Investment Commentary 267

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Investment Commentary No. 267 December 7, 2009

Facing a year of decisions

1. Yet another conundrumWhen representatives of the central banks arepuzzled, they dont admit it, or at least not di-rectly. Rather, because they feel they ought not to

find themselves in such a situation, they concealtheir lack of insight behind impressive phrases, or,better still, puzzles. There is indeed some sort ofintellectual appeal to discussing puzzlement interms of puzzles, and a master of the art was un-doubtedly the previous head of the Fed, AlanGreenspan. Almost till the end of his long term ofoffice, he was renowned for the way his speeches,which mostly lasted for hours, avoided sayinganything really tangible. He even spoke in riddleswhen there was nothing puzzling about the topic.So, when in 2005 he found himself confronted byan apparently unanswerable question, he took

refuge behind a similarly incomprehensible an-swer, as if he were a doctor obliged to communi-cate a terminal diagnosis. The magic word wasconundrum. A logically deduced contradictionthat is not susceptible to a simple resolutionundoubtedly sounds better than perplexity orhelplessness, for there is a notion that perplex-ity or helplessness is not an option for the head ofan institution whose only value resides in theconfidence that a global public places in it.

That particular conundrum concerned a peculiarsituation with regard to interest rates and the US

dollar. It was also, if were right about this, thefirst sign of the subsequent catastrophe in thefinancial system. For it was in 2005 that the de-gree of momentum that was being generated bythe global players in the system the big bankingand insurance conglomerates, the investmentbanks, the non-banks operating in their orbit,such as hedge funds and Special Purpose Vehi-cles began to become apparent. They were allspeculating on one and the same scenario: thecontinuation of the (so far) extremely successfulmonetary policy of gradualism, combined with

the Feds guarantee of liquidity, which washed allthe real problems away. This mass speculation inone and the same direction resulted in distortionsin supply and demand for money at various terms,

and this was the source of Greenspans conun-drum. The voices of those who thought that therewas really no conundrum at all were too few andtoo weak or the message too unwelcome andso the party was allowed to carry on. Two moreyears of boom nice.

We might feel that conundrums should be rela-

tively infrequent, for, firstly, todays highly scien-tific approach to economic theory should leavelittle unclarified. Secondly, in purely morphologi-cal terms, conundrum is linked with Cassan-dra an unwelcome state of affairs when it con-cerns the future intrinsic value of ones own as-sets. Thirdly, there is a vague feeling that theexistence of irresolvable contradictions might benot unrelated to the far too frequent occurrenceof catastrophic events in the financial system.

The fact is, however, that we are again confrontedwith a puzzle, or rather, several puzzles. As we

are not central bankers, we prefer to talk of per-plexity or helplessness, not least in the belief thatthose who admit honestly to their current lack ofknowledge may acquire and enjoy trust and con-fidence. Our problem is a constellation of devel-opments that should theoretically not be simulta-neously possible:

- Firstly, we have this year all observed, and tosome extent benefitted from, a significantglobal boom on the stock markets. This can beequated with more or less positive expectationsconcerning companies future revenue situa-

tions. The (mostly successful) cost reductionprogrammes launched by many companies byno means justify the rise in their stock prices.Rather, the rise anticipates strong growth in fu-ture cash flows, which implies a significant im-provement in the economic situation. Put an-other way: the stock markets are reflecting theexpectation of an end to the recession, fol-lowed by a sharp upturn.

- However, the bond markets seem to be sendinga contradictory message. Over the year, returnshave fallen again, to the benefit of creditors;

the interest rate curve would be relatively flat,were it not for the disproportionately lowshort-term interest rates resulting from an ex-tremely accommodating monetary policy. The


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Investment Commentary No. 267 Page 2

bond markets offer no signs of an imminent up-turn, and certainly no indication of inflation.The credit markets too indicate stagnation, oreven a further decline in economic activity on

the part of the Western industrial nations. Thecentral banks exceedingly generous monetarypolicy seems to be having absolutely no impact;bank lending is at a historical low. This is notwhat either an upturn or imminent inflationlook like.

