summitV I E W summit creek But the most important point is that almost two years since a normal financial panic, the polity has still not managed to absorb the consequences of that event. The politically summitVIEW contrived corporation, and particularly the financial corporations, stands accused of undermining the wealth of nations. As Adam Smith understood, markets are not natural entities but the result of political decisions, as is the political system thatThe creates the allocation of risk that allows markets to function. When that systemGlobal Crisis of Legitimacy appears to fail, the consequences go far beyond the particular financials of that 1This report is republished with permission of STRATFOR. Segments ofarticle shown below. The entire article is worth reading. Click the link event. They have political consequencesabove to access the article. and, in due course, geopolitical conse- June 2010 he crisis was rooted in the appearance that it quences. (emphasis added) was triggered by the behavior not of small townbanks or third world countries, but of the global fi- George Friedman, PhD, Founder andnancial elite, who took advantage of the complexities CEO STRATFORof law to enrich themselves instead of the sharehold-ers and clients to whom it was thought they had prior Willem Buiter, chief economist of Citi, usesfiduciary responsibility. rather blunter language. “Today’s ‘best of breed’ may be the same dog that yesterdayThis is a political crisis then, not an economic one. was fit only for the World’s Ugliest DogThe political elite is responsible for the corporate Contest – an indicator of just how far theelite in a unique fashion: The corporation was a po- fiscal conditions in most advanced indus-litical invention, so by definition, its behavior de- trial countries have deteriorated,” he says.pends on the political system. But in a deeper sense,the crisis is one of both political and corporate elites, The difficulty for governments is thatand the perception that by omission or commission loading deficit reduction on to still fragilethey acted together — knowingly engineering the economies in the coming decade of ageingoutcome. In a sense, it does not matter whether this is and increased demand for public serviceswhat happened. That it is widely believed that this is rarely brings popularity. This week Greecewhat happened alone is the origin of the crisis. This has shown that there might not be any al-generates a political crisis that in turn is translated ternative.into an attack on the economic system. Chris Giles, Financial Times, London April 28, 2010But for now, the important thing is to understand thatboth Europe and the United States are facing funda- Investors pour money into emerg-mental challenges to the legitimacy of, if not the re- ing-market bondsgime, then at least the manner in which the regimehas handled itself. The geopolitical significance of Investors are fleeing from sovereign debtthis crisis is obvious. If the Americans and Europe- of Western European and other developedans both enter a period in which managing the in- countries, shifting funds into emerging-ternal balance becomes more pressing than manag- market bonds. The move is an effort toing the global balance, then other powers will have bolster returns, but is also a bet on theenhanced windows of opportunities to redefine strength of emerging markets. “Any num-their regional balances. ber of [issuers] are able to come to market see disclaimer on last page that wouldn’t normally be able to -- and
summit creeksummitVIEW2June 2010 they can come at lower spreads than they other- U.S.A. where we have massively indebted State wise would,” said Matthew Ryan, a co-manager and local governments. And then … well, take a of the MFS Emerging Markets Debt Fund. look at the mania in Toronto and Vancouver real estate as an example. Bubbles will be popping. The Wall Street Journal (06 May 2010.) David Rosenberg, Breakfast with Dave, Gluskin Sheff Canary in a Coal Mine & Associates, Inc., May 6, 2010 ....Dubai was the real canary in the coal mine Debt Ratios to Rise Further on the sovereign credit front, and now Greece is very likely going to be the touch-off point In the final analysis, if the EU lends money to for other high-debt/high-deficit countries with Greece or to any other problem country in the weak economic structures such as Portugal, zone, debt ratios (including contingent liabili- Spain (already rumoured to be in talks with the ties) in the region will only rise further. It will IMF) and even Italy. Next will be the U.K. whose be interesting to see how the rating agencies end balance sheet is not far off from what Greece up handling this. It cannot be lost on them, or looks like and looming political uncertainty to the global investment community, that while boot. So it pays to not be complacent at this time, loans, guarantees and central bank provision- and to try to identify what the next chapters of ing can deal effectively with liquidity issues, the deleveraging book are going to be — espe- they are ineffective in addressing what’s really cially since the McKinsey report tells us that the at stake here, which are structural fiscal issues. aftermath of a global credit collapse typically So the deal over the weekend is only going to last 6-7 years. It doesn’t mean that we won’t go be successful insofar as they are backed up by through whippy bear market rallies like we did meaningful reforms (it must be emphasized in the past year, but these rallies, despite their that the rescue package critically hinges on the intensity, are rallies you rent in a secular bear Club Med countries accepting deep budgetary phase. Do not overstay your welcome. retrenchment notwithstanding their weak eco- nomic structures. Indeed, it will be interesting to Once we are through with Euroland and the see how Spain can manage to meet EMU deficit U.K., perhaps the next problem spot will be requirements at a time when the unemployment China where the government is tightening to rate is currently at 20%, just as one example.) combat what well could be a significant prop- erty bubble. Then it may come right back to the David Rosenberg, Breakfast with Dave, Gluskin Sheff & Associates, Inc., May 10, 2010
