As one of the few who saw this crisis coming and how it might play out across the board, not just in particular areas, he deserves a listen. As one of the most successful investors of the last 30 years he would warrant a listen anyway.

Watch the whole thing.

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Technorati Tags Asset Allocation, credit crisis, Emerging Markets, equities, Housing Market, investing, Jeremy Grantham, Risk, value investing

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

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

China turned in yet another double digit year:

China’s economy grew by 11.4 per cent in 2007, the highest pace in 13 years, but the trend of decelerating exports to a slowing US recorded in the final two quarters is expected to be carried into moderating growth this year.

China’s economy has now grown at double-digit rates for five straight years, an achievement hailed by the government as a “hard won gain” of difficult policy decisions.

New York Insurance officials are pressuring banks to bail out the insurers:

Leading US banks are under pressure from New York state’s insurance regulator to provide as much as $15bn to support struggling bond insurers, people familiar with the matter said on Wednesday night.

I am not sure if that is the right move for the banks, but you have to think they are saying to themselves, “How lovely, we pay these guys to insure bonds, when they cannot pay us they want us to provide the money they need to pay us back. Just lovely.”

The Congress has passed a stimulus bill. Of course, when are the checks supposed to arrive? In June. Haven’t I spoken about the time issue before? I think I have. Yes.

Steven Dubner has a similar observation, and some support. Bruce Bartlett throws in this chart to illustrate history supports we skeptics (click image to enlarge)

Which goes to prove that recessions end and stimulus rarely appears until after they are over.

Are we in recession? Calculated Risk looks at a little covered set of data from the Philadelphia Federal Reserve Bank.

Bespoke compiles some data to help us understand how a Bear Market behaves. That is part of my next post, I have some thoughts on that as well.

I stand by the claim that as investors we should pretty much discount fiscal stimulus as a plus any time soon. Greg Mankiw doesn’t think things are bad enough for this to do much good in any case, and potentially is a long run negative.

Tyler Cowen discusses the law of unintended consequences:

Dubner and Levitt have an article in the NYTimes with three examples of the law of unintended consequences, the Americans with Disabilities Act made it more costly to hire people with disabilities and reduced their employment, ancient Jewish sabbatical law intended to help the poor has made them worse off, and the endangered species act has resulted in habitat destruction.

If it isn’t a law it is certainly a key risk factor.

Oh, and about that fraud, 7.1 Billion dollars worth by a single trader.

Which leads Barry Ritholtz to feel the Fed intervened for the wrong reasons. I lean his way on this. In fact, this kind of makes the point that he is right.

Hat tip: as always, some of this is from Abnormal Returns. Even if not, go there.

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Technorati Tags bond insurers, China, Federal Reserve, fiscal policy, fiscal stimulus, Links, recession

Click here for Global Correction

*Mouse over the cities on the maps to get the hard numbers.

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

Technorati Tags bear market, correction, equities, global equities, stocks

What does this mean for investors. Quite a number of things – none of which are particularly good over the long term:

1) Why Cut today? What was the motivation for today’s cut? Would waiting 7 days have done anything. other than allowing some of the excesses to get wrung out of the system?

2) Equity Market Dysfunction? Is it that the equity markets are not working properly? Likely not. Are rates too high? I doubt that’s the reason for any of our economic woes. Then what is it – are lowered equity prices a problem?

Globally, equity markets have been in the process of “Repricing Risk” – why is the Fed disrupting that? Further, there is now a recognition that S&P500 earnings were priced way too high – especially in the event of a European and Asian slow down. That lowered “E” in the P/E adjustment is also under way.

3) TANSTAAFL: The free lunch crowd (a/k/a Long & Wrong) has been chanting for Fed cuts. However, these are not with0out consequences, as Inflation remains a pernicious threat.

Here’s a question: What goes to $5 a gallon first – Milk or Gasoline? How about $6?

4) How Independent is the Fed? The Fed is supposed to be an independent entity, whose mission is a) price stability (inflation) and b) maximizing employment (growth).

However, today’s action reveals an apparent third obligatory goal – protecting investors and market prices. I had no idea that back-stopping speculators and hedge funds was part of their mandate…

5) Capitulation? The Market gapped 400 points, and is now climbing higher (off 300 as I type this). My second biggest concern is that the Fed merely delayed the inevitable. This market saving cut prevented a thorough, 5% wash out. In other words, all the Fed did was prevent a healthy capitulation.

6) Pushing on a String? My biggest fear is that we close down 500 points anyway. That would be the worst of all worlds: A compromised, political Fed, working on behalf of speculators, to the detriment of ordinary taxpayers, is proven to be a paper tiger. That scenario would but the “F” in Fugly.

7) Decoupling US Equities from Global Slowdown? Other markets were down much more than the US. But that makes sense, seeing as they have been a whole lot more than the US over the past 5 years . . .

Bill Gross echoes Barry and I:

“It’s a sad testament to think the Fed has to cut interest rates eight days in front of a meeting to salvage the equity markets. The U.S. economy is in a rather sad state of affairs in that it depends on housing and stock prices to keep going.”

-Bill Gross, founder and chief investment officer, Pacific Investment Management Co. (PIMCO)

Paul Desmond in the Wall Street Journal builds on the theme:

In many ways, this is what a classic bear market looks like: After a long period of exuberance, a downturn hits one part of the economy — in this case, the housing market and mortgage-backed securities. Eventually, that leads to broader losses, even for strong companies, and markets begin a prolonged grind downward. . .

The current market looks a lot like the beginning of past bear markets, such as the ones that began in 2000 and in the 1970s and 1987, said Paul Desmond, president of market-research firm Lowry’s Reports in North Palm Beach, Fla. First, the most troubled stocks decline — home builders and financial stocks in the current case — and then others gradually get hit, including small stocks, retailers, technology stocks, and foreign stocks. Finally even stocks of strong companies are affected.

What happens, Mr. Desmond says, is that trading volume and price movement get heavier and heavier for stocks that are declining, and lighter and lighter on the buying side, as more investors look for a way out. When the selling reaches a climax, the bear market is nearing an end, but Mr. Desmond says he doesn’t see any sign of a climax yet.

“We feel we have been in a bear market since July. Everything that we have seen since then has just been a progression, almost like a disease that you are monitoring and the disease is spreading,” he says. “We are still a long way from a major bottom.”

He is watching for a sign of panic selling, but says it hasn’t gotten to that point yet. “Everything we are seeing looks like a typical bear market,” he says.”

Update: Barry has two interviews with Paul:
Q&A: Paul Desmond of Lowry’s Reports
Part II — Q&A: Paul Desmond of Lowry’s Reports

Technorati Tags Barry Ritholtz, bear market, decoupling, Employment, equity markets, Federal Reserve, Inflation, interest rates, monetary policy, Paul Desmond, stocks

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