Money tends to go where it is best treated, as measured by an asset class, hedge fund or by a traditional investment adviser. As a result, a lot of money will be shifting by year-end, and it is bound to have a disruptive market effect as well as likely to feed continued volatility.

If you delegate investing to an adviser, here are several questions that you may consider asking during a 2008 year-end review of your investment performance:

1. What were your adviser’s expectations for the stock market’s returns in 2008, and how did these expectations compare to the actual results?

2. How did your investment performance compare to that of the major indices? In what areas did you outperform, and in what areas did you underperform — and why?

3. What was your adviser’s economic and credit expectations, and how did these expectations compare to the actual events? Where and why were his assumptions wrong?

4. Did your adviser change his strategy as economic and financial events changed? If he didn’t, ask why?

5. Did you experience outsized individual stock or large specific industry or sector share price losses? Did your adviser institute a discipline to stop losses, or were your losses allowed to compound? Did your adviser “double down” on poor investments?

6. Ask your adviser whether he “eats his own cooking” — that is, did he invest along with you in the same investments, and are both of your interests aligned?

Briefly, I think I will answer for those of you who do invest with us, how I would answer the questions. Feel free to question us more closely in person. Note: While this discussion applies broadly to all of our clients, it is specifically addressed to the vast majority of our assets under management, accredited and qualified investors (those with a net worth of 1 million and up) in our model portfolio’s.

1. What were your adviser’s expectations for the stock market’s returns in 2008, and how did these expectations compare to the actual results?

In our case this discussion really should not be constrained to 2008. We believe we are in the midst of a long term bear market that began with the bursting of the tech bubble in 2000, especially for US financial assets. We participated in the cyclical bull that began in 2003, with significant allocations to international, emerging market, real estate and other high flying assets. Starting in 2006 we began to become more defensive as valuations became more and more unreasonable, allowing our portfolio to move forward based on those areas we felt were most attractive. That allocation allowed us to post strong results through the third quarter of 2007, but the portfolio was dominated more and more by assets not dependent on the general direction of the market. By 2007 we felt returns were likely to turn negative, the economy would struggle and a defensive portfolio was the most prudent path. We had by February of 2007 scrubbed nearly all exposure to financial stocks from our portfolio.

In general our expectations have been met. The markets, especially financial stocks have struggled. Following our strong showing through the first three quarters of 2007 we had a strong burst in the fourth quarter as the markets in the US fell. We weathered the storm in January with a small gain and when all was said and done had a solid first half of the year, with positive returns in each quarter, with solid gains in June to finish off the second quarter.

We began to have concerns short term with our exposure to commodity stocks, especially energy, and hedged that exposure somewhat. We assumed that some of the relationships in our hedged positions might have a short term reverse as well. Unfortunately all of our main performance drivers reversed from the middle of July to the middle of August. It was unusual that all would reverse at the same time, as opposed to being spread out. Unfortunately most, if not all, of our gains during 2008 were lost, though we were still positive since the downturn in the broader equity markets began in October. We feel that most of what we are doing now is still well positioned, with the most likely trouble spot being our unhedged positions, specifically commodity stocks and Asia. Depending on their relative performance we will have a flat to positive end to the year. Our expectation is we will finish the year with returns in the high single digits, which is what we expected at the beginning of the year.

What about surprises? The relative strength of small cap and real estate stocks stick out. We feel they will resume their under performance going forward. Commercial real estate is starting to roll over and we expect that to weigh on REITs. Small cap stocks are still very overvalued, and earnings likely to continue to disappoint. As credit markets and the economy become even more strained access to credit will hit them hard. If they struggle greatly relative to larger, higher quality stocks we could see our expected return numbers increase markedly.

2. How did your investment performance compare to that of the major indices? In what areas did you outperform, and in what areas did you underperform — and why?

We have outperformed broad market indices handily year to date, since the downturn began, and for trailing one, three and five year periods. Heck, we are positive for the year! Accomplishment enough, if unspectacular. Compared to the indices the various areas of our portfolio have performed from okay to fantastic. No major underperforming areas.

3. What was your adviser’s economic and credit expectations, and how did these expectations compare to the actual events? Where and why were his assumptions wrong?

