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Diversification will be crucial in 2003 Back  
A global market and a difficult geopolitical backdrop make it increasingly difficult to plan ahead but diversification across the full spectrum of investment instruments is an important way to cope with unforeseen events writes Mark Merrigan.
Although the final count has yet to be announced, 2002 has been a challenging year for fund managers and investment analysts alike. The Dow Jones Industrial Average has operated in a 3,350-point range (33 per cent of the opening year value) and 10 year US. Treasury bonds have moved in a 200 basis point range so nobody can say that 2002 has been a quiet year!
The equity bear market delivered a massive blow to valuations in mid-May and had done most of its work by July. Bond yields plummeted in a flight to quality and a backdrop of ever-lower interest rates. There has been a moderate reversal in this scenario in recent weeks, but the pendulum has swung away from equities to a visible degree.
It is fair to say that equity investors have been negatively affected by, among other things, a market where corporate governance slid into disrepute. High profile cases such as Enron, WorldCom and Tyco left investors wondering just what information they could trust. You cannot put a valuation on an investment where the future cash flows are either unknown or untrustworthy.
Whilst the Securities and Exchange Commission, the New York Stock Exchange and the National Association of Securities Dealers in the U.S. all came to the rescue by providing regulatory frameworks to rebuild investor confidence, much remains to be done. Legislative provisions requiring CEOs of public companies to sign-off on their companies’ accounts form part of the response produced by the U.S. Government. We could conclude from the pronouncements of these various bodies, that all of the rules have been put into place to prevent a further outbreak of scandals involving corporate governance in the U.S.
There will always be re-statements and errors to correct, but these are a matter of routine. We cannot conclude, however, that legislation and rules will be enough to change a culture. This culture has at its root greed and personal aggrandisement. A culture where the price of a company’s share overrides other decisions points in the business model will naturally lead to skewed decisions and short-term goals. It is hoped that such a culture can be dismantled in an orderly fashion and thereby preserve the integrity of the market.
In tandem with trouble in the governance departments it is apparent that investors have been given sufficient cause to doubt the motives and recommendations of investment analysts. This has been shown itself to be particularly true of analysts working within investment banks. We have witnessed the high-profile case of former telecom analyst for Salomon’s, Jack Grubman, and the apparently disingenuous recommendations that he produced.
Align this case with that of Merrill Lynch, which paid $100 million in fines to New York State for corrupt practices during the stock market’s boom. One e-mail from Mr. Grubman to the head of Salomon Research sums the problem up - ‘Most of our [investment] banking clients are going to zero and you know I wanted to downgrade them months ago but got huge pushback from banking’.
There is a clear conflict of interest demonstrated in this e-mail. The price paid by all for not doing the right thing has been enormous: analysts brought into disrepute, investors suffering from poor allocation decisions, fines levied by the authorities and a general slide in confidence. Whilst, there have been no such significant cases arising in Europe, it is reasonable to surmise that the contagious effects of the problem have been strongly felt here.
The Association of Investment Management and Research (AIMR), a global leader in educating and examining investment managers and analysts launched a draft set of research objectivity standards in response to the fall-off in the perceived integrity of analysts’ recommendations. The draft standards relate to the entire process of analyzing a company and impose a strict compliance regime. At the heart of the standards, however, is research analysts’ compensation.
AIMR want analysts to receive compensation based solely on the quality of research. This excludes the possibility that they are motivated by how their recommendations affect the investment banking arm of their company (where relevant) and/or the financial performance of their company. This establishes the principle of independence for analysts. Naturally, there are difficult considerations for smaller firms involved in this proposed standard - they may not have the resources to implement the required compliance which total analyst independence requires. Market forces will drive the necessary changes into place as investment banking houses struggle with their internal structures.
The auditing profession has been similarly affected this year. Andersen, Enron’s auditors, overlooked escalating worries about Enron’s desire to push the bounds of acceptable accounting in order to hold on to their second biggest client. In the past year Andersen was found guilty of obstructing justice to protect Enron. It had spent the previous few years finding ways around the law when Enron presented it with financial tricks and accounting gimmicks such as off-balance sheet partnerships designed to hide debt and to swell profits.
In Europe there have, again, been no such scandals or wanton breakdowns of professional independence involving analysts or auditors. This is in spite of many different markets operating in different legal jurisdictions. Compensation systems in Europe do not provide the support for blurring the lines of independence witnessed in the U.S. That said European equity markets have greatly under performed their U.S. analogues. This brings us to economic fundamentals.
If we had a crystal ball, we would probably just consult it for the winning lottery numbers every couple of years and generally just enjoy a life of luxury. This fantasy applies equally to the business of forecasting how a market is going to perform. There appears to be two main sets of circumstances outlined in current research documents.
One school envisages that a heavily indebted consumer will eventually resolve to stop discretionary purchasing and will pause in an effort to pay down mortgages, credit cards et al. This will induce a slump in economic activity leading to job losses and deep recession. Naturally, a war in the Middle East could exacerbate this story. Low interest rates thrown into this mix has given rise to speculation that deflation is looming. Bond yields would plummet and a low-numbers world beckons for a considerable time.
The other scenario is that low interest rates will give consumers the confidence to continue re-financing, keeping them in the shops and in jobs. Capital will be keen to find enterprises where returns are attractive creating a culture of innovative investment. Corporate profitability will stabilize and perhaps increase as cost-cutting measures kick in along with sustained or improved sales. Consumers remain confident and are ‘softened’ for the eventual upturn in interest rates. Equity prices find good ground in which to grow and, September 11th - style event excepted, return to a pattern of sustained growth.
The effects of an increasingly global market and a difficult geopolitical backdrop have to be considered in any investment plan. Nobody can plan for the unexpected but diversification across the full spectrum of investment instruments is an important way to cope with unforeseen events. Valuations are another consideration - will they induce any further ‘corrections’ or have price/earnings ratios settled on to a new secular plain. 2003 is bound to throw some new considerations into the mix.

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