Asset Allocation in a Flat World (think globally, not locally)

Global Diversification
One of the three big questions investors must consider today is: How and how much should one allocate to stocks in and outside of the U.S.? In his book, "When Markets Collide," author Mohamed El-Erian describes a multilateral economic future in which domestic demand in emerging markets is a counterbalance to U.S. growth. His recommendation is that U.S. investors be exposed to a globally diversified set of stocks, with only a third to one-half in the U.S.


If you agree, and we do, then what does "globally diversified" actually mean and how do you determine how much and where?


The difficult issue is determining a valid reference point. The obvious approach would be to start with an established benchmark as a frame of reference. A good neutral frame of reference would be the total world stock market value, except for the risk that constantly annoys capitalization weighted markets - you potentially overweight overvalued markets! A better alternative might be economic size as measured by GDP in that the weightings are not affected by short-term market momentum or overvaluations.



The total world stock market value and GDP for 2008 is as follows:
mkt. value GDP
U.S. 36% 23%
Europe 26% 36%
Asia Pacific 28% 26%
Mid East/Africa 3% 6%
Americas 4% 7%
Canada 3% 2%


Implementation


The most common approach is to achieve targeted international equity country weightings using a combination of developed international and global emerging markets strategies. Alignment with the MSCI EAFE (Europe, Australasia and the Far East) and the MSCI EM (Emerging Markets) Index will accomplish this.


These markets vary from relatively to significantly inefficient, therefore our suggestion would be to engage active portfolio managers who have the ability to create alpha (excess risk-adjusted return) consistently (keep the index funds for your short duration fixed income funds and large cap U.S. funds).


It is possible that the next ten years will bring lower correlations of international markets with the U.S., as regions like Asia decouple as they mature and become less dependent on the U.S. and continue to demonstrate growth in their domestic economies.



Christopher Blakely Sept. 2009

sources: International Monetary Fund, MSCI

Out of the Frying Pan into the Other Frying Pan?

Recession Ending?

The pace of U.S. job losses slowed more than forecast last month and the unemployment rate dropped for the first time since April 2008, the clearest signs yet that the worst recession since the Great Depression is easing.
Payrolls fell by 247,000, after a 443,000 loss in June, the Labor Department said today in Washington. The jobless rate dropped to 9.4 percent from 9.5 percent.
The report stoked optimism for a recovery in the second half of 2009. While the Obama administration’s fiscal stimulus efforts are projected to have a significant impact on the economy, any rebound in hiring may be delayed as this recovery like the last may be labeled a jobless recovery. Unemployment is a lagging indicator.
We – as consumers - are by no means out of the woods, but we are moving in the right direction, many economists have revised forecasts to reflect moderate growth in the second half of 2009 and more of a pickup in 2010.
Even so, economists predict consumer spending, which accounts for 70 percent of the economy, will be slow to gain speed. Wages and salaries fell 4.7 percent in the 12 months through June, the biggest drop since records began in 1960, according to Commerce Department data issued this week.

Tax Increases?

The current administration recently raised its estimate for this year’s federal deficit by 5 percent to a record $1.84 trillion as the recession reduces tax receipts and increases the costs of propping up the economy. U.S. consumer prices may rise from 2 to 4 percent in 2010, according to economists in a Bloomberg News survey, and may head higher from there.
On August 2, 2009, on ABC's This Week, Treasury Secretary Timothy Geithner refused to rule out middle class tax hikes in an interview with George Stephanopoulos. Following is some of the exchange from the show:
George: "I know you believe that passing health care is central for getting the deficit under control. But independent analysts say even with that you are going to need to find new government revenues. The former deputy Treasury Secretary Roger Altman said it is no longer a matter of whether tax revenues should increase but how. Is he right?"
Tim Geithner: "George, it is absolutely right and very important for everyone to understand we will not get this economy back on track, recovery will not be strong enough to sustain unless we can convince the American people that we're going to have the will to bring these deficits down once recovery is firmly established."
The U.S. Treasury expects the U.S. national debt to bump up against the debt ceiling of $12.1 trillion (yes that’s trillion with 15 zeros) in the final quarter of 2009. One way to bring down deficits is to raise taxes.

Monetary Policy as the Economy Recovers

From the Board of Governors of the Federal Reserve System Monetary Report to Congress (July 21, 2009):
At present, the focus of monetary policy is on stimulating economic activity in order to limit the degree to which the economy falls short of full employment and to prevent a sustained decline in inflation below levels consistent with the Federal Reserve's legislated objectives. Economic conditions are likely to warrant accommodative monetary policy for an extended period. At some point, however, economic recovery will take hold, labor market conditions will improve, and the downward pressures on inflation will diminish. When this process has advanced sufficiently, the stance of policy will need to be tightened to prevent inflation from rising above levels consistent with price stability and to keep economic activity near its maximum sustainable level. The FOMC is confident that it has the necessary tools to withdraw policy accommodation, when such action becomes appropriate, in a smooth and timely manner.
In short, the Federal Reserve has a wide range of tools that can be used to tighten the stance of monetary policy at the point that the economic outlook calls for such action. However, economic conditions are not likely to warrant a tightening of monetary policy for an extended period. The timing and pace of any future tightening, together with the mix of tools employed, will be calibrated to best foster the Federal Reserve's dual objectives of maximum employment and price stability.

