Boosting Emerging Markets Equities Weighting Further

We've been taking baby steps, and are increasing our Emerging Markets Equities weighting now to 3% from 2% (with an ultimate goal of roughly 15%).  We went into the financial crisis with a 0% weighting. 

We continue to think a series of emerging economy crises is about to happen, but we've been boosting our weighting because we see the bear case as slightly less likely.  In the past several days, China has guaranteed Russia $25b in financing (a move to protect China's energy interests, but something that China could repeat across many emerging economies), the IMF has significantly increased its loan availability to emerging markets (and has lent Ukraine 8x its normal loan limit), the Fed has opened $30b swap lines with several emerging economies, and interbank lending rates have pulled back slightly further worldwide.  Investing in emerging markets satisfies the William Bernstein criteria of feeling like you're "throwing money down a rat hole" (investing near potential market bottoms).

The Closet of Shoes is About to Drop

This article ("Currency Crisis is Gathering Storm" -- click on this link and scroll down) perfectly summarizes why we'll continue to wait for major emerging markets to experience financial collapses before we'll consider raising our equity allocation back to our "policy allocation." We probably won't be waiting long.

Kudos to the blogger Yves Smith for also pointing out a few ways that catastrophe can be postponed -- China could prop up collapsing currencies, and international agreements could help too. Postponing disaster increases the chances of a softer landing, but we expect more downside to risk assets in the near term, and tough battles beyond that.

Boosted Equity Allocations Slightly

Given today's sharp worldwide equity selloff and a slightly lower probability of emerging economy collapses (due to chatter about an IMF plan to consider loans up to 5 times quotas to emerging economies), we're slightly boosting our allocation to U.S. and emerging market equities.

We're still underweight -- at only about 2/3 of our target U.S. Equities allocation, and at a mere 1/7 of our target emerging market equities allocations -- because we think the IMF probably can't head off the crisis we're anticipating. Recall, we've been waiting for widespread emerging economic collapses before raising our equity exposure to our "policy allocation." But IMF flexibility could buy the world more time to re-balance the accumulated "global imbalances" in leverage, currencies and current accounts.

A bit more background: In addition to above-mentioned imbalances, discussed at length here, emerging markets are seeing capital flight to the developed markets, which the U.S. has afforded access to vast quantities of dollars, and where governments have been quicker to announce bigger bailout plans. Global capital flight is taking out the weakest link in the global financial chain ..... currently, the weakest link is emerging markets; if this link is strengthened by the IMF and other efforts, capital flight will probably find another weak link in the global finance chain. So we're not turning bullish, but are instead preparing to be fully-weighted in equities closer to an ultimate market bottom, which we won't be able to time perfectly.

House Sales Jump -- Blip in a Longer Bear Market

News has traveled fast in the real estate agent community that California home sales have jumped by about 2/3 in the latest period owing to low, foreclosure-induced market-clearing prices, as Bloomberg reports.

But your home could remain a depreciating part of your asset allocation for some time to come.

That's why we say caveat emptor.

• A major new wave of job losses will probably flood the market with new homes, which will drop the market-clearing prices further.
• Mortgage rates could stay high as the credit crisis rolls further around the world, further shrinking the number ultimate buyers for U.S. mortgage paper.
• And, after the current "flight to safety" in U.S. treasuries passes, interest rates in the U.S. could rise broadly as huge buyers of U.S. securities -- emerging foreign economies -- hit deep crises of their own.

Allocation for Short Selling

Something which could become a game-changer for asset allocation worldwide, as investors pick up the pieces of the current financial catastrophe: We believe that many more asset allocators will initiate an allocation for shorting -- bets that a security class will drop. This is not common today, but a natural extension of the recent trend to add market-neutral hedge funds to one's asset allocation. It has occurred to us more than once as we held 0% in emerging market equities this year (because of our avidly bearish case, as discussed in this blog), that we should have had a negative allocation here all year long. (And it's not too late, as our last post argues.) The case for shorting would fit many asset allocators' small allotment for a "trading allocation," but we think negative bets could become a more enshrined piece of asset allocation, particularly as we may be staring into several more years of sideways markets.

