Sunday, July 5, 2009

Can We be Independent?

We have just celebrated Independence Day to commemorate that brave band of Americans who have declared their independence from, at that time, the most powerful nation in the world. On late night cable on July 4th the film “1776” was broadcast. The plot centers on the days of wrangling that went on among the delegates to the Continental Congress. Until the final day, there were not enough votes to pass the bill. What is quite clear is that this remarkable group of men chose to lead rather than merely represent the popular will of the people. As investors do we have the wisdom, courage and fortitude to declare our own independence? Just like those earlier patriots we are facing a tyrant. At that time the tyrant was not just the King of England, but the tyranny of experience. The American Revolution had no historic precedent; no people’s revolt had ever created a new nation.

As investors we have suffered mightily from a sharp decline in market prices. More importantly, the world has gone through an economic devastation. The tyranny that we are now facing is the normal reliance on experience. We are looking at the events of the past as just another cyclical series with the thought that we will rise once again to the former heights. I, for one, doubt it. What was quite clear from the American Revolution, was there would be deaths and other casualties to our lives and to the ways that our society and economy worked.

Before we put too much weight on our ability to order the future, we need to remember, as with all wars, the losing side contributed more mistakes than the winning side. Luck was with us in the sense that the storms off Newport, Rhode Island kept the superior British Fleet bottled up, rather than doing battle with the French Fleet. Thus, Cornwallis could not evacuate his losing army from Yorktown and had to surrender to the forces commanded by the indispensable General George Washington. This was the last major battle of The Revolution, but it took two more years before a peace treaty was signed. What Americans in general (and investors in particular) did not appreciate was that the “peace party” in Parliament at the time was gaining the upper hand, and wanted the war ended, for they had better things to do with their resources.

How should we learn from the American Revolution today as investors? First, do not hold up a mirror to the past cycles. Though we can still learn from sound principles from the past in terms of risk management, they will be broader than in the past. Second, look for changes in structure in both the world economy and in the market place. We have seen the rise of sovereign wealth funds and the expansion of central banks, which could be the tyranny of new attempts at central controls. We have already seen the disappearance of floors of securities exchanges in favor of electronic exchanges, which will operate from the ether, domiciled in the least regulated locations. We are finally close to getting some of the derivatives, (e.g. credit default swaps) clearing through a series of central clearing houses. Finally, within a relatively few years, we will see new leaders arise who will be much better equipped to manage themselves, their own activities and perhaps even governments. Just as the leaders of the American Revolution succeeded through the much more difficult task of writing a Constitution and creating a new form of government, we may see new groupings of people, not based on location but rather their own particular interests.

In looking to a brave new and frightening new world, we may have to get rid of old ways of thinking. For instance, the so-called “prudent man rule” has been the foundation for courts and learned investment opinion since it was handed down by a Massachusetts state court in 1830. The case questioned whether Harvard College was managing its endowment properly. Judge Putnam ruled against Harvard, by defining prudence as what other intelligent people did with their own money. (Seems as if Harvard has a slow learning process.) Despite this definition of prudence, we could be entering a period that new and thoroughly thought-out investment policies should be followed. For example, is the legal form of an investment as important as the predictability and terminal value of a security? Thus, we may find that compartmentalizing a portfolio into stocks, bonds, funds, and various forms of illiquid investments is not as important as the variance of future year-by-year returns, expected or tolerated. Another consideration that may come increasingly important is the evolving body of corporate and civil law, e.g. stipulating the priority position of senior secured bond holders or the imposition of “gates” on hedge fund redemptions, etc. Will changes in estate taxes alter the motivations and valuations of various investments in public and private securities? The list of examples is far from complete. The purpose of these radical, perhaps not revolutionary, ideas is to indicate some of the range of changes that should guide us to seek a new way of thinking.

In the end, tyranny of all forms is self-defeating, as it can never for all times be complete. Eventually the unknowns become known, which some people identify early enough to survive, and in some cases prosper.

Be alert, and share with us what we should be seeing.

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