Jeremy Grantham is one of the current asset allocation gurus on Wall Street.  He was co-founder of Batterymarch Financial Management in 1969 prior to founding his current firm, GMO. Mr. Grantham has been featured in Forbes, Barron’s and Business Week and is routinely quoted by the financial press. He earned his undergraduate degree from the University of Sheffield (U.K.) and an M.B.A. from Harvard Business School. 

Jeremy Grantham projects 10 flat and volatile years for stocks from the average of 10 previous bubble bursts. 

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As one can see, the historic precedent for the equity market over the next decade would not thrill most investors.  Grantham, for his part, has a few areas in which he sees the potential for returns (or at least the avoidance of losses).  He calls for a normal weighting to the global equity markets, but one should steer clear of low quality domestic stocks.  Larger companies with sustainable cash flows and solid business models will be able to deliver higher returns over the next seven years than their risker small cap counterparts.  In fact, Grantham calls for a negative real return for small capitalization stocks. 

Safety, as it turns out, serves as Grantham’s primary theme.  He recommends investors “tilt” their portfolios toward safer assets wherever possible.  For instance, with interest rates at record a low, Grantham suggests avoiding duration risk in bonds.  The price of bonds move inversely with interest rates; so if interest fall, the bond is worth more and vice versa.  When, not if, interest rates rise, bondholders with more duration (interest rate sensitivity) will suffer more than those whose bonds have shorter duration.  His firm’s seven year asset class forecast predicts most fixed income asset classes will also have negative real returns, with Emerging Market Debt as the exception returning a modest real 1.3%.   Grantham also stress that investors should not be too proud to hold “substantial” cash reserves over the foreseeable future.  Finally, Grantham is a firm believer in limited natural resources on the planet.  In the past, he has eloquently defended the Malthusian argument that exponential population growth and economic development will strain many, if not all, of Earth’s natural reserves.  Subsequently, as an investor, he has taken interest in commodities as well as companies that help bring them to market.  Grantham recognizes that volatility in commodities make it difficult for many investor, therefore, he is constructive over the long-term (10 years) on many natural resources.  He does admit, however, that there is a coin flip’s chance that the current global slowdown and normalized weather patterns may provide a lower entry point for investors.  That is, commodities very well may see price declines in the short-term.

DON’T FIGHT THE FED

While Grantham has a less than rosy outlook over the next seven to ten years, numerous factors such as fiscal policy, a global economic slowdown, a trade war, unexpected new technologies and industries or multitude of other factors could dramatically change the forecast.  Perhaps the most influential factor for the United States is the Federal Reserve’s monetary policy.  Certainly over the past few years, the Fed has had a profound influence on markets as the chart from Doug Short (dshort.com) below illustrates.

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The graph displays that while fiscal policy (PDCF, TALF, TARP, etc.) was not immediately effective in the markets; the Fed’s zero interest rate policy as well as quantitative easing (QEs) had an enormous influence.  The S&P 500 (indicated in blue above) rallied significantly during both QEs periods in which the Fed injected more money into the economy exhibiting investors drive for more risky assets.  On the other hand, at the end of each easing period, the stock market fell as investors became more risk adverse. 

The key question becomes what will be the Fed’s policy going forward.  The central bank has already declared its intention to keep their benchmark interest near zero through at least 2013.  As the economy stumbles again with threats of a credit crisis in Europe, would the Fed undergo more quantitative easing programs, and would it have the same effect of driving investors into riskier assets?  The consensus remains that while further monetary stimulus may occur in the near term, over the intermediate term the Fed will significantly reduce its balance sheet, which has ballooned over three times since 2007.  Whatever happens over the next few years with monetary policy, investors should remember the old maxim of “Don’t Fight the Fed!”

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IMPLICATIONS FOR ASSET ALLOCATION

The common thread between Grantham, central bank policy, and market analysts as whole is that volatility and lower real returns from traditional assets will be around for the next few years at a minimum.  Thus, it is important for institutions to examine their return expectations and ways to meet their required investment returns.

Most institutional investors such as endowments, foundations, and pension plans, have an investment goal of 5% over the rate of inflation.  This is in line with the actuarial interest rate assumption of most pension plans which averages 7.5% to 8.0% nationwide, and accomplishes the most common spending policy of endowments and foundations, which is 5%, plus keeping the principal indexed to inflation. 

Asset allocation has always been one of the most important decisions investors make, and with the volatility and uncertainty of the current environment, it is one of the most difficult.  Studies indicate that the asset allocation decision accounts for a majority of an investor’s experience in both risk and return.   Most sophisticated investors have an asset allocation policy including a target allocation for each asset class, and an allowable range collared around each target.  This is known as Strategic or Static Asset Allocation.  Over long periods of time Strategic Asset Allocation has accomplished the goals of most investors.   However, long term is more than 25 years!  In the shorter term the investment goals have been difficult to achieve with only a Strategic Asset Allocation system, and the traditional 60% equity / 40% fixed income indexed strategy has failed to meet the goal.

THE IMPORTANCE OF ASSET ALLOCATION

The chart below displays various asset class returns over the past 15 years.  As one can see, returns vary greatly year to year.  For instance, look at emerging market equities (purple box color).  In 2007, the index returned nearly 40%.  The next year, however, it fell over 53% and in 2009 it rose 79% (though still below its level at the end of 2007).  With that much volatility, many investors lost faith in the emerging market asset class at the wrong time and missed the subsequent rally in 2009.  In fact, a recent study by J.P. Morgan Asset Management found that stocks and bonds both returned 7.7% and 6.1% respectively over the last 20 years.  There is no combination of stocks and bonds over this period that would earn the required 8% return of most pensions, foundations and endowments.  J.P. Morgan also found that an average investor returned a mere 2.6% over this period.  Clearly, investors buy and sell assets at less than ideal times. 

 Past performance is no guarantee of future results. This graphic is for illustrative purposes only and not indicative of any specific investment. An investment cannot be made directly in an index.

ACTIVE ASSET ALLOCATION

So what steps can institutional investors take to meet their return requirements?  For decades, a blend of stocks and bonds, traditional assets, appeared to be the answer.  Over the past fifteen years, however, the mix of 60% stocks and 40% bonds (black dot on the chart) has not met the common bench mark of inflation plus 5% for spending (light blue).  The next step involved diversifying into new asset classes.  These assets classes may have included foreign securities, real estate, commodities and master limited partnerships (MLPs).  By doing so, investors could beat the inflation plus 5% benchmark (red dot) albeit by taking on slightly more risk.  As illustrated in the asset class table above many of the new asset class added had more volatility and during times of markets stress like 2008, they did not offer the correlation benefits investors had previously expected. 

The final step to a stronger asset allocation, which should be beneficial with the expected market turbulence over the next few years, is to add a level of dynamic risk management.  Equitas’ dynamic risk management tool aims to identify asset classes that exhibit either positive or negative intermediate trend on a monthly basis.  In other words, invest in asset classes that appear to being going up for the next month and do not invest in those that appear to be going down.

While the dynamic risk management tool may be extremely helpful in identifying investments, it does not complete the active asset allocation process.  In order to build a more efficient portfolio, assets should be rebalanced from the negative (non-invested) to the positive asset classes.  The green dot below displays a hypothetical back-test when implementing Active Asset Allocation.  As one can observe, the Active Asset Allocation both lowers risk and increases return historically.

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*Please see important disclaimers at the end of the paper

*Disclaimers & Disclosures

The preceding slides are an illustrative backtest based on a hypothetical allocation following a rules-based technical indicators approach using underlying indices or managers.  They do not represent an actual portfolio returns and past performance is no guarantee of future results.  Additionally, trading, tax, and management costs are not included.

The pro forma numbers reported above are models only, based on the quantitative rules based approach discussed above; however, the fund’s investment strategy was not employed during the time period shown for the pro forma results.  Furthermore, the fund’s actual strategy and investment selections may vary substantially over time from that used to determine the model results.  Thus, the pro forma model is of limited use in predicting future performance and actual results may vary significantly from the pro forma model.

This information has been prepared by Equitas Partners L.L.C., and while it has been obtained from sources deemed to be reliable, no guarantee is made with respect to its accuracy. Past performance is not necessarily indicative of future results. This does not constitute an offer or a solicitation of an offer to buy a security. Any offer or solicitation must be made only by means of a delivery of a definitive private offering memorandum.