Collapse of Some Emerging Markets is Probably Very Near

Interbank borrowing rates are again across many of the emerging markets, after a several day lull. And today, three-month LIBOR (the London interbank borrowing rate -- widely used worldwide) rates fell by the smallest margin in nine days, according to this Bloomberg article. The credit freeze is getting colder again, which is plunging many emerging markets toward deeper recession and ultimately defaults. This shock will provide the next leg-down in global risk markets, including the U.S. equity market, we believe. We thought that recognition of this pending "day of reckoning" would send U.S. equities plunging yesterday (Thursday). It might be today. It might be in the next few weeks, but it's coming real soon. When it happens, we're going to raise our U.S. and emerging market equity weightings closer toward our long-run "policy allocation." How much we invest depends on how badly equity markets crater.

The BIG Risk is Becoming Real -- Collapse of "Global Imbalances"

This powerful article by economist Brad Setser (which I located via Yves Smith), explains that the global current account imbalances are collapsing. There is a lot more pain to come before the current bear market ends. To fund their purchasing binges, U.S. consumers were using artificially cheap debt provided by the U.S. financial system, which was given artificially cheap capital by the likes of China and other "emerging economies" that were buying U.S. dollars to keep their own currencies artificially low to boost exports. Now that the U.S. consumer "leg" of the stool has been kicked out, the U.S. financial system and thus emerging economies who have lent so much to the U.S. are now in BIG trouble because they bought way too much U.S. debt at low prices that will cause them formidable losses. Equity investors are only now beginning to understand that there will probably be a resulting collapse of numerous emerging economies. This disaster scenario is becoming more of a certainty with every passing day, and today's 10% declines in some emerging economy stock markets is representative of that. So we maintain our determination to stay underweight equities until we see more emerging economies collapse -- Hungary, Russia, others. We wish we'd been more underweight all this time, but must keep looking forward. We're preserving capital fairly well now (despite wishing we were preserving all of it), and hope to be at our full equity "policy allocation" near the bottom and end of the current bear market. '09 is our hope, but '10 or beyond is perfectly conceivable.

Detail on Two Pending Disasters, And Why We're Underweight Equities

Though we recently boosted our equity weighting, we're still not yet 2/3 of our "policy allocation" because we think additional tsunami waves of crisis are on the way. Last week we let this post sum-up our cautions. (And did you see Nouriel Roubini on CNBC this morning, reiterating all these points?) Today we are linking to two further elaborations on just how bad and likely these tsunami waves are:

• CDOs. Banks, especially foreign banks, are only just starting to reveal the holes [scroll down that page for article] in their balance sheets left by Collatoralized Default Obligations (CDOs), which are bundles structured credit products (the kind that has been blowing up recently). Buyers of CDOs were doing so on faith in the credit ratings; they lacked the personnel to evaluate the garbage they were buying unwittingly. The gaping new holes in bank balance sheets that we're seeing could lead two another shock wave of asset-selling and illiquidity, and gaps down in public markets.
• Emerging Markets. Global de-leveraging, bursting investment bubbles within emerging market economies, and tumbling commodity prices, are creating a rush for liquidity (namely, dollars). Many emerging economies can't get the dollars they need [scroll down that page for article] to finance their economies, so asset prices are dropping even faster in those places. We continue to wait for several major financial crises in emerging economies before raising our allocation from 1% currently toward our long-run allocation of roughly 10%.

Inner Peace and the Path to Wealth

We recently received simple satisfaction in successfully encouraging a friend to shift equity assets from a high-churn retail broker with a poor track record (even before taxes!) to a Vanguard equity index fund. Here's to hoping that the current bear market will shake loose many more "investors" from retail brokers who masquerade as friendly advisors.

Deeper Developing Markets Crunch Likely; We Started Nibbling Anyway

A deeper crisis in several major developing markets is on the way, we think. Securities prices in these financial systems -- which are so fragile and untested in crisis -- can go a lot lower since we're still not finding many articles about the risks (but here's a very good one indeed). As we've said many times, we're not going to raise our equity allocation to our long-run "policy allocation" until we see financial panic take down a few big developing markets players.. That's why we'd been 0% developing markets this year, and happy, even though we slashed our allocation about a year too early.

