The Global Flags

It's no good just writing scenarios. You have to supply the flags that would suggest you are moving from one scenario to another. Moreover, as the flags go up or down, you must adjust the probabilities that are assigned to each scenario. This means continually assessing the changes in the environment around you 24/7.

For example, in late 2006 the world was still firmly in the 'Long Boom' scenario on the right of the global gameboard illustrated below:



But we identified one flag that - if it rose - would signify the end of the boom. The flag was a decline in asset values in the US, particularly property and equities. Our reasoning was that American consumers were borrowing more to spend more and the only reason they could borrow more was because they were worth more. If their assets started diminishing in value, that game would come to an end.

Furthermore, since American consumers are two-thirds of the US economy and the latter is 30% of the world economy, a halt in consumer spending in America would precipitate a global 'Hard Times' scenario (pictured on the left of the above gameboard). In January 2007, the official US property index started falling and, by mid-year, with that flag half up we were giving a 50% probability on a shift from 'Long Boom' to 'Hard Times'. When the stock market turned later in the year, we upped the percentage to 80%. By December 2007, we were saying to clients that, according to our analysis, 2008 would most likely be a horrid year.

Indeed it was, and the globe moved firmly into the 'Hard Times' - classic recession -scenario the like of which has not been seen since the early 1980s. We missed the flag of toxic debt, but our motto is: "it is much better being vaguely right than precisely wrong".

So what are the scenarios and flags now? There are two exits from the 'Hard Times' scenario (see diagram below). The first is a recovery along the lines suggested by Ben Bernanke and Barack Obama where green shoots will proliferate in the remainder of 2009 and lead to a mild recovery in 2010.



By 2011 we'll be back in the game but it will be a new game that we call 'New Balls Please'. Credit will not be as easy to obtain as it was in the 'Long Boom'; banks will be more heavily regulated; the East will be the economic equivalent of the West (a historic moment bearing in mind that the West has dominated the global economy since 1400); and a new technology will propel the new game, probably around new energy sources and energy savings given the importance of addressing the issue of global warming.

The flag for this scenario is a continuous improvement in US property prices over a period of at least three months. Another clear flag would be a drop in the US unemployment rate. Neither flag has risen as yet, but commentators are already talking about a bottoming-out of the property market, while the monthly figure of jobs lost is now declining. We therefore accord this scenario a 60% probability despite no clearly visible positive signs. Some of you reading this article may vote for a lower figure, but this is the whole point of our methodology - to get people debating not only the selection of the flags but also their estimate of each scenario's probability.

The second exit from 'Hard Times' is a much more sinister scenario called 'Perfect Storm', which is also depicted on the above gameboard. It is a protracted recession or depression resembling a 'U' rather than a 'V'. The 1930s was an obvious example, but in a way Japan has been in a similar scenario since 1990. It is sobering that the Dow Jones Industrial Average only recovered its peak before the 1929 crash in 1954. Likewise the Nikkei is still around 25% of its December 1989 peak.

We have four flags to indicate the approach of a 'Perfect Storm'. The first is the intensification of protectionism in the form of trade barriers that would fragment the global market a great deal more than we see today. The second is a major war to stop nuclear weapons ending up in the hands of terrorists - or, if they do, a nuclear strike on a Western city as envisaged in our letter to Mr Bush in June 2001. Obvious candidates for a war are Iran, which has nuclear ambitions, and Pakistan, which already possesses nuclear warheads. Whichever, it would be much larger than Iraq and sorely test America's already overstretched budget. Bad economic times make for a divisive world; Hitler would never have ascended without the Depression. Moreover, North Korea is once again a problem.

The third is a national bankruptcy of note. We have already had Iceland, but if a European Union member goes down (e.g. Hungary, Poland or Ireland), the event would severely disrupt the international monetary system. The fourth is a meltdown in China where the halving of the economic growth rate triggers widespread social unrest, possibly causing a switch from outward-looking to inward-looking government policies. China becomes a brake instead of an accelerator on the world economy.

None of these flags is flying at the moment, but the probabilities of one rising in the near future are growing. At present, we accord a 40% chance to the 'Perfect Storm', which is significantly up on the odds we were giving at the beginning of the year.

