CIC Paper - Post 2008 Investing

Abstract We are a generation of history makers; a generation participating in the most profound shift in economic theory since the Florentine credit markets of the 12th century. Just as Haley’s Comet came and went during the Reagan-Thatcher era, it is unlikely that present and subsequent generations will experience the opportunities that are currently available ever again. As much as the Regan-Thatcherites have kicked and screamed to the very end, make no mistake; this is a once in a lifetime opportunity, which once gone, will only be retold in academic texts.

Introduction In 1980, Margret Thatcher paved the way forward for the global deregulation of markets. A case in point; at that time, Iceland happened to not only be one of the least free countries in the world, but also the poorest in Europe, while Ronald Reagan not only advocated Thatcherism ideology, but also his own style of supply sided economics in the United States. While this neo-liberalism supported the notion of perfect markets and optimal market efficiency, curiously, our case in point by the end of 2004 was the 9th most free country in the world and Iceland was the richest in all of Europe. The deregulation of markets offered by Reagan-Thatcherism gave free market access to speculators, and when speculators are allowed to control a market only the absurd will follow. These policy bases gave private capital the opportunity to rule in the

stead of the government; it gave the passions of men the right to govern the allocation of resources.

In 2009 however, this anti-statist view was dealt its final blow, with the dawn of a new President in the Oval Office; Iceland having been bankrupted in the 2008 financial meltdown, and a return to a global social democracy in order to stave off an implosion throughout the global economy. Capitalism must now evolve in a new direction; the problems the 2008 global economic crisis was far more than merely a lack of credit analysis.

Theoretical Underpinnings of a By-gone Era The Reagan-Thatcher methodology was not simply an ideology imposed upon the economic community, it was an ideology girded by the most progressive economic theories at the time; the Rational Expectations Hypothesis and Efficient Markets Theory, both having received support from the leading academic proponents of the day - Harry Markowitz with Modern Portfolio Theory, and Bill Sharpe and his Capital Asset Pricing Model. These theories though intellectually elegant, were impractical and perpetuated the divide between academia and the markets they studied.

The Rational Expectations Hypothesis contended that the sum of all individual market trading decisions, filtered through the institutions of the market, are never to be found systematically wrong. Discretionary monetary policy was unable to

impact on unemployment or economic growth, and only being able to influence inflation, it was said to be a poor means to improve economic performance. The application of this ideology saw monetary policy being implemented to support inflation targeting and maintenance, denying central banks the opportunity to reflect upon other consequences to be suffered. In a sweeping attempt to eliminate fundamental analysis of any kind, a subset of Rational - Expectations Hypothesis, Efficient Markets Theory, considered the market as the digest for all economic and financial information, and in that capacity it was to reflect the equilibrium of all possible influences and the accurate future return of any security in question. No further analysis could possibly add anything to its conclusive character.

After the stock market crash of 1929, Andrew Mellon advocated the liquidation of labor, stocks and farmers (in that order). In today’s climate he would no doubt support the recently demised Reagan –Thatcher ideology that would allow the financial system to collapse by allowing the banks to realize their toxic debts until bankruptcy terminated their operation. Indeed, a clear sign of lunacy is repeated behavior expecting different results. The fact that this was not adhered to signals not only a dramatic shift away from Reagan-Thatcher ideology, but its end.

Clearly, if the likes of Treasury Secretary Hank Paulson, a supporter of Thatcherism were not superseded by Larry Somers and the Obama regime, the world would have

tumbled into another Great Depression. Instead, it has taken a mere six months for a change in government, and with decisive action taken to regulate the financial system, the US economy has begun to recover. It is this fact alone that exemplifies the need for hasty action to regulate markets. Clearly they suffer from inefficiencies and the longer regulation is delayed, the exponentially greater the corrective action that will be needed.