This document is preliminary and for information purposes only. It is not an offer of, or a solicitation for, the sale of a security, nor shall there be any sale of a security in any jurisdiction where such an offer, solicitation, or sale would be unlawful. An investment in the Equitas Active Asset Allocation strategy may only be made pursuant to the applicable offering documents.

This document is intended for authorized recipients only and must be held strictly confidential. This document may not be reproduced or distributed in any format without the prior written approval of Equitas Partners, LLC or its investment manager.

Past performance is not necessarily indicative of future results. The information contained in this document should be considered in conjunction with the Disclosures and Definitions at the end of this document. Certain information contained herein has been obtained from third parties deemed to be accurate and reliable. While such information is believed to be reliable, Equitas Partners, LLC and its investment manager assume no responsibility for such information.

 All information in the above report comes from sources deemed to be reliable but Equitas makes no guarantee of its accuracy. Both the Active Asset Allocation and Base Asset Allocation Portfolio are hypothetical backtested portfolios and here for illustrative purposes only.  They do not represent actual portfolio performance returns.  The Active Asset Allocation Portfolio is calculated net of a 1% annual management fee deducted quarterly, no portfolios account for trading, tax, underlying management or other expenses.  Past performance is no guarantee of future results. Risk and return are measured by standard deviation and arithmetic mean, respectively. This graphic is for illustrative purposes only and not indicative of any specific investment. An investment cannot be made directly in an index.

 The various benchmark indices referenced in the performance results portrayed herein are broad-based measurements of changes in market conditions based on the performance of widely held equity and debt securities.  The strategies used to deliver the performance results portrayed herein may not invest in all securities comprising the benchmark indices. The inclusion of benchmark indices is intended to be for comparative purposes only because the indices are typically used to gauge the general securities markets or particular relevant sectors; they are not meant to be indicative of either the Base Asset Allocation Portfolio or the Active Asset Allocation Portfolio’s performance, asset composition or volatility.

• Price to earnings ratios are at 10.5X, which is well below recession averages for the last fifty years.
• Stocks and Treasury Bonds are priced for a recession.
• Real 10-year US Treasury Yields are close to 0% when netted to core inflation.
• But the July economic numbers look OK.
• Buying stocks when investor confidence is this low has historically proven profitable.
• Diversification and time are the best weapons against volatility.

At Equitas we continue to preach asset diversification, strong manager due diligence, and disciplined re-balancing of portfolios.  We stand ready to talk to clients and friends of the Firm about specific portfolio related questions or general market related inquiries.

For more information, please feel free to contact Rich Bouchner at 504.569.9619.

The company is listed as a top 50 wealth management registered investment advisor (RIA) in the most recent issue of Registered Rep. Based on its 2009 year end assets, Equitas would rank between 11 and 12 in Financial Advisor’s RIA Rankings. The company is also recognized as one of the nation’s top 100 financial consultants by Pension & Investments magazine.

The second article is a more in-depth analysis of the complex budget problems facing Greece. The article is called Greece Fire. We hope you enjoy these articles and find them informative and helpful.

Federal Budget 101

The U.S. Congress sets a federal budget every year in the trillions of dollars. Few people know how much money that is so we created a breakdown of the federal spending in simple terms.

Let’s put the federal budget into perspective. The 2011 Federal Budget analyzed in simple terms:

• U.S. income: $2,170,000,000,000
• Federal budget: $3,820,000,000,000
• New debt: $ 1,650,000,000,000
• National debt: $14,271,000,000,000
• Recent budget cut: $ 38,500,000,000 (about 1 percent of the budget)

It helps to think about these numbers in terms that we can relate to. Let’s remove eight zeros from these numbers and pretend this is the household budget for the fictitious Jones family.

• Total annual income for the Jones family: $21,700
• Amount of money the Jones family spent: $38,200
• Amount of new debt added to the credit card: $16,500
• Outstanding balance on the credit card: $142,710
• Amount cut from the budget: $385

So in effect last month Congress, or in this example the Jones family, sat down at the kitchen table and agreed to cut $385 from its annual budget. What family would cut $385 of spending in order to solve $16,500 in deficit spending?

It is a start, although hardly a solution.

Now after years of this, the Jones family has $142,710 of debt on its credit card (which is the equivalent of the national debt).
You would think the Jones family would recognize and address this situation, but it does not. Neither does Congress.

The root of the debt problem is that the voters typically do not send people to Congress to save money. They are sent there to bring home the bacon to their own home state.

To effect budget change, we need to change the job description and give Congress new marching orders.

It is awfully hard (but not impossible) to reverse course and tell the government to stop borrowing money from our children and spending it now.

In effect, what we have is a reverse mortgage on the country. The problem is that the voters have become addicted to the money. Moreover, the American voters are still in the denial stage, and do not want to face going into rehab.

Greece Fire

With the backdrop of nearly a decade battling ongoing debt issues, Greece’s risk of default has come to a forefront this past June. Its impact directly affects the Euro and puts Germany and France in the difficult situation of leading a potential bail out. Much of the Greek situation is already priced into the market, but it is worth examining the causes behind the crisis.

In late 2009, Greece found itself with a looming government deficit.    Greece’s debt level could lead to a loss of investor confidence across all the less prosperous European Union countries, namely Portugal, Ireland, Italy, and Spain. Germany and France, seeking to preserve stability with the euro, are now stepping forward to address Greece’s troubles, creating a delicate balancing act.

The upshot of not achieving this delicate balance is a potential destabilizing effect on the whole Eurozone. Moody’s has already downgraded Portugal to junk bond status. A potential bailout of Portugal could lower stock markets in the Eurozone, even if the Greece debt issue is currently priced into the markets. Much of the Eurozone, even the larger economies of Spain and Italy, are starting to feel vulnerable, as their fate to some degree lies in the hands of the rating agencies. As an example, the risk premium for Italian bonds recently went up, as contagion continues in the 17 country Eurozone.

Do not be surprised if the number of member countries in this young European Union experiment increases or decreases over time as the Union settles into a structure and matures. Readers of the Bible will recall that the reformation of the old Roman Empire will have ten members.

In the past two years, Greece benefitted from aid from its more prosperous European Union member countries, while simultaneously exacting austerity measures. The result of Greece’s struggles was higher interest rates for the Greek government and less access to capital, which might have helped catapult the economy.    In April 2010, Greece’s Prime Minister George A. Papandreou formally approached his EU neighbors, requesting a $60 billion bailout plan. Greece’s economy decreased by 6.6 percent in 2010, and estimates from economists expect close to an additional four percent reduction in 2011, according to the New York Times.

In June 2011, Greece suffered from a recession in the wake of a political crisis. While addressing internal turmoil of organized workers protesting, the necessary austerity measures were put in place by the Greek government, in return for a 12 billion euro bail out from EU member countries. Prime Minister Papandreou faces a difficult challenge as he tries to avert bankruptcy of the country while leading a fractious Socialist Party, but he was able to gain enough support to pass the recent austerity plan on June 29th, 2011. The plan follows a previous austerity package put forth in 2010 by Greece. The 2011 austerity plan focused on tax increases, wage reductions, and the privatization of approximately 50 billion Euros in state-held assets.

In terms of external bodies, the IMF gave Greece an infusion of credit on April 11th, 2011, of $15 billion, along with $30 billion from the EU. The fiscal measure passed in June by Greece, which was tied to aid from the IMF, leaves open the possibility of another tranche from the IMF. While these recent measures solve a short term problem, EU member countries anticipate a potential bailout some time in 2012 as it appears Greece’s sources of income from selling government bonds will likely no longer be a tool to raise funding for Greece.

According to the New York Times, Greece’s debt, amounting to more than 150 percent of GDP, puts Papandreou in a tight situation, with limited vehicles at his disposal. The European Central Bank and France have come to a consensus with Germany that rollovers of debt from private banks be voluntarily initiated by the banks themselves. As the largest holders of Greek debt, both France and Germany would find themselves in a very serious quandary if Greece were to default. External pressure includes greater privatization on the part of the Greek government and tougher tax collection. The ongoing goal is for Greece’s economy to develop over time in order to pay back its debt with a longer period to recover.