We felt the US faced a high probability of a recession coupled with a worldwide slowdown. We felt the credit markets were the most vulnerable, due to a severe housing downturn, and inflation would be an concern. Interest rates were a bit uncertain since, with inflation an issue and growth vulnerable, the fed would be pushed in both directions. More importantly, due to the difficulties in the credit markets we felt interest rates would be relatively insensitive to the federal reserves efforts and interest rates would remain stubbornly high, with credit spreads likely to widen dramatically. Thus we felt diversifying credit exposure internationally would be prudent and bonds would not be as positive a counter to equity risk as they were in the last downturn.

That has all come true, but our moves to diversify in fixed income have not proven of much benefit. However, our emphasis on other strategies to reduce risk versus fixed income has added value, demonstrating that an over reliance on traditional fixed income to protect in a downturn would not be optimal. In fact, fixed income has been a drag on performance on both the upside and downside of the market over the last two years for us.

4. Did your adviser change his strategy as economic and financial events changed? If he didn’t, ask why?

Yes, though our change occurred before the downturn. We have made some small tactical changes as the year has progressed, though our fundamental approach we feel is still sound. We are preparing for some significant changes in the near future, especially if the equity markets weaken substantially from here and we position the portfolio for a more positive market environment.

5. Did you experience outsized individual stock or large specific industry or sector share price losses? Did your adviser institute a discipline to stop losses, or were your losses allowed to compound? Did your adviser “double down” on poor investments?

This question really doesn’t apply to us since we don’t trade individual securities, though we have hedged positions where one side or the other have struggled. That of course is the expectation for a hedged pair of positions targeting an absolute return. Nevertheless we wish some had been more successful, even if as a pair they outperformed the indices.

6. Ask your adviser whether he “eats his own cooking” — that is, did he invest along with you in the same investments, and are both of your interests aligned?

Not only do we, it is a core value at our firm, and that is exactly how we put it. “We eat our own cooking.”

Hat Tip: Barry Ritholtz

Thanks for visiting Risk and Return. Please feel free to contact us with any questions and/or comments. Please note our disclaimer. For information on our investment process see here.

Technorati Tags absolute returns, advisors, assessing performance, bonds, investment performance, markets, stocks

Finally it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks. For it is in the essence of his behaviour that he should be eccentric, unconventional and rash in the eyes of average opinion. If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy . Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally
-John Maynard Keynes

Random Roger wants to know what his readers think of the strategy of trying to replicate the type of portfolio that David Swensen of Yale has created.

It is certainly a good question, as Yale’s returns are stunning. His interest is peaked by taking a look at this article in Registered Rep magazine.

So what do I think? I suspect regular readers, and our clients, know we are enthusiastic about the approach, though we do tackle it a bit differently. So Let’s take a look at what Yale does, and David Swensen recommends for retail investors:

YALE ENDOWMENT ASSET ALLOCATION TARGETS

Real Assets 27%
Absolute Return 25%
Private Equity 17%
Foreign Equity 15%
Domestic Equity 12%
Fixed Income 4%

Source: Yale Corporation

SWENSEN’S RETAIL ASSET ALLOCATION TARGETS

Domestic Equity 30%
Foreign Developed Market Equity 15%
Foreign Emerging Market Equity 5%
Real Estate 20%
Short-Term U.S. Treasuries 15%
Inflation-Protected U.S. Treasuries 15%

Source: David Swensen

Actually, not a bad strategic allocation on the retail side, and according to Registered Rep it did pretty well through last Summer. What it lacks is any direct hedging similar to the absolute return option, Real assets other than Real Estate, and Private Equity.

Real Assets can be replicated to some extent through ETF’s and some mutual funds. Absolute Return vehicles can include long/short funds, Managed Futures, and for some, actual hedge funds. In addition, direct hedges from mutual funds can be used where appropriate. You will not have access to the favorable cost structure that Yale gets.

A word about Private Equity.

David Swensen speaks to this in his book Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment but some of the lack of volatility is a statistical artifact present in some of his real assets and private equity. Since they are illiquid, the value of these investments often cannot be known, it is estimated or marked to model, rather than to the market. In reality Private Equity is both very volatile, and likely very correlated to the public equity market.

What Private Equity really provides to Yale, is higher returns. Swensen believes they can get top managers, but he admits that if you don’t have top managers that Private Equity does not even outperform once adjusted for risk. He feels though that the dispersion of skill is higher, and that with proper due diligence it can be identified. His results seem to confirm that.

