Portfolio Construction - Part 4

In addition to the intelligent scepticism of Stephen Roach, JP Morgan seems rather more open-minded than many other US investment houses right now. They think it is too soon to call the end of the recent correction. It bothers them that the volumes are higher on down days then they are on up days. Moreover, volatility levels have moved back towards previous lows. Technically, global equities are at critical turning points and it is possible there could be further moves down.
This is in direct comparison to the folks at BlackRock Merrill Lynch who recently published “The case for investing in equities”. Their view of economic history in this document dates all the way back to ... 1982. Try to imagine a view of world history that begins with Reagan and Thatcher and fails to recognise anything at all prior to that. Our first inclination is to feel sorry for them and our second is to feel sorry for their clients.
This myopic attitude continues when they then move to discuss asset classes. For them it would appear that asset allocation is entirely driven by deciding which S&P sector to allocate to. They consider the following: Consumer Discretionary, Consumer Staples, Energy, Financials, Healthcare, Industrials, Information Technology, Materials, Telecommunication Services and Utilities.
In fact they discuss the relative merits of all investable asset classes and their understanding of these is limited to: International Equities and then US Fixed Income, US Equities Large Cap Core, US Equities Large Cap Growth, US Equities Large Cap Value, US Equities Mid Cap Core, US Equities Mid Cap Growth, US Equities Mid Cap Value, US Equities Small Cap Core, US Equities Small Cap Growth, US Equities Small Cap Value.
So, according to BlackRock Merrill Lynch there are 11 asset classes but 9 of these comprise different kinds of US equities, only one (International Equities) has any global exposure and only one (US Fixed Income) has any non-equity exposure. Now, we know that BlackRock Merrill Lynch is better than this but it does make you wonder about how biased their reporting is.
What conclusions can you draw from this? Your portfolio allocation needs to be done by someone who understands the full range of asset classes - we’re happy to take advantage of BlackRock Merrill Lynch’s speciality in managing specific sectors from time to time because we recognise that this is a very different job to portfolio allocation. Horses for courses! If you want to restrict your asset allocation to less than 10% of available global investable assets don’t be surprised if the results are very volatile and the performance is poor. Choose an active multi-asset allocation specialist or face the consequences! There can be clear and specific dangers of what we tend to view as the complacency of the equity-infatuated, especially with their ability to attempt to justify the unjustifiable. Construct a sufficiently contrived way of looking at data and you can argue that black is white or rather that expensive is cheap.
An interesting article in the FT recently looked to challenge the virtually consensus view that you have to buy equities right now because they’re considered to be cheap. The basis of what it said is that markets look expensive when using trend earnings. They also went on to say that earnings have been above trend for so long now that they have to start to go below trend.
London-based Smithers & Co have analysed the actual and the cyclically adjusted price-earnings ratio of the Standard & Poor’s composite index since 1881. The cyclically adjusted measure follows the method of Professor Robert Shiller of Yale University: it is the ratio of stock prices to the moving average of the previous 10 years’ earnings, deflated by the consumer price index. This shows that the actual P/E ratio is now very close to its long-run mean of just over 15.
The most recent cyclically adjusted P/E ratio, however, is 26.5, or about two-thirds above its long-run average. It is not quite as astronomically high as in 2000, but it is very high, by historical standards. The US and, indeed, most of the world, has experienced a massive upswing in corporate earnings. What emerges from this research is the undoubted cyclicality of earnings. What can also be seen is the scale of the recent surge: in real terms earnings rose by 192 percent between March 2002 and December 2006 (real earnings also rose by 170 percent between December 1991 and September 2000, before collapsing in the ensuing months: in March 2002 real earnings of the companies in the index were only 19 percent higher than at the previous trough, over a decade before).
The bottom line is that it is always a mistake to confuse a cycle with a trend. In the case of corporate earnings, it is worse than a mistake, it is a huge blunder. The intense cyclicality of corporate earnings is the most important reason why the unadjusted P/E ratio is a worthless indicator of value. The question one has to ask is whether somehow this time will be different and they will be sustained or fall back again, as they have done in the past.
To be continued…

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Graham Macdonald on [email protected]@mbmg-international.com.com

Snap Shots: by Harry Flashman

Camera – Analyze – Action!

Take a look at the photo with this week’s column. It is one of the best “action” shots I have seen for some time. This is a very professional shot, but one that you could take yourself. But first you must develop the critical eye.

