“Tail risk (the risk of large losses) is dramatically underestimated by many investors and the tools we have available to manage such risks are hopelessly inadequate. Financial theory which is taught at business schools and universities all over the world is plainly wrong.”
This week we turn to my friend Niels Jensen of Absolute Return Partners in London for our Outside the Box offering, in which he looks at tail risk, Modern Portfolio Theory, and a risk he identifies as Birthday Risk. It is a lively and easy read, which is also designed to make you think about your basic investment principles.
Your loving NYC weather today analyst,
Nearly everyone I talk with has the sense that we are at some critical point in our economic and national paths, not just in the US but in the world. One path will lead us back to relative growth and another set of choices leads us down a path which will put a very real drag on economic growth and recovery. For most of us, there is very little we can do (besides vote and lobby) about the actual choices. What we can do is adjust our personal portfolios to be synchronized with the direction of the economy. The question is "What will that direction be?"
Today we are going to look at what I think is a very clear roadmap given to us by Dr. Woody Brock, the head of Strategic Economic Decisions and one of the smartest analysts I have come in contact with over the years. This week's Outside the Box is his recent essay, "The End Games Draws Nigh." For those who have the contacts in government, I urge you to put this piece into the correct hands so that Woody's very distinct message gets out. I think this is one of the most important Outside the Box letters I have sent out.
Woody normally does not allow his work to go beyond the circles of his clients, but I suggested to him that this piece was quite macro in cope and important for both individuals and policy makers everywhere to understand. In my own simple terms, trees cannot grow in some unlimited manner to the sky. Families cannot grow debt without limit beyond the growth of their incomes. And countries have the same constraints. While growth of debt in the short term is viable, growth of debt faster than the growth of GDP is not viable over the long run. This is not debatable. It is a simple fact. Therefore, as Woody says, it is important that you get the growth side of the equation right as you increase the debt side. Without the proper balance, you are heading for disaster.
From his intro:
"We weave these three concepts together so as to make possible an extension and generalization of "macroeconomic policy" as normally understood. Central to this extension is the need for policies that drive down the nation's Debt-to-GDP Ratio over time. Accordingly, we identify 15 policies that jointly reduce the growth of federal debt and increase the growth of GDP over time. Doing so not only points to a new set of policies for exiting today's quagmire, but also permits an appraisal of the Obama administration's current policy proposals. Regrettably these proposals do not fare well with respect to growth. Furthermore, the extension of macroeconomics we propose applies not only to the US economy, but to most all others as well. It should thus be of interest to readers everywhere."
This is longer than the usual Outside the Box, and will require you to put on your thinking cap. But you need to digest this, and especially the conclusions. But it is very important that you understand the principles and concepts Woody discusses. We are at a very critical juncture, and the paths we choose will have profound impacts on our lives and fortunes. I cannot overemphasize the point. If we choose a path of growing debt faster than we can grow GDP, the negative implications for many traditional asset classes are enormous.
Let me again thank Woody for allowing me to send this on to you. And for those who post this letter on various sites, just be sure to include a link to Woody's website, www.sedinc.com. For those interested in his subscription service you can contact Woody at firstname.lastname@example.org or visit his website.
This week we look at a remarkable and important essay by my friend Dr. Woody Brock who is one of my favorite "Outside the Box thinking" economists. I seriously look forward to Woody's quarterly insights and devour them as soon as the come in.
I especially urge you to read and re-read the first few paragraphs, and then think about what mean reversion will mean to US wealth growth, and to the developed world in general. This is a very important concept, and basic to economics, but one that has not had enough attention drawn to it. Coupled with high valuations, the headwinds facing traditional investments are getting stronger.
Woody is president of Strategic Economic Decisions, Inc. (www.SEDinc.com), an economic consulting and advisory firm that works with institutions and funds. For those of you who are looking for real insights into today's world, I suggest you look at some of Woody's material. I think you will be very glad you did.
General reader, today's Outside the Box is one that you are going to want to put your thinking caps on for. My good friend Woody Brock has kindly allowed me to present you with one of the sections from his quarterly comments. In his chapter "Deconstructing Today's Ongoing Revolution in Finance," Woody has written a particularly interesting and somewhat controversial section titled "Why the Economy Needs Vastly More Derivates, Not Less."
An all too common myth is that the total value of derivates is in and of itself dangerous because they are a form of leverage...but that is not the case. Derivatives, per se, are not a form of leverage; rather they afford the opportunity and make it easier and less risky for others to use leverage across many different assets and instruments (i.e. - mortgages, insurance, etc...). It is the leverage which is then the issue, as paradoxically, the decreased risk (hedging) aspects of derivatives allows investors to feel more comfortable with increased leverage, which sends a variety of signals to market participants.
The problem lies not in the instruments but in how the risk is distributed. While many of the larger, institutional players have used the offshoots of derivates to better hedge themselves, much of the smaller investor community has unwisely used the medium in a speculative manner. If a small homeowner is in trouble because of leverage on their mortgage, there just isn't anyone left to bail them out. Just as in the greater fool theory, the party only continues while someone is more foolish and irrational than the last fool.
Again, this is one of the more insightful articles featured in an Outside the Box. I believe it to be very important as its implications tie into what we are now seeing in the subprime mortgage market. May you enjoy Woody's insights and analysis.