Our twist upon this theme

So, whether we are talking about non accredited, or accredited, investors, how does our approach differ and can it be replicated? We add a tactical element. That goes for private equity as well. In our discussions we have been very wary of private equity, we didn’t think money being invested over the recent past was being invested in a way likely to generate much return, and possibly it would be disastrous. In essence we saw a Private Equity bubble about to pop.

The returns had been reasonably good mostly due to leverage built on easy access to credit. Leverage is fine if you know what you are buying, our suspicion is that most people didn’t realize the risk they were facing if the market turned south, credit dried up, recession, etc. To put it another way, the risk vs. return ratio was out of whack. I think our fear during that time of greed was as usual a good thing to have. We may get a bit greedier when there is a lot more fear in general.

Yale has a pure strategic asset allocation, in essence the managers in the Real Asset and Absolute Return spaces make the tactical decisions. We do the same, but we also tactically increase and decrease (within the constraints of the Investment Policy Statement of our clients) our net exposure to any given traditional benchmark, or beta. We are quite willing to hedge our exposure to US stocks for example, or to go short one part of the market, long another. That is, if we see the expected gap in performance over a two to three year time span as being quite large. We don’t want to be operating in the area where random noise can eliminate that potential return. “Fat pitches” only need apply when it comes to such strategies.

In addition, when upside returns look low, and the potential downside looks high, we increase our allocation to absolute return managers and strategies.

That goes to the problem I have with the strategic retail portfolios I see discussed by Roger and his links (including in the comments.) While over the long haul I believe a portfolio such as the ones examined might do better than more traditional allocations with consistent rebalancing (they have in the past) I don’t think it will get investors where they want to be over the nearer term, say the next five years, and it will take some awfully good years for them to ever catch up to the type of compounded rate of return investors expect.

Unlike 2000-2006, a period that started with a few over valued areas and many components of the market ranging from reasonably priced to under priced, nothing as an asset class is cheap right now. The reasons Real Estate (in the form of REIT’S) was such a fine diversifier are not as applicable now. Traditional asset class diversification may help (though adding huge slugs of Real Estate, something until recently we have always had, made little sense when the article Roger is discussing was written) but it will likely lead to very low returns relative to history. After eight years of low returns another five to seven more is likely to really alter people’s financial plans.

Rather, we suggest adding in diversification of strategies as well. That means portable alpha, or portable alpha inspired strategies, hedges and other strategies to emphasize absolute returns at the portfolio level until markets go through an extended cathartic sell off. Until that happens, whether over the next six months or three years, permanent returns are likely to be hard to get with a mix of diverse, but over valued securities. The eventual sell off will likely eliminate most of the returns gained during any upturns, leaving the investor with returns barely above, and quite possibly below, the rate of inflation. The most over valued areas should likely just be avoided or used as a hedge.

Of course, as Jeremy Grantham recently pointed out, cash isn’t such a bad thing either.

To put it another way, the publicly traded diversifiers of the past have been bid up in price and are now likely very correlated, at least on the downside.

What is the longer term problem with tactical approaches?

They are difficult to do. Both from a knowledge standpoint, and psychologically. Most investors, including professionals, have no idea what the historical valuation of the market is, or what return the market is priced to deliver in various asset classes. Essential information to adequately pursue this kind of strategy.

As the quote I began this post with states, the largest constraint is the psychological will to allow themselves returns that do not track the larger market. We say we want non correlation, but what we mean is we don’t want to go down with the market. The idea of not tracking the market on the upside is not what we want to hear. Even tremendously successful investors, like Jeremy Grantham, Rob Arnott and John Hussman suffer for the impatience of their clients, no matter their great track records and the logic of what they are doing.

Yet, unless one has the ability to time pretty closely the market, that is exactly what you have to do to carry off such a strategy. That will also be true of the type of replicated portfolios Swensen and others are proposing. The goal is performance over several years time. Hedges which over time turn out hugely profitable will not be received kindly during the upward marches which populate even extreme bear markets. Intelligent active asset allocation is therefore the province of the few and the thick skinned, thus the popularity of static strategic asset allocation.

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Technorati Tags Asset Allocation, bonds, Commodities, David Swensen, Hedge Funds, portfolio management, private equity, real assets, real estate, Risk, stocks, Yale

Heavy selling hit each Asian and European stock market as soon as it opened. Some of Asia’s easternmost exchanges, which had closed on Monday before the sharpest declines occurred in India and then Europe, suffered particularly steep drops.