All that said, we've now raised our developing markets allocation from 0% to a mighty 1%. It makes little sense to deal in numbers so small, but we wanted to "break the ice." We expect to average down.

Timeless Words to Invest By

William Bernstein's The Intelligent Asset Allocator is growing into a classic of the genre. It offers far more than hard evidence that smart diversification and rebalancing ar e the ways to enhance your lifetime wealth. It also says what you're up against -- yourself -- and helps readers gain conviction in the discipline of asset allocation:

• An important assumption underlies all of the portfolio discussions thus far: that at the end of each year the investor rebalances the portfolio back to the target compositions [% U.S. equities, % treasuries, etc]. If a particular asset has done extraordinarily well, its portfolio weighting will increase; consequently, enough of it must be sold and reinvested in the poorly performing assets, to return to the target composition. This target composition is often referred to as the "policy allocation." You cannot underestimate the amount of discipline and patience required for this process, because it means doing exactly the opposite of what most of the investment world, almost all of whom are professionals and experts, is doing. A psychologist friend points out that this is an effective way of becoming a "contrarian," always moving in the opposite direction of the crowd. You will of necessity be selling what everybody loves and buying what they hate. You have only to remember that the great buying opportunities in U.S. stocks in 1974 and Japanese stocks in 1970, to name a few, followed several years of grinding bear markets. But be forewarned: investment during market bottoms has the distinct feel of throwing money down a rat hole.

We strive to asset allocate decisively instead of programmatically; meaning, we want to make judgements about how and when to rebalance toward the weakened performers. We'll be comparing our performance to a programmatic rebalance, and to other "classic" asset allocations. Berstein's book is a treasure trove for us in this endeavor, and for all kinds of investors.

Grantham's 3Q Market Letter

Jeremy Grantham is about the best at providing accurate long-run returns expectations for asset classes. His 3Q investor letter is here.

Reading it, we realize that our 40% equity weighting may be right for someone with a several year time horizon. But it's likely too low for someone with a 10-year (or more) time horizon and a strong stomach such as we think we have, despite the systemic risks we highlighted in recent posts. Equity valuations based on dividend yields may be too reasonable, and too much of the global crisis may be "in the market" for someone with a 10-year horizon to be only 40% in equities. (Register for and log into www.gmo.com to see Grantham's long-run return forecasts, which are based on dividend discount models and the expectation for mean reversion.) To quote from Grantham's October letter:

• "Rounds I and II – the asset bubbles breaking and the credit crisis – will soon be mostly behind us, but the effect on the real world of economic output lies, unfortunately for all of us, almost entirely ahead." [The question for us is, how deep & long will the economic recession be, and will it lead to other asset and credit crises?]

We're cognizant that you pay a terrible price for being underweight equities, if you're wrong. Putting it all together, we'll be keen to raise our 40% equity weighting further if sentiment worsens or we gain conviction when the market isn't. Also, how could anyone with a long-term horizon ignore the Warren Buffet op-ed piece this week? There's more math behind his thinking than the article tells.

Why We're Still Underweight Equities (Just Less So)

We believe that economist Nouriel Roubini, whose dead-on predictions regarding the financial crisis have saved people fortunes, has done us another service by listing reasons why investors will get more opportunities (at lower price points than today's close) to raise their equity allocations. We've been citing several reasons for remaining underweight (just less so) that make Roubini's list. But his list packs a real punch, so here goes (from Naked Capitalism):

• details of these [recapitalization] plans are still very fuzzy and ambiguous and with uncertain effects on various assets classes (common shares, preferred shares, unsecured debt of financial institutions, etc.);
• macro news will surprise on the downside as the economies sharply weaken and contract while fiscal policy stimulus is lagging;
• earnings news for financial and non financial firms will surprise on the downside;
• the damage done to confidence and to levered investment is already severe and the process of deleveraging of the shadow financial system will continue;
• major sources of future stress in the financial system remain; these include the risk of a CDS market blowout, the collapse of hundreds of hedge funds, the rising troubles of many insurance companies, the risk that other systemically important financial institutions are insolvent and in need of expensive rescue programs, the risk that some significant emerging market economies and some advanced ones too (Iceland) will experience a severe financial crisis, the ongoing process of deleveraging in illiquid financial markets that will continue the vicious circle of falling asset prices, margin calls, further deleveraging and further sales in illiquid markets that continues the cascading fall in asset prices, further downside risks to housing and to home prices.