Now we will experience a shift backward in time to that of fundamental analysis. The idea that traders making consistent profits year after year are simply lucky is ludicrous. The benefits of fundamental knowledge and analysis, the adoption of disciplined and objective trading practices and the ability to react to changing conditions despite the contrary fascinations of the market, is precisely why these traders make money. It is a revisit to 1934 when the great Ben Graham provided economists with a mantel upon which they could seek refuge from the short-lived impulses of the highly leveraged bucket shops, subject to the euphemistic short squeeze and experimental economics. “Security Analysis” (1934) having sold over 1 million copies, has much to hold for academia and the broader market community. Surely it is mere coincidence that Mr. Warren Buffet has not only been fortunate in his investments for a frighteningly extended period of time, but has also had the good fortune to be the only student of Ben Graham to ever receive an “A’.

The purpose of investment in Graham’s view was to acquire cash. Therefore, capital gain on equities will represent the present value of cash to be generated in the future. Obviously, the present value itself is a function of interest rate projection and here too, the alternative investment of bonds will need consideration.

Trade Implication: As a consequence of Rational- Expectation theory, we have lost track of what value really is. The imminent Fundamentalism that now sits precariously balanced on the cusp of the markets will engulf participants with renewed warmth. It is the prudent who embrace it before hand.

The concept that markets are the product of precise assumptions made about expectations is unsound. Further, justification of Rational-Expectations theory abounds in the alleged absence of errors when predicting the future; deviations for perfect foresight are supposedly merely random occurrences. The benefit off hindsight shows that while it was a poor replacement for Adaptive Expectations theory, a unique combination of the two may optimistically, warrant recognition. Still, when market expectation is altered by convincing influences, life imitates art, and self-determination paves the way to precisely mimic expectations. The telling sign however, that Rational-Expectation theory failed in its accountability to the economic community, is in the notion of ‘falsifiability’ propounded by Karl Popper. With this he exposed the fluid position RationalExpectation theory occupied in economic theory. In Pooper’s view, when empirical

evidence such as the 2000 stock market collapse were presented, economists could simply modify their reasoning and proofs without bringing Rational-Expectation theory into dispute.

Yet mankind has not evolved into the complex social animal he is today without the device of the mutual mistake. Individuals often use heuristics to make decisions, and these cognitive biases are not necessarily rational. Indeed, the human mind is both complex and unique - how is it that the motivation of a man be discerned? While the Western philosophy of learning derives its basis from the Ancient Greeks who believed in the learning of theory before a practical application in the real world, it is time for a move away from educational schemes that cannot provide the markets with tangible expertise. We need to adopt the Eastern philosophy of learning through practical experience. The free markets, devoid of any regulation that was the policy of the ReaganThatcher era, were clearly a product of mutual mistake; the collective market was induced into what science calls the expectancy - valency model; where a decision is based upon an expectation that a need will be met, strong bonds are formed with this type of behavior when that need is indeed met. When a flight to quality causes the gold price to shoot upward, the principle is only more firmly entrenched into market ideology each time a response is shared without proper justification. Indeed, begs the question, was the market ever truly free? Exemplifying the phenomena in the meltdown of 2008, while the source of numerous fundamental problems were recognized to emanate from the United

States, the engrained herding mentality of the market, directed its attention once again to the US dollar and Treasury Bonds.

Market Efficiency propagated the price of index investment strategy basing the weighting on the market capitalization of each stock making up the index. Again, in the Dot Com bubble, investors paid exorbitant amounts for companies such as simply based on their trading price, while disregarding their operational cost structure and balance sheet mechanics.

Discarding market efficiency theory in 2005, Richard Arnott’s value indexing method which adopts a method of fundamental analysis is reminiscent of Graham & Dodds in 1934. Here, Arnott extols the virtues of value indices such as the infamous price to sales ratio, which has been found to outperform the market more than any other indicator.

The New Frontier - Behavioral Finance Instead, it is out with the old and in with the new, and it is Behavioral Economics theory that will lead the new revolution, hand in hand with the field of psychology. Integrating psychology with Keynesian economics of old, it is the emotional factors, unique dispositions, skills, education and attitudes of individuals that are the subject of behavioral economics. In the same vein as Jeremy Bentham and his beloved utilitarianism, it is no accident that Daniel Kahneman a leading psychologist with little economic training can win a Nobel Prize of Economics in 2002.