- The price of gold, however, seems to suggestsomething different again. Gold races frompeak to peak. What, if not the expectation ofimminent depreciation, would motivate marketplayers to buy and hoard a precious metal thatgenerates no revenue and has little direct ap-

plication in the economy?- Lastly, we also encounter contradictory signals

from surveys of the prevailing mood, and inparticular sectors of the economic system.While almost all manufacturing surveys indi-cate an improvement in the situation, the factslook a good deal more sobering. In the USA,sales for private consumption, building permits,construction expenditure and corporate in-vestments are at best stabilizing at a low level.Unemployment has reached 10 percent; werethis to include the unregistered illegals, those

whose entitlement to benefits is exhausted, in-valids and those working involuntarily on apart-time basis, reliable estimates indicate afigure of over 15 percent. Where in the worlddo the companies surveyed find their opti-mism? And who will be the consumers of allthe products that will flood the markets afterinvestment picks up again?

Look at it how you like: a combination of risingstock prices with lower returns on bonds, coupledwith record prices for gold and the discrepancybetween the prevailing mood and the facts, must

raise serious questions. What we would of courselike to do is to arrive at clear conclusions basedon consistent analysis. Lets be clear: this is notgoing to be possible. But well do the analysisanyway.

2. What is truth?

Analysis! Analysis? What does it actually mean?Normally, the gathering of some facts, to the ex-tent that they are indisputable, and the applica-tion of a model that seems appropriate to the casein question. Appropriate in the sense of itsability to explain and to forecast. This is what we

all do, day in, day out, and the result is some-where between sobering and shattering. For eventhose who, for instance, had in some way

anticipated the technology bubble of 2001 and thesubsequent recession; even those who warned ofexcesses in the run-up to the financial crisis of2007, must admit that their whole choice of lan-

guage and their behaviour patterns remainedalmost completely oriented on their experience ofnormality, and this normality did not include thecumulation of extremely extreme events.

The model that underlies our thinking, explicitlyor implicitly, is based on the assumption of a nor-mal distribution of events; that is, a continuousdistribution of the probability that events willoccur. It is continuity alone that enables state-ments (and thus forecasts) that things appear tobe highly improbable or highly probable.This model enables calculations to be made and

potential future stress situations to be modelled.Thus, for example, according to a paper by MarkRubinstein, professor of applied investmentanalysis at Berkeley, a day on the stock exchangeon which stock prices drop by 29 percent has aprobability of 10

-160with a (normally observed)

volatility of 20 percent. Such an event should nothave occurred during the entire existence of theuniverse (probably around 20 billion years). So,we might regard ourselves as lucky to have ex-perienced such an event just once. The probabil-ity that we might experience it (or somethingeven worse) is extremely low. But in fact it hap-pened extremely recently in terms of billions ofyears: in the legendary crash of 1987.

Of course, the real problem lies not in the occur-rence of this unique event in 1987 that mighthappen, even if the probability is extremely low.It lies in the objectively ascertainable cumulationof similarly disastrous events in the subsequentdecades. 1998, 2001, 2007: this is a good deal toomuch. Put differently, the explanatory power ofmodels based on normal distribution is low. Forour purposes, they are useless, devoid of explana-tory power, pointless.

The only serious critics of the received wisdomthat we see are the mathematician Benot Man-delbrot (The (Mis)behavior of markets, 2004) andthe economist Nassim Taleb (The Black Swan,2007). Mandelbrot, who recently spoke at anevent in Zurich organized by our bank, had al-ready pointed to the discontinuities in probabilitydistribution in cotton prices in the 1960s. Afterco-founding chaos theory, he then returned tothe financial markets at the beginning of the cen-tury. His warning was clear enough: risks occur inclusters, and much more frequently than we think,

but are impossible to forecast specifically. Man-delbrots risk distribution has been described aswild randomness. The accusation has been


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made that his theory is useless, because it cannotbe used for forecasting. As if the insight thatthings can go wrong much more frequently thangenerally expected were not in itself a forecast to

be taken seriously!In The Black Swan, Nassim Taleb not only reiter-ates Mandelbrots insights, but also provides themwith theory and application. His key insight is thatwhile black swans are relatively infrequent,they are not as improbable as generally assumed.On the contrary, they actually dominate history.Models based on normal distribution, such asMarkowitz Optimization, CAPM, the Black-Scholes Formula, the Sharpe Ratio, and so on, areall unusable. Volatility without reference to dif-fering time periods is not suitable for the meas-

urement of risk. Betting against so-called improb-able extreme events can end in disaster. In a newworking paper (Errors, Robustness, and theFourth Quadrant, 2008), Taleb advocates thedevelopment of a risk landscape containing fourcategories:

- A category of simple, proven structures, wherethe occurrence of events can be calculated ea-sily. The purchase of a sunshade for the gardenin the winter sales would belong to this cate-gory of risk, which Taleb describes as ex-tremely robust.