On July 2nd, 2011, as a start to what appears to require an ongoing bail out strategy to be revisited in September 2011, the 17 EU finance ministers approved a measure to extend an 8.7 billion euro package, as part of a 110 billion euro package put in place in 2010. In addition, the International Monetary Fund will likely move forward with a 3.3 billion euro package. These measures will help to counterbalance the risk of default for Greece and insolvency by late July. The next step is a second issuance of credit to Greece to bolster the economy through 2014. The latest meeting of the euro zone ministers was on July 11th, 2011. Following the meeting, the Eurozone finance ministers announced a number of possible initiatives, including reductions in interest rates and extensions of loan maturities. Another option still on the table is buying back bonds in the secondary market.

The meeting did not give any conclusion to the debate on private sector involvement or how it might tie into the risk of a selective default. Some read this lack of comment as a tacit willingness to accept a selective default if necessary, even though it poses risk of destability to the Eurozone as a whole. Maintaining the selective default as a rating agency decision, rather than actual default, would likely be the key to any acceptance of such a risk.

The Greek economic struggle demonstrates the tenuous nature of constraints created by the euro.    It would be a drastic measure to bring back the drachma, similar to Britain exiting the gold standard in 1931 or Argentina’s actions with its currency board in 2001. Greece is no longer able to devalue its own currency to foster greater competitiveness and must work within the constraints of the ECB. One alternative is an orderly restructuring of Greek debt, which may cause some Greek banks to close, but might not disrupt the current market if it has already priced the risk of default into the market.

Greece’s debt of 340 billion euros alone may not cause a huge resulting impact globally. The potential collapse of the Eurozone, however, if other less prosperous EU states find themselves with mounting pressure to pay back debt or take on higher interest rates, would pose a devastating threat to Europe as a whole. S&P has already cut Greece’s long term rating to CCC, which occurred on June 13th, 2011. Moody’s also cut Portugal’s credit rating to Ba2 on July 5th, signaling the repercussions of loss of investor confidence across EU member states. thS&P actions could lead to a fall in 10 year yields of Treasury bonds, as evidenced by the fall on July 5 .

The Greek crisis, if mishandled, could set off lower confidence in the EU stock markets.    The less prosperous countries could find it harder to sell future debt, raising interest rates.    Germany may lower interest rates in an effort to rescue Greece. Italy, in particular, is finding its stock market hit hard by the uncertainty across the Eurozone. Prior scares where Greece’s situation has put pressure on Italy and Spain, looking at the positive side, have historically proved temporary.

It is a good time to be careful before entering the European markets and take a “wait and see” approach. The worst case scenario could include a credit crunch similar to that which caused Lehman Brothers to fall. That scenario, however, seems unlikely, given both German and French vigilance in addressing actively these bailouts, in addition to efforts by private institutions to restructure Greek debt and possibly Portuguese debt. Investor panic, as a result of any default by Greece, could create a ripple effect with investors pulling out of Portugal, Spain, Greece, and possibly Italy.    The worst case scenario could mean a retreat from liquid assets such as corporate bonds and emerging market stocks, as investors move to cash. Money market mutual funds in the U.S. have particular exposure to private European banks, which are slated to restructure debt voluntarily. Credit default insurance would have repercussions on U.S. insurance firms and U.S. banks. The Euro is now at is its lowest level since March, hurting its purchasing power.    The coinciding dollar rise has put pressure on U.S. energy expenses, as the U.S. experiences a resulting effect. Japan’s stock market has fallen recently amidst the issues of the Eurozone sovereign debt situation combined with the federal deficit of the United States, based on concerns about lack of global economic growth.

China and most of the emerging international market countries continue to grow stronger, and are without the debt problems of the industrialized Western countries. What a change in the global economics we are witnessing in our lifetime.

S&P Downgrade
On Friday, the credit rating agency Standard and Poor’s announced that it would lower the US credit- rating for Treasury debt one notch from the top-rated AAA to AA+.    The downgrade, which came on the heels of the much publicized debate over the fiscal budget in Washington DC, represents the first time in American history that US sovereign debt fell below the sterling AAA level. In addition, S&P also placed the US on “negative” outlook, meaning that a further reduction in the Treasury credit rating was possible in the next two years.

According to S&P, the change in rating drops America’s capacity to fulfill its financial commitments from “extremely strong” to “very strong.” S&P serves as one of three major credit rating firms. The other companies, Moody’s and Fitch, kept the United States at their highest-rated level, although both have warned of potential future downgrade should the status quo remain in Washington.

S&P Credit Ratings of Select Countries

Credit ratings remain important to both borrowers and lenders. If a bond has a lower rated credit, then there is higher possibility that a borrower (the US Treasury) does not repay its lender (Treasury bond holders). In turn, the lenders will require more compensation (interest rates) to mitigate the risk of loaning money. In the case of US Treasuries, a lower credit rating could raise the cost of borrowing not only for the government, but also American companies and consumers. Some estimates put the added interest expense for the US at an additional $110 billion per annum.

In the immediate aftermath of the downgrade, however, we have witnessed the opposite effect: the market has purchased Treasuries, thereby lowering the borrowing cost. The 10-year Treasury yield fell from 2.58% before the announcement on Friday to 2.34% as of the close of business on Monday, August 8. Perhaps more telling, the 10-year dropped to its current level from 3.36% at the beginning of 2011before the credit rating agencies began warning of potential downgrades, compared to many European sovereigns which have witnessed their cost of borrowing rise dramatically.

The yields illustrate several points. First, while the market may factor in credit rating agencies, it is by no means beholden to them. Next, in uncertain economic times, as much of the past few years have been, the world still views US debt as a safe haven investment. Finally, and perhaps most important, it displays that the United States is in no imminent danger of defaulting on any of its future obligations.

While the Treasury market has shrugged off the downgrade in the short-run, the news has reverberated through other markets, and Washington, as well as the American people, should use the downgrade as a wake-up call to curb their enormous spending habits. Deep, fundamental issues remain with the US balance sheet. Over the past decade, the US has enacted tax cuts, engaged in three wars, and dealt with the largest recession since World War II. All have had an enormous impact on both the budget deficit and the national debt. The deal recently passed in Congress on August 2, 2011 made only a small dent in the fiscal issues (See: Equitas’ “Federal Budget 101”).

The greater long-term threat, however, stems from the unfunded liabilities such as Social Security, Medicare, and Medicaid. With the American population growing older and the Baby Boomer generation beginning to retire, nearly all analyst estimates expect the size of the budget deficit to increase substantially. In the near future, expect more political fighting as entitlement reform, along with tax increases and spending cuts, will be forced to be address.

The future impact of the S&P downgrade remains to be seen. At Equitas, we hope that the event will serve an inflection point in economic policy leading to a return of sustainable, long-term American growth and prosperity. As investment advisors, we will continue to closely monitor the situation and search for opportunities in the volatility.

Eurozone Debt Issues
While the US has many long-term structural issues, many solutions exist with political will and sacrifice that can stave-off a long-term crisis. On the other hand, Europe faces a more pressing sovereign debt problem. Numerous countries have already raised taxes and enacted austerity in order to solve fiscal issues.

In order to better understand the current problems facing the Eurozone, a simple analysis of ways of solving debt issues is necessary. In essence, three methods exist for a state to pay off its debts:

• Increase its revenue (raise taxes).
• Decrease expenditures (cut spending through austerity).
• Make the debt outstanding worth less by slowly debasing its currency through inflation.

The last option represents the most politically palatable choice because the effects appear the most subtle to a country’s citizens (provided inflation remains in at reasonable levels). At Equitas, we expect to see a mixture of all three options to solve any US debt issues; though we would expect that currency debasement will continue to play a prominent role.

Europe is different. The Europe Union serves as monetary entity and has no fiscal authority. Therefore, the EU has no power to tax citizens or cut spending, thus eliminating two avenues to reduce debt levels. Fiscal authority falls on the individual nations, which have heterogeneous economies as well as debt levels. Recently, tax hikes and spending cuts have caused social issues from Athens to Madrid.

