Page 2 of 2 BOOK REVIEW Show me the exit! When Markets Collide - Investment Strategies for the Age of Global Economic
Change by Mohammed El-Erian
By Julian Delasantellis
structural changes fall outside the comfort zone of many. After all, by
definition such changes are hard to identify because we tend to use
backward-looking frameworks."
To even further prove just how hip and with it he is with the cool crowd,
El-Erian throws in the now seemingly obligatory reference to Nassim Nicholas
Taleb's "Black Swan" theory, one of the now over 4.5 million hits that phrase
returns on Google.
In a succeeding chapter, El-Erian goes on to elaborate on some
of the major changes that have been seen in the world economic superstructure
these past few years, changes that he seems to be classifying not as noise, but
as signals foretelling the current crisis. Among these are the rise of emerging
economies as both exporters to, and creditors of, the West, derivatives and
securitization.
The book went to press last summer, so it does contain El-Erian's take on year
one of the financial crisis. It does not contain any commentary on the
mid-September fall of Lehman Brothers, which turned the financial system's
previous low-grade fever into a raging infection.
According to El-Erian, PIMCO saw it all coming.
"As far as I know, very few professional investment managers followed the
advice that Bill Gross gave a few years ago to PIMCO's mortgage team led by
Scott Simon. Scott and his colleagues looked closely at the way the housing
market actually functioned at the micro level. Their research included
participating in 'ride alongs' with local real estate and mortgage agents.
Their findings ... spoke clearly to the excesses taking place."
That's nice, but what El-Erian does not seem to think is important is just how
this information affected PIMCO's trading decisions. PIMCO is basically a bond
trading house; it's profits are primarily driven by picking up lots of small
bid/ask spreads upon billions and billions worth of bond trades. It does not do
a whole lot of what is called the "direction" trade - taking a position whose
profit or loss will be determined by which way the market will move on any time
frame more extended than just a few minutes. That's the way the vast majority
of us attempt to make money in the markets.
This is another dimension of the signal/noise dilemma not really addressed by
El-Erian. It's not only that you have to determine what are signals and what is
noise, you also have to determine just when it is that the markets will agree
with your interpretation that something important is going on here.
For most of this decade many others besides El-Erian and PIMCO saw the froth
and madness in US real estate and realized the danger this would eventually
cause to the financial system. El-Erian seems to be saying that investors
should have taken more cognizance of the many signals of irrationally high real
estate prices up to the bubble's burst, and acted accordingly.
But would it really have been that easy?
The stock of Toll Brothers, maker of so many of the huge McMansions that were
built with all the funny-money financing, topped out in the summer of 2005.
That was right in the thick of those halcyon days of the Anglo-Saxon world's
easy money through real-estate psychosis, when America and many other places
were so besotted at the prospect of the easy riches to be made from borrowing
on, and then buying and selling, real estate that you had secondary school
algebra teachers having students earn extra credit by doing the profit/loss
workups of their next real estate flip.
OK, let's say you saw the decline of Toll Brothers from their 2005 highs.
Clearly, that has turned out to be a major signal, possibly one of the most
important in decades. What were you supposed to do with this wisdom?
In mid-2005, the real-estate bubble was not even near its full inflation; there
was still plenty of money to be made from out of the froth. If then you had
shorted the stocks involved in it you would have either been stopped out (if
you were wise enough to be carrying a protective stop on the position, which
you should always do) or have had the position sold out from under you with
your broker's margin call.
Citigroup was trading in the low 40's when Toll topped out, it went on to rise
to its highs at 57 late in 2006, before commencing its current, meteoric,
ongoing fall towards bankruptcy and eventual government control. JP Morgan
topped out in May 2007; Goldman Sachs in late October. The US stock market
itself topped out in early October 2007 - more than two years after Toll.
In that that last easy money summer of 2007, many pundits, just as the markets
had seemed to be doing, were laughing off the supposed threat of the mortgage
crisis. Now, the Dow and S&P 500 are down almost 50%; the shares of the
financial sector much more than that. If you're right, but at the wrong time,
especially if you're dealing with the leverage of borrowed money, you're wrong.
I saw no cognizance in the book of this decisive fact.
About 50 pages in the book are used by El-Erian to provide his explanation on
how the crisis has unfolded prior to the publication date; none of it should be
particularly new or revelatory to those who have followed the commentaries
published on this site.
One place where El-Erian has apparently mistaken noise for symbols is with his
warnings on stagflation, simultaneous inflation and stagnant growth arising
from out of "an inflationary headwind on account of the natural evolution of
labor and wage conditions in emerging economies". In actuality, just a few
weeks after publication, the inflation wave peaked and broke, then began to
recede into the tremendous commodity price deflation that it is the world's
current great overriding problem.