Seeing risks like these play out (or be surmounted) will give us more willingness to further narrow our underweight stance in equities.

Raised Equity Allocation at 10am

Based on the rapid string of positives that emerged in the last several days, we raised our equity allocation this morning from roughly 35% to 40%. When the market rallied another 6% this afternoon, we were happy to be getting such rapid payback for a long-term decision.

But more importantly, we need to continue to strategize how we'll get back to our full long-run equity allocation target while equities are still close to their lows ... or making new lows. We'll watch for the triggers and fundamentals we've discussed in our last few posts. When buying this morning, we thought there would be at least two more opportunities to raise our equity allocation in coming months or quarters. We'll be on the lookout for those opportunities.

Two More Positives? Time To Slightly Boost Equity Allocation If You're Far Below Target

(1) European countries may be close to agreeing to recapitalizing some of their banks.

(2) Exposure on credit default swaps may not be as bad as "$55 trillion."

One of the major reasons banks won't lend to one another, is that they're hoarding cash to prepare to make big payouts for the bond insurance (CDS) they've written, and they don't trust that other banks haven't written the same type of insurance. But "$55 trillion" in outstanding CDS may be far more than the amount of actual liability. A NakedCapitalism post this afternoon explains:

• Reader Tim sent us a link to a press release from The Depository Trust and Clearing Corporation which says that the net payout on Lehman credit default swaps will be comparatively minor, a mere $6 billion, versus the gross exposure, which has been widely reported as in excess of $400 billion. If this proves correct, that will be the best news we have heard for some time, since one of the unknowns hanging over the market has been the prospect of further bank failures resulting from Lehman payouts.
• DTCC's report, if accurate, is consistent with the industry's claim that protection writers hedged their exposures, and in this market, the only effective way to do so was by entering into an offsetting swap).
• The problem is that even if many of the trades were hedged, for any dealer, the quality of its hedges depends on the quality of its counterparties. Even though CDS protection-writing was concentrated among a short list of names (all big suspects), hedge funds were also writing protection. So way BigBank had $30 billion of Lehman CDS exposures, $15 billion each way. Let's say 15% of the protection was written by hedge funds that can't make good. That leaves a $2.25 billion failure, which multiplied by the payout, is a $2 billion loss. In this environment, any meaningful losses would be a source of worry.

Why only make a slight boost to equity allocations, and then only because we're way underweight? Because the tsunami of crisis has yet to roll across most U.S. and European banks, and the Asian and the Middle Eastern banks and economies. Also, there will be fresh opportunities for the banking system to freeze up further; for example, payment on Lehman CDS paper aren't due until October 21.

After the Dam Breaks...

....we'll be more free to swim.

As people pick up the pieces of their portfolios -- which they'd thought were diversified effectively to avoid losing as much money as they did -- we expect to see waves of new product offerings for individual investors: more "market neutral" equity funds (which rise only when fund managers' longs do better than their shorts), more portfolios that promise to have uncorrelated components based on recent history, more "bear market" equity funds, even more "hard assets" funds, and so on.

The choices will be bewildering to many individual investors, but there will be a few new offerings that will make us better off, too.

Pack of Bears

The NY Times posted an excellent graphic on how the current U.S. bear market compares to previous bear markets since 1929 in terms of severity and duration.

You can't draw any conclusions from the graph because it's entirely "historical," but you can consider whether the severity of the risks faced today -- relative to the recently-ended boom -- are as serious as they were in the past.