In October 2008, former Chairman of the Federal Reserve, Alan Greenspan, admitted to Congress his disbelief that banks, in their embracing of irrational risk through investment in unregulated financial exotics of 2007 & 2008, would act so far contrary to their shareholders interests. It is not with a childlike naiveté that Mr. Greenspan makes these remarks, but with an underpinning belief in an ideology shared by many; rational – expectation theory. The deregulation of markets was something that infected first the academic world through rational-expectation theory, and then the political world during the ReaganThatcher era. Until disproved in 2008, market efficiency theory was a matter of course for most of the world’s financial executives.

Economics has traditionally been hailed as an inexact science that pervades the boundaries of all aspects in our lives. Politics and law are the first to suffer invasion, but through osmosis, sex, crime, education, health and even entertainment are subject to economic scrutiny. Our own Chairman of the Federal Reserve has recently validated research that shows in times of financial scarcity or threat thereof; men will not expend cash on replacing their underwear. Subsequently, the Underwear Index has been found to be particularly accurate in terms of economic healthy and consumer sentiment.

Given the inexorable link between price and value, policy makers nearly always demand that an innovation rising from a particular area of human endeavor be subject to an economically characterized filter. In this sense, economists are the

gatekeepers that control the flow of science and innovation from its genesis in academia, to becoming a political reality.

In the past, this economic superiority was discharged in light of an underpinning belief that people being self interested and rational, will result in collective market efficiency. The integration of psychology and economics collaborates beautifully in the field of Behavioral Economics, and exposes the fallacy that human behavior in markets is rational. It identifies the limits to human cognition and illustrates the use of intuition, heuristics, and emotion, rather than what was previously assumed to be informed decision making through the filter of highly specialized cost-benefit analysis.

The Achilles heel of capitalism is held out for all to see; delusional optimism. Here it is revealed that market participants not only believe they will be successful, but that they are absolutely ignorant of the risks they are taking and their probability of success. Undeniably the product of the human condition and propensity to error, Professor Sendhil Mullainathan of Harvard portrays this rationale quite simply. With 69% of female itinerant fruit vendors in India constantly in debt to moneylenders charging 5% per day, the 10% profit made each day is also eroded by 1-2 cups of tea each day. If they simply consumed one less cup of tea each day, they would be free of debt and self sufficient with twice their income. Only 31% of women have adopted such a

strategy and presently enjoy financial independence. The remnant reveals the familiar irrationality that the financial markets at large are imbued with.

Extending this periphery, the study of human beings making decisions under conditions of scarcity is an old yet particularly pertinent question. People in such poverty are required to make higher quality decisions but cannot do so due to lack. Such is the ironical nature of poverty. When contrasted with those in abundance, poor decisions in this latter category are supported by a cushion of tangible advantage in the form of administrative delay, political influences, legal implication or simply, the device of bankruptcy is able to rescue the proponent from the haste, ignorance and irrationality entered into.

Indeed, Richard Thaler contends that the four constitutional principles of Behavioral Economics are bounded rationality, bounded selfishness, bounded self control, and bounded arbitrage. While the first three are spawned from the tenets of psychology, the fourth is instructive in that it demonstrates clearly the limited capacity of the markets to protect individuals by virtue of exploiting their mistakes within the allegedly perfect market.

One of economics’ oldest divides has been to do with the correct regulation of society. Liberals admonish regulation due to the harm in reducing individual choice being allegedly worse than the benefit accruing; the market will reach equilibrium. Marx

on the other hand took for granted the need for a controlled working class; choice is not an option.

Thaler’s intriguing metamorphic result is a combination of the two; a liberal paternalism, a poignant example of which is the New Zealand and Australian political response to the global economic crisis. These two nations hailing from the underbelly of the world, developed political support for their financial systems by offering a bank guarantee. The guarantee was entirely voluntary, and served as a subliminal yet clear signal to the market that financial markets down-under were robust and healthy. Had the opposite been adopted, a mandatory conditional guarantee would most certainly have had the drastic effects – the suggestion that there was indeed something rotten in Denmark….