- A category where the events appear complex,but the probability of occurrence is clear.Structured products of the type we avoid, withpay-out structures dependent on various fac-tors (such as the worst of products, which ul-timately deliver either a fixed amount or possi-bly the worst performing stock), but which areguaranteed tradable at any time on a secondarymarket, belong in this category. According toTaleb it is quite robust.

- The third category, also quite robust, con-tains easily comprehensible structures that may

easily fall victim to extreme events. Those whobuild holiday chalets at the edge of a slopedown which no avalanche has thundered inliving memory are operating in this category.

- The fourth, and most dangerous, category(not robust) contains risks where the occur-rence of events is dependent on many factors,and where it is virtually impossible to calculateprobability. A large number of political pro-cesses, whose outcomes are well outside eco-nomic (and thus forecastable) efficiency belongin this category, and with them, sadly, the

rights to life, liberty and property defined bythese political processes. But it now also seemsthat the constellations on the financial marketshave become far less robust; not least,

perhaps, on account of the ultimately politi-cally motivated implicit state guarantee forvery big players in the system, and the resultingdistortions, which are way beyond any idea of

economic efficiency.The big question now, however, is how to thinkabout the risks in the fourth category by far themost crucial ones. If the current models are unus-able, what can replace them? If linear extrapola-tion produces excessively optimistic results, whatalternatives are there? If we cannot avoid theblack swans risks of the fourth kind in life andin business, but we wish to limit their impact asmuch as possible, how can we have any idea ofthem? For without some idea of what one is try-ing to contain, it will be impossible to contain it.

Deduction and logic alone are unlikely to suffice.Its more likely that we need to do something thatpeople have always done, but have done less andless since Descartes and the Enlightenment: weneed to tell tales and stories. The many myths andsagas, the Holy Scriptures, Grimms fairy tales,and the Thousand and One Nights: it is here, andnot just in logical deduction, that we will find thestuff with which we can turn the future, with itsopportunities and risks, into a time that is imagin-able for us.

That may sound dangerously esoteric, but it isnt.

For when rigorous, rational methodologies fail asblatantly as they have been seen to do in the fi-nancial crisis, any kind of arrogant superioritywith regard to apparently less scientific methodswould be quite out of order. The philosopher PaulFeyerabend (19241994), wrongly dismissed asthe anarchist of economic theory, has pointed tothe inadequacy of pure logical deduction, andtried to give more prominence to empirical me-thods. With his Anything goes! he provoked hiscolleagues in order to open the way for theoreti-cal pluralism. Feyerabend was convinced that

more help is often to be found in popular storiesthan in scholarly papers. He also provided, ifwere right about this, a recipe for dealing withTalebs fourth category of risks, for black swansin ones own personal environment: What mat-ters is having a few friends around thats all. Apiece of advice, as attractive as it is simple, forprotection against risk. The consequences of theabsence of genuine friendships, often to be ob-served among wealthy rational optimizers, are alltoo obvious when extreme events occur, whetherof a medical, family or monetary nature.

Very good then: lets make up some stories! Letus try to turn the currently highly contradictoryconditions into scenarios that make sense for our


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purposes, or at least have some entertainmentvalue as stories.

3. Scenario I: the comfortable lazy L

It is evident that not only has the financial crisisseen the implosion of a banking system based onexcessive debt and hyperactivism, but the lengthyperiod of entirely unproblematic financing hasalso created distortions in the real economy,which will now be corrected in the global reces-sion.