We think the balance of risks today are a bit more severe now than during past bear markets, so that the rapid, sharp declines in equities in the past few months are justified. That's why we're not rushing to raise our equity allocation to our strategic target of 65%, though we became more positively inclined in the past couple of days. The prospect of an unwinding of the dollar as a reserve currency, the potential breakdown of the European Monetary Union, and other threats -- alongside the "good" news that some governments are starting to recapitalize their nations' banks -- means we think there's an "even" chance of earning better-than-cash returns in the next 3-5 years.

We're still waiting for some emerging markets to face a severe financial crisis, and for more bank failures, before we're comfortable raising our equity weighting to our long-term strategic target.

Another Sign That The Freefall May Decelerate

The comment below adds to our slightly diminished fear. As a result we're firming up our rebalancing stance: We're not going to actively move our equity allocation lower than 1/3, but instead will look for opportunities to raise our equity exposure over time, based on the parameters we laid out yesterday morning (mainly, waiting for true financial crisis in some emerging markets, and for more financial institutions to fail). We're remaining very patient in this regard, fully believing that systemic risk and a deep recession could linger for a couple of years.

One of the additional positives today is that the Lehman CDS auction may have gone "smoothly." Orderly markets are a necessary condition for reducing panic, especially when some participants previously feared chaos. This may bode well for inevitable future CDS auctions. From Marketwatch this afternoon:

• Similar auctions earlier this week to set the price of Fannie and Freddie debt were "messy," undermining confidence in the process, according to CreditSights, an independent fixed-income research firm.
• However, the Lehman auction Friday went "smoothly" and "efficiently," according to Robert Pickel, chief executive of the ISDA, which represents major dealers in the CDS market.
• Traders and other CDS market participants marked the fair value of their exposures and posted more collateral as Lehman's troubles increased, Pickel explained. This discipline means that sellers of protection should not have trouble paying to settle the contracts related to Lehman, he added.
• The result of the Lehman auction means sellers of CDS protection on the firm will need to pay 91.375 cents on the dollar to their counterparties.
• Roughly $400 billion will be paid out on Lehman CDS, but, once all positive and negative positions are "netted" out, about 2% of that money will actually change hands, Pickel estimated. Payments are due on Oct. 21 to settle Lehman CDS in cash, he said.

Finally, A Meaningful Step to Deflect Disaster?

Doomsday observers may yet meet their match in the form of government officials. I confess to being astonished at how quickly the authorities are acting on behalf of the financial system, even though they're often acting carelessly.

From the Wall Street Journal:

• The U.S. is weighing two dramatic steps to repair ailing financial markets: guaranteeing billions of dollars in bank debt and temporarily insuring all U.S. bank deposits.

Guaranteeing bank debt is the more important of the two, because this step would probably forestall some payouts on credit default swaps (CDS), which far exceeds the value of the bank debt, and which is the black hole in the financial system right now, a major reason why banks won't lend to banks. There is roughly $55 trillion in CDS, the insurance that many financial institutions have promised to pay to holders of corporate debt (for a fee). If the government prevents banks from defaulting on debt, then other financial institutions who issued the insurance against this probably won't have to pay-up to the holders of the insurance. As a result, such a move by the U.S. could help prevent some bank failures and restore some confidence to the banking system.

A U.S. move to this effect would appear to follow a U.K. plan, and if it went into effect, it would show how quickly the international community can learn from each other, if they choose to. Coordinated global action is the only thing that can deflect financial system collapse, so greater signs of real cooperation could slow down equity markets' retreats.

There's another piece of slightly reassuring "news" out there. We're reading that the $700b U.S. "bailout" plan may, after all, allow the U.S. government to "recapitalize" U.S. banks -- i.e. buy a stake in them in order to facilitate trust in them. A major criticism of the bailout has been that the U.S. should have done this.

But as we've explained in prior posts, we're not tempted to raise equity exposure from our current 1/3 of our long-run strategic objective.

Further Reducing Equity Exposure, At Least for the Moment

A new wrinkle in the financial crisis has caused us to purchase some protection against further precipitous market declines.

In a post titled, International Trade Seizing Up Due to Banking Crisis, author Yves Smith cites contacts saying that some banks aren't writing international letters of credit (assurance than an exporter will get paid for the goods he's delivering to the other side of the world). If this kind of news continues, exporters will be less willing to ship goods, we could start seeing some empty shelves, and U.S. exporters will suffer too. There are government agencies that can step in and offer letters of credit, but this may take time.

