorded the largest gains, followed closely by equities and real estate and finally hedge funds that rose steadily throughout the year. A recent measure of home price to rent suggests that problematic markets such as that of the U.S. are now close to their historical fair market value (could that really be?). The same measure also indicates that certain European countries such as Spain, U.K. and France and bubbly places like Hong Kong are substantially overvalued which means that we can expect the slide to continue in those markets.