The final option, a slow debasement of the Euro currency, seems unlikely for several reasons. First, the stronger economies (Germany and France) want to avoid a weaker Euro. In addition, Europe has a bad history of inflation. The German Weimar Republic in the 1930s experienced hyperinflation which leading to the economic hardships that many historians believe aided to rise of Adolf Hitler. Finally, while the US Federal Reserve has dual mandate of an inflation target around 2% and maximum employment, the European Central Bank only one: an inflation level below 2%.

The European countries facing the most pressing debt problems include: Portugal, Ireland, Italy, Greece and Spain (the so-called PIIGS). Over the past decade, the PIIGS have become over-levered by borrowing large amounts debt at artificially low EU interest rates. While Greece represents the audacious offender, all the countries have significant concerns. In addition, many French and Germany banks hold large amounts of sovereign debt from the PIIGS. Should the any of the countries default on their obligations, the European banking sector could face systemic risk.

The European sovereign debt crisis will not be solved overnight. European policy makers must derive a coordinated, comprehensive plan that will address sovereign debt. Ad hoc intervention in the markets will not solve the long-term problems. Investors should expect bailouts of the PIIGS to continue as Europe muddles through.

Going Forward

As investors digest both the S&P downgrade and news from across the Atlantic, expect volatility to continue. The CBOE Volatility Index (VIX) has more than tripled from July 1 to August 8, 2011 to levels not seen in over a year, although volatility is still only half of levels reached in 2008. Markets will remain unpredictable over the near-term as participants digest economic data.

While volatility will remain, trading ranges could also start becoming evident. With the massive selloff over the past few weeks, valuations on the US equity market have become extremely attractive. Rebalancing a portfolio back to equities and commodities could provide for solid returns in the near term.

Although much stronger than in 2008, the US economy remains on fragile terms. While the headline unemployment rate stands at an elevated 9.2%, the more comprehensive U-6 unemployment rate, which includes “marginally attached workers and those working part-time for economic reasons,” sits at a staggering 16.1%1. In addition, the housing market has yet to recover from its bubble bursting, and consumer confidence remains weak.

Should the economy continue to struggle, expect more stimulus programs from the government. While the Fed’s QE2 program helped prop up asset prices, most notably equities and commodities, it failed to spur employment and became the target of political anger as many blamed it for the dollar’s continued decline. If the economy falters, the Fed will attempt to generate a new form of stimulus, just not call it “QE3.”

The Advantage
At Equitas we continue to closely monitor the developments in the markets. Our extensive due diligence and rigorous asset allocation process should dampen the expected volatility. We believe that the current market environment may serve a buying opportunity for our clients with a long-term time horizon for investments. For instance, many blue chip companies are flush with cash and offering dividend yields higher than some fixed income markets, an occasion not seen since the 1950s. As always, diversification and low correlation between asset classes will offer opportunities to navigate tumultuous markets and reach your objectives. Long-short equity managers, hedge funds, and managed futures all can capitalize on market volatility and offer opportunities for solid returns during market environments similar to the current one.

As always, do not hesitate to reach out to us with questions or comments.

If you play your cards right things are going to happen in the long run. In the short run, it is anybody’s guess. ‐ Ron Livingston ‐ Actor

Play your cards right…and things will work out. Play your cards right, and you will come out on top. How many times have we heard the phrase, “Play your cards right and……”? We think that it also applies to investing, but we have added our unique Equitas insight to the phrase. Our one hundred plus years of combined firm investment experience tells us: “Play your CARDs right, and your portfolio will be well positioned in all types of market environments.”

An investment in knowledge pays the best interest. ‐ Benjamin Franklin

Our senior research analyst, Rachel Kaplan, created what we refer to as the Periodic Table of Asset Classes (located on the following page). Rachel analyzed performance returns for seventeen different asset class indices and created a chart that ranked each sectors’ performance for each year for the 20 year period from 1991 through 2010. Besides creating something that looks very familiar to anyone who ever had a high school science class, she did a great job visually depicting the power of diversification. The random pattern of the colors in the chart graphically illustrates what investment gurus have been telling us for decades: Don’t bet too heavily on yesterday’s winners, and don’t completely discount yesterday’s losers.

Rachel’s research got us thinking about the power that diversification and rebalancing provide, when used together, to reduce risk and to increase returns. When combined with Equitas’ research on correlation, asset classes and risk, their power to affect a desired outcome on a portfolio is even greater. We coined
the term CARD, (Correlation, Asset Allocation, Rebalancing/Reducing Risk and Diversification) to better capture the flavor of each of these inputs in portfolio engineering.

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Correlation
In the world of finance, correlation is a statistical measure of how two securities move in relation to each other. We do extensive correlation research as we think about risk and returns in clients’ portfolios.

Correlation is computed into what is known as the correlation coefficient, which ranges between -1 and +1. Perfect positive correlation (a correlation co-efficient of +1) implies that as one security moves, either up or down, the other security will move in lockstep in the same direction. Alternatively, perfect negative correlation means that if one security moves in either direction the security that is perfectly negatively correlated will move in the opposite direction. If the correlation is 0, the movements of the securities are said to have no correlation; they are completely random.

A well balanced portfolio will have multiple asset classes that have low correlation to one another. When done correctly, the art and science of blending a variety of low correlated asset classes allows a portfolio the opportunity for a smoother ride than otherwise possible with a more concentrated blend of asset classes. If a portfolio is diversified among asset classes that are all perfectly correlated (+1), there is no benefit to the diversification. Correlation is the power behind diversification.

Goodness is the only investment that never fails. ‐ Henry David Thoreau

Asset Allocation

An asset class is a group of securities that exhibit similar characteristics, that behave similarly in the marketplace, and that are subject to the same laws and regulations. The three main asset classes are equities (stocks), fixed-income (bonds) and cash equivalents (money market instruments), however when Equitas researches and constructs a portfolio, we include as many as sixteen different classes. They may include international securities, MLPs, real estate, and commodities among others.

The terms asset classes and asset class categories are often incorrectly used interchangeably. In other words, describing large-cap stocks or short-term bonds as asset classes is incorrect. These investment vehicles are asset class categories, and are used to increase diversification.

Each asset class is expected to reflect different risk and return investment characteristics, and will perform differently in any given market environment. Using multiple asset classes in portfolio construction helps achieve a lower risk, less correlated portfolio, and it is the first step in diversification. Our return attribution analysis indicates that proper asset allocation is the most powerful tool in portfolio construction.

The time of maximum pessimism is the best time to buy and the time of maximum optimism is the best time to sell. – Sir John Templeton

Rebalancing Reduces Risk – The Three “Rs”
To rebalance is to bring a portfolio back to its original asset allocation mix. Though it may feel counterintuitive, rebalancing entails selling winners and buying underperformers. This is necessary because over time, allocations to asset classes and individual managers become out of alignment with investment policy guidelines. Some asset classes will grow faster than others. Rebalancing ensures that a portfolio is not over or under weighted in relation to guidelines. By selling outperformers and reinvesting in laggards, a portfolio locks in its gains, and re-invests in underperforming sectors while they are “on sale”. As long as the initial investment thesis still rings true, and there is no fundamental change in a manager that may require putting them on a “watch” list, buying on dips is a great way to reposition a portfolio for increased alpha.

There are three different methods to rebalance a portfolio:

• Periodic: Pick a period, such as annually, and sell investments from over-weighted asset categories and use the proceeds to purchase investments for under-weighted asset categories.
• Event Driven: Whenever an asset class falls out of the acceptable range noted in the Investment Policy, rebalance the portfolio back to the Policy’s Target allocation.
• Cash Flow: Use new contributions and withdrawals to rebalance the portfolio. Purchase new investments from cash flows with-in the portfolio to buy under-weighted asset classes, and make the sales from the appreciated, over-weighted asset classes.

The Cash Flow method is the smoothest for money managers. Event Driven has the greatest impact on performance. We use all three methods at Equitas. Regardless of how it is achieved, a portfolio should be rebalanced on a regular basis in order to optimize returns. Equitas monitors clients’ portfolios continually to seize rebalancing opportunities.

Rule No.1: Never lose money. Rule No.2: Never forget rule No.1. ‐ Warren Buffett

A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk that an investor is willing to take on, the greater the potential return. In other words, investors need to be compensated for taking on additional risk.