nteresting the recent return of the label Gen- eration X in the mass media. Until I read aninterview of a man from Canada who popular-ized the term Generation X, consideration of the“generational-descriptor” was little given. Curi- adjustment to an energy force. In that adjust-ously, I find the label somewhat suitable. ment there are patterns of flow that disperse the energy. To the naked eye the swirls in the water summitVIEWUpon graduating from college I read I was a are vortexes of bubbles and beauty. In flow dy-member of Generation X. I thought, what to do namics the turbulent disruption would be mea-with this name? Perhaps X means I should go sured and modeled.ahead and follow my immediate response. SinceI’m of the X generation perhaps my generation In past periods of disruption (we’ve had a fewis meant for little. To what does a generation even though they are now merely words and im-amount when they bear a letter with such nega- ages to the many with short term memories) ative connotation? Shall I head for a remote island transition ensues. As one who sits just behind aand enjoy the passing of time staring at the sea large passing generational wave, I wonder how the transition will unfold for the country and the 3since my generation will amount to little? Whywere we not generation Y? Now, I’d take gen- developed world. Speculating on outcome anderation Y over generation X any day of the week. opportunity is daunting and exciting. June 2010Generation Y has such existential qualities. Gen-eration X: watch out for the gangsta. Generation One daunting concern is the economic and gov-Y: welcome the philosophers. ernmental obligation the baby boomer genera- tion has decreed it deserves in its fade to glory.Recently, though, I’ve come to appreciate the As a Generation X member am I to have the samesubtleties of my generational moniker. Wikipe- fate of prosperity and wealth of the boomer gen-dia, for what it’s worth, says of Generation X the eration? Is my generation at an inflection pointfollowing: where economic outcomes for many do not meet indoctrinated dreams and expectations? Con- Coming of age after the Vietnam War had ended, versely, what exciting prospects await those their political experiences and cultural perspective who embrace the oncoming waves and prepare were shaped by the end of the cold war, the fall of accordingly? the Berlin wall, and a series of US economic calam- ities such as the 1973 oil crisis, the 1979 energy crisis, the early 1980’s recession, and the savings and loan crisis - instilling a sense of economic un- certainty and a reduced expectation of long term fidelity between employers and employees.Further, TIME magazine in an article from April16, 2008 asked is Gen-X: The Ignored Generation?Generation X, Wikipedia further states, “wasoriginally referred to as the ‘baby bust’ genera-tion because of the drop in the birth rate follow-ing the baby boom.” SummitVIEW’s responseand view is that following the baby boomer gen-eration is like bobbing in the water just after theforce of a boat’s wake passed through. Disrup-tion ensues with settlement forthcoming. What waves will be forthcoming? What is theDisruptions in the global economic framework cycle of disruption and opportunity passingover the last three years represent the passing through? Everyone is familiar with the refrainof the baby boomer generation. As a member that if you don’t know history you are bound toof Generation X, I feel as if I’m bobbing in the repeat it. Certainly, one can still be aware of hiswater after the wake of the baby boomer genera- or her history as a country or people and stilltion blew through, leaving disruption and tem- succumb to historical tendencies. I find fascinat-porary chaos in its wake. The interesting infer- ing the United Kingdom’s modern history. Theence here is that the disruption one feels as the country pushed itself to the edge of bankruptcywave passes through is not so much chaos as an twice within a century. The consequence of the www.summitcreekcapital.com
What does exist is systematic risk or, rather, en- dogenous risk. Humans have a tendency to- wards excess and that tendency is reflected in the systems we build. The next wave of financial research and innovation will center on under- standing our endogenous risk. What are the best measures of endogenous risk and how best doessummitVIEW one respond and invest according to the levels of endogenous risk? As these measures are qualita- tive and quantitative in nature, new models will need to be built. As I mentioned there are excit- ing prospects for my time, Generation X. Recently, the Nobel Prize winning economist William Sharpe published a piece in the Finan- cial Analysts Journal (FAJ) May/June 2010 issue titled Adaptive Asset Allocation Policies. In the4 article Sharpe asks, “Why should market values first blowup was loss of global leadership, eco- inform forecasts? Because an asset’s current mar- ket value reflects the collective view of the prob-June 2010 nomic and political. The consequence of the sec- ond blowup remains to be seen. abilities of future prospects. This information is valuable and should be taken into account when For the first time in over six decades the UK has managing a portfolio.” Further, summarizing a coalition government. The last time there was his argument, Sharpe adds “The inevitable con- a coalition government was in 1945. In a post clusion is that an investor’s asset