summitV I E W hen engaging with the unknown and working summit creek with speculative ideas, I find it comforting torecall that the discovery of fundamental structurehas always come as a surprise and been met with As we define our system of conceptsskepticism and resistance. Oddly enough, not more precisely, as we streamline itjust the general populace, but sometimes even the and make the connections more and more rigorous, it becomes increasingly summitVIEWvery people who suggest underlying structureshave been reluctant to believe them at first. detached from the real world. Lisa Randall, first tenured woman theoretical physicist Fritjof Capra, The Tao of Physics at MIT and Harvard. Warped Passages: Unraveling the Mysteries of the Universe’s Hidden dimensions. At the beginning of the twentieth century, much of what being published by leading physicists in leading journals was, in retrospect, nonsensical...A comparable meltdown is now occurring within financial economics. Whether it is the 1 latest “quantum mechanical theory of market volatility,” or the latest conference May 2010 on “portable alpha,” arrant nonsense is being heard everywhere. Once useful concepts like alpha and beta have been stretched to the breaking point. H. Wood Brock, “Solutions to the Portfolio Problem,” Strategic Economic Decisions, September 2004 The financial markets paid a lot of people extremely well for narrow expertise and a few people, poorly, for the big, global views you needed to have if you were to allocate capital across markets. Michael Lewis, The Big Short I was right 70 percent of the time, but I was wrong 30 percent of the time,” said Alan Greenspan as he testified last week on Capitol Hill. Greenspan - aka the Oracle during his 18-year-plus tenure as the Fed chairman - could not have more vividly illustrated how and why geniuses of his stature were out to lunch while Wall Street imploded. No doubt he applied his full brain power to that 70-30 calculation. But the big picture eludes him. If the captain of the Titanic followed the Greenspan model, he could claim he was on course at least 70 percent of the time too. Frank Rich, The New York Times columnist April 11, 2010 see disclaimer on last page
The Morton Investment Doctrine A transitioner’s guide to transitionssummitVIEW2May 2010 need to cut back. In theory that sounds simple. Pondering the future of global economic activity “ In practice it will be fiendishly hard to get the is not for the faint of heart as many outcomes balance right. Investors may worry about seem viable as the world recovers from the Great Recession. One school of thought believes the the sustainability of public debt long before United States will rebound from the doldrums private-debt reduction is over, forcing a lot of of the Great Recession to continue its twentieth belts to be tightened at once. The most painful century position as the global superpower. bits of deleveraging could well lie ahead. Another school of thought considers the post Great Recession era the beginning of the end The above quote addresses the fundamental of the United States as the global superpower. question regarding long term, global, economic Considering the amount of debt accumulated growth: what will be done with all the debt? by the public and private sectors of the United States, the former scenario appears unlikely. As the US consumer fueled the growth of export driven Asian economies, word of the Asian economic decoupling from the US economic “ The Economist summarized a McKinsey study titled Debt and Deleveraging: The global engine became gospel. The simultaneous crash credit bubble and its economic consequences of all global markets in 2008 removed speculation in January by saying the following: of decoupling of Asian economies from the US economy. At this juncture in the global recovery, [T]here are several reasons why today’s the US consumer continues to tighten its spending, mess could be more protracted than previous whether due to job loss, the threat of job loss, episodes. First, the scale of indebtedness is or an increasing belief that former, prior to the higher. The highest debt ratio in the report’s economic crisis, spending habits were profligate. group of belt-tighteners was 286%, in Britain after the second world war. Today more than Although the US consumer remains still the half the rich countries in the McKinsey sample driver of global consumption, the process have debt totaling more than 300% of GDP. of changing spending habits, from the Second, the number of countries afflicted US consumer saving more to the Chinese consumer spending more, will not be straight simultaneously means that rapid expansions line. Without developed, internal demand of exports, which have supported output in the markets, emerging economies will continue to past, are harder to achieve. Third, big increases rely on foreign consumption of domestically in public debt, while cushioning demand in the produced goods. As consumption ebbs over short term, increase the overall debt reduction the next number of years in the developed that will eventually be needed. Once private world, returning to a level in line with long deleveraging is done, the public sector will term averages, what happens to the emerging
economies? When will domestic consumptionincrease sufficiently to capture a significantpiece of the goods produced domestically? Asinfrastructure development continues, whathappens to the emerging economies if capacity alpha.” For the investor, each has a uniqueutilization rates drop and layoffs occur? risk profile, or risk aversion, that determines one’s asset allocation as per the Capital Asset summitVIEWPeriods of transition, historically, while Pricing Model (CAPM) and Modern Portfoliocommon, are often disruptive. With the Theory. Once the appropriate asset allocationaforementioned in mind the US investor is faced is determined, the investor is expected towith the challenge of positioning portfolios to maintain that asset allocation, assuming ofprotect against financial market volatility as course, the extenuating circumstances or inputscycles of consumption, economic growth, and used to derive the allocation remain constant.debt reduction play out over the next ten years.How does one position a portfolio of assets MPT’s theoretical foundations are based onto realize wealth preservation in addition to assumptions that do not reflect the real world, as in the belief that asset class returns are derived 3achieving growth during these