Look critically at the photo – the blurred background, slight blurring of the cyclist’s legs to show movement there, crisp sharp subject with everything else out of focus and lighting to show the mountain bike to best advantage. You can practically “hear” the whoosh as the cyclist whizzes past you on the dirt trail. So how did this photographer manage to do all this?
Again it helps if you look critically and analyze the shot. Let’s take the background first. You produce this by moving the camera as you take the shot. This is called “panning” and has been covered in this column before. Between 1/15th and 1/30th of a second was probably the exposure time used as the photographer swung the camera at the same speed as the cyclist. This slow shutter speed will also allow the slight movement to be seen in the cyclist’s legs.
Now look at the focus. Sharp, sharp, sharp! This is not the kind of focus you can get “on the run” so to speak. This is achieved by pre-focussing. The photographer would have had the cyclist do the runs several times so that there was a track to follow, then focussed on the position on the track and, Hey Presto! Correct focus!
Now the lighting for this photograph. Look carefully and you will see that there are two sources of lighting for this shot. Yes, two. One is the great lighting technician in the sky, directly overhead and the other is side on about 45 degrees to the front. Look at the flare on the front brake and you’ll see what I mean.
That second source of lighting is from a flash mounted off camera to the left. It would have been mounted on a tripod and its output would have been matched to the ambient lighting from the celestial sunlight. Probably about one stop less than ambient would be a good guess. You can also say that with the light overhead, the shot was taken around the middle of the day.
But there is even more that you can deduce from critically looking at this photograph. Note that the front wheel looks much larger than the rear. If this were taken by a long lens, the further away wheel would begin to look larger. With the slight exaggeration and bias towards the front, this was taken with a wide angle lens. Probably only about 35 mm, though a 28 mm one could also fit. Since nothing other than the bike is in focus, the photographer would have used a short depth of field. This is produced by using a large aperture and being very close to the subject. Here the photographer probably chose an f stop around 5.6 to 4.
So by critically looking at one photograph we have deduced the likely shutter speed, aperture, source of light, lens used and even time of day. So what does that do for us? A lot! It means that you can use all these tricks of the trade when you want to produce a similar “action” packed shot. Just remember that the photographer did not just take one exposure and went and drank beer for the rest of the day to congratulate himself on being such a fine photographer. That photographer would have spent at least two hours in just setting up that shot and then another hours worth of shooting. Probably around 100 shots were taken and the best shot selected using a magnifying glass.
Good shots don’t happen – they are made! Go and make some yourself this weekend.

Modern Medicine: by Dr. Iain Corness, Consultant

We’ll just run a few tests...

One of the common questions that doctors get asked, after a patient has had a blood test, is “What was my blood group?” or even, “How was my AIDS test?” It may come as a surprise, but neither blood groups or HIV testing are really ‘routine’ examinations (though there several good reasons why they should be).
The tests we order are designed to assist the treating doctor work out the “Definitive” diagnosis from the initial or “provisional” diagnosis. Unhappily for the doctor and the patient, this can sometimes be a complex and expensive net-throwing detective story.
Take someone who presents with unexplained bleeding. Haemophilia? Sure, it might be - Factor VIII, Factor XI, Factor XII or even Factor XIII. Unfortunately the cause might also be from metastatic carcinoma, drug ingestion, poisons, kidney failure, systemic lupus erythematosis, von Willebrand’s disease or even something called the Bernard Soulier Syndrome, about which I could write all I know on the back of a matchbox and still leave room for the national anthem (long version and hand written).
Tests are ‘tailored’ to identify, or exclude, the diseases that the doctor feels are ‘possibles’ after the initial clinical impression. If the ‘most likely’ causes turn up negative in the initial batch of tests, then the doctor has to rack his or her brains a little more and start going into the ‘less likely’ ailments and testing for those. This is why you may need more than one round of tests to come up with the definitive diagnosis. And then after that you will need repeats of the tests to see if you are in fact getting better.
Another poorly understood concept is that of the “Normal Range”. Just how or from where do we get this “Normal Range”? Actually it is relatively simple. We examine the blood of 1,000 people, take off the bottom 25 low results and the top 25 high results, and we keep the 95 percent in the middle. That now gives you the Normal Range, but this does not mean that it is the “healthy” range, as we could be sampling 1,000 people with high levels of something!
Take Cholesterol as an example. If you live in a Western community that has a diet high in Cholesterol, the majority (the 95 percent in the middle) will have higher levels than a similar community living in the East that has a diet low in saturated fats. So the “Normal Range” can be different between communities (and even between laboratories). So what may be considered within the guidelines for one group may be outside the 95 percentile limits for another. So if you just “scraped in” under the top level for the Normal range, I wouldn’t be too complacent about it!
The “recommended” levels may also not follow the “normal range”. Cholesterol is a classic example. The cardiologists have been progressively lowering the “recommended” range over the past 30 years, and to keep your cardiologist happy, you should aim for the low end of the so-called “normal range”!
However blood testing has even more traps for young players. If the tourniquet is left on too long while taking the blood, the Cholesterol can be falsely raised by up to 20 percent! If the sample is too small, the Potassium will appear to be elevated when it is not. Samples kept too long in the fridge can also be inaccurate as far as blood sugar is concerned. Some medications, including the (so-called) health store ‘natural’ medications can also affect the tests, giving false positive or negative readings too.
No, interpretation of tests is a veritable minefield out there - that’s why we have specialist Pathologists to lead us through that minefield! Now getting back to your blood group - if you want to know you will have to ask the doctor to add it in - or even better, go and donate blood and they will tell you what you are.

Learn to Live to Learn: with Andrew Watson

Education or indoctrination?