Organ donor opt-in strategies have similar effects; the choice people are afforded results in vastly different behavior. Similarly, unit pricing in supermarkets has not had the cleansing effect many had predicted. Wealthier people believe they have far less time; time is uniformly distributed yet appears to be a progressive tax. Busier people have a scarcity of time, and so make decisions similar to those in poverty; poor quality decisions made in respect of high value decisions – the scarcity trap. As the great Daniel Kahneman contends, a subtle influence radically shifts the behavior of individuals; cheap metaphors capture our attention.

Indeed it has been said by advocates of Behavioral Economics that lending at lower rates will not stimulate liquidity; the shift that is needed is to lend at the same higher rates but address mankind’s chronic limitations in conditions of scarcity by providing asymmetric payoffs. It is with this measure of insight that the world can redistribute wealth to both those in poverty, and also those in abundance. While holding the essence of the new order about to impose its fundamental character upon the financial community, behavioral finance holds dear the intuitive nature of heuristics, the presentation of a choice remaining essential to decision making, and the inherent presence of market inefficiencies. Market momentum for example, cannot suffer a proof from market efficiency theory, but indeed finds support from behavioral finance.

Shortcomings of the Old Regime When the foundation of Reagan –Thatcherism has been shattered, all that remains is an ideology. Shortly to celebrate its 20 year anniversary, the 1980’s saw the Berlin Wall come crashing down, and the color of the political water underwent dramatic change. It was said that the state had not the right to intervene, that an individual’s rights were paramount, and that the rule of law was supreme. Still, it is interesting to note that quite opposite of the laissez faire indulgences of Thatcherism, Chile has allegedly labored under a military dictatorship for decades, and yet proves that it is economic

freedom not the mere device of a democratic institution, that is a condition precedent to economic growth. We know where most of these institutions are right now; some are desperately legislating to rescue their governments from the insurmountable bad debts that have been absorbed, others are doing the same to cover the unprecedented economic stimuli the global economy has recently experienced. Still others are now undertaking deep study into the types of regulation that will prevent this fiasco from recurring. It is now time for social democracy to correct what has been the greatest political and economic error in judgment of our time. Mankind has not made such a blunder for 800 years.

The peace dividend that was promised by the Reagan-Thatcher administrations never really became a reality. The guns versus butter model has been reignited. The infamous Joseph Goebbels and Herman Goring advocated that guns will make Germany powerful whereas butter will only make them fat. Its appears that while free markets only serve to estrange a dictatorship from participation in global markets, defense spending in the United States has increased at the expense of health, education and a raft of other public necessities deprived of her people. This marvelous turn of events results in the United States being identified as the White Elephant in the room, no longer the victorious juggernaut she emerged to be after World War II.

The Benefits of Inflation; an Oxymoron? The monumental 18% inflation of 1970’s was indeed well contained by the advent of Reagan-Thatcherism. The economy prospered, and inflation remained relatively modest. Today however, the inflation contingency that Regan and Thatcher sought to grapple with is what is desperately needed. Inflation will now be our saving grace that will allow allocation of capital into the future and preservation our financial system. What has always been seen as the one drawback of our economic model, its leaking valve, will now be the golden parachute that the world is searching for. More importantly, our capital markets are the link between the present and the future, providing an inheritance for our children, and through the allocation of resources, the capital markets perform a function that is on any level, indispensible. A revolution is presently underway; one upon which both politicians and academia concur.

The debt of today’s global economy is astronomical. To reduce it, a number of alternatives are possible, not all of which will operate in isolation. Reducing debt by fiat, while practiced in Biblical times and also in Ancient Greece, is unlikely. Defaults such as what has been experienced will merely result in the same devastation of capital, and displacing the element of trust once more, will place the financial system in further jeopardy. It appears that the only feasible solution to eradicating debt is to inflate the value of the debt into oblivion. In this fashion, inflation will be embraced with open arms.