For example, a U.S. Treasury bond is considered to be one of the safest (risk-free) investments and, when compared to a high yield bond, provides a lower rate of return. A corporation that can only borrow in the “junk” market is much more likely to go bankrupt than the U.S. government. Because the risk of investing in a junk bond is higher, investors expect a higher rate of return.

A well-constructed portfolio consists of multiple asset classes that are positioned on various spots on the risk return spectrum. When done correctly, this lowers overall portfolio risk while optimizing returns. The whole portfolio becomes safer than the sum of the parts.

Money is like manure. You have to spread it around or it smells. ‐ J. Paul Getty

Diversification
Diversification is a risk management technique that mixes a wide variety of asset classes 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 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 asset classes and managers in the portfolio are not perfectly correlated.

Our asset allocation studies have shown that maintaining a well-diversified portfolio of asset classes and managers yields the most cost-effective level of risk reduction. We strive to provide the lowest possible level of volatility that still allows a portfolio achieve its return targets.

Diversification benefits are gained by investing in asset classes that have low correlation to one another. For example, an economic downturn in the U.S. economy may not affect Japan’s economy in the same way; therefore, having Japanese investments would allow an investor to have a cushion of protection against losses due to an American economic downturn. This happened very effectively in the decade of the 1970s.

Most investors wait for investments to go up and then they buy after the investments have appreciated. Investors tend to buy what they wished they had bought. Conversely, they sell after the investment has gone down. Correlation, Asset Classes, Rebalancing, and Diversification are tools to help avoid these problems. Playing your CARDs right can keep you from falling into these traps and yield a more prosperous investment experience.

Equitas Capital Advisors is proud to serve as your investment management consultant. We appreciate your business, and value the trust and confidence that you place in us. We look forward to continuing to engineer and deliver investment solutions to you for years to come.

“History teaches us that man learns nothing from history” – Georg Wilhelm Friedrich Hegel

“Predictions are hard to make, especially about the future” – Yogi Berra

These are macroeconomic visions which we have been writing about in the KnowRisk Commentary and we concur with the contradictory quotes. Forget predicting the future, observing the present is hard enough and very few people do it.

David Iben, the Chief Investment Officer of Tradewinds Global Investors, a $30 billion global investment manager that we utilize for many of our clients, recently stated: “While bottom-up analysis and valuation remains absolutely prerequisite to sound investing, doing so while remaining oblivious to bubbles and other major macroeconomic dislocations in the economy equates to the proverbial ‘rearranging of the deck chairs on the Titanic.”

In 1929, it really didn’t matter what stocks you picked, what mattered was that you shouldn’t own stocks. During the ‘guns and butter’ days of LBJ, not owning bonds for the next fifteen years was much more important than picking the ‘right’ bonds to own. In the 1970s John Templeton avoided the US bear market because he found better bargains in Japan. He returned to US stocks in the 1980s since Japan had appreciated so much it was no longer a bargain. In 1980, with Paul Volcker reining in the money supply, getting out of gold, oil and other commodities should have been at the forefront of everyone’s mind.    In 1999, recognizing that there was no growth rate high enough to make the math work for investors in tech stocks was all that needed to be done. Analyzing tech stock fundamentals was generally a waste of time until 2002 (except for short-sellers). During the 2005 through 2008 period, asking the question – will mortgages on overpriced houses, extended to unqualified, over- extended borrowers likely be repaid? – was all that analysts needed to do when assessing financial stocks.

Which brings us to 2011!

The most important analysis that a prospective investor can perform today is to ask the question: Will governments that have obligations that far exceed their ability to honor, eventually make good on them?

If you were considering making a loan to your neighbor for 10 years, you would want some data. High on the list might be: other obligations, integrity, employability, assets/collateral, and income. Low on the list (if there at all) might be: what do the government bureaucrats claim was the CPI or unemployment rate last quarter, what was the ‘output gap,’ whether Bernanke is speaking this week, or what economists are suggesting next quarter’s growth rate will be. Why should loans to governments be treated differently?

That Japan, the U.S., and the U.K. won’t honor their commitments is a given in the opinion of David Iben who says: “When and how they renege is a more legitimate topic. We do not know the answer, we do believe that loaning money to them for 10 years at a sub-3% yield is madness! While it may or may not ultimately work out for buyers, the risk is far greater than the prospective return.” You might even say you are buying return free risk, instead of risk free return.

Our government’s management of our fiat currency has resulted in a loss of purchasing power exceeding 90 percent over the past half-century. In other words, the millionaire from 50 years ago is equivalent to a deca-millionaire now (and probably the hector-millionaire of the not too distant future). It is likely even more pronounced if one believes that purchasing power has declined even more than what the CPI fesses up to. It is highly likely that debasement over the next half century will be no less than it was during the past half-century. In addition to preservation of capital, investors must be mindful of preservation of wealth!

The mounting national debt is a potential danger to the long term health of the US economy. What once seemed unthinkable — that one day the United States government would no longer be accorded the highest credit rating — is now not only thinkable, but increasingly probable. “I am concerned about the unsustainability of our long-term situation,” said Peter G. Peterson, a co-founder of the Blackstone Group and a prominent deficit critic, said in a recent New York Times Article.

In a quarterly report on the nation’s credit risk, Moody’s Rating Agency said there was an increasing probability of revising its outlook on its Aaa rating for the United States to negative from stable within the next two years if no action were taken. That stops well short of actually reducing the rating. But even a small revision, if it comes, would probably rattle the financial markets and might even hamper America’s ability to borrow the money it needs to finance its deficit. Moody’s has been rating United States government debt since 1917, and has always rated it Aaa. Within the last 20 years and counting, (known as the “lost decade”) Japan’s debt rating has gone from Aaa to A and is only back to Aa.

As an American, I’d like to see us return to sound value, more production and less consumption, a hard currency and a government that doesn’t have the authority to saddle our grandchildren with debt. If we must spend, why not invest in our future: energy independence, modern airports and roads, education, water conservation, mass transportation, and other infrastructure?

While many countries of the emerging markets are now embracing their own version of the “American Dream”, many Americans are asking, “Have we outsourced the ’American Dream’?” Possibly. But with turmoil comes opportunity.    As long term investors, we must find ways to leverage the lessons from the past to maximize our returns going forward. Rest assured that Equitas will continue to search the globe in 2011 and beyond for the most profitable investment themes and best managers to execute those themes so that our clients will continue to have the tools necessary to navigate the perils that invariably lie ahead and so that they may prosper into the future.

The branch of economics dealing with the broad and general aspects of an economy, as the relationship between the income and investments of a country as a whole. The part of economic theory that deals with national income, total employment, and total consumption.

Macroeconomics is one of the most complicated and least understood branches of economics. Yet with the continuing, interconnected, globalization of the world’s economies, it is becoming one of the largest factors affecting investments world wide.

The “Rise of the Rest”

The “rise of the rest” is a remarkable achievement, bringing with it unprecedented improvements in living standards for the majority of people on the planet. But there is another, less happy, explanation for the rapid shift in the global centre of economic gravity: the lack of growth in the big rich economies of America, Western Europe and Japan.

Look at the world economy as a whole, and you could easily think that the recovery is in pretty decent shape. This week the IMF predicted that global GDP should expand by 4.8% this year—slower than in the boom before the financial crisis, but well above the world’s underlying speed limit of around 4%. Growth above trend is exactly what you would expect in a rebound from recession.

Yet this respectable average hides a series of problems. Most obviously, there is the gap between the vitality of the big emerging economies, some of which have been sprinting along at close to 10%, and the sluggishness of many of the rich countries from 0% to 2%. Research calculations from Harvard University and the National University of Singapore make the point starkly. They show that the average underlying annual growth rate of the G7 group of big rich economies between 1998 and 2008 was 2.1%. On current demographic trends, and assuming that productivity improves at the same rate as in the past ten years, that potential rate of growth will come down to 1.45% a year over the next ten years, its slowest pace since the second world war. A big difference from the sprinting 10%.

Economy Haves and Have-Nots

Are the “haves” and “have-nots” reversing?

Across the rich world the supply of workers is about to slow as the number of pensioners rises. In Western Europe the change will be especially marked. Over the coming decade the region’s working-age population, which until now has been rising slowly, will shrink by some -0.3% a year. In Japan, where the pool of potential workers is already shrinking, the pace of decline will more than double, to around -0.7% a year.