This phenomenon of distortions with real conse-quences and the necessity for real corrections ismost obvious in the case of Dubai. The results ofan excessively low threshold for project financeare plain to see. In a place in which it is only pos-

sible to be outside for six months of the year atmost, and in which everything is literally artificial,who in the world was supposed to fill the thou-sands of offices, hotel suites and penthouses, andpay vast sums of money for the privilege? Vacantproperties were a foregone conclusion. It is saidthat credit buys time. But too much credit gener-ates too many ill-considered projects in too shorta time. That is the problem with excessive debt. Itwas the case in the American real estate sector, itwas the case in Dubai, and it is also the case in thebalance sheets of various, mainly European,banks, that have been happily stuffed with Dubairisk. (According to an estimate by MorganStanley, of the current 113 billion dollars of Dubairisk, 87 billion is held by European institutions, 50billion of which by British ones. What was thatabout lightning never striking in the same placetwice?)

The financial hype was and still is, in some partsof the world reflected in the exuberance of thereal economy. This perspective also explains thepartial paralysis of the global economy, mademanifest in the collapse in cargo rates towards theend of 2008. The financial crisis provided an occa-sion for releasing the excessive pressure in theglobal economy, and because this happenedabruptly, a significant amount of collateral dam-age was unavoidable. Overall however, apartfrom this tectonic shift downwards, little haschanged in the basic structures of the global econ-

omy, which means that from about 2010, businesscan continue unhindered, if at a lower level. Thedevelopment of the economy would thus resem-ble a slanted, lazy L: sharp drop, gentle recov-ery.

The roles of the individual economic blocks have

also changed little, and without any additionalsigns of real crisis. American consumers will ten-dentially become less important, but they will

remain the dominant source of demand for goodsfrom the Far East. This is reflected in the stillsignificant balance-of-trade surpluses that theAsiatic countries have vis--vis the USA. Europe

will be able to resume its lucrative export of capi-tal goods. Any company in this sector that hasimproved its productivity through cost reductionswill be able to continue to exist with this lowerlevel of sales; greater demand will improve mar-gins in due course. To this extent, the profit im-provements already anticipated in stock pricesseem not unrealistic.

Economic development at this lower level willnot, though, be sufficient to generate inflationarypressure, given the productivity improvements.On the contrary, there is still enormous global

overcapacity, which will put a sharp stop to anyupward pressure on prices. As in this moderatescenario there is little room for political pressurefor protectionist moves, regional and sector rigidi-ties will play only a secondary role. This alsomeans that the central banks will be able to keepinterest rates low for a long time. An end toquantitative easing, the radical provision ofliquidity by means of a zero-interest policy andthe inflation of the central banks balance sheets,remains some way off. And as all the importantcentral banks in the system the Fed, the ECBand the Bank of England are following more orless the same policy, there will be no abrupt shiftsin currency relationships.

The banking system benefits greatly from thismonetary policy of the central banks. Essentially,the financial conglomerates can take on debt atno cost and, at minimal risk (!), deploy a quantity-based strategy to earn generous revenues effort-lessly. Those who still have some clearing up todo can get on with it calmly, and everyone elsecan return to the habitual frivolities of excessivebonuses and political arrogance.

And what of Dubai? And the further billions ofwrite-offs that Dominique Strauss-Kahn, the Di-rector of the IMF, recently said would be requiredin the global banking system? Well muddlethrough, see-sawing between hope and fear; fromtime to time some institution with deep pockets,such as the Abu Dhabi Investment Authority, willstep in to prevent a return to the acute phase ofthe financial crisis. The Western nations, heavilyburdened by the consequences of the financialcrisis, will begin to come to terms with their newlevels of debt. As nominal interest rates will con-tinue to be low, debt servicing will remain feasi-

ble. The continued inflation of the central banksbalance sheets will mean that the necessary


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treasury auctions will be able to be held relativelyunproblematically.

No doubt about it: this normal scenario repre-sents a continuation of the developments in 2009,

in the direction of a somewhat better future. Itdoes not seriously contradict the current devel-opment of stock market prices, and nor are thelow returns on bonds unjustified with an L thatis not heading upwards too sharply.

4. Scenario II: the blood-red abyss

The rising price of gold and the rapid increase incredit risk premiums for national finances in thewake of the Dubai crisis are the first signs of aninexorable spiral that will end in the downfall ofthe Western industrial nations, in the abandon-

ment of their function of ensuring order internallyand externally, in a chaos of increasingly illusion-ary promises made to the various social groupswithout the capital to honour them, in greaterprotectionism and an inclination towards expro-priation, and ultimately in violence. Abyssus ru-ber, a blood-red abyss brought about by the radi-cal increase in the already almost hopelessly ex-cessive level of debt in the USA, Japan, theUnited Kingdom, Germany and other Europeancountries, in the wake of the financial crisis.