transition years?Considering the inadequacy of Modern Portfolio independently of one another and that returnsTheory (MPT) to facilitate proper portfolio are identically distributed, that is the return distribution of one asset class is mirrored in May 2010construction relative to one’s risk profile, theinvestor’s challenge to construct the most another. Theories concerning the “knowledge”suitable asset allocation is as formidable as ever. of the market, where all pertinent information is reflected in the current price, utilize theOver the last five decades MPT has become assumptions of MPT as its basis. What is realthe theoretical foundation for asset allocation, is that the market can and does often fail toproviding investors a framework to build represent all that is real, all that is or shouldan optimal portfolio commensurate with the be affecting the asset price. See the priceinvestor’s risk profile. The theory’s foundations performance of assets during 2007 - 2008 for anstem from the false premise that the returns example of prices not reflecting all available data.of assets classes are each identically andindependently distributed (as like a coin flipwhere the prior flip as no affect on the result ofthe next flip). The idea that asset returns areidentically and independently distributed alsofeeds into the random walk theory of marketreturns, where one cannot predict futurereturns based on past performance. Further,MPT is grounded in the assumption that theinputs into the model can change but the modelitself does not change, known as stationarity.As H. Wood Brock states, “when stationarityprevails, all investors will be able to predict thecorrect probability of all future events from thehistorical data alone. In this sense, no investor willmake ‘mistakes’ in his probabilistic forecasts.”All who are participants in the markets know The above comments about the inherentthat all investors make mistakes in estimating, fallacies in MPT are not to be interpreted asforecasting, or foretelling what the markets will do. extending to the fundamental MPT assertion that investment returns are best achievedThe result of MPT is the belief the investor through asset diversification. As it is throughshould maintain an asset allocation (appropriate portfolio diversification that an investor canfor the investor’s risk profile, of course) that will achieve returns commensurate with his riskwithstand and benefit from various economic aversion level. Where MPT breaks down is in itscycles. Tactical adjustments are made to the application, where the investor has one optimalallocation through such measures as rebalancing portfolio allocation. MPT is grounded in the beliefto prior determined allocation percentages that all investors have all the facts, as reflectedor by using constructs such as “portable in asset prices, and cannot make mistakes.
An investor in financial markets has to be proactive in developing asset allocation models that better capture economic and market realities (or states) and that reflect the investor’s risk aversion. One cannot rely on the belief thatsummitVIEW an asset allocation that worked in the past will work in the future as asset class performance over various periods of time has been irregular. The mantra of an asset manager should always be “first, do no harm.” With the mantra in mind how does one advise clients and allocate assets so as to minimize risk and maximize return? LLC, echoed the same sentiment in discussing For an investor, the question of most pertinence is, the housing bubble of the United States. Schiller4 did the value of the assets grow or did it decline. wrote in April 2010 in the New York Times, “In To an investor the growth of the wealth, not the short, a public case began to be built that we really relative performance of the various asset classes, were experiencing a housing bubble. By 2006 aMay 2010 matters most. With the aforementioned thinking variety of narratives, taken together, appear to in mind, how does one develop an asset allocation have produced a different mind-set for many that best meets the investor’s risk profile? people - creating a tipping point that stopped the growth in demand for homes in its tracks.” How does an investor develop asset allocations The following questions are in an environment where qualitative factors relevant to developing a suitable have such an impact on return outcome? asset allocation for investors: • What kind of return distributions do As a student of history, I believe the behavioral markets have? aspects or factors can be derived from an assessment of current political, economic, • What distributions do asset classes and social states. For example, in our debt have if not independent and laden society, how will the efforts to reduce identical? household debt affect the long term growth • How does an investor respond to of the US economy and the continued shifts in the relative returns of asset development of the export driven economies classes? that relied heavily on the US consumers’ debt driven consumption over the last ten years? • What factors best indicate an asset class’ future performance? Late last year, while considering investment • To what extent does investor options for United States citizens over the next sentiment effect total return ten years, I laid out how one should begin to outcome? think about their investment options. Using an aerial view of the current global landscape • Does investment optimism and factoring in the above thinking, I decided or pessimism effect return to ground future investment decisions in beyond economic and financial terms of political thought, specifically the fundamentals? Monroe Doctrine introduced in 1823 by then U.S. President James Monroe. In response to a Brock’s work points to the reality that it is political policy issued to protect United States the investor’s belief structure (the proportion interests in the Western Hemisphere in the early of investors at a given point in time who 19th century, I have revised the policy to reflect hold below average to above average return US investor interests in the 21st century. Namely, expectations) that greatly alters the asset return how does a US investor derive the appropriate outcome. Recently, Robert J. Schiller, professor risk/reward relationship in his/her particular of economics and finance at Yale and co- asset allocation for the future? Specifically, founder and chief economist of MacroMarkets how does one protect and grow their assets?