There is also a hybrid scenario where we have a V-shaped recovery, but it proves to be a 'False Dawn'. The flag is an increase in the American inflation rate without any reduction in debt during the recovery process. As interest rates rise to compensate for the higher inflation, so do the loan defaults (yet again) and we have a repeat of the present recession. Only it is a much deeper one. Consequently, the flags that differentiate 'New Balls Please' from 'False Dawn' are a significant decline in America's total debt-to-GDP ratio and a decline in its household debt-to-income ratio. If pressed, we would split the 60% probability of a 'V' outcome equally between these two scenarios.

To summarise then, we give a 30% chance to a long-term sustainable recovery, a 30% chance to a short-term (say 5-year) recovery followed by another crash, and a 40% chance to no recovery at all. We hope this informs people sufficiently to calibrate the size of the bet they are prepared to take as a proportion of their own individual wealth or the wealth of their companies. It's all about weighing up the impact of each scenario in terms of the potential for profit or loss and then, on the balance of probabilities, deciding on a strategy which matches your risk profile.

Good luck, watch the flags and be prepared to adapt your strategy if the probabilities change (or a new scenario emerges). No other approach can handle the sheer unpredictability of the future and the volatility of the markets today.





The South African Flags

The hedgehog approach to the future is to try and project it in a single, expertly derived forecast. If and when the 'expert' forecast proves wrong, it is belatedly amended. Foxes, on the other hand, hold multiple scenarios in mind; and as the future unfolds, they gradually adjust the odds they give to each scenario. This involves far less shock and horror because whatever happens, it is usually captured in one or other scenario.

Moreover, as the odds on the scenario change, foxes modify their strategy accordingly - whether they are running a business, investing money in the market or taking someone out on a first date. It involves a continuous evaluation of the signs and possibilities and, where something really unexpected happens, immediately incorporating the event into the scenario mix.

The steps are straightforward. First, identify the scenario that you are actually in at the moment. Second, look at the possible pathways that could lead to the other futures and convert them into plausible scenarios. Third, select the flags that would suggest you are moving from the present scenario into the other ones. Fourth, based on whether these flags are up or down (or at half-mast), assign relative probabilities to the different future scenarios. Then, on a balance of evidence in front of you, survey your options and make the most appropriate decision.

Each scenario should be a unique, internally consistent narrative that requires its own special response from you as a player. Foxes work out the best response beforehand so that they know what to do if the scenario materializes. They can then adapt faster than their competitors to the new circumstances.

Let's apply this process to the possibilities for South Africa in light of the country's 2009 General Election (and against the backdrop of the global economy in recession). We have been in the 'Premier League' scenario, shown on the gameboard below, since 1994 - the year of our first truly democratic election. For most of the time since then, we have resided in the middle of the league, which is where we should be. We are not a Manchester United (about to beat America, Japan, Germany and China). We are more like a West Ham or Manchester City.



Nevertheless, according to some global surveys, we have lost considerable ground in the rankings, which puts us perilously close to the 'Relegation Zone'. Reasons given are that violent crime is driving talent out of the country; HIV/AIDS is shortening the lifespan of the average South African; our infrastructure is showing signs of disrepair; and some of our industries (such as our textile industry) are looking distinctly uncompetitive compared to Eastern players.

Given our current predicament, there are three alternative scenarios (all shown on the gameboard above). The first one is that we get relegated to the 'Second Division', where the bulk of the Third World resides - poor but peaceful. Companies will still make money (as they do in plenty of Third World countries); and they will always have the option of extending their geographical footprint into other African countries, or even overseas.

By contrast, for the Government the scenario is an unmitigated disaster because they can't change clubs! Certainly their tax revenue will be a whole lot less than they received when they were in charge of a Premier League nation; and they won't have the same access to international capital. Altogether it makes the perfectly honourable maxim of 'a better life for all' seriously harder to achieve. The flag for this scenario is that we disappear from the 'A' list according to an increasing number of internationally accredited surveys.

The second scenario is 'Failed State' into which the principal flag for entry is widespread political or criminal violence. Examples of countries either in or on the border of 'Failed State' are Somalia, Pakistan and Iraq. Nothing trashes a national brand like violence. The world turns its back on you.

The peaceful nature of the 2009 elections in South Africa means that the current odds on this scenario are negligible. It is more like a cautionary tale. This leaves the third scenario that South Africa returns to the middle of the Premier League - comfortably outside the 'Relegation Zone'.

