When Markets Collide, by Mohamed El-Erian, was published in May of 2008. Mr. El-Erian is well known from his previous tenure managing Harvard’s endowment and for his current role as co-CEO of PIMCO. The principle theme of the book is that we are experiencing dramatic changes in the structure and flow of global capital markets and that investors need to be aware of these shifts if they are to be successful. He also emphasizes that these shifts have important policy implications—certainly appropriate given that he worked at the IMF for a substantial portion of his career. My thoughts here do not constitute a full review—more a set of thoughts on a few of the major themes in the book.
Mr. El-Erian’s world view includes the following:
1) The U.S. has been living beyond its means for some time
2) Other countries enable us to do this by purchase of government and corporate bonds and mortgage debt
3) Emerging markets are seeing increased internal demand
4) Emerging market growth leads to higher inflationary pressure for the U.S., both in terms of wages paid to overseas workers and commodity prices
5) At some point, U.S. debt will look less attractive so our cost of credit will become prohibitive
6) The ideal allocations to U.S. equities (as a whole) are diminishing
The issue of the increased indebtedness of the U.S. to other nations has been around for quite some time—although the effects have been delayed by easy credit. Consider this Q&A with Peter Bernstein in 2004:
Q: Why has the low saving rate in this country not caused the problems most experts predicted? How worried should we be that no one saves anything anymore? Or are we not correctly measuring our savings?
A: Savings figures are very difficult to interpret. Nevertheless, I am deeply concerned over this problem, because spending beyond income means borrowing, and all of economic history proves that too much borrowing is the core of economic disasters and chaos. The corporate sector at this point is in excellent shape, which is one good thing, and some of the excitement about households is overdone because moving from a rented apartment to a house means more debt service but also less rent. But the [Federal debt], which promises no solution of any kind, and the heavy dependence on foreign investment in our government securities, scares me plenty. It is like giving foreigners a huge demand deposit on the U.S., and we have nothing to redeem it with if they want to withdraw it.
These factors suggest that the U.S. will come under increasing pressure from all sides. Domestic consumers are running out of purchasing power because we have tapped available credit—including in our homes. These debts have been securitized and sliced up in various ways and are held largely by investors in other nations. Emerging economies are modernizing and increasingly putting pressure on developed economies further up the value chain. This leads to wage growth in these economies and inflation in commodities and in other areas as these workers want, and can pay, for a higher level of consumption.
These forces point to a future in which non-U.S. economies will grow much faster than the U.S. and should provide greater potential for higher investment returns (relative to their risks) than the U.S. Domestic wage growth has stagnated for much of the population, but the impacts of this stagnation have historically been offset by the availability of cheap overseas labor and commodities. As inflation increases, however, the flat real domestic wages will combine with higher commodity prices and the high debt maintenance to create a future in which U.S. consumers are strapped.
One of the themes that I wish Mr. El-Erian had discussed more in this comparison of emerging markets and developed ones is the issue of risk by country or region. The expected returns and risks of emerging markets have traditionally put investments in these countries at the high risk/high return end of the spectrum. The high risk in emerging economies has historically meant that most investors did not have the risk tolerance to hold substantial positions.
To some extent, we can see a tempering of risks associated with a range of emerging markets, but to what extent was this risk simply muted by the extended period of low volatility in global capital markets? It is a standard feature of capital markets that periods of low volatility lead investors to pursue more volatile assets to garner the higher returns and because they assume that volatility has been conquered permanently. How large a player is this effect in the increasing popularity of emerging markets in recent years? As volatility returns to global markets, will we find that emerging markets have created the stabilizers to keep volatility in check? The key risks in these markets include political stability and risks of adverse regulation, as well as financial stability.
Mr. El-Erian critiques the argument that investments in emerging and developed markets are de-coupled—and I agree—but this has implications for risk contagion from developed markets to emerging ones. Additional specific risk factors in emerging markets have to do with the ability to modernize on a national scale. Infrastructure is crucial. I read of firms with outsourcing facilities in India that must first build their own power plants, for example, because of the sketchy utilities infrastructure.
The Suitability of Our Models
I particularly like the way that Mr. El-Erian brings attention to the formulation of the models (conceptual and quantitative) that drive strategy. Mr. El-Erian’s discusses a philosophical approach for how to look at events and make decisions based on observations. He discusses separating “signal” (something persistent and important) and “noise” (a temporary aberration). He is looking for systemic shifts that require that we understand that the future will not look like the past. For investors, deciding whether an apparent market shift represents a structural change or simply a brief move of markets out of equilibrium is often the difference between success and failure. This theme applies very nicely to two very popular conceptual ‘models’ over the last several years that have now been largely rejected—and Mr. El-Erian discusses both:
1) The idea of de-coupling between emerging and developed markets
2) The idea that market volatility had been permanently suppressed
In discussing these themes, Mr. El-Erian also introduces a critically important idea about how to evaluate conceptual models—using a framework proposed by Milton Friedman:
“taking a cue from the work of Karl Popper, a highly regarded philosopher, Friedman argued that the best test of a model is to compare its predictions with actual outcomes. To this end, it was defensible to construct a model on the basis of simplifying assumptions.” (p. 67)
The idea here is that model assumptions may be highly idealized, but a model must be judged based on how well it reproduces reality rather than on whether or not we feel that the assumptions are “realistic.” This approach motivates a process for thinking about apparent market dislocations. While I have read critiques of this book that complained about its ‘academic’ tone—and I would not be surprised if this was a section that led to such reactions—investors will benefit from understanding this philosophic construct. All of portfolio construction comes down to a series of assumptions about the world—and these are inevitably gross simplifications of the real world. Too many investors apply conceptual models to their investing without understanding the theoretical underpinnings. To use models most effectively, one must understand their limitations and where they are applicable.