To purchase protection, we bought the SDS (ProShares UltraShort S&P 500) and RWM (ProShares Short Russell 2000). We purchased these ETFs (exchange traded funds) because they go up when the S&P 500 and Russell 2000 go down. SDS is supposed to go up at 2x the rate that the market goes down, and RWM is supposed to go up at the same rate that the market goes down. We purchased both to compare how they behave in reality. We're a bit nervous that their mechanisms for tracking the indices inversely are loosening amidst the market's turmoil, and we want to further investigate this risk. But "short ETFs" are the quickest way for retail investors to make money if the market declines. We made the purchases in our taxable account because we think we'll have enough tax losses this year to offset gains in these ETFs (which are taxed 60% long-term and 40% short-term).

And to reiterate a comment from our last post, it's important to be ready to reverse such "short" positions quickly, because equity markets have been known to rebound with lightening speed from panic troughs.

The Quaint Notion of Asset Allocation?

I left off this blog an April 30th in order to help a friend who underwent medical treatment.

A few wide-ranging observations on the intervening period:

This friend is now my hero. In a few months, she persevered through more ordeals than most people I know face in their lifetimes. She is a happy, bright person. This could not have happened without the support of other friends who showed consummate tranquility, skill and optimism. My friend's sister helped her enormously because of her cheer, kindness, and gentleness far beyond my previous ability to understand.

So many people are dedicated to the good of others (or at least, more than we'd thought). I have never met so many people so driven and satisfied by helping other people. From the surgeons to the nursing staffs to the supply clerks at the hospital, I came away humbled. Equally true, I learned of qualities within some of my friends and family members that run deeper than I could have imagined. One family member told me, "This [helping my patients] is why I was put on this earth." We often don't learn these things about people until it's too late.

I have surpassing reverence for today's first-rate medical practice, and the science and people upon which it is built. If my friend had been in almost any other time or place in human history -- or even in another neighborhood nearby -- she would not have survived. Our capabilities as people are great, yet they are fragile because they depend on highly complex interactions between people, science, and society. We have achieved this in the last few decades after a mere 200-year period of industrialization, which is only a drop of time for the human species, and not a "norm" that should be taken for granted. We can lose all of this quickly if we not more careful.

Inquire (into everything) as if your friend's life depends on it. My friend's condition was poorly understood at first, rare, changing, and not consistent with any previous example. We inquired with everyone we could, dug up every case study we could, and listened intently to everyone -- especially the experts, but anyone -- because a tidbit from someone's life experience just might make a difference. (Now I'll start turning the discussion toward investing.) I think most successful people, and certainly great lifetime investors, do the same kind of incessant. I could have avoided a couple of investment mistakes this year if I'd asked more questions of people I remember starting conversations with.

Many truths don't last -- figure out which will and won't. The "truths" most people proclaim are mere lessons they can recall from the past few decades. In world changing so fast, these truths are not as useful as they were over the period of human evolution when we developed our brains' system for finding certainty. Applying this view to investing, I believe we can and must have a well-informed call on markets to supplement strict, mathematical asset allocation.

• Why is simple "asset allocation" now exposed as just a quaint notion? It holds that (1) a diversified investment portfolio that is (2) readjusted to keep proportions constant, results in (3) best returns over a lifetime. This "truth" of asset allocation became most popular in recent years after a 20-year bull market -- but this truth assumed we wouldn't experience a period when (1) almost all asset classes would lose value, (2) prolonged drops in value would cause investors to buy lagging asset classes far too heavily and too soon, and (3) best lifetime returns are always calculated over the most recent generation -- the times change with the generations, and a new one is always beginning (especially now).

Put another way, the power of thinking "what could happen" far exceeds the power of analyzing what strategies worked or failed in the recent past. Volumes have been written about how humans are pattern-making machines, with a bias toward believing the recent past will predict the future. Giving in to this bias can be devastating for investment returns.