America’s demography is far more favorable, but the growth in its working-age population, at some 0.3% a year over the coming two decades, will be less than a third of the post-war average. With millions of workers unemployed, an impending slowdown in the labor supply might not seem much of a problem. But these demographic shifts set the boundaries for rich countries’ medium-term future, including their ability to service their public debt.

The Economist Magazine states that unless;

1. more immigrants are allowed in,
2. or a larger proportion of the working-age population joins the labor force,
3. or people retire later,
4. or their productivity accelerates,

the aging population will translate into permanently slower domestic growth.

Optimists point to America’s experience over the past century as evidence that recessions, even severe ones, need not do lasting damage. After every downturn the economy eventually bounced back so that for the period as a whole America’s underlying growth rate per person remained remarkably stable. Despite a lack of demand, America’s underlying productivity grew faster in the 1930s than in any other decade of the 20th century. Today’s high unemployment may also be preparing the ground for more efficient processes.

A world out of balance

In the emerging world the macroeconomic errors come from politicians behaving as if growth there were more fragile than it is. The pace has slowed a bit, but from breakneck speed to merely very fast. Most vital signs, from productivity to government debt, are healthy. Yet many policymakers are buying boatloads of dollars to stop their currencies rising as foreign capital pours in from Western investors seeking better returns. Emerging economies, as a group, still save more than they invest, which explains why global imbalances—notably the controversial surplus in China and deficit in America—remain so big.

Monsoon rains bring relief after the heat of summer but they can also cause flooding. A flood following a drought is a reasonable description of recent flows of private capital to emerging markets. During the worst of the crisis these flows collapsed, sending at least a few emerging economies into the arms of the IMF. Now, attracted by the developing world’s better growth prospects and exceptionally low interest rates in rich countries, money is surging back.

It is hard to know just how much cash is flowing in. Complete data on countries’ balance-of-payments positions are available only with a long time lag. An economist at Goldman Sachs has worked out a measure of net capital inflows from figures on countries’ foreign reserves and current-account balances. He reckons that flows into 20 big emerging countries are now running at a faster pace than before the crisis. According to his estimates, net capital inflows to these countries between April 2009 and June this year ran at an annualized pace of $575 billion, well in excess of average annual inflows of $481 billion in the two years prior to September 2008.

The economists note that the currencies of emerging Asian countries face the strongest upward pressure because of changes in the destination of private capital. As flows to Eastern Europe and Africa have shriveled, Asia’s share of the total flow of capital to the emerging world has gone from 61.3% in 2007 to 78.6% in the first half of 2010. Latin America’s share has also increased, from 15.2% to 20.9% over the same period. These are rising shares of a growing total, meaning that both regions are now getting more private capital than they were before the crisis. This effect is particularly strong for emerging Asia (see chart).

Upward Pressure for one Currency Means Downward Pressure for Another

Not every emerging country’s currency is under the same kind of upward pressure. India, for example, seems not to have intervened much in the foreign- exchange market, but its currency has not moved much over the past year either. Part of the reason is that capital inflows have gone mainly to finance its persistent current-account deficit. By controlling for this kind of thing the analysts find that Malaysia and Thailand have had the most “appreciation-friendly” regimes in Asia. Malaysia has largely been content to let its currency float upwards. The ringgit has risen by over 10% against the dollar since the beginning of the year. Malaysia’s reserve accumulation has been much smaller in 2010 than in 2006. South Korea, by contrast, has been absorbing virtually all of the upward pressure on the won by accumulating additional reserves. Peru is the country that has been trying the hardest to prevent its currency from rising. Interventions by Brazil look relatively modest once its size is taken into account. Colombia has pretty much allowed its currency to rise.

In the rich world the danger is the reverse. Big asset busts are usually followed by years of weakness as the over-borrowed repair their balance-sheets. Experience suggests that several years of slow growth lie ahead. Rich countries are planning tax rises and spending cuts worth 1.25% of their collective GDP in 2011, the biggest synchronized fiscal tightening on record. In many places a budgetary squeeze is necessary, but not all; and, taken as a whole, cutting this much this early is a risk. Even if demand remains strong enough to cope with this onslaught, the rich world’s longer-term growth prospects are darkening.

Ten years ago rich countries dominated the world economy, contributing around two-thirds of global GDP after allowing for differences in purchasing power. Since then that share has fallen to just over half. In another decade it could be down to 40%.

The bulk of global output will be produced in the emerging world. Europe’s working-age population is about to start declining; Japan’s is already doing so. Even in America the ageing of the baby-boomers points to a slower-growing workforce. In theory, faster productivity growth could offset this, but in most rich economies that was waning before the crisis hit—and the crash has clobbered productive potential. A feeble recovery could make matters worse, as the unemployed lose their skills, public debt builds up and firms put off investment.

A gaping growth gap between the emerging and rich worlds will, of course, shift economic might more quickly towards emerging economies. A fast-growing emerging world is fine, but a stagnating rich one serves nobody—especially if trade tensions start to rise. Western voters may find it intolerable that the likes of China still run big surpluses, thanks in part to those weak currencies. Protectionist rhetoric is already rising in the United States. The “have-nots” are beginning to “have”.

From the Macro to the Micro

The world would be better served by policies that both improve rich countries’ prospects and reorient growth in emerging economies. These should come in two parts. First, macroeconomic policies must be recalibrated. Emerging economies need to allow their currencies to rise more. The rich countries should tread carefully with fiscal consolidation: sensible budget repairs should be less about short-term deficit-slashing and more about lasting fiscal reforms, from raising pension ages to trimming health-care costs.

Second, and just as important, is microeconomic reform. There is a crucial missing ingredient just about everywhere in the world. The “micro” structural reform of each country, without which current growth rates are unlikely to last. The structural reform needed is different for each country, and sometimes the complete opposite.

Many emerging economies are slow to let their currencies rise to reflect their strength, even as the fragile rich economies are embarking on austerity programs. No matter what Congress threatens about the Yuan, China’s trade surplus will not disappear until it boosts investment in services, removes distortions that depress workers’ share of income and encourages households to save less. From telecoms to insurance, China is full of service oligopolies that need to be broken up.

Similar growth tonics need to be applied in much of the rich world, both to boost domestic spending in surplus economies, such as Germany and Japan, and to raise productivity. America is more productive than the euro zone and Japan largely because the latter both have a lousy record in services (too many rules and not enough competition). Many labor markets also need an overhaul, especially in southern Europe, where it is still far too difficult to adjust wages or fire permanent workers. One advantage of the crisis for Spain and Greece is that they have been forced to make a start on this.

The United States also has its own microeconomic to-do list, albeit of a different sort. The most urgent item is the festering mass of underwater mortgages. Almost 25% of homeowners with mortgages owe more than their houses are worth. Faster, more thorough debt restructuring is needed, to make it easier for workers to move to where jobs are more plentiful and to hasten financial recovery. Schemes for unemployment insurance and training also need attention, so that high joblessness does not become entrenched.

None of these structural reforms is easy. Peer pressure could help. Rather than being fixated on harsher budget-deficit rules, the European Union’s members should pledge to complete the single market in services, to open up cozy national markets to greater competition. The members of the G20 big economies could commit themselves to specific structural goals, from raising retirement ages to deregulating things like transportation. A bold microeconomic agenda will not yield instant rewards. Nor is it a substitute for getting the macroeconomics right. But without it, global growth will eventually falter.

Faster growth is not a silver bullet. It will not eliminate the need to trim back unrealistic promises to pensioners; no rich country can simply grow its way out of looming pension and health-care commitments. Nor will it stop the relentless shift of economic gravity to the emerging world. It is unavoidable. Since developing economies are more populous than rich ones, they will inevitably come to dominate the world economy. (China has already overtaken Japan as the world’s second largest economy.) But whether this shift takes place against a background of prosperity, or stagnation, depends on the pace of growth in the rich countries. For the moment, unfortunately, too many rich countries seem to be headed for stagnation.