“ To be sure, if you are an Anglo-SaxonAs previously discussed, Modern Portfolio country with a stable financial base, limitedTheory has failed to provide proper guidance government intervention and containedto investors due to inherent flaws in the theory. “ deficits along with heavy resource exposure, summitVIEWTherefore, what are the steps one has to take to your currency is in demand – as we have seenensure proper asset allocation commensurate of late with the Kiwi, Aussie, and of course, thewith one’s risk tolerance? As I considered the Loonie. These currencies are overbought andamount of debt in the US, held both publicly and expensive but are retaining a premium for aprivately, substantially accumulated over the reason – stability and commodity orientation.last couple of decades, I reflected on historicalexamples of empires gone bust due to colonialism Stepping back and assessing the current stateor imperialism, coupled with excessive expansion of the global economy, the potential for globalof credit (e.g. the Roman Empire and the British growth far outweighs any other time in the recentCommonwealth). Albeit, the US does not 5 past. The migration to urban environments willcontinue to expand its borders geographically. continue for years to come in countries such as China, India, and Brazil. As the People’sUsing the thinking behind the development of May 2010 Republic of China’s experiment with capitalismthe Monroe Doctrine to protect the long term has proven, prosperity is a great motivator.interests of the United States, I have developed the As more move up the socioeconomic ladder,Morton Investment Doctrine (MID). Essentially, demand will continue to grow. Increasingthe MID relies on both geographic proximity of per capita gross domestic product (GDP) is aforeign, investable free markets and countries of great indicator of potential product demand,common ancestry to facilitate the US investor’s where, for example, more durable goods anddevelopment of appropriate asset allocation higher protein content foods are desired as permodels during what are expected to years offinancial market volatility. As global consumptiondeclines in the developed worlds and increasesin the developing worlds, the transitionperiod likely will be shaped by uncertainty.The Federal government continues to pile ondebt to solve an over levered prior state. Inan environment of burgeoning bureaucracyand ever increasing debt and entitlementspending, one is forced to contemplateoptions for protecting and growing wealth: • Does one use blind faith that the US government will be successful developing the processes and methods by which the levered consumer and government are able capita GDP expands. As the urban migration to reduce debt to a normalized level? continues, infrastructure to meet the needs of the migrating worker will grow. China appears “ • Will the processes and methods to be poised to experience its own Industrial developed and deployed by the Revolution with wealth expansion for all classes. Federal government return the US economy to a past normal state of In 2006 The McKinsey Global Institute wrote: growth anytime soon? The rising economy in China will lift hundredsAs a discerning investor one has to weigh of millions of households out of poverty. Todayprobable outcomes of the steps and policies 77 percent of urban Chinese households live onthe Federal government is using to correct less than 25,000 renminbi a year; we estimatethe highly levered state of the US consumer. that by 2025 that figure will drop to 10As David Rosenberg said in April 2010, percent. By then, urban households in China
summitVIEW6 “May 2010 will make up one of the largest consumer into markets where risk/reward parameters markets in the world, spending about 20 are suitable. Considering the aging population, trillion renminbi annually — almost as the high ratio of retirees and non-workers to much as all Japanese households spend today. workers, increasing entitlement spending by (note: as of April 2010, 25,000 renminbi is approximately 3,660 US dollars) the Federal government, growing public debt burdens, leaders unwilling to lead, no long term How does a US investor position resources energy policy, little to no regard for infrastructure to benefit from the long term trends in global, improvement, and a public unwilling to force socioeconomic development? Investing politicians to make responsible decisions, at directly in China and India is difficult and what point does the primary economic trend restricted; difficult in that the local markets are change? The U.S. economy will continue to grow, not as developed as the liquid, open markets just not at a pace at which most are accustomed. found in the United States, United Kingdom, or Hong Kong, for example. In addition, in So, what are the implications of lower economic growth coupled with higher and higher debt “ India and China there exist restrictions on foreign direct investment (FDI). In Brazil, loads? High systematic risk and little economic FDI is not so much restricted as it is taxed. reward. Again, Woody Brock offers insights into the current economic state of the United States: The Morton Investment Doctrine proffers to investors a thinking by which one can develop a The failure