The additional debt turns out to be essentially

unproductive, as it only serves to maintain thenotoriously inefficient structures in the financialsystem, to cement in place the sinecures providedfor the big financial conglomerates by the implicitstate guarantee, and to perpetuate the distortionsin the real estate sector and the short-term savingof face in industrial policy (car manufacturers!).

Political errors, particularly on the part of theUSA, aggravate the situation in that, on top of thealready existing reservations about Americasdebt situation, measures are taken that increas-ingly deter foreign capital from financing US

debt. The Foreign Account Tax Compliance Actof 2009, on top of the already extremely off-putting plans to reform the Qualified Intermedi-ary system, and together with the inclusion underAmerican inheritance law of tax liability for for-eign holders of American securities, with highrates of progression, begin, slowly but surely, toerode the basis on which America is financed.The US dollar comes under increasing pressure,not least as powerful voices in the country, suchas the bond expert Bill Gross and the stocks guruWarren Buffett recommend greater diversifica-tion. At a certain point in the erosion of the cur-

rency, and under the impact of a crash on thebond markets the creditworthiness of statedebtors is no longer accepted globally the

Americans are obliged to raise interest rates atthe worst possible moment.

Meanwhile, the world as a whole is seriously dis-appointed by the way the economy develops.

What had been described as stabilization at a lowlevel turns out to be merely a plateau on the edgeof the next abyss. The stimulation packages forcar manufacturers and home owners turn out tobe expensive flashes in the pan in fact, mistakeninvestments. The US real estate market falls by afurther 20 percent, and General Motors finallyceases production. In Europe, the medium-sizedcompanies, which had managed so well during thefirst phase of the crisis, are seriously wrong-footed, as they had just started to ramp up pro-duction. Given their already stretched financial

situation, bankruptcies are inevitable. Politiciansbehave erratically, pressure from the street onbusiness grows, and results in many cases in out-breaks of violence.

The guiding light of 2009, the Peoples Republicof China, experiences in 2010 one of its most dan-gerous internal crises. As American imports dryup, large, labour-intensive enterprises have to beshut down; it proves impossible to absorb thehordes of unemployed workers elsewhere inChina. The result is social unrest, which increas-ingly threatens the tender shoots of an emerging

middle class. Uncertainty settles like a leadencloud over the Chinese colossus.

And so on. Theres not much fun in outlining thefuture Armageddon in the style of a pulp novelist.But seriously: can all this, and even worse, reallybe dismissed out of hand? A Russian futurologistrecently forecast the collapse of the USA and thepossibility that Russia might get Alaska back.Apart from the notion that Sarah Palin mightthen one day become President of Russia, suchscenarios often appear to be little more than irra-tional fantasies. The thing is, the history of the

world is full of such irrational courses of events.So, in our view, it would be unwise to devote toolittle attention to the consequences of suchblood-red abysses. They do exist; indeed, his-torically speaking, there is little else. And there isthis:Abyssus abyssum invocat one mistake leadsto another. Proverbs, too, belong to the treasuryof mankind, along with myths and legends.

5. Scenario III: the East is golden

This story too starts with the rising price of gold.This rise is due to continuous, secret purchases ofgold by the central banks of India and China. In

part, the banks are interested in diversifying theexcessive currency reserves held in dollars, butthis is not all; they are also preparing for the


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launch of an Asian alternative to the US dollar asthe monopolistic reserve currency. Backing such acurrency with as much gold as possible is oneaspect; another is the preparation of a market for

Chinese treasury bills issued via the financialcentre of Hong Kong. For the Chinese, crasslyunderestimated in the West as mere copyists,have, as accurate observers and excellent econo-mists, realized why the euro has never been ableto win a position as a serious reserve currency:because it lacks a liquid market for risk-free pa-per. In Hong Kong, they have a versatile plat-form, oriented both inwards, in the interest ofinvestments in mainland China, and also out-wards, towards the global financial universe,which is well known to be thirsting after diversifi-cation possibilities for zero-interest Treasurybills have only a limited appeal.