A tender topic perhaps, to be treated with appropriate sensitivity. Using the term ‘indoctrination’ in conjunction with ‘education’ is liable to lead to spirited debate. So much the better.
So what would render education, ‘indoctrination’? Perhaps it would be when beliefs that education attempts to teach are delivered as ‘absolute truths’. Or if the celebration of cultural diversity was to be manipulated or distorted and instead bred cultural intolerance?
In my view, the seemingly inevitable adoption of an ideological position towards education would not necessarily mean that teaching and learning was an indoctrination process unless the process was aimed at some form of extreme manipulation.
The manner and style of the application of curriculum models in international schools depends entirely upon the individuals charged with the day to day implementation of a particular educational philosophy. In some cases, this is a worrying prospect. I mean, precisely what kind of educational philosophy can we expect our children to be exposed to when the Head states quite wantonly that he expects “student x to commit suicide in a couple of years.” This, a “throw away comment”! If you’re shocked, you should be. But there exist such a multifarious variety of international schools, (they defy a universal definition) that we might at least feel reassured that such instances are few and far between. Or perhaps not.
Consider an “International” curriculum programme, such as the IB (International Baccalaureate) diploma whose programmes are delivered by a “National” system school, as almost 50% of IBO schools are, or ‘transplanted’ national system schools such as British, American or French. Some “International” schools quite deliberately peddle their (for instance) “Britishness” at the expense of their “International” dimension. This can create significant difficulties when there is a perception amongst interest groups (students, teachers, parents) of a clash (or at least inconsistencies) between the predominant national educational system they deliver (such as the English National Curriculum) and their international school status.
Much is also dependent on the region where the school is situated and the expectations of the school populous, which can be expected to be affected by social, economic and cultural factors. It sometimes feels like a “small world” but sometimes it feels that it’s populated by “small people”, looking inwards instead of outwards, savouring nationalism above internationalism. But what about roots of the curriculum?
According to Kelly, (2004) a truly “educational” curriculum is one which is consonant with the underlying principles of a democratic philosophy. He describes three main curriculum models:
Firstly a “Content” model, where the role of content is central and the criteria of selection lies in the presumed intrinsic value or usefulness of the content.
Secondly, an “Objectives” model, which places aims and objectives first and offers these as the criteria for selecting content.
Thirdly, he identifies a “Process/Developmental Model” whose central concern is with individual empowerment located in a democratic social context.
This general movement has been termed ‘child-centred’ because of its concern with the nature of the child and with his or her development as a human being. It is rooted in a concept of social democracy. But try asking some Heads promoting this kind of education in their school what they mean by it and be prepared for them to be flummoxed. Look beyond the spin.
The first two models are in my view unsuitable for a truly educational system as they are essentially linear and lead to loss of freedom for teacher and pupil. The third model is the only one compatible with the values of democracy - if we believe in that! Where else to look next other than that paragon of democracy, the United States?
Examination of educational philosophies in the USA reveals the philosophic traditions that have influenced education there: idealism, realism, pragmatism and existentialism, the first two being traditional and the latter two contemporary.
Just to get complicated (stay with me!) there are four educational philosophies that have roots in one or more of these philosophic traditions and draw on their principles. The approach to curriculum of four educational philosophies are described as follows:
1. “Perennialism” which is rooted in Realism. The curriculum is subject centred and draws heavily on disciplines or logically organized bodies of content. Education is constant, absolute and universal and its goal is to develop the rational person and to uncover universal truths. There is one common curriculum for all students with little room for elective or vocational subjects. Much of colonial and post-colonial American education up to the late 1800’s was dominated by “perennialist” thinking.
2. “Essentialism”, which is rooted in Idealism and Realism. The curriculum should be geared to the essential skills (three R’s) and “essential” subjects. This philosophy surfaced in the 1930’s and developed more in the 1950’s and 1960’s during the Cold War. It is similar to perennialist philosophy but allows some room for elective or vocational subjects. The “back-to-basics” movement and demand for excellence in education in 1980’s were influenced by this philosophy.
3. “Progressivism”, which developed from pragmatic philosophy and was a protest against perennialist thinking. Unlike the previous two philosophies, Progressivism places an emphasis on “how to think” and not “what to think”. Curriculum is interdisciplinary in nature and books and subject matter are part of the learning process rather that the sources of ultimate knowledge. It focuses on the child as the learner rather than on the subject and emphasizes activities and experiences rather than verbal and literary skills. Perhaps unsurprisingly, “Progressive” education is accused of ignoring social issues. The Humanist approach to curriculum is based on Progressivism, although a common criticism of a humanist curriculum is its perceived lack of attention to cognitive learning and intellectual development.
4. “Reconstructionism” was called ‘crisis’ philosophy by Theodore Brameld. This kind of curriculum seeks to emphasize cultural pluralism, internationalism and futurism. It places an emphasis on education that considered the needs of all classes in society and argues that Progressivism puts too much emphasis on child-centred education. Students are taught to appreciate life in a world of many nations - a global village - with many alternatives for the future.
Andrew Watson is a Management Consultant for Garden International Schools in Thailand. andreww @gardenrayong.com
All proceeds from this column are donated to the Esther Benjamins Trust. www.ebtrust.org.uk email: [email protected]
Next week: Driven by Ideology