There are three flags associated with this scenario. The first one is inclusive leadership. The last thing that South Africa ought to be in the global 'Hard Times' scenario is a divided team. Inclusivity means on the one hand keeping the rich minority - who have the capital and a fair measure of skills - on side; but also creating the opportunities for the marginalised poor to become part of the mainstream economy. In other words, it's a delicate balancing act, and it's reassuring that Jacob Zuma has made inclusivity central to his initial presidential theme.

The second flag is to show tangible results in rectifying the problems that have caused South Africa's recent slide in the Premier League. This has nothing to do with ideology on the Left or the Right, and everything to do with back-to-basics management. The best way for South Africa to raise this second flag is for all of us to recognise the pockets of excellence that exist in our midst and then benchmark other similar organisations against those pockets of excellence.

For example, while there are many complaints against service delivery in the public sector, there is one world-class Government department - the South African Revenue Service. It is as good as any revenue collection service in the world. All other departments should be benchmarked against the excellence of delivery of SARS. In the health sector, a pocket of excellence is the Red Cross Children's Hospital in Cape Town. It shows that a properly managed state hospital can combine state-of-the-art equipment with medical care for children only obtainable at the best hospitals in Western capital cities.

The third flag is about the evolution of a dual-logic economy consisting of an outward-looking economy that earns enough foreign exchange to cover the country's export bill (which is real issue since the current account deficit is around 7% of GDP); and an inward-looking economy that creates enough new jobs to make a dent on our appalling unemployment rate of 23,5%.

The success of the outward-looking economy revolves around choosing one's spaces carefully in light of how competitive the global economic game is. South Africa has three spaces where it can dominate: mineral and agricultural resources, but we need to add more value here before we export them (a pocket of excellence being our wine industry); tourism, which can benefit from our ability to host major sporting events; and playing the gateway role into a continent that is opening up for business. South Africa is the 'America' of Africa in that it produces 30% of the continent's GDP with a little less than 5% of the continent's population. Such a position confers huge competitive advantage in this particular trading space.

The success and inclusivity of the inward-looking economy will very much depend on the growth of small business in South Africa and overcoming the problem of a 'two worlds' economy. We have a First World formal sector and a Third World informal sector with virtually no linkage between the two. Yet a glance at the 'Premier League' reveals that the three countries that made it to the top fastest all began their ascent with an entrepreneurial burst of energy - Japan and Germany after the Second World War and China after 1978. They are now respectively the 2nd, 4th and 3rd largest economies in the world.

Family-owned businesses were a critical element in the lift-off. Consequently a flag that will demonstrate progress in this area will be the transformation of the micro-lending industry. Why not invite Nobel Laureate Dr Muhammad Yunus, who founded the Grameen Bank in Bangladesh, to be a consultant on what we should do here? A second flag comprises more generous tax incentives to compensate for the risk of starting a small business, e.g. offering a complete tax holiday on profit up to a cumulative total of R1 million and exemption from capital gains tax for investors in businesses below a certain size.

The odds that we give at the moment are 70% to a U-Turn in the 'Premier League' and 30% to being relegated to the 'Second Division'. This may sound optimistic to some; but we're probably out of the 'Relegation Zone' already, not because we've gone up but because the rest of the world has gone down. A positive flag is that in the 2009 World Competitiveness Yearbook, produced by the International Institute for Management Development, South Africa has risen to 48th out of 57 countries, compared to 53rd out of 55 last year. Reasons given include our resilience to the global financial crisis and our recovery from the rolling electricity blackouts experienced at the beginning of 2008. Indeed, our financial and insurance sectors have almost escaped the whole toxic debt tsunami unscathed; and we are relatively unencumbered by debt as a nation.

In addition, despite the dramatic decline in our GDP, we shall probably experience a shallower 'V' than Europe and the US. All these sporting events on our calendar act as an excellent gap-filler. On top of that, Zimbabwe has every chance of resurrecting its economy in the near future, for which we will act as a gateway. On the other hand, we have to make tangible progress in the areas where we rank lowest in the 'Premier League' - unemployment, brain drain, available skills, life expectancy/health problems, pupil-teacher ratios in secondary schools and organised crime!

In conclusion, we feel that South Africa is not a bad place to see out the global economic 'Hard Times', or even the 'Perfect Storm' if it looks like engulfing the world. Obviously quite a few young South Africans living overseas agree with us. They are returning home.





Market Flags

A three horse race

2009-07-30 12:20
Clem Sunter

In response to my last column about the history of making money on Wall Street, "Tuscanite" asked whether I could provide some scenarios and probabilities on the future of the market