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April 30, 2007

Financial 12-Step Program: What next?
by Wilfred Hahn

Everything ... absolutely everything, it seems ... is on an up escalator. It's as if the Otis Elevator Company has discontinued its down model. Most forecasters are optimistic about the upward sustainability of current global financial conditions, few daring to gainsay further escalation. We will review 12 of these escalators. They may all be near their top rung. But, markets can indeed yet rise for an undetermined period of time longer. Why? Simply because these are the product of human action and expectations. Humans are capable of a lot ... including collective mania.

All the same, the present financial hubris is remarkable given that the lessons of past asset inflations should still be quite fresh. The same old thing is unfolding again -- a credit inflation -- albeit dressed in different clothes. Although a mania can yet take place, the reality is that risk premiums right now are at rock bottom levels. In fact, according to a recent estimate by Jeremy Grantham of GMO, investors are actually paying to take on risk. In others words, risk-premiums may be actually be negative right now. That makes it very difficult for prudent portfolio managers to be fully invested.

More remarkably, this is unfolding even as the globe is aggressively entering a future of unprecedented financial and geopolitical change ... and, with still-increasing imbalances and residual risks. That the future may be uncharted is not new. But, what's different is that there is a lot of future happening more quickly and on a bigger, globalized scale. Underneath the fog of it all, the ancient motive of hoarding is expertly at work. Investors right now need to keep their wits and their hands on their pocketbook.

The Big Picture -- Standing Back From the Rail

Every major advance in financial wealth, whether domestically or globally, is a function of both secular and cyclical factors. Some of these are sustainable and self-propagating, while others are not. We take a brief (and highly selective) retrospective of major contributing factors to the financial wealth explosion that washes into our portfolios at this very time. We could start this story four or five centuries back. However, we keep it pertinent and begin our retrospective only some 5 decades ago -- roughly the span of a working career -- ending with the most recent dynamics. We then come back to the question of risk and also "buy & hold" strategies.

#1. Back in the early 1950s, according to estimates of UNCTAD, approximately 2-4% of world economic output was attributable to the TNC (transnational corporation). Today, though estimates are somewhat vague, the TNC may account for anywhere between 25% and 40% of world economic output. TNCs have been the seedbed of the attendant flowering of globalization, securitization, and thankfully, high market-capitalization stock markets for portfolios.

#2. Related to #1, is the emergence of a global and homogeneous behavioral system possibly more powerful and controlling than anything ever before -- even more so than the medieval religion or the Macedonian phalanx. Every corporate executive, financial officer or portfolio manager around the globe today studies the same theories and aspires to the same common values. Mostly, these are shaped by the executive stock option and profit growth. (Don't believe this? Work for a hierarchical TNC and try to run the show your own way).

#3. Piled on high is what you want in a discount merchandise store. But what about financial relationships? Apparently, these can also be piled on high and are infinitely profitable. In the early 1950s, the US financial sector contributed only to a small portion of total corporate profits. In recent years, this contribution has ranged between 30% to 40% and more. In fact, worldwide, making money from money is the largest industry. According to recent IMF estimates, total world financial assets were equivalent to 370.3% of GDP at the end of 2005. This level has been estimated to be closer to 60%, 50 years ago -- only one-fifth of the financial intensity recently. This development has been good for the market value of portfolios.

#4. While some quantitative theorists may be surprised to learn that financial markets are somehow connected to the limitations of the homo sapien, the fact is that the foundation of almost all real wealth remains human. Either it is labor that is the prime transforming agent to this wealth or it is the eye of the human beholder that assigns such value. Therefore, we cannot lose sight of populations and demography. Here, one great precedent has followed the other. First, somewhat before the modern time frame that we are reviewing, global populations boomed as never before. (To no surprise, this will have had an effect on the historical record of GDP growth and investment performance.) Even more significantly, this unprecedented phenomenon is now followed by another -- an unprecedented slowdown in population growth never witnessed before. Its ultimate effect still lies ahead. To this point, it has been a boon for financial markets.

#5. We are now in the early 1980s. Just-in-time inventory management techniques begin to transform production systems. Corporations began to shrink their working capital dramatically (from 15% of the balance sheet to near zero or less today.) For these and other reasons, capital efficiency booms, this being very different than productivity and often confused for capital productivity. But it does make financial markets percolate more peppily. The existing stock of money therefore goes farther, supporting financial asset values. Innovative developments continue today, especially so in the area of creative buy-outs.

#6. Beginning in the early 1980s, interest rates began a long decline, continuing generally until mid-2005. The average GDPweighted global interest rate today, we estimate, at roughly only a third of levels in 1982. Can it fall another one-third? (Consider #4.)