of President Obama’s policy of suitable asset allocation based on their particular “engagement” to achieve any bargaining risk profile. By allocating assets to the neighboring concessions by Russia, by China, or by Iran is economies of Canada, Brazil (and other Latin fully consistent with this analysis of declining American countries), and to Australia (although US power. Finally, as the US evolves over not a neighbor, Australia is a developed country the next two decades into yet another ageing “ with similar ancestry and legal structures), an welfare state where fiscal expenditures shift investor gains both systematic and economic from defense to social welfare expenditures, diversification. By allocating assets outside its loss in overall power will increase still United States borders, a U.S. based investor further. If the US’s looming “fiscal red hole” gains diversification into growing economies evolves as predicted over coming decades, the that have considerable less private and public nation is likely to disarm while China arms. debt, have stable, transparent governments run by elected officials, and are directly exposed One might as well look beyond US borders to to the middle class development of 40 percent achieve the investment returns one expects and of the world’s population in India and China. needs, regardless of where one fits on a risk aversion scale. Once an analysis of one’s future The challenge to investors is not so much liabilities (be they retirement income, education “achieving alpha” as it is allocating resources tuition or some other future, quality of life
expectation) and current assets is complete, coupledwith expected future income flows, the properallocation to fulfill those obligations can be developed.Earlier this year in February 2010, Brazil’s countries and empires to provide perspective.“wealthiest person, Erik Batista, was on Charlie Rose. Who is to say the country cannot succumb toDiscussing Brazil’s prospects for the global economic the same fate of the British Commonwealth? Perhaps the immediate circumstances are summitVIEWfuture, Batista, the CEO of OGX said of Brazil, not exactly the same, but similarities persist. It’s the highway between Brazil and China that the Based on the current path of the United States, world should start paying attention to, because it’s its long term, primary trend, is one of declining “ fabulous. Most things that the Chinese need we global influence. The path can change, have in abundance, and we can export, and there’s but change is slow in a democratic society. an entrance market on the other side within, because what does the world [need] in an economy, you need In May 2008 Parag Khanna said, “I believe that pent-up demand. China has an endless pent-up Latin America will emerge as the solution to the demand for these products, oil, food, and iron ore. problem of the United States’ future competitiveness. 7 The answer doesn’t lie in worrying about ChinaWhen asked by Charlie Rose what investments or expanding influence in the Middle East orBatista had in the United States, the answer was none. restoring transatlantic ties. The answer lies in our May 2010 own backyard. Literally.” I couldn’t agree more.As Americans we have become accustomed todriving the world’s economy for the last fifty Understanding the truth of the United States’years, especially in the last twenty-one years since economic reality will facilitate thriving in futurethe Berlin Wall fell. Consequently, adjusting one’s economic regimes, and by embracing changeperspective to reflect new global realities is not easily the US investor can position assets to benefitaccomplished. Viewing Brazil, and other Latin from this transitional period in which we exist.American countries (pick one: Mexico, Colombia,Argentina), through a lens tainted by past experience As William Faulkner said, “Facts and truthwill bring one to surmise the risks are too great given really don’t have much to do with eacheach countries’ former systemic problems. Will other.”hyper inflation consume Latin American economies?Will civil unrest rise, endangering investmentcapital? Is the sovereign risk too high; could acurrency default ripple through the global economy?“A rose tinted view of United States history will dolittle to ensure a future as prosperous as the past.In When Markets Collide, Mohamed El-Erian wrote, Inevitably, the particulars of the individual action “ plan involve revisiting elements of conventional wisdom. Some imply a change in mindset; other a retooling of institutional and organizational parameters. As such, they are not easy to implement. And they involve risks. But these difficulties pale in comparison to the consequences of not adjusting.In assessing the current state of the United Stateseconomy one can easily return to prior historyand assume, all things being equal, that the pastis prologue for the fate of the United States. Twothings are important to consider in the priorsentence. One, will things continue to be equal? Arethe circumstances that fueled United States growthand success over the last century the same as thecircumstances of the country now? Two, which pastis prologue? One should consider the paths of other
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