The Federal Reserve, predisposed to inflation targeting, have already indicated intent to contain inflation at 2%. In an attempt to protect the taxpayer’s investment in the US Assets Relief Program, it appears likely that inflation will indeed be far more acceptable at a higher level of at least 5%. With the consequences of the greatest fiscal stimulus the world has ever seen yet to come, it is suggested that this level of inflation will be quite easily reached. Forecasting in respect of the next the decade, it seems futile to argue in favor of an inflation rate of a mere 2%.

Trading Implication: To this end, our recommendation is to sell nominal US Treasury Bonds Futures and invest in Treasury Inflation Protected Securities (TIPS) or select equities. The synthetic sale of debt is, it ought to be remembered, the selling of US Treasury Bond Futures. That being the case, acquiring corporations laden with debt is unnecessary.

US Banks Get the Inside Rail In the fullness of time, there is some irony in the fact that today both the US and UK administrations are pregnant with institutional debt. The bank rescue package in the US is going to require a staggering $2 trillion dollars to rectify, this representing twice the budget deficit, and approximately 12% of GDP.

A judicious rationing has been employed with the disclosure of bad debts to the market, along with nothing short of an outright declaration that the US government will leave no stone unturned in a bid to rescue the financial system. Nothing will stand in the way of the redemption of the banking system. A recent study by KBW Inc. has found that lenders will need to recoup $1trillion simply to compensate for their losses. Yet, the precision of statements such as these are however, bound to err toward optimism. The ongoing investigation into government acquisition of toxic assets is needful enough of a delicate touch. Tact will be employed to prevent a further run on asset prices that would compound the problem. An inflated price will similarly affect a far more immediate and increased burden on the taxpayer’s investment.

Given the enduring nature of over 300 million spending consumers, it appears therefore to be a mere extension of principle that the US taxpayers investment will be protected as a matter of public policy; the advantage of over valued assignment values will be exploited in the interests of preserving market stability.

Intriguingly, for the first time in almost a millennium, the taxpayer confounds the problem by remaining present on both sides of the equation. Low asset pries in the government acquisition of toxic assets will hurt the banks, and set a negative market precedent for the empirical valuation of newly acquired assets by taxpayers. Artificially inflated asset prices will consume more of the taxpayer’s funds, placing

this investment at marked to market unrealized losses almost immediately. The argument is circular.

Accordingly, US banks enjoy a historically unprecedented position of somewhat curious immunity. The US government will ensure the longevity of financial institutions through fiscal and monetary policy decisions, and the life blood of the banks revenue will continue to flow from a positive yield curve. The taxpayer is the creditor at risk of default and where possible the government will protect the investment that it has inherited. The ability to value an asset accurately is not a luxury that can be enjoyed at present, and valuations currently underway appear to be arbitrary. In the current accounting environment, optimistic over valuation policies by the banks will no longer prevail upon a balance sheet; legislation will demand it. Indeed, many balance sheets rely on the unrealized nature of their investments to support artificial valuations. When these hopes are diminished over time, the inability to avoid valuation will prove unstoppable, and creates the risk of a double bottom in the economy. Buying the rumor and selling the fact will indeed follow in due course, and this is sure to precipitate into a secondary bear market should balance sheets succumb to a further wave of despondency. The Assets Relief Program itself will then require revision as its Congressional supporters find that the cupboard is bare.

Trade implication: Our contention is to now replicate the position of the banks in indeed selling short dated securities with an investment further across the yield curve. Here will be the fulcrum for an economical anomaly. It will be unlikely to be present ever again; the unwritten protection of the state. Even while charged with protecting the slope of the yield curve in order to allow the banks to earn a consistent profit, the Federal Reserve will be demonstrating the very shift in Reagan-Thatcher ideology proposed in this paper, by regulating the markets with such drastic intervention. As alluded to above, the inflationary surprises that he market will experience will be frequent and substantial. In this event there will be pressure on bond prices. It is in reply to this contingency that we specifically recommend selling nominals and buying TIPS.

