AUGUST 2011                                                                         Download PDF Version

Secrets and Lies: Assets and Liabilities                                                                             

In the 1950s a a friend of a friend was lucky enough to be working with Sir John Templeton, the great philanthropist and mutual fund pioneer. In an effort to impart some level of wisdom onto his young apprentice he offered the following words of advice:

“You must remember, all assets are dubious but all liabilities are good”

These words resonate very strongly now and illustrate the prime reasons for the current troubles in the market. There is a complete lack of belief in the assets that are purported to lie within the finance, insurance and real estate sectors (the FIRE sector); there is a ‘crisis of collateral’ (we will be writing in greater depth about this in early September).

There are three main solutions that can be applied to resolve the banking crisis:

  1. Recapitalisation

  2. Consolidation

  3. Nationalisation

The USA has taken the former route. Bernanke announced that he would be maintaining the zero-interest-rate policy until at least 2013. The Fed also conducted a massive asset purchase programme from banks over the last 2 years and both these policies have started the recapitalisation process. However, on 2nd April 2009 the FASB rule 157 was suspended. This rule relates specifically to the need for US banks to mark their balance sheet assets to market; while this rule remains suspended so too does investor confidence in the entire US FIRE sector.

The UK took more dramatic action, nationalising a number of their banks and, effectively, wiping out the private shareholders. Europe has yet to decide and much of the market movements we have seen over the last 2 weeks has been due to the uncertainty this injects into investors’ minds.

This crisis of collateral has decimated the market-cap of the FIRE sector in the western world and much of the fall in value in the indices has been due to the permanent loss in value of bank shares. This collapse has been seen before in Japan; in 1989 the FIRE sector represented 50% of the market-cap of the TOPIX, but by December 2010 it represented slightly under 20%. This is a considerable headwind for equity markets to face and it is one that is now blowing against the USA and Western Europe. It is interesting (and worrying) to note that the FIRE sector currently makes up 52% of the Chinese equity markets and it is likely that China may soon face similar problems; Bank of America’s desire to sell its stake in China Construction Bank may give us advance warning.

shanghai composite: sectoral breakdown as at december

Asset Allocation vs. Stock Selection

What also becomes apparent from the last three years of stock market movements is that asset allocation has not been sufficient to produce good portfolio returns; stock selection, or in Clarmond’s case, manager selection, is now crucial.

By way of a simple illustration over the last three years Citigroup share price has fallen from a high of $231 to $28 while Apple’s share price has risen from $86 to $400. If a client had just been allocated to an S&P ETF as a way of gaining market exposure he would have benefitted from Apple, which has added c.$200bn of value to the index, and would have been negatively affected by Citigroup (and all other FIRE sector stocks).

It is likely that readers will accuse me of cherry-picking the above example, to which charge I plead guilty. However, the graph below shows the differing results over the last three years of the Nasdaq Bank Index and the Nasdaq Industrial Index (the latter is meant to be representative of a non-FIRE sector).

nasdaq bank vs. nasdaq industrials index: 3 year performance

For an even more compelling example I will turn to Japan, a market which many western investors have not enjoyed a good experience (but which Clarmond is now researching in some depth). Below is a table which shows the compound return (in US$’s) achieved by some large Japanese companies (the top line of each table) versus their European and US peers. The returns are calculated from two points, the peak of the Japanese market in December 1989 and the market bottom in December 2002; the results are fascinating:

What do these figures show? They certainly do not suggest that Japan has been an unrewarding place to invest, and therefore, if you were only looking at these figures and did not know about the falls in the Japanese market it would come as some surprise to learn that from December 1989 to December 2002 the annualised US$ return on the TOPIX Index has been (2.8%), whereas the return from the S&P 500 was been 8.5%.

Of course the above sectors and companies do not tell the whole story as we know the FIRE sector in Japan collapsed during this period and this accounts for much of the disappointing result of the TOPIX. However, it further illustrates the point that indiscriminate asset allocation to Japan over this period has produced poor results whilst active and intelligent stock-picking would have yielded very satisfactory returns.

It will no longer to suitable to allocate generally to markets and at Clarmond we strive to invest in the managers that believe will continue to navigate the future years in a sensible and conservative manner, avoiding sectors where they could suffer permanent losses of capital.

Clarmond Outlook

  1. The FIRE sector in Europe, UK and the USA remains ‘dubious’; the FIRE sector in China may be the next epicentre of the ‘crisis of collateral’.

  2. High inflation and close-to-zero interest rates is the way the FED has decided to deal with their debt problems. This policy may continue for the next decade; the alternative solutions of austerity, default or hyper-inflation remain unacceptable, and the economy does not look able to grow its way out. The UK is heading the same way.

  3. The graph below, which we have highlighted in previous reports, shows that the advanced economies (red line) and the emerging markets (green line) enjoyed negative real interest rates from 1945 to 1980 of (1.94%) and (4.04%) respectively, and only since 1980 has inflation run below interest rates. 1945 represented the previous peak (or trough) of global debt and therefore we anticipate the next period of time to follow a similar path.

Source: Reinhart, “Liquidation of Government Debt” April 7, 2011

  1. A zero cost of capital may be seen as a drag on the economy. However, we would argue it is only a drag on the FIRE sector. For the majority of the economy it will be the energy price and not the interest rate that is of most importance.

  2. The search for yield will continue and will lead to the outperformance of certain sectors of the markets.

  3. Investors must be specific about the managers they invest with and the risks they are taking, there will be a wide divergence of returns.

  4. Hedge funds and funds of hedge funds are going to be placed under the microscope of performance and fees. It is likely that there will be a great majority found wanting. 

Please do not hesitate to contact Christopher Andrew:

Christopher Andrew                       
Tel: +44 20 7060 1400




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