To understand economic indicators, we must understand the ways in which economic indicators differ. There are three major attributes each economic indicator has:

Three Attributes of Economic Indicators

Relation to the Business Cycle / Economy

Economic Indicators can have one of three different relationships to the economy:

• Pro-Cyclic: A pro-cyclic (or pro-cyclical) economic indicator is one that moves in the same direction as the economy. So if the economy is doing well, this number is usually increasing, whereas if we’re in a recession this indicator is decreasing. The Gross Domestic Product (GDP) is an example of a pro-cyclic economic indicator.
• Counter-Cyclic: A counter-cyclic (or counter-cyclical) economic indicator is one that moves in the opposite direction as the economy. The unemployment rate gets larger as the economy gets worse so it is a counter-cyclic economic indicator.
• Acyclic: An acyclic economic indicator is one that has no relation to the health of the economy and is generally of little use. The number of home runs the New York Yankees hit in a year generally has no relationship to the health of the economy, so we could say it is an acyclic economic indicator.

Frequency of the Data
In most countries GDP figures are released quarterly (every three months) while the unemployment rate is released monthly. Some economic indicators, such as the Dow Jones Index, are available immediately and change every minute.

Economic indicators can be leading, lagging, or coincident relative to the economy.

Timing
Economic Indicators can be leading, lagging, or coincident which indicates the timing of their changes relative to how the economy as a whole changes.

Three Timing Types of Economic Indicators

Leading: Leading economic indicators are indicators which change before the economy changes. Stock market returns are a leading indicator, as the stock market usually begins to decline before the economy declines and they improve before the economy begins to pull out of a recession. Leading economic indicators are the most important type for investors as they help predict what the economy will be like in the future.
Lagged: A lagged economic indicator is one that does not change direction until a few quarters after the economy does. The unemployment rate is a lagged economic indicator as unemployment tends to increase for 2 or 3 quarters after the economy starts to improve.
Coincident: A coincident economic indicator is one that simply moves at the same time the economy does. The Gross Domestic Product is a coincident indicator.

Next we will look at some of the economic indicators distributed by the U.S. Government.

Many different groups collect and publish economic indicators, but the most important American collection of economic indicators is published by The United States Congress. Their Economic Indicators are published monthly and are available for download in PDF and TEXT formats. The indicators fall into seven broad categories:

• Total Output, Income, and Spending
• Employment, Unemployment, and Wages
• Production and Business Activity Prices
• Money, Credit, and Security Markets
• Federal Finance
• International Statistics

Each of the statistics in these categories helps create a picture of the performance of the economy and how the economy is likely to do in the future.

Total Output, Income, and Spending

These tend to be the broadest measures of economic performance and include such statistics as:

• Gross Domestic Product (GDP)
• Real GDP
• Implicit Price Deflator for GDP
• Business Output
• National Income
• Consumption Expenditure
• Corporate Profits
• Real Gross Private Domestic Investment

These statistics are all updated quarterly. The Gross Domestic Product is used to measure economic activity and thus is both pro-cyclical and a coincident economic indicator. The Implicit Price Deflator is a measure of inflation. Inflation is pro-cyclical as it tends to rise during booms and falls during periods of economic weakness. Measures of inflation are also coincident indicators. Consumption and consumer spending are also pro-cyclical and coincident.

These statistics cover how strong the labor market is and they include the following:

• The Unemployment Rate
• Level of Civilian Employment
• Average Weekly Hours, Hourly Earnings, and Weekly Earnings
• Labor Productivity

Unemployment and job creation has differed dramatically under different presidents.

These statistics are all updated monthly. The unemployment rate is a lagged, counter-cyclical statistic. The level of civilian employment measures how many people are working so it is pro-cyclic. Unlike the unemployment rate it is a coincident economic indicator.

The following graph illustrates the Unemployment Rate under the last four Presidential administrations.

Also, the rate of Job Creation under these same Presidential administrations proves interesting.

Production and Business Activity

These statistics cover how much businesses are producing and the level of new construction in the economy:

• Industrial Production and Capacity Utilization
• New Construction
• New Private Housing and Vacancy Rates
• Business Sales and Inventories
• Manufacturers’ Shipments, Inventories, and Orders

These statistics are all updated monthly. Change in business inventories is an important leading economic indicator as they indicate changes in consumer demand. New construction including new home construction is another pro-cyclical leading indicator which is watched closely by investors. A slowdown in the housing market during a boom often indicates that a recession is coming, whereas a rise in the new housing market during a recession usually means that there are better times ahead.

This category includes both the prices consumers pay as well as the prices businesses pay for raw materials and include:

• Producer Prices
• Consumer Prices
• Prices Received And Paid By Farmers

The Federal Reserve is much more concerned about inflation than deflation.

Consumer prices other than the cost of food and energy rose slightly in May after staying flat in April while the index of leading economic indicators barely rose in May after no change in April. Taken together, the data confirm once again that the U.S. economy is making a painfully slow exit out of recession.

These statistics are all updated monthly. These measures are all measures of changes in the price level and thus measure inflation. Inflation is pro-cyclical and a coincident economic indicator.

While the price of small items such as haircuts and boxes of cereal seems to be going up, the bigger driver of inflation is wages, and on that score, we are clearly in a deflationary environment. Most workers aren’t getting wage increases; rather, they’re getting laid off or working fewer hours. The Federal Reserve is much more concerned about inflation than deflation, but the Fed has to walk this tight wire right now.

The consumer price index (CPI) for May declined 0.2%, posting a 2.0% increase over the last 12 months, the U.S. Bureau of Labor Statistics (BLS) reported in mid-June. The CPI is a major indicator of inflation, and the recent figures show a striking lack of price pressure.

Fighting inflation is a matter of simply raising rates, but deflation is harder to fight. Generally, the government prints money and banks lend more and people spend more, but the dollar would be worth less, which would be bad for the economy and interest rates.

Money, Credit, and Security Markets

These statistics measure the amount of money in the economy as well as interest rates and include:

• Money Stock (M1, M2, and M3)
• Bank Credit at All Commercial Banks
• Consumer Credit
• Interest Rates and Bond Yields
• Stock Prices and Yields

The following graphic illustrates the state of the Federal Budget Surplus/Deficit under the most recent four Presidential administrations.

These statistics are updated monthly. Nominal interest rates are influenced by inflation, so like inflation they tend to be pro-cyclical and a coincident economic indicator. Stock market returns are also pro-cyclical but they are a leading indicator of economic performance.

Economic indicators help us understand where we are and where we may be headed.

Federal Finance

These are measures of government spending and government deficits and debts:

• Federal Receipts (Revenue)
• Federal Outlays (Expenses)
• Federal Debt

These statistics are updated annually. Governments generally try to stimulate the economy during recessions and to do so they increase spending without raising taxes. This causes both government spending and government debt to rise during a recession, so they are countercyclical economic indicators. They tend to be coincident to the business cycle.
International Trade
These are measure of how much the country is exporting and how much they are importing:

• Industrial Production and Consumer Prices of Major Industrial Countries
• U.S. International Trade In Goods and Services
• U.S. International Transactions

When times are good people tend to spend more money on both domestic and imported goods. The level of exports tends not to change much during the business cycle. So the balance of trade (or net exports) is counter-cyclical as imports outweigh exports during boom periods. Measures of international trade tend to be coincident economic indicators.

While we cannot predict the future perfectly, economic indicators help us understand where we are and where we may be headed.

What is Asset Allocation?
The asset-allocation decision is one of the most important factors in determining both the return and the risk of an investment portfolio.

Asset allocation is the process of developing a diversified investment portfolio by combining different assets in varying proportions.

An asset is anything that produces income or can be purchased and sold, such as stocks, bonds, or certificates of deposit. Asset classes are groupings of assets with similar characteristics and properties. Examples of asset classes are large-company stocks, long-term government bonds, and Treasury bills.

Every asset class has distinct characteristics and may perform differently in response to market changes. Therefore, careful consideration must be given to determine which assets you should hold and the amount you should allocate to each asset.

Factors that greatly influence the asset-allocation decision are your financial needs and goals, the length of your investment horizon, and your attitude toward risk.

Diversification REDUCES Risk, BUT does not eliminate the risk of investment losses

Reduction of Portfolio Risk
Diversification is the strategy of holding more than one asset class in a portfolio in order to reduce risk. This image depicts the relationship between portfolio volatility, measured by standard deviation, and the number of asset classes in a portfolio. Standard deviation measures the fluctuation of returns around the arithmetic average return of the investment. The higher the standard deviation, the greater the variability (and thus risk) of the investment returns.