Recognize and resolve your conflicting beliefs. In the hospital with our daughter, we appreciated doctors' conflicting views and interpretations of her condition and what to do about it.... and then we all used the information to choose a single treatment path. What seems self-evident in the hospital is often ignored in one's notion of his finances. Investors often don't confront their hunches, doubts and inconsistent strategies with a the goal of inquiring, researching, and resolving on action. Yet great investors do, as a habit.

The best investment book I read while standing by my friend in the hospital was Drobny's Inside the House of Money. Top global macro hedge fund managers discuss details of their investments, strategies, worldviews and daily approaches. It gets the mind working hard on current opportunities and risks.

The best personal investment book I read was The Retirement Savings Time Bomb, and How to Defuse It. Hardly any financial advisors -- and even fewer "investment advisors" -- bother with the make-or-break details of how your savings will be taxed when you're retired, and when you're trying to pass wealth to hears.

Where We Were Right and Wrong, And What We Think Today

Several of the observations listed above inform our next few words on picking up where we left off this blog on April 30.

1. We were right to be underweight equities and risky asset classes generally, and to be postponing the decision to fully "rebalance" underweight positions. And so far, we were right to say the financial crisis wouldn't run its course until the emerging markets experienced a financial crisis, which we believed (and still believe) would follow the U.S. and Europe's crises.

2. We were wrong to be adding to equity allocations, even though we remained underweight. We should have gotten more underweight equities, not less. We had all the information and the right hunches about the pending crisis, but trusted recent history too much to stay away from equities.

[Note: Even while we were, and still are, saying that an emerging markets crisis has to happen before we would consider the crisis fully in people's expectations, we were still creeping into equities. An inconsistency we should have stared in the face, because we think we would have stuck with our overall view, not bought equities here and there. There were other inconsistencies in our views that we rationalized instead of challenging.]

3. We were right to start discussing the role of absolute return strategies for individual investors. We were wrong to move slowly on this.

4. We didn't have our hedges ready at a moment's notice. Yet this is crucial because you don't want the cumbersome process of unwinding your core positions to cause you to procrastinate in making important decisions about your asset allocation.

So now, our most basic views are:

1. We remain underweight equities, waiting for a major emerging market financial crisis. China's GDP slowing from 12% to 8% does not satisfy this criteria. Nor does Russia's "bailout" of Iceland, or Indonesia's suspension of its stock market. We are also waiting for more financial institutions to fail as a result of the insurance on bonds (credit default swaps) that they sold far too much of -- and will be unwilling to pay off when the bond issuers default. Banks need to find out who will be bankrupted as a result of their CDS selling before they know who they can't and can lend money to. There is about $55 trillion of CDS outstanding, most of it insurance on the bonds issued by highly leveraged firms like Lehman, Washington Mutual, General Motors, etc.... so we think trillions more will need to disappear before we can say we're close to the bottom.

2. We may remain underweight equities for even longer than that. The crisis may not yet be half over, because: (1) $700 billion bailout pales in comparison to the risk of a downward spiral of asset values, and then there's that $55 trillion credit default swap market... (2) The U.S.'s efforts to save itself from crisis by spending trillions of dollars could boomerang, and cause a loss of faith for the entire dollar-based global complex. (3) International tensions could flare up during the economic deprivation that is coming the world's way.

3. We are about half our typical equity allocation now, signifying we expect a 1-3 year global recession, and at least some chance that banks' "confidence" could begin to heal in the next 3-6 months. We're still pretty bullish long-term (10+ years) given human innovation, information diffusion, and freer markets. But we think 20th century U.S. returns won't occur in any major countries in the 21st century because the pending environmental time bomb is beginning to weigh on business costs very broadly, and are also increasingly straining international relations given the quest for resources. A continued pullback in commodity prices could cause us to temper this view, at least for a single economic cycle.

4. We've got our shorts ready -- as a near-term hedge against our long-term equity holdings -- in case we begin to fear a further major pullback in equities.

5. We've got our buy orders ready just in case we see the conditions we're waiting for (see #1 above). Equity markets could quickly double off of much lower levels than we're seeing today, and some investors will capture the upside.