#7 & #8. We could review the impact of the multi-headed trend of globalization. Instead, we focus in on China and India joining the NICS (newly industrialized countries) in the 1970s and 1980s and the dramatic shift in the world's hydrocarbon industry. Today, more than one-third of world oil is produced by state-owned companies; almost three-quarters and over 50% of world petroleum and gas reserves, respectively, lie under predominantly Islamic countries; the major oil importing countries have 5X and more the per-capita energy consumption rates of the primary exporting countries; and roughly 40% of all oil traded in the world passes through the Strait of Hormuz. Among other things, this has played a role in the rise of the price-insensitive buyer of financial assets -- these being the surplus central banks and state investment companies of the surplus or oil exporting countries. More than half of estimated world official reserves are now concentrated with just 5 countries. A myriad of conclusions might follow. But none will argue for increased or perpetual stability. Rather, the opposite. Concludes a recent World Economic Forum report (Global Risks 2007) "... levels of risk are rising in almost all of the 23 risks on which the Global Risk Network has been focused over the past year."

#9. All the same, financial volatility and risk measures have been in a long period of contraction ... though interrupted every now and then with a minor tremor. This again has been a one-way boost for financial valuations.

#10. Not only has the "price insensitive" buyer of financial assets been a boon (see points 7 & 8) so has been the impact of booming world trade, especially as it has promoted the shift of labor-intensive production to low-wage countries. The world's trade turnover according to the WTO and other estimates has risen to over 100% of GDP in 2005 as compared to only 50% in 1960. It is a phenomenon, which in recent years has suppressed price inflation (though not inflation itself, which is alive and well). This has provided another positive sinecure to financial valuations in general. And some countries, like the US, by letting trade deficits run up, have also even been able to create the façade of higher productivity. This has also been a good thing for portfolio valuations.

#11. Yield spreads (of any kind) have contracted sharply, providing yet another boost to riskier asset prices. Many of these spreads -- whether between debt tranches or countries -- are at record lows. Can spreads continue to narrow to zero? Instead, could they reverse?

#12. And lastly, (and only because we are running out of space) corporate earnings are now tugging at their upward bounds, measured as a ratio of national income. If competitive capitalism has not yet been repealed, then these will be sure to come down ... eventually. If not, the age of crony capitalism will have arrived.

There you have it -- a 12 step program of escalators. They have collectively brought us to this recent piste. It's all very exhilarating, riding up the 12 chairlifts to the Black Run. However, one is advised to be an excellent downhill skier or expect a monetary helicopter. There is no other way down.

Next Steps

Emboldened and conditioned by a few years of financial boom and a long period of successive escalators, the future can look friendly to both serious analysts and shills alike. The problem for the investor that is seriously seeking value is not just that history is in uncharted waters, but that the theoretical boundary stones of value, acceptable risk and sustainable economic growth are being moved. So what to do?

We opt for theory and causality. It remains a planet of people who, behaviorally, are still humans. Therefore, we have taken this brief look backwards. But, now with this bit of historical perspective, there may be sensations of acrophobia. We see a collage of unprecedented onetime effects that have produced the latest bubble environment in financial markets today.

Yet, despite the amazing escalator ride, one set of expectations remains virtually the same -- future, long-term return expectations. Heaven and earth shall pass away, but the long-term annual return of the S&P 500 shall be 10% ... thus spake Ibbotson & Sinquefield.

With such faith in the continuance of flat-line growth rates in virtually everything, it will make sense to many to fully index portfolios or to simply "buy and hold." After all, in time, a new high is always attained in every investable sector, no matter the inconvenience of intervening lows or temporarily excessive risks. But just how deep and how long the low? Figure #1 frames this question to the tastes of the individual investor with respect to US equities. It shows the extent of top-tobottom interruptions in US equities (MSCI US Equity Index).

While most investors may be willing to hold on throughout a 10% downside, far fewer are willing to keep the faith during cumulative declines of up to 50%. As the chart shows, these have happened. Even stalwart index-investors or "buy & hold" devotees do not like to open their account statements during times like these.

Can such types of declines happen again? Yes ... easily. What we do know for sure is that such declines, greater or smaller, do not start from market bottoms or the flats of human pessimism. These have a higher probability at the top of rosy consensus.

We have briefly reviewed 12 steps. Difficult as it is to precisely negotiate that last exit step off any escalator, it remains probable that all 12 are nearer their tops than bottoms. Portfolios now need to be well diversified, and high in cash.

Wilfred Hahn
Hahn Investment Stewards & Company Inc.

The Global Spin is published and distributed by Hahn Investment Stewards & Company Inc., serving to provide comment and analysis on important economic and investment issues of relevance to general investors not otherwise widely available in the public domain.

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This report was produced by: Hahn Investment Stewards & Company Inc. Phone: 888-957-0602 and is for distribution only under such circumstances as may be permitted by applicable law. It has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient. It is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness or reliability of the information contained herein, nor is it intended to be a complete statement or summary of the securities, markets or developments referred to in the report. The report should not be regarded by recipients as a substitute for the exercise of their own judgment. Any opinions expressed in this report are subject to change without notice. © 2005 All rights reserved. This report may not be reproduced or redistributed, in whole or in part, without the written permission of Hahn Investment Stewards & Company Inc. The Global Spin is published twice monthly at an annual subscription price of $250.

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