The Revolutionary Order Due to the conservative stance that any financial institution will no doubt adopt in today’s climate, the practice of borrowing and lending will become all the more guarded; banks will simply lose the ability to accept risk without policy, procedure and legitimacy. We admit that the slowing of growth rates accompanied by lower wealth creation is consequential to social democracy; with the adoption of certain regulatory measures, more so. This of course is counterbalanced by an increase in confidence within the global financial system, and which serves as the lubricant to any modern economic model.

Interesting to note is that the word ‘credit’ is derived from the Latin root ‘to believe’. Today it is belief that keeps the global financial system intact, not capital, for she is our gift to future generations.

While ex- Treasury Secretary Hank Paulson carried on the legacy of the ReaganThatcheristic aversion to regulated markets, the new regime in the Oval Office were committed to implementing controls on what was by then proven to be a financial catastrophe. Indeed, one of the justifications for participation in the exotic securitization of mortgages and credit default swaps was that the risk was distributed to those best able to bear it. Sadly, this could not have been further from the truth; those that bore the risk of these investments knew not their position, exposure or even their counterparty. That being said, it remains only the US government that resembles a party able to bear the risk, and in doing so it will ensure market stabilization and an opportunity for US banks to recover their vigor. Clearly, this unprecedented administrative market intervention holds nothing less than the stability of the global economy in the balance – rarely will the world ever see again the coordinated action to secure profitable participation for financiers.

Of particular concern to the IMF and the World Bank in the Thatcher-Reagan era was the increase in capital accumulation, and for this reason, deregulation of financial received their assent at that time. Today however, while lenders are under more pressure than ever before to secure quality borrowers, they are far less able to

provide investment innovation and expertise with the capital it requires to fund these types of operations. Supporting this premise is the fact that US banks having received the first fruits of the bailout package, as yet do not appear to have increased lending levels to any considerable level. Particularly if any accuracy is to be adopted in the valuation of assets, lenders who have found the new regime of lending practice limiting, will be surprised at the extent their operations will be curtailed if indeed assets are valued at their correct price.

The benefits of inflation however, will be the balm to soothe the sting of debt, and inflationary effects in the near future will reduce the banks debt to society along with having commensurate influence on household debt.

Aging Population The advances of the 20th century were unparalleled in the history of the human race. Technological and scientific progress has seen the longevity of the elderly, and the rapid aging of the population provides a further interesting variable that will challenge past economic theory. The savings of many baby-boomers already eroded in the 2008 meltdown, will mean that many will continue in the workforce longer than they had anticipated. Further they will adopt a practice of saving that while relieving the public purse to some extent, will have significant consequences on demand.

Property Market While a 30% increase in mortgage refinancing has recently occurred, and there is evidence of some improvement in the US property market, there yet may be seen an oversupply of housing; one that a particular sector of the demographic including the aging and young families that simply cannot afford a home. Further benefit to the property market will no doubt manifest with inflation once again rising to the centre of the fray.

China Laden with Green Paper While it may be intriguing to know that the US is capable of indeed exporting something to China, unfortunately it will be found to be inflation. This is now shown to be a matter of course between fixed exchange rates, and is derived from the inflated revenue experienced by China’s export sector. In response, it is possible for China to raise interest rates and quell the tide of inflation however; it may well be inevitable that she entertain the thought of floating the Remmenbe.

Trading implication: If this is indeed the path to ensue, investment in Chinese development projects and infrastructure will offer attractive returns. Not only does this resolve the difficulty in acquiring Chinese currency through application, but it allows potential for an inflation proof investment to flourish in the Chinese

economy while also retaining the benefit of the large capital gain when the Yuan is revalued or better still, floated. A word of warning to the wise; if the opportunity to invest in Yuan and other Chinese investment projects is forgone, when the eventual revaluing of the Chinese currency does take place, those preferring Yuan yet holding US dollars, will suffer an unprecedented loss.

