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helped cushion portfolio returns when markets declined. We won't know until the data comes in, but we expect the same
to happen this time.
[5] The "Eye on the Market" has endlessly chronicled this year the fissures which are now affecting financial markets:
European sovereign risk and inadequate bank capitalization; weak labor compensation as an Achilles heel of the US
profits recovery, given its negative impact on spending; the political divide in Congress over how to deal with falling
government revenue and rising entitlement spending; inflation risks in Asia and Latin America and the resulting need for
more policy tightening; and the mixed track record of low interest rates to sustainability solve structural problems. The
cover of the 2011 Outlook (a printing press, out of control) expressed our concern regarding a recovery built upon a
stimulus machine. I would contrast this with the cover of a competitor's 2011 publication, which had a picture of George
Washington crossing the Delaware, with the caption "America's structural resilience, fortitude and ingenuity will carry
the economy and financial markets in 2011 - and beyond". Our job is not to point to where we would like the
financial markets to go, but rather to point to where they might end up. It's like the scene in Oliver Stone's Nixon,
when Nixon looks up at a portrait of JFK and says, "When they look at you, they see what they want to be. When they look
at me, they see what they are." Our job is to see financial markets for what they are.
[6] All that said, we have lessons to learn here.
Too many of our investment discussions this year focused on the negative real return characteristics of
cash, and why to reduce it. In a world of deflation risk on financial assets (rather than of goods and
services), cash retains substantial option value at times like these.
We could have connected the dots more aggressively on our views on weak growth and easy monetary
policy, and owned more gold. While we have had rising price forecasts for gold and owned it in
portfolios, we did not have large enough allocations.
Given the all-time high of US government transfers to households and negative real interest rates, we
should not have interpreted positive economic data earlier this year as being highly representative of the
true run-rate of the US economy. The same goes for the global economy, which has been the beneficiary
of a lot of stimulus that is now fading, for a variety of economic and political reasons.
Great corporate profits are no guarantee against a problem in financial markets. Corporate profits and P/E
multiples were fine in June 2007, but rested on top of a systemic problem in private sector credit markets
and private sector balance sheets. This year, strong corporate profits and low P/E multiples sit on top of
systemic problems in public sector finances.
[7] In the wreckage, as usual, there are opportunities, and we will be reviewing them with you in the days ahead. There
is a benefit to having held back on our firepower this year. With risk to spend held in reserve, there are oversold assets
with considering, particularly among multinationals with strong balance sheets, high dividends and which trade at very
low multiples, something we reviewed earlier in the week."
Michael Cembalest
Chief Investment Officer
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