The key eastern countries are currently enjoying arobust upturn. India, always characterized by astrong domestic economy, is successfully disman-tling significant internal trade barriers. With itsAnglo-Saxon legacy, it is increasingly coming torepresent a significantly more youthful clone ofEurope. The low level of debt enables Indiancompanies not only to keep pace with the currentwave of innovation, but at times to play a leadingrole in it.

After many years as the last bastion of real social-ism, bleeding its labour force dry and flooding theworld, and the USA in particular, with the cheapgoods they produced, China began in 2005 todistribute the national assets that had accumu-lated at the highest level of the state, by means ofenormously ambitious and extremely rapidlyexecuted infrastructure projects. The millions ofengineers, craftsmen and other workers areachieving a degree of private prosperity, andmoving upwards to form a sort of middle class.This middle class corresponds in size roughly tothe population of the USA or Europe. At thesame time, the Chinese are cautiously beginningto spin the strands of a social security network.The Chinese savings rate falls in parallel withthese developments: the Chinese have becomeconsumers. Growth, the only determinant of po-litical stability in China, enables the regime,nominally communist, but de facto an oligarchywith monarchical characteristics, to retain controlwithout significant problems.

Both neighbouring countries (Hong Kong, Tai-wan, South Korea) and those further away (Indo-nesia, the Philippines, Australia, New Zealand)

benefit greatly from the Chinese upturn and sta-bility in the east. The whole region orients itselfon the new reality of the shift in the global

balance of power. To what extent changes in se-curity policy occur, to reduce the dominance ofAmerica in this part of the world, remains, how-ever, uncertain.

Europe and the USA are battling with an eco-nomic double dip. The economy collapses for asecond time in 2010, as the disadvantages to thewestern industrial nations of excessive state debtand overindebted social security systems becomemanifest. The forces of reform have not yet man-aged to regroup, however. Thus the new coalitionin Germany completely drops the ball playedthem by the electorate, and tries to force throughtax increases, instead of freeing the country andits citizens at last from the burden of excessivesolidarity. The President of Americas halo has

long faded; the hoped-for leader has become amere cheerleader, no longer taken seriously byhis weary and shrinking public. The only compa-nies benefitting from the Asian boom are thosethat still had sufficient financial room for ma-noeuvre after the first phase of the recession, andthat were able to get sufficient finance for theirinvestments from the banks.

For one thing has become clear. Not only has theeconomic geography of the world changed; therecession of 2008/2009 has also unleashed a fur-ther technological revolution. There is no sector

and no market in which the same products canstill be manufactured or distributed with the samestructures. From car manufacture to energy gen-eration, the media and financial services; it is theflexible, quick-acting market players that havegained ground, while the old dinosaurs at bestsuffer and decline.

6. Undecided

Which story do you find most appealing? Thethird, because it oozes optimism and belief inprogress? Hang on a minute have you given anythought to your own personal situation in such ascenario? Have your children already learnt Man-darin? Have you come to terms with the relative and indeed, absolute reduction in Western eco-nomic activity? And already said farewell to theprospect of benefitting from a social insurancesystem based on growth? Have you adjusted yourlifestyle to the foreseeable reduction in your as-sets? And what about your financial investmentportfolio? Is the new world adequately repre-sented in it? Has your advisor taken account ofthe need for greater financial power in his stockselection? How do you intend to deal with the

end of the US dollar as the only reserve currency?Abyssus ruber, the blood-red abyss we none ofus want that! But, because it is conceivable,


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should we not at least take some precautions, soas not to be entirely unprotected should the worsthappen? Not easy, for it might develop into eithera deep depression or inflation hyperinflation,

even. The responses in terms of investments arecontradictory: in the one case, liquidity is the bestremedy; in the other absolutely not. Furthermore,the blood-red abyss scenario almost inevitablyinvolves expropriation and possibly physical dan-ger; the possibilities for individual precautions areseriously limited. Where to live will be a questionof the utmost importance. Switzerland, with itscitizen-based society (and the resulting limitationson politicians ability to take extreme actions) hasbeen able to get through comparable historicalabysses. But would it be able to do so this time?Would Dubai or Singapore be alternatives? Orrather, New Zealand?

