Instead let us look at what expectations for them are now. From Citigroup (pdf.)

What we see here is that expectations for profits and loan growth are far higher than past crises show are likely. The question we have to ask is whether it is as bad as those past events? I don;t know, but if it is as bad as it appears expectations are still too high.

Key points:

Earnings (of course) collapse, driven in part by soaring bad debts. However, these periods also suffer massive shrinkage in loan books and (more modest) shrinkage in deposits and total balance sheets. Pre provision operating profit also tumbles, in part reflecting this balance sheet shrinkage. Applying even the least damaging of these episodes (Hong Kong 1997-2002) to the current sector would see loan books halve and earnings, equity and operating profit all fall c40% from current forecasts.

[...]

To be clear, none of our economists forecast depression or deflation in Europe, but as recent IMF analysis demonstrates, recessions preceded by financial crisis tend to be long and deep. We might find ourselves rereading this report in a few years time and thinking that we were way too bearish to even raise this spectre. Or we might not.

My suspicion is that the specific problems mentioned earlier make these outcomes far more likely than many people wish to admit.

Hat Tip: Alphaville

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Technorati Tags banks, Citigroup, debt, deflation, European banks, Financial crisis, loan growth

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

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

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.

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