The Japanese stock market dropped 5.7 percent, for the worst two-day loss in 17 years, while the Australian stock market tumbled 7.1 percent, its worst single-day loss in nearly two decades. The Shanghai market lost 7.2 percent while the Hang Seng index in Hong Kong plummeted 8.7 percent.

Technorati Tags asia, europe, international stocks, markets

Stock markets around the world plummeted Monday, prompted by pessimism about U.S. President George W. Bush’s plans to boost the U.S. economy.

Share prices in Asia, Europe and the Americas all plunged by significant amounts; Wall Street only avoided joining the tumble because U.S. markets were closed Monday for Martin Luther King Day.

Markets in Europe reacted with London’s FTSE 100 Index down 5.5 percent at 5,578.20; the CAC-40 in Paris down 6.8 percent to 4,744.15; and Frankfurt’s DAX dropping 7.2 percent to 6,790.19.

In Japan, the benchmark Nikkei 225 index closed on 13,325.954 points, a slide of 3.9 percent and its biggest dip in two years. Shanghai’s Composite index fell 5.1 percent.

Read the rest if you want to feel depressed.

This is probably a mix of the need for stimulus being a bad sign for the world economy, and a realization that the stimulus is also not going to be sufficient. I agree on both conclusions. My concerns over the economy have been expressed in no uncertain terms for some time, and I have given my reasons for doubting the efficacy of fiscal stimulus packages. Fiscal stimulus that relies on increasing spending is an especially false hope, except in rare circumstances. Tax packages that make the adjustments businesses and investors need to make less expensive can help, but to do so they would have to be substantial, and politically I doubt they will amount to much.

Interestingly, Paul Krugman has historically felt similarly. Unlike Paul, I doubt monetary policy can do much either.

An important thing to remember when we discuss the government stimulating the economy, is that the numbers involved are completely out of whack. Let us pretend that the government spending $145 billion actually subtracted not a whit from other people’s spending or investment. That it was all added spending in our economy that would not exist otherwise. This is frankly ridiculous, but let us for the sake of argument pretend it were true. Folks, when we are talking about a 13 trillion dollar economy, that seemingly large $145 billion seems awfully puny. Around 1%. That one percent is supposed to make a difference?

Of course, that is a completely unrealistic scenario, because in fact the government will borrow the money from somewhere, money that would largely have been spent or saved in another fashion anyway. Academic studies show large amounts of the stimulus will be used to pay down credit cards and other debt. Some will be saved. Whatever that is, it isn’t a stimulus.

Similarly, the Federal reserve, for all the sturm and drang in the papers over the massive liquidity injections, is similarly poorly positioned. They control approximately $30 to $40 billion in reserves. That is it. The amount of liquidity “injected” has been essentially nil. Almost all of it was just the federal reserve rolling over existing repurchase agreements with banks. They can attempt to lower interest rates, but that will have a long delayed impact. Politically the Fed and the government need to be seen doing something, but what they can do is vastly overrated.

I bring this up not to scold our politicians, or the Fed, but to emphasize that we as investors should not be fooled about such policies rescuing us if we are not appropriately positioned. Certainly we should be mindful of the last time investors were urged not to “fight the Fed.” Huge losses followed as many investors walked hand in hand with the Fed to interest rates as low as 1%. I chose to fight and I am glad I did.

The economy and markets may recover, but policy will not be the major determinant.

Other views:

Tyler Cowen points out that rebates don’t always accomplish what they are supposed to do.

Menzie Chen looks at business incentives.

James Hamilton makes his case against fiscal policy, and echoing my own thoughts thinks Bernanke was not giving the green light to it that many believe.

Paul Krugman has his own thoughts about what to do now.

Mark Thoma questions the efficacy of making tax cuts permanent.

Finally, via Abnormal Returns, Greg Mankiw asks great questions:

If some journalist out there talks to a member of the Federal Open Market Committee, here is the question I would ask:

If the economy now gets the fiscal stimulus being proposed (about 1 percent of GDP), does that mean that the Federal Reserve will cut interest rates less than it otherwise would?

My follow-up questions:

If the answer to the first question is No, then ask, Why the heck not? Monetary and fiscal policy are two tools available to increase the aggregate demand for goods and services. The goal here is to prop up demand sufficiently to maintain full employment without causing inflation. If the U.S. government is using fiscal policy more, it should use monetary policy less.