In this context, the idea that emerging and developed economies were increasingly de-coupled was interesting and could be well supported using theory, but the evidence was not there based on “actual outcomes.” Well before the current downturn, correlations between emerging and developed markets remained fairly high. Just as important, Betas of emerging markets were consistently greater than 100% relative to the S&P500. Similarly, the idea that market volatility was permanently suppressed was never well supported—even if plenty of people came up with interesting theoretical mechanisms to support the idea of a “great moderation” in risk.
Mr. El-Erian also cites the work of Thomas Kuhn, a highly important figure in the philosophy of science (I read his book, The Structure of Scientific Revolutions, at least three times during my undergrad in Physics). Kuhn proposed that the models that underpin a scientific discipline provide a framework upon which practitioners can assemble their data. Over time, there will be data that the model cannot explain or deal with—and Kuhn called these “anomalies.” Eventually, there are so many anomalies that a model fails to explain that the model is scrapped and a new paradigm emerges. A key question in When Markets Collide is whether we are sitting as such a paradigm shift with regard to portfolio management.
Mr. El-Erian notes major changes underway in the workings of global capital markets. Many market participants and authorities are dismissing these as temporary aberrations (noise), but Mr. Erian believes that these represent long-term changes—what he refers to as secular trends. Mr. El-Erian proposes that we are in the grips of a paradigm shift now---but that too many people are ignoring the fact that their models don’t match the data. What follows is that those market participants who make bets based on the old (and not terribly relevant) paradigm will suffer in the new market conditions. Do the old models still work, or do we need to radically revamp these models? The book cites the models used by ratings agencies and the risk management infrastructure at banks and other financial firms as data points that the current models are failing to capture the current reality.
So, what is an investor to do? Chapter 6 of the book takes on the topic of how to deal with the changing landscape that Mr. El-Erian describes:
“Investors will do well in the coming years if they remain anchored by the secular themes described earlier in this book. Having specified their expected return target and their risk tolerance, they must adequately design and execute the three basic steps of portfolio management: choosing the right asset allocation, finding the best implementation vehicles, and conducting risk management.” (p. 195)
Chapter 6 describes the institutional investor’s approach to thinking about portfolio design and construction---a far cry from the way that the vast majority of investors and advisors approach portfolio management. This book is well worth its price for Chapter 6 alone. How many investors “specify their expected return target and their risk tolerance”? Very few. There is an old saying that applies well here: if you don’t know where you are trying to go, you are unlikely to get there.
Slightly further on in the chapter, Mr. El-Erian describes the value of defining a broad asset allocation that emphasizes effective diversification:
“Many sophisticated investors have found that a disciplined approach to asset allocation provides structure that performs an important anchoring function. Such anchoring facilitates constructive outcomes and makes destructive outcomes less likely.”
This is precisely the kind of message that investors needs to understand about how institutional money is managed. This theme echoes David Swensen:
“…close observers can say that the real secret to Yale's remarkable success is defense, defense, defense. But how, you might ask, can defense be so important to Yale's remarkably positive results? Starting with that great truism of long term success in investing—if investors could just eliminate their larger losses, the good results would take care of themselves—we remind ourselves of the great advantages of staying out of trouble.
Yale's rigorous defense in investing combines a series of rational initiatives rooted in the powerful body of investment theory developed at Yale and other universities. The architecture of Yale's portfolio structure is designed to locate the Endowment portfolio on the efficient frontier in trade-off between risk and return."
The emphasis on portfolio-level management is a core theme in institutional management, but is very rare in discourse aimed at individual investors.
Mr. El-Erian is suggesting that the best recourse for investors is an objective approach to asset allocation and portfolio management—which is achieved through the use of models—even as we are cognizant of the fact that these models are not perfect and may not capture certain features of markets. This is a crucially important point. Mr. El-Erian believes that the models are flawed or that there could be massive disruptions. On the other hand, Mr. El-Erian is saying that a rational and objective (read model-driven) approach to portfolio planning is still the best approach.
There is another theme in this chapter that is implied (based on my reading), but not stated explicitly. Mr. El-Erian proposes investing in a way that will be well-positioned if the results the he foresees come to pass, but it is still a good portfolio based on portfolio analysis performed today—even without any special assumptions. My firm’s portfolio model (Quantext Portfolio Planner) ‘likes’ many of the features of Mr. El-Erian’s portfolio, using all baseline inputs and without any special assumptions about emerging markets, commodities, etc.---this topic is discussed in detail in a follow-up article.
In considering the challenge of separating meaningful ‘signal’ from ‘noise’ in developing successful portfolio management, many (if not most) people get caught up in the noise. Mr. El-Erian makes a broadly compelling case for his world-view, but he also comes back to a ‘no regrets’ policy with regard to portfolio construction that emphasizes portfolio analysis and asset allocation—and this will be discussed in detail in Part II. I am a something of a Reversion-to-The-Mean kind of guy, so I put less stock in the ability to predict ‘inflection points’ in global markets.
That said, I also believe that the mean to which markets revert evolves in time—markets are not stationary things. The forces that Mr. El-Erian describes are tending to shift the baselines of how global markets work. I believe that market volatility generally captures this signal—which means that data-driven quantitative models can deal with these shifts—while Mr. El-Erian appears to have less faith that this is the case. Time will tell.
I firmly believe that portfolio managers using the conceptual framework that Mr. El-Erian espouses will generate far better results than most will achieve otherwise. His thinking matches well with a number of other successful institutional managers and it is incredibly encouraging that retail investors increasingly have access to this type of world view. For me, it is a lot of fun to find a book on finance and economics that cites the likes of Karl Popper, Thomas Kuhn, and Richard Feynman. This is about as far from a Jim Cramer book as you can find.