While the Fed has done a yeoman’s job averting depression it looks as if they have given short shrift to recovery plans. Specifically on dealing with the expected inflation that heavy economic stimulus brings.
We’ve had this massive fiscal stimulus, massive monetary stimulus, and it’s hard to see how that doesn’t translate into pretty substantial inflation. Therefore, inflation-hedge securities should be in most investor’s portfolios when the economy begins to gain some traction. (Refer back to the beginning of this piece.)
A well diversified portfolio includes asset sub-classes such as agribusiness, managed timber, Treasury Inflation-Protected Securities, known as TIPS, commodities, energy and others. These mostly real assets have historically done well in inflationary environments.

CPB, August 2009

Sources: Bloomberg LP, the Board of Governors of the Federal Reserve

Portfolio Management: Focus on the Future

Failures in Conventional Thinking

As we near the end of the first decade of the new millennium there are several new terms we use that rarely appeared in common conversation just 10 years ago, terms such as GPS, MP3, Blog, Plasma TV, Subprime and Stem Cells to name a few. All around our society, information describing our world expands at daunting rates and this explosion requires advancing analytics to make sense of it all. For most of the investment advisory business, portfolio building techniques and analyses sit in a conventional state lacking in thinking adapted to the world we know today.

Synonyms for diversification are words such as assortment, divergence, variety, and potpourri. In the in vestment business though, diversification has a very specific meaning: “A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.”

The notion of this specific diversification definition shows up on a wide variety of advisory websites under common concepts such as ”reduce the fluctuations”, “moving in the opposite direction”,” least amount of fluctuation”, “reduce the overall variability”, and smooth out the ups and downs.”

Truly, combining one asset class in the top quartile of the correlation continuum and one in the bottom quartile will smooth returns. However execution of this concept fails theory. Over time, asset classes have become highly correlated mathematically, defined as the top quartile in the correlation continuum – or correlation values of 0.5 to perfect correlation of 1.0.

Consider these facts:
* There are over 300 benchmarks correlated to the S&P 500 and average correlations have increased from 0.38 in 1996 to 0.63 in 2008 – an average solidly in the top quartile where little diversification exists.
* Bonds which used to be uncorrelated to U.S. stocks have moved from a negative correlation (-0.77) during the period from 1997-2002 to a positive correlation (0.68) during the time period 2002-2007.
* Corporate bonds which were clearly not correlated to all stocks10 years ago moved from -0.686 to a positive correlation over the last five years of 0.203.

Many investors have noticed the increased correlations of the capital markets. In a recent study of wealthy investors by PNC, the following quote appeared:
“The ultra wealthy likely are looking longer term, knowing that historically the stock market has advanced when interest rates are falling.”

Actually, investment theory says that a market that is good for bonds (falling interest rates due to recessionary pressure) is bad for stocks. In recent years though, it’s clear that the stock market benefits with interest rate declines and suffers with interest rate increases - to cool down an overheating economy. We also can see in the newspapers that global markets are highly integrated with our markets, reflected in a correlation of the MSCI EAFE (Europe, Australasia, and the Far East) index to the S&P 500 of 0.9 – remember 1.0 is perfectly correlated!

What we end up with is a portfolio built with the presumption of return diversification – smoothing returns over time – but in reality, a portfolio that delivers little real benefit.
Many advisors are quick to show reduced return and volatility factors using a mixture of asset classes. This is a bit of investment sleight of hand. Correlations reflect patterns of returns, the ups and downs of the market as shown in the chart below. High correlations between investments do not mean the actual returns are the same, just the pattern of returns. That does not mean investment diversification has been achieved. Think of it this way, varying the ingredients will make cakes look and taste different, but, in the end, you still have cake!

The world is flat and correlated
A successful portfolio funds your future needs or liabilities; anything short of this is a failure. It makes sense, then, that the portfolio must handle future events, not those of the past. Investment analysis uses past returns as the essential data for risk and return statistics. Consequently, the advisory business puts too much emphasis on past returns of funds and managers, when in fact it is subordinate.
Returns are the result of an economic environment. An economic environment has vast numbers of variables that play out in unpredictable ways, to this point, would anyone dispute that a single industry (banks) can alter an economy? A portfolio defined today must play out in the uncertainty that is the future.
Proper diversification weights the portfolio toward asset classes with the strength to handle the future.

Chris Blakely - May 2009

Sources: Dictionary.com, Investopedia.com, Bloomberg L.P., Investment News (12/14/2007)