If the answer to the first question is Yes, then ask, How much higher will interest rates be kept as a result of the fiscal stimulus? And is it really better to have a fiscal stimulus and higher interest rates than a smaller deficit and lower interest rates?

More from Greg here, and here.

Update: Megan McCardle echoes my concerns:

As talk of stimulus plans grows, readers are asking for my thoughts. Which are: stimulus rarely works unless it is massive and very rapidly applied, and if it is massive and very rapid, it usually has much larger problems.

The difference between tax cuts and spending is irrelevant in theory. In practice, because so few people pay significant income tax, it has distributional effects. Since rich people seem to save more money than poor people, this blunts the effect of the stimulus. On the other hand, spending is generally much more distortionary than tax cuts, because the government picks what the money is spent on. One more reason not to like fiscal stimulus packages.

Thanks for visiting Risk and Return. Please feel free to contact us with any questions and/or comments. Please note our disclaimer.

Technorati Tags federal government, Federal Reserve, fiscal stimulus, monetary policy

This is quite an education. Click for a larger image.

Although the economies of countries like China and India are growing at an incredible rate, the US remains the nation with the highest GDP in the world – and by far: US GDP is projected to be $13,22 trillion (or $13.220 billion) in 2007, according to this source. That’s almost as much as the economies of the next four (Japan, Germany, China, UK) combined.

The creator of this map has had the interesting idea to break down that gigantic US GDP into the GDPs of individual states, and compare those to other countries’ GDP. What follows, is this slightly misleading map – misleading, because the economies both of the US states and of the countries they are compared with are not weighted for their respective populations.

Pakistan, for example, has a GDP that’s slightly higher than Israel’s – but Pakistan has a population of about 170 million, while Israel is only 7 million people strong. The US states those economies are compared with (Arkansas and Oregon, respectively) are much closer to each other in population: 2,7 million and 3,4 million.

And yet, wile a per capita GDP might give a good indication of the average wealth of citizens, a ranking of the economies on this map does serve two interesting purposes: it shows the size of US states’ economies relative to each other (California is the biggest, Wyoming the smallest), and it links those sizes with foreign economies (which are therefore also ranked: Mexico’s and Russia’s economies are about equal size, Ireland’s is twice as big as New Zealand’s). Here’s a run-down of the 50 states, plus DC:

Unsurprisingly California and Texas have the largest GDP’s. Some of the others are very surprising. My home state routinely is ranked at the bottom of many statistics, yet in GDP terms this little state with a population of only about 4.5 million ranks 16th. Not bad when you consider the cost of living. Check out the nations which rank below it in the following list.

Other’s talking about it: Barry Ritholtz and Carl Stormer:

When seeing Norway’s GDP in the context of this map, one realizes why Norway is one of the last countries U.S. companies consider when expanding to Europe.

My two cents (not in the blog): In addition to small GDP, little competition has enabled local players to build monopolies or duopolies in many industries. Add high state ownership to this mix, and you understand why Norwegian consumers are unused to good service and competitive prices. Other than that, Norway is a great country.

Fascinating:

1. California, it is often said, would be the world’s sixth- or seventh-largest economy if it was a separate country. Actually, that would be the eighth, according to this map, as France (with a GDP of $2,15 trillion) is #8 on the aforementioned list.
2. Texas’ economy is significantly smaller, exactly half of California’s, as its GDP compares to that of Canada (#10, $1,08 trillion).
3. Florida also does well, with its GDP comparable to Asian tiger South Korea’s (#13 at $786 billion).
4. Illinois – Mexico (GDP #14 at $741 billion)
5. New Jersey – Russia (GDP #15 at $733 billion)
6. Ohio – Australia (GDP #16 at $645 billion)
7. New York – Brazil (GDP #17 at $621 billion)
8. Pennsylvania – Netherlands (GDP #18 at $613 billion)
9. Georgia – Switzerland (GDP #19 at $387 billion)
10. North Carolina – Sweden (GDP #20 at $371 billion)
11. Massachusetts – Belgium (GDP #21 at $368 billion)
12. Washington – Turkey (GDP #22 at $358 billion)
13. Virginia – Austria (GDP #24 at $309 billion)
14. Tennessee – Saudi Arabia (GDP #25 at $286 billion)
15. Missouri – Poland (GDP #26 at $265 billion)
16. Louisiana – Indonesia (GDP #27 at $264 billion)
17. Minnesota – Norway (GDP #28 at $262 billion)
18. Indiana – Denmark (GDP #29 at $256 billion)
19. Connecticut – Greece (GDP #30 at $222 billion)
20. Michigan – Argentina (GDP #31 at $210 billion)
21. Nevada – Ireland (GDP #32 at $203 billion)
22. Wisconsin – South Africa (GDP #33 at $200 billion)
23. Arizona – Thailand (GDP #34 at $197 billion)
24. Colorado – Finland (GDP #35 at $196 billion)
25. Alabama – Iran (GDP #36 at $195 billion)
26. Maryland – Hong Kong (#37 at $187 billion GDP)
27. Kentucky – Portugal (GDP #38 at $177 billion)
28. Iowa – Venezuela (GDP #39 at $148 billion)
29. Kansas – Malaysia (GDP #40 at $132 billion)
30. Arkansas – Pakistan (GDP #41 at $124 billion)
31. Oregon – Israel (GDP #42 at $122 billion)
32. South Carolina – Singapore (GDP #43 at $121 billion)
33. Nebraska – Czech Republic (GDP #44 at $119 billion)
34. New Mexico – Hungary (GDP #45 at $113 billion)
35. Mississippi – Chile (GDP #48 at $100 billion)
36. DC – New Zealand (#49 at $99 billion GDP)
37. Oklahoma – Philippines (GDP #50 at $98 billion)
38. West Virginia – Algeria (GDP #51 at $92 billion)
39. Hawaii – Nigeria (GDP #53 at $83 billion)
40. Idaho – Ukraine (GDP #54 at $81 billion)
41. Delaware – Romania (#55 at $79 billion GDP)
42. Utah – Peru (GDP #56 at $76 billion)
43. New Hampshire – Bangladesh (GDP #57 at $69 billion)
44. Maine – Morocco (GDP #59 at $57 billion)
45. Rhode Island – Vietnam (GDP #61 at $48 billion)
46. South Dakota – Croatia (GDP #66 at $37 billion)
47. Montana – Tunisia (GDP #69 at $33 billion)
48. North Dakota – Ecuador (GDP #70 at $32 billion)
49. Alaska – Belarus (GDP #73 at $29 billion)
50. Vermont – Dominican Republic (GDP #81 at $20 billion)
51. Wyoming – Uzbekistan (GDP #101 at $11 billion)

Technorati Tags GDP, Louisiana, map, Norway, US States

…the annual expansion in China’s trade has been larger than India’s total annual trade during last several years.

Tyler Cowen hones in on this point, amongst a bounty of good points:

The most important factor that still holds back large [Indian] firms from entering these products is a set of draconian labour laws in India. Under these laws, it is virtually impossible for a firm with 100 or more employees to fire the workers even in the face of bankruptcy. It is equally difficult for the firms to reassign the workers from one task to another. These provisions impose very low worker productivity or a high real cost of labour. Large-scale capital-intensive sectors such as automobiles, where labour costs are a tiny proportion of the total costs, can profitably operate in such an environment. But the same is not true of large-scale labour-intensive sectors labour. Few foreign manufacturers are willing to enter India outside of a small subset of capital- and skilled-labour intensive sectors.

These kinds of rules damage economies around the world, but countries with the enormous poverty present in India are the least able to afford the luxury of such self inflicted wounds. Which goes to the point of the first chapter of the latest Index of Economic Freedom report.

Economic Fluidity: A Crucial Dimension of Economic Freedom

This essay argues that whether the economic infrastructure is “successful” or “perverse” and whether the “reward structure” is conducive to innovation and entrepreneurship rests on the degree of economic fluidity. Without constant mixing across boundaries, without the creation and testing of ideas, and without learning and adaptation, the specific character of the institutional structure matters little. Fluidity determines whether or not the structure will be successful in facilitating growth.

It isn’t capital, natural resources or education, it is the opportunity for all of those things to be deployed and redeployed. Entrepreneurial activity.

Technorati Tags China, economic fluidity, Economic Freedom, Economics, Index of Economic Freedom, India

Fortunately, the Fed has some ideas on what they should–and shouldn’t–do. Bernanke’s remarks came with a warning that any fiscal bailout “could prove quite counterproductive” if it’s not done in a timely manner or if it’s not temporary.