allocation, ex- World War II bombed-out environment one can pressed in the traditional manner as percentages imagine the disruption socially and politically in of total value in each asset class, should change the United Kingdom. To think in 2010 no politi- over time to reflect changing market values, even cal party could come up with a vision for the fu- if the investor’s characteristics are unchanged. ture to inspire voters to elect a government with This conclusion is the key tenet of this article.” a mandate is amazing, really. In the same FAJ publication, the magazine editor The question that has fascinated me over the Rodney N. Sullivan, CFA offers the following in years is how does humanity break patterns of the Editor’s Corner: excessiveness. Tales of excessiveness riddle our history as humans. Whether flying too close to The primary tenets of investment success can be the sun or staring into a reflective pond, the al- found in a liability-sensitive form of the Tobin- legories are many to remind us we can and do Sharpe two-fund separation theorem, which holds take what we enjoy to excess, often with dras- that all efficient portfolios can be formed with a tic consequence. Knowing these stories has not combination of the risk-free asset and the market stopped the many from finding reason to con- portfolio of all risky assets.1 Because all investing tinue ways of excess. Just look to the continued is intended to support future consumption, one use of leverage to gear the US economy and to must also incorporate expected future needs, or li- drive financial institution profitability for a re- abilities, into the portfolio strategy. Therefore, this cent example. strategy means constructing a multi-horizon plan that matches the asset mix with the liabilities.2 The sensation of bobbing in the wake of a large wave is telling for me. Interestingly, I believe A combination of current endogenous risk fac- we are at a time when tendencies towards excess tors, asset-liability management (or liability can begin to be measured. Answering questions driven investment), and investor risk aversion related to why we embrace excess I leave to the should form the basis of one’s portfolio construc- philosophers. Answering questions associated tion process. Building a portfolio that reflects the with the relative level of excess I find engaging market’s endogenous risk will prove, over time, and exciting. 1. See James Tobin, “Toward a Theory of Market Value of Risky Assets,” Review of Economic Stud- ies, vol. 25, no. 2 (1958):65–86; William F. Sharpe, “Capital Asset Prices: A Theory of Market Equi- librium under Conditions of Risk,” Journal of Finance, vol. 19, no. 3 (September 1964):425–442. As we have witnessed in this still new millenni- um, risks exist. The Great Moderation proffered 2. See M. Barton Waring and Duane Whitney, “An Asset–Liability Version of the Capital Asset Pricing Model with a Multi-Period Two-Fund Theorem,” Journal of Portfolio Management, vol. 35, by Alan Greenspan and others is non-existent. no. 4 (Summer 2009):111–130; Philip H. Dybvig, “Using Asset Allocation to Protect Spending,” Financial Analysts Journal, vol. 55, no. 1 (January/February 1999):49–62.
to be ineffective at protecting ones wealth andpurchasing power. As we have seen in the re-cent past, often the risks of the market far out-weigh potential rewards. As markets adjust topotential economic outcomes one should assessif the adjustments reflect his/hers needs and be- “liefs of those future outcomes. summitVIEWIn closing, the words of James Montier of therenowned investment advisory firm GMO LLCsummarize well the beliefs of Summit CreekCapital. In the recently released paper “I Wantto Break Free...” Montier writes: In this paper, I argue that policy portfolios and various successors (such as risk parity and life- cycle/glide-path funds) are deeply flawed from an 5 investment perspective. In particular, two common failings they share are a mismeasurement of risk and an indifference to valuation. I conclude that a June 2010 strategic asset allocation that alters the asset mix based upon the opportunity set offered by Mr. Mar- ket makes far more sense from an investment per- spective. (In modern parlance, this translates as a benchmark-free, real return focus.)In words that echo SummitVIEW’s, Mr. Montiercloses his article by saying: A willingness to be contrarian is also vital. You will inherently be doing the opposite of what every- one else regards as sensible. Being a contrarian in- volves three separate elements: 1) having the cour- age to stand against the dominant view; 2) being an independent thinker; and 3) having the firmness of character to stick to your guns. All three of these traits are unnatural of human beings! Providing that one can be patient and contrarian, there is simply no reason why strategic asset allo- cation implies static asset allocation. Changing the asset mix of your asset allocation in response to the fluctuating opportunity set offered by Mr. Market seems like common sense to me. Sadly, of course, common sense tends to count for little in the world of high finance!Perhaps it takes a Gen-X member to put to prac-tice the asset allocation suggestions made above.Why not? Generation X, as quoted above, is in-stilled with a sense of economic uncertainty.SCC rests its pursuit of exemplary financial ser-vice in its dedication to understanding endog-enous risk through analysis of historical, politi-cal, economic, and social factors. The pursuit, in Disclaimer: All material presented herein is believed toan effort to sound as academically high-brow as be reliable but we cannot attest to its accuracy. Neitherpossible, is called dynamic beta analysis. the information nor any opinion expressed constitutes a solicitation by us for the purchase or sale of any securities. www.summitcreekcapital.com