Almost inevitably, we come back to the normalscenario; the continuation of what we know,although we also know that this is not what willhappen. It takes a great deal too much, perhaps till one reaches the point at which one is readyto give up the comforting warmth of the familiar.This is understandable, particularly when it con-cerns real issues such as where to live, or where tolocate a company or a factory. For the costs ofpacking up and moving are enormously high, andthe degree of uncertainty in the new location mayalso be high. Physical presence is a long-termproject, and we are well advised to measure thesustainability of locations in global historicalterms.

Things are different with the most mobile of allassets, financial assets. Assuming that we do notwish to squeeze the last farthing out of the assets(or need to, on account of our situation), we arefairly free to invest on a scenario-oriented basis.This affects, for example, the question of wherethe assets shall be managed from. The variouslegal systems in the world are reliable to varyingdegrees in regard to attacks on private property.It is worthwhile studying history here. In additionto pogrom-like expropriations, there is also awide range of types of fiscal confiscation, as wellas the possible threats from an excessively elabo-rate legal system with too many greedy lawyersand arbitrary courts. Should it look more likelythat the world is heading towards the worst-casescenario, we would urgently advise a review of thegeographic aspect of asset management. Diversi-fication across various legal systems might wellnot be a bad idea.

Those measures that can be taken at portfoliolevel are a good deal less expensive. We regardthe possibility that the world will turn, so to

speak, so that the Far East will gain in economicimportance, but also that Latin-American coun-tries, Brazil or Chile, will become more signifi-cant, as relatively likely. It will be necessary to

reflect this development in the investment ofassets. In doing so, it will be important not toinclude the new markets indiscriminately in theportfolio, as they are mostly still fairly illiquid andparticularly subject to waves of enthusiasm anddisillusionment. Here in particular, it will be nec-essary to pay special attention to the question ofsustainability.

Withdrawal from familiar, and often successfulinvestments in the declining industries of theWest will be harder. But it may often not be nec-essary particularly with regard to the stocks of

internationally well diversified companies. Thegeographic diversification effect of the stocks ofBASF, Holcim, Nestl or Royal Dutch Shell isconsiderable. Things look different with fixed-interest securities, however. Bonds, often re-garded as a safety component, are very oftenissued by semi-state enterprises whose businessmodels may be questionable over the longer term:certain German provincial banks for instance, orsome utilities. Their economic performance isoften poorly diversified geographically, and theyare entirely dependent on their political environ-ment. They would seem to be threatened underall three scenarios. The safety component in theinvestment assets thus requires consideration, notleast as interest rates are so low that capital gainson these positions are no longer really conceiv-able. We suspect that their nominal value belongsin Talebs fourth category.

Gold? Without at all wishing to give way to thetemptation of backtrading that is, makingunfair reference to a successful past recommenda-tion we must come back to our position in 2006.We then recommended holding a strategic posi-tion in gold, to the tune of 5 to 10 percent of thetotal assets, for a rainy day, so to speak. Wesuggested possibly keeping it in a separate portfo-lio, so as to ring-fence it from future investmentdecisions. We stand by this, despite the far highercurrent price of gold. Gold and, as a logical exten-sion, our real-value portfolio (Realo), are a formof insurance, and should be understood, and han-dled, as such. Its not their value that counts, buttheir presence.

_______________

Feyerabend described the requirement to decide

between scenarios, or even just to allocate themprobabilities of occurrence, as barren. WithMandelbrot and Taleb, we now know that this is


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not only barren but can be wrong and stillwrong even if everyone does it in the same direc-tion. Dispositions based on these (and other con-ceivable) scenarios cannot be definitive. Marko-

witz Optimization is replaced by concepts thatdeliberately incorporate inefficiencies and re-serves. Methodological pluralism leaves its traces.Our profession as advisors in this jungle of sce-narios, possible measures and various intellectualmodels, will become vastly more demanding thanit was.

One final reference to the black swan: the pos-sibility not entirely to be dismissed of totalpersonal catastrophe. As mentioned, Feyerabend

had an answer: What matters is having a fewfriends around thats all. Which may well bewhy, over the thousands of years of human his-tory, people have created times of the year at

which attention can be paid to this last insurance,friendship. In this spirit, we wish you all a happyfestive season.

KH, 7.12.2009

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