The Single Most important Investment For all intents and purposes, with $2trillion of US Treasury nominal bonds held as a matter of course, investment capital and demand will ensue from China. She may well be reluctant to maintain such exposure to the Greenback. While she has been careful to acquire investments along her supply chain, it is those that are as yet omitted that represent prudent investment. Due to the oversupply of capital, and the under supply of innovation and expertise in investment services, this frontier will remain pivotal to China’s future prosperity. In the agricultural economy of old, it was land and resources that dominated wealth creation. In time, the acquisition of empires to obtain raw materials would augment the wealth of the landowners and aristocracy. Today however, post industrialization economics has found that acquisition of a supply chain is of limited value; it is intellectual property that is sought; innovation, investment expertise, and creativity in an increasingly vigorous and dynamic economic environment.

Unique to intellectual property, accounting conventions will continue to omit their true value from balance sheets. It is the prudent investor that applies fundamental analysis to reveal these inefficiencies in the market place and capitalize on them. Intellectual property will replace land and resources as the hallmarks of wealth. Those who are able to concentrate intellect under concerted action will rule the modern world.

Again, in the area of manufacturing it seems China is a seasoned participant however, it is marketing expertise that will be in demand into the future, and this too will form part of China’s best interests into the dawn of a new era. It will be noticed that the US may be impecunious however, she is fat with investment expertise, and this matching of complementary spheres of expertise is a recipe for success.

Given that the economics books are being rewritten to revert back to the Keynesian school of thought, the current generation of academics and graduates in the market are untrained and will be found to be unqualified to meet the needs of the new order. Indeed, if the truth be known, the academic community at large suffer from a vast deficiency of fundamental theory. Instead, they have been reliant on a staple diet of rational – expectations theory. Is it indeed the blind leading the blind?

For the next 20-30 years Chinese investment will demand tolerance of a vastly different market environment. The post –Reagan-Thatcher ideology will balance an

aging population, the accelerating technological advances of the 20th century, carbon emissions and their profound threat to industry and manufacturing, and of course, the possible nationalization of the banking system. If the new regulatory regime is not enough to challenge market participation, the consequences lurking behind the greatest fiscal stimulus in economical history may well do so.

Given the inevitable inflation rate that will rise like a fortress amid the recovering US economy, China will be met with enthusiastic demand in the US, and so will import inflation. In time, China will raise interest rates in order to contain her inflation, but re-pegging of the Yuan to a basket of currencies or the Euro may seem the conservative alternative to floating the currency. Unfortunately, the Euro and other currencies will provide little solution to China’s exposure to the Greenback, given that many financial institutions in those economies also shared in the same toxic paper of the US banks; one alarming difference being that the European banks however, did not receive the financial assistance that US banks have enjoyed.

Trading implication: In response to this we recommend investment in Chinese infrastructural projects, application for Yuan acquisition, or raw purchase of the Yuan in offshore synthetic markets.

Considering that US banks will be under close scrutiny and heavy regulation, it is extremely unlikely that they will lend to support investment in innovation

as they did in the future. Private equity funds have been crippled by the 2008 crisis; hedge funds have suffered a similar fate, and the prospect of junk bond finance is unlikely after the Milken Affair. The future funding source for innovators will be India or China. Certainly, investment expertise, management and marketing will be imported from countries like the US, but yet the dynamics of the global economy will shift with China filling the vacuum that the US has left quite exposed. Our contention here is to provide the expertise that available capital naturally seeks out. Given the scarcity of these types of resources, now governed by a new paradigm, organizations such as the CICC need innovation and foresight in their investment strategies that are all the while substantiated by coherent economics.

Stocks v Bonds Traditionally, equities have commanded a 5% premium over the bond yield, largely due to bonds remaining the asset class that is routinely ignored, and investors preferring stocks and currencies for reasons yet to enjoy proper justification. Not only has this become entrenched in the psyche of investors everywhere, but significantly, the fundamentalist revolution will tolerate it no more.

As history shows us, other stock markets around the world have suffered a number of catastrophic events, to provide the investor with as much as two opportunities to lose 100% of their investment in the past century. The United States however,

remains the exception. It is extraordinary that it has not come to the same grim end as the Japanese or European stock markets, and in that respect ought to be treated discriminately.