Do you know what they call untenured Harvard economics professors who get
something like that so wrong? University of Chicago professors.
Finally, after over 200 pages, our weary traveler comes upon the true holy
grail, El-Erian's actual "investment strategies for the age of global economic
change".
They're not really all that new or earthshaking. The retired insurance agent on
your bowling team might call them "not putting all your eggs in one basket";
the stockbroker with an office in the mall might call it "diversification", in
the Mohammed El-Erian's pricey world of high class money management, it's
"asset allocation."
"Disciplined asset allocation also helps investors avoid some of the traps that
too many have fallen victim to over the years. They include the tendency to
view individual investments in isolation (that is, through a 'broad framing').
They also include the tendency of some investors to exhibit time-inconsistent
preferences, to be seduced by herd mentality, and to overreact at the wrong
time and in the wrong way. Many sophisticated and successful 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."
El-Erian goes on to proffer a well-diversified sample model investment
portfolio, with recommended percentage ranges for each investment class. Some
of these are US equities, with a 12-18% recommended range; international bonds,
with a 6-12% recommendation; and real estate, with a 3-9% recommendation. He
also recommends that investors look into "special opportunity" investment
classes such as hedge funds, private equity, and actual physical possession of
commodities such as timber, which El-Erian says he had great success with while
using Harvard's money.
Both hedge funds and private equity are traditionally the investment vehicles
for investors with resources far above most of us; as for investing in the
actual physical possession of timber, except for those who want to fill their
basements with lots of fireplace logs, I'm not sure how practical that is,
either.
There's a chapter on what international institutions such as the International
Monetary Fund should do in the new environment; that kind of stuff always goes
down well among the global, inner-party super elite that are always jetting
from one international financial cattle call to another, but everybody knows
that entreaties like this are only international financial organization
onanism, since it is still just the US Treasury and US Federal Reserve that are
the world's only real economic powers.
There is counsel that investors should better protect themselves with "tail
insurance"; or cover against highly unexpected and unplanned for financial
circumstances. I suppose that's good advice, but, since we are currently
suffering through some very unexpected and unplanned for financial
circumstances, these days the option positions that would constitute "tail
insurance" are very expensive. Such advice would have been highly valuable in
2005-06, back when nobody thought they needed it.
All in all, when finishing the book, I felt very little more enlightened or
informed than I was when I picked it up. It was almost as if I had just
attended a meeting of one of those local Rotary or business groups, where a
junior economics professor at the local community college has been invited to
give a talk on the current business and economics environment.
The fuzzy-faced academic gets a free chicken dinner and maybe a few bucks
thrown his way for his efforts; the local businessmen, much like many of the
readers of El-Erian's book, get to think of themselves, if only for just a few
hours, as important local community leaders and entrepreneurs, veritable modern
day Medici's, rather than just soda machine vendors and plumbing supply
salesmen.
Do you know what I'd like to see in an investment book? I'd like to see one
that answers the eternal conundrum I refered to above - when to sell.
Specifically, if an investment turns against you, should you sell out early and
cut your losses, knowing full well that the day after you sell your investment
could very well turn around and head for new highs that you won't participate
in? Or hold on, hope for the turnaround, knowing full well that you're
continuing to expose yourself to the possibility of a total loss, a possibility
that has lately become a reality for many, if not most, of the investors in the
stocks of the companies of the world financial system?
The answer of this question won't be the same for everyone, and it will change
over time, and as market volatility surges and ebbs-a key factor in its
complexity. When someone does answer it, in that review, I will (from Psalm 130
of the Old Testament), "Praise the Lord, you his angels, you mighty ones who do
his bidding, who obey his word."
Until then, and even after reading When Markets Collide - Investment Strategies
for the Age of Global Economic Change, you'll still be just another guy
sitting on a park bench eating lunch.
When Markets Collide - Investment Strategies for the Age of Global Economic
Change by Mohammed El-Erian. McGraw-Hill, 2008. ISBN-10: 0071592814.
Price US$27.95, 304 pages.
Julian Delasantellis is a management consultant, private investor and
educator in international business in the US state of Washington. He can be
reached at juliandelasantellis@yahoo.com.
(Copyright 2009 Asia Times Online (Holdings) Ltd. All rights reserved. Please
contact us about
sales, syndication and
republishing.)
Head
Office: Unit B, 16/F, Li Dong Building, No. 9 Li Yuen Street East,
Central, Hong Kong Thailand Bureau:
11/13 Petchkasem Road, Hua Hin, Prachuab Kirikhan, Thailand 77110