You can limit the effect that any individual security or asset class may have on the performance of a portfolio by investing in a combination of asset classes. As a result, declines in the total returns of one or two assets may be offset by increases in others. Notice that as the number of randomly selected assets in the portfolio increases, the risk level decreases. While it is impossible to completely eliminate risk, diversifying your investments can reduce the overall volatility experienced by your portfolio.

Past performance is no guarantee of future results. Risk is measured by standard deviation. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index.

Potential to Reduce Risk or Increase Return 1970–2008
Historically, adding stocks to a portfolio of less volatile assets reduced risk without sacrificing return or increased return without assuming additional risk.

The graph below illustrates the risk-and-return profiles of three hypothetical investment portfolios. The lower risk portfolio, which included stocks, had the same return as the portfolio comprised entirely of fixed-income investments, but assumed less risk. The higher return portfolio had the same risk level as the fixed income portfolio, but produced an increased return.

Although it may appear counterintuitive, diversifying a portfolio of fixed-income investments to include stocks reduced the overall volatility of a portfolio during the period 1970–2008. Likewise, it is possible to increase your overall portfolio return without having to take on additional risk.

Because stocks, bonds, and cash generally do not react identically to the same economic or market stimuli, combining these assets can often produce a more appealing risk-and-return tradeoff.

Past performance is no guarantee of future results. Risk and return are measured by standard deviation and compound annual return, respectively. They are based on annual data over the period 1970–2008. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index.

Effective diversification requires combining assets that behave differently

The Case for Diversifying
Diversifying your portfolio makes you less dependent on the performance of any single asset class.

Effective diversification requires combining assets that behave differently when held during changing economic or market conditions. Moreover, investing in assets that have dissimilar return behavior may insulate your portfolio from major downswings.

The graph above illustrates the annual returns of three different portfolios over a seven-year time period. Stocks represent a 100% investment in large-company stocks. Bonds represent a 100% investment in long-term government bonds.

When the stock and bond asset classes were combined into an equally weighted portfolio, the portfolio experienced less volatility than stocks alone and still maintained an attractive return. Notice that stock returns were up at times when bond returns were down, and vice versa. These offsetting movements assisted in reducing portfolio volatility (risk).

Past performance is no guarantee of future results. Time period illustrated is from 1956–1962. This time period was chosen as a dramatic illustration of stock and bond return behavior and how their often opposite movements reduced portfolio volatility. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index.

“The Free Lunch”

Stocks and Bonds: Risk Versus Return 1970–2008
An efficient frontier represents every possible combination of assets that maximizes return at each level of portfolio risk and minimizes risk at each level of portfolio return. An efficient frontier is the line that connects all optimal portfolios across all levels of risk. An optimal portfolio is simply the mix of assets that maximizes portfolio return at a given risk level. This image illustrates an efficient frontier for all combinations of two asset classes: stocks and bonds.

Although bonds are considered less risky than stocks, the minimum risk portfolio does not consist entirely of bonds. The reason is that stocks and bonds are not highly correlated; that is, they tend to move independently of each other. Sometimes stock returns may be up while bond returns are down, and vice versa. These offsetting movements help to reduce overall portfolio volatility (risk).

As a result, adding just a small amount of stocks to an all-bond portfolio actually reduced the overall risk of the portfolio. However, including more stocks beyond this minimum point caused both the risk and return of the portfolio to increase.

Past performance is no guarantee of future results. Risk and return are measured by standard deviation and compound annual return, respectively. They are based on annual data over the period 1970–2008. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index.

More Assets Do Not Always Mean Greater Diversification

Holdings-based style analysis can be used to determine security overlap
The graphs below illustrate two different equity portfolios that individually comprise four mutual funds. Each oval within the style box represents an ownership zone of a mutual fund, which accounts for 75% of the fund’s holdings. The level of diversification provided by each portfolio is quite different.

The funds in Portfolio A significantly overlap with one another, which indicates that each fund may hold stocks sharing similar style characteristics. While some overlap is acceptable in a portfolio, too much of it defeats the purpose of using multiple funds to create a diversified portfolio. In contrast, Portfolio B contains funds that span across many different styles. While the holdings in Portfolio A are more concentrated in the giant and large-cap value and blend segments, the holdings in Portfolio B are widely distributed among different investment styles.

Past performance is no guarantee of future results. Risk and return are measured by standard deviation and compound annual return, respectively. They are based on annual data over the period 1970–2008. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. The investment style matrix was designed by and is the copyrighted property of Morningstar, Inc.

Asset-Class Winners and Losers
It is impossible to predict which asset class will be the best or worst performing in any given year. The performance of any given asset class can have drastic periodic changes. The table below illustrates the annual performance of various asset classes in relation to one another over the past 15 years. In times when one asset class dominates all others, as was the case for large stocks in the late 1990s, it is easy to ignore the fact that historical data shows it is impossible to predict the winners for any given year.

Investors betting on another stellar performance for large stocks in 1999 were certainly disappointed as small stocks rose from the worst performing asset class in 1998 to the best performing in 1999. Similarly, international stocks were the top performers from 2004 to 2007, but disastrously sank to the worst performing position in 2008. These types of performance reversals are evident throughout this example. A well-diversified portfolio may allow investors to mitigate some of the risks associated with investing. By investing a portion of a portfolio in a number of different asset classes, portfolio volatility may be reduced.

Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index.

Correlation can help evaluate Potential diversification benefits

A well-diversified portfolio should consist of individual investments that behave differently.

It is possible to determine how closely two asset classes move together by evaluating their correlation. Correlation ranges from –1.00 to 1.00, with –1.00 indicating that the returns move perfectly opposite to one another, 0.00 indicating no relationship, and 1.00 indicating that the asset classes react exactly the same.

For example, small stocks and large stocks have risen and fallen to the same market conditions. Their high correlation suggests combining them may do little to lower the risk of a portfolio.

In contrast, the negative correlation of small stocks and intermediate-term government bonds illustrates the potential for better diversification. Investments still need to be evaluated for investor suitability, but understanding asset class behavior may help enhance the diversification benefits of investor portfolios.

Past performance is no guarantee of future results. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index.

Diversification in Bull and Bear Markets
Diversification is the strategy of combining distinct asset classes in a portfolio in order to reduce overall portfolio risk.

The graph on the left illustrates the hypothetical growth of $1,000 in stocks, bonds, and a 50% stock/50% bond diversified portfolio, from 2002 to 2007. Stocks provide increased growth in bull markets. It is important to understand, however, that this greater wealth was achieved with considerable volatility in stocks compared to the diversified portfolio.

The significance of holding a diversified portfolio is most apparent when one or more asset classes are out of favor. The graph on the right illustrates the hypothetical growth of $1,000 in stocks, bonds, and in a diversified portfolio, between 2007 and 2008.

Notice that by diversifying among the two asset classes, the diversified portfolio experienced less severe monthly fluctuations than stocks or bonds alone. While bond prices tend to fluctuate less than stock prices, they are still subject to price movement. By investing in a mix of asset classes such as stocks, bonds, and Treasury bills, you may insulate your portfolio from major downswings in a single asset class. One of the main advantages of diversification is that it makes you less dependent on the performance of any single asset class.

Past performance is no guarantee of future results. Risk and return are measured by standard deviation and compound annual return, respectively. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index.

Diversification can limit your losses during a severe market decline

Diversified Portfolios and Bear Markets
The benefits of diversification are most evident during bear markets. The graph below illustrates the growth of stocks versus a diversified portfolio during two of the worst performance periods in recent history.

The blue line illustrates the hypothetical growth of $1,000 invested in stocks during the mid-1970s recession and the 2007–2008 bear market. The red line illustrates the hypothetical growth of $1,000 invested in a diversified portfolio of 35% stocks, 40% bonds, and 25% Treasury bills during these same two periods.

Over the course of both time periods, the diversified portfolio lost less than the pure stock portfolio. Over longer periods of time, the more volatile single asset-class portfolio is likely to outperform the less volatile diversified portfolio. However, you should keep in mind that one of the main advantages of diversification is reducing risk, not necessarily increasing return, over the long run.

Past performance is no guarantee of future results. Risk and return are measured by standard deviation and compound annual return, respectively. This is for illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index.