Simply, the 5% premium in favor of equities is concomitant to the risk that stocks pose vis a vis bonds. If the risk is not reflective of a 5% premium it cannot be justified. Economic growth is achieved through innovation. If there is no innovation to speak of, there will be no economic growth and neither in this situation can a 5% premium be argued. The premium that equity enjoys over bond yields is dependent on inflation; if inflation is rising, bond prices will be under pressure. Due to the fact that equities are a good hedge against inflation, the premium in this scenario however, may well merit some consideration. The incontrovertible truth however, is that fundamental analysis of the real interest rate achieved is mandatory in the counter-revolution that will emerge.

Currently, inflation is targeted by the Federal Reserve to be 1.8% over the next 10 years. The inflationary component priced into the 5-year bond is 1.8% and that priced into the 10-year bond is 2.1%. In the fullness of time, as the economy builds momentum, the target will appear to be more and more inappropriate. RationalExpectation theory would of course have demanded that the target only need be reached – it did not matter if it overshot. See now, when inflation is at 5% it will still receive the familiar rhetoric of a central bank who will insist that their target is 1.8%, in an effort to coerce the market. On this occasion however, the power of

suggestion as fortified by efficient markets theory, will prove ineffective. Regardless of those that cling to the familiarity of rational- expectation theory and therefore (through the Maastricht Treaty and its inflexible ideology), the ideology that the role of a Central Bank does not include leave to consider other economic implications, the global economy including Europe will set a course along the path of inflation.

Further, there is ambiguity in the real rate of inflation. Hedonic adjustments have been rife, and while it may assist a Central Bank in the discharging of its duties, the real rate of inflation will be considerably magnified. It is intangible anomalies such as these that efficient markets theory fails to consider, and it is precisely what will be required of sound investments in the coming new environment – fundamental analysis. Again, traditionalists have held the view that stocks will outperform bonds however, in the past 10 years bonds have triumphed, with considerable economic growth resulting despite a return being postponed by equities. Growth stock investors have disregarded the importance of dividends in the past, but now alternatives will be available. The divide between fixed interest markets and equity will be a practice of the past. Comparisons will be made between the yield offered by bonds and the dividend yield on stocks.

Both corporations and investors ought to discriminate more effectively between a stocks performance and corporate bond yields. These ought to be fungible as they lay side by side representing the true market capitalization on a balance sheet. In

such a capacity, they ought to be able to be exchanged one for another after undergoing scrutiny for the most favorable yield returned.

Conclusion: Two Contingencies to Bear in Mind for the Future For now, it appears that the scheme that is Bretton Woods II is intact and unaffected. Still, the future appears to hold some concern for the fact that a number of other nations including China are holding vast reserves of US dollars, while the US maintains non existent savings and continues to borrow in order to service an insatiable consumerism, all the while running a pretentious budget deficit. Certainly this deficit may indeed be necessary to fuel economic growth the world over however, in the past the US provided her investors with the service of enforcing economic and defense policy where ever it was needed, in return for the benevolent act of holding large amounts of US dollars. Today, circumstances are vastly removed.

In the 19th century the British had dominion, in the 20th century the US emerged after World War II as the economic superpower, and now the 21st century holds promise for the country that has the ability to acquire and retain the intellectual reserves of the world. Today, the Cold War is over – there is no one to protect against, and given the risk of US dollar exposure beginning to strain many relationships, the US may well be passed over when it comes time to review a possible reserve currency.

Another risk that results from the tumultuous nature of the 2008 financial crisis is that the financial institutions suffering from toxic debt, will realize losses far in excess of what has been disclosed. If this were to be the case, the global financial markets would again lack the good faith that behooves interbank lending, and the global economy will grind to a halt. In such an event a secondary meltdown may ensue, placing at risk all that we hold dear today.

Trading implication: In the event that a successful bank rescue package in the Untied States fails to come to fruition, banks such as Wells-Fargo will be found to have avoided the toxicity that her peers indulged in. Prudential decisions were taken with caution at Wells Fargo, and her recent acquisition of Wachovia Bank will provide the intangible asset of now achieving national coverage without bad debts to inhibit her operations and security. While other banks are burdened with conditional aid from the US government, Wells Fargo will enjoy lucrative returns.

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