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Abstract
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
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
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
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
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.
The Reagan-Thatcher methodology was not simply an ideology imposed upon the
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
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
The fact that this was not adhered to signals not only a dramatic shift away from
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
The idea that traders making consistent profits year after year are simply lucky is
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
“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
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
Trade Implication:
value really is. The imminent Fundamentalism that now sits precariously
balanced on the cusp of the markets will engulf participants with renewed
The concept that markets are the product of precise assumptions made about
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
Still, when market expectation is altered by convincing influences, life imitates art,
propounded by Karl Popper. With this he exposed the fluid position Rational-
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
The free markets, devoid of any regulation that was the policy of the Reagan-
Thatcher 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,
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
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.
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.
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
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.
The deregulation of markets was something that infected first the academic world
through rational-expectation theory, and then the political world during the Reagan-
Thatcher era. Until disproved in 2008, market efficiency theory was a matter of
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
belief that people being self interested and rational, will result in collective market
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
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
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
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
implication or simply, the device of bankruptcy is able to rescue the proponent from
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
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.
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
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
As the great Daniel Kahneman contends, a subtle influence radically shifts the
rates will not stimulate liquidity; the shift that is needed is to lend at the same
It is with this measure of insight that the world can redistribute wealth to both those
While holding the essence of the new order about to impose its fundamental
character upon the financial community, behavioral finance holds dear the intuitive
making, and the inherent presence of market inefficiencies. Market momentum for
example, cannot suffer a proof from market efficiency theory, but indeed finds
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
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
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
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
The monumental 18% inflation of 1970’s was indeed well contained by the advent
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.
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
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
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
Trading Implication:
equities.
Treasury Bond Futures. That being the case, acquiring corporations laden
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
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
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
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
Given the enduring nature of over 300 million spending consumers, it appears
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
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.
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
The ability to value an asset accurately is not a luxury that can be enjoyed at
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
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
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
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
will be frequent and substantial. In this event there will be pressure on bond
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
confidence within the global financial system, and which serves as the lubricant to
Today it is belief that keeps the global financial system intact, not capital, for she is
While ex- Treasury Secretary Hank Paulson carried on the legacy of the Reagan-
Thatcheristic aversion to regulated markets, the new regime in the Oval Office were
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,
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
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
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
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
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
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
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
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.
to be a matter of course between fixed exchange rates, and is derived from the
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:
projects and infrastructure will offer attractive returns. Not only does this
A word of warning to the wise; if the opportunity to invest in Yuan and other
Chinese currency does take place, those preferring Yuan yet holding US
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
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
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.
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
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
carbon emissions and their profound threat to industry and manufacturing, and of
course, the possible nationalization of the banking system. If the new regulatory
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:
Considering that US banks will be under close scrutiny and heavy regulation, it
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
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
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
As history shows us, other stock markets around the world have suffered a number
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
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
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. Rational-
Expectation 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
as these that efficient markets theory fails to consider, and it is precisely what will
analysis. Again, traditionalists have held the view that stocks will outperform bonds
however, in the past 10 years bonds have triumphed, with considerable economic
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
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
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
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
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
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.