Brian Wingfield goes inside the fed chiefs mind:

Translation: Get to work immediately and spread out the costs over time. The price tag? Bernanke says a $100 billion package would have a “significant” impact on the economy.

Here he explains why he is dubious:

“It’s very difficult to engineer a well-timed fiscal stimulus,” says Vincent Reinhart, a former Federal Reserve economist, now a scholar with the American Enterprise Institute. The 2000 recession was resolved by a “happy accident” of circumstances, he says. President Bush ran for office on a proposal to cut taxes, which helped the economy just as it was slowing. At the same time, the Fed took an expansionary view of monetary policy, cutting interest rates to spark growth (fueling a housing boom, which is at the core of the current downturn).

It might be difficult to time such an economic rescue correctly this time around. “You’re just not sure when you start the process where you’ll end up when legislation’s involved,” says Reinhart.

I have made my own concerns known. Read them, my guess is it is pretty much the gist of what Bernanke is driving at, and probably he is managing his public perception more than expecting it to make any large difference. Either way, I don’t expect it to have any meaningful positive effect on longer term investment results. Douglas Elmendorf is skeptical as well:

One circumstance in which fiscal stimulus is an appropriate complement to monetary stimulus is when achieving full employment with higher interest rates is better than achieving full employment with lower interest rates. In particular, further cuts in short-term U.S. interest rates heighten the risk of investors deciding to flee U.S. assets. The result would be further turmoil in financial markets and a large and quick drop in the value of the dollar, which would be disruptive to the U.S. economy and foreign economies and might slow economic growth further. Moreover, any decline in the dollar puts upward pressure on inflation (beyond any inflationary pressure from the level of employment) because higher prices for imported goods act as a negative supply shock.

However, he does cite some potential positives.

Meanwhile housing starts were even worse than expected, and expectations were pretty bad to begin with:

Home construction plunged in December, tumbling to its lowest point in 16 years, while a sign of future groundbreakings also dropped sharply.

Housing starts decreased 14% to a seasonally adjusted 1.006 million annual rate, after falling 7.9% in November to 1.173 million, the Commerce Department said Thursday. Originally, Commerce reported November starts 3.7% lower at 1.187 million.

The big decline surprised Wall Street. The median forecast of economists surveyed by Dow Jones Newswires was a 5.0% drop to a 1.130 million annual rate. The level of 1.006 million was the lowest since 996,000 in May 1991.

Commercial property is not looking immune either:

The credit crunch that roared through the residential real-estate market is starting to bite commercial projects, too.

Yesterday, Ian Bruce Eichner, the developer of a twin-tower casino resort in the heart of Las Vegas, defaulted on a $760 million loan from Deutsche Bank AG after he failed to get refinancing. The default on the loan supporting the $3 billion Cosmopolitan Resort Casino is a signal of trouble for Mr. Eichner, who gained notice during an earlier real-estate downturn in the early 1990s when he lost several projects in New York City.

Merrill Lynch also did worse than the already awful expectations. My emphasis:

The company recorded a net loss of $9.83 billion, or $12.01 a share, compared with year-earlier net income of $2.3 billion, or $2.41 a share. Write-down expectations were running as high as $15 billion. The company recorded $7.9 billion in mortgage-related write-downs in the third quarter.

Net revenue was negative $8.19 billion because of the write-downs.

The mean per-share loss estimate of analysts polled by Thomson Financial was $4.93 on revenue of $399 million.

Twelve dollars in losses a share!

In addition people are wondering about this whole “de-coupling” thesis (also here.)That is the idea that emerging markets and other countries overseas can avoid a downturn if the US slides into a recession. I admit to being skeptical as well, though I suspect they will only slow down, and while they will be volatile, they will not decline as much as US markets will if things get really ugly.

(ed.- haven’t you already said they were ugly?)

Uglier than people have thought, but I am no longer so lonely and markets have discounted the possibility of recession, not it actually happening. That is a key distinction people have missed. I regularly hear that markets have a recession “in the price.” That is why they have gone lower. If so, then why do prices keep going lower when more bad news hits? Markets discount the probability of something. Shares have declined as investors have felt that probability rising, as it becomes more obvious that profits will decline they will go lower still. If things get worse, it will get a lot uglier in the markets. An actual recession is not in the price.

In fact, the prices in my mind still imply earnings growth over the long term which are unreasonable for the broader indices.

Of course, a good question is, are bonds the answer? I don’t think so, and Doug Kass is downright bearish (H/T:Abnormal Returns.)

The bond market is in a bubble that is reminiscent of (and quite possibly as extreme as) other bubbles during previous eras.

From my perch, the only issue is the timing of this trade.

Surprisingly, today’s 3.68% yield on the 10-year U.S. note is lower than the yield during the recession of 2001. This low yield appears to be artificially affected by a number of temporary and backward-looking factors.

His rationale for this shows the uncertainties surrounding this asset class, though I am not sure now is the time to sell. Let us just say we have deemphasized bonds as a defensive measure and concentrated on other techniques. Bonds have been a drag on our portfolios since November, and so far this year. So we are pretty happy with that choice. The other ways of dealing with this have been far more effective. I expect that will remain true.

What about the risk from insurers of debt I have mentioned before? It is looking grim for them as well. Calculated Risk looks at the latest PR from AMBAC:

Translation: You thought 14% was a steep yield for MBIA to pay on the surplus notes (See: “How many other AAA rated companies are raising money at 14%?”). With this possible downgrade, we might not be able to raise capital even at 20%!

Also note, from Merrill this morning, the $3.1B credit valuation adjustments related to hedges with financial guarantors (ACA financial). There is no party in counterparty. (thanks to BR!)

I did notice that little tidbit on Merrill, which goes to the biggest known risk that hasn’t really hit yet, all those insurers, including investors behind credit default swaps, who may not be able to pay up! What is the level of counterparty risk?

Funny you should ask, because the ratings agencies say they don’t know (my emphasis below)and probably will not know:

The complexity of the global financial system and the imbalance of information available to market participants means the ability to track risk has declined “probably forever”, Moody’s Investors Service said . “It is extremely unlikely that in today’s markets we will ever know on a timely basis where every risk lies,” analysts at the ratings agency, led by chief international economist Pierre Cailleteau, wrote in a report.

Read the whole thing.

Various links from Abnormal Returns:

Tech spending does fall in a recession. (Silicon Alley Insider)

You think?

News you should (already) know. A study finds that “..clowns are universally disliked by children.” (Scientific American)

You think?

A new primer on behavioral economics. (Odd Numbers):

From a new blog by M.I.T. economist Dan Ariely tied to his new book Predictably Irrational. I read and would highly recommend the book if you’re looking for case after case of the failure of rational man.

Definitely going on my blogroll.

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Technorati Tags AMBAC, behavioral finance, Ben Bernanke, clowns, Emerging Markets, Federal Reserve, fiscal policy, fiscal stimulus, housing, MBIA, Merrill Lynch, Moody's, recession

Cafe Hayek fans take note, it is finally out. Short review from Tyler Cowen:

This is the best popular book explaining the benefits of international trade. Imagine Bastiat for 2008, or a Cajun updating of Henry George’s Protection or Free Trade. Sadly it is expensive but I’d sooner give a student this book than say Henry Hazlitt’s Economics in One Lesson.

High praise. Here is Amazon’s description:

The contemporary era of globalization demonstrates that the local and global aspects of business and government are increasingly intertwined. Over the past fifty years, international business has evolved from the realm of the largest multinational corporations to the base scenario; every business and every citizen who participates in economic activity–by creating, buying, and selling products and services–is now a member of the global economy. But moving our thinking and actions beyond the local sphere is both challenging and problematic; the international domain is more complex, and introduces a new dimension of risks and uncertainties. Yet it it also ripe for business opportunity and wealth creation for those who learn how to navigate in it. Globalization defines and makes sense of the workings of the global economy–and how it influences businesses and individuals on a local scale. Each chapter identifies common questions and issues that have gained exposure in the popular media–such as outsourcing, the high cost of international travel, and the impact of a fast-growing China–to illustrate underlying drivers and mechanisms at work. Covering international trade, national wealth disparities (the haves vs. the have-nots), foreign investment, and geographical and cultural issues, and supported with illustrations, maps, charts, a glossary and timeline of key events, this volume illuminates the dynamics of the global economy and informs readers of its profound impact on our daily lives.

Technorati Tags Bastiat, books, Don Boudreaux, Economics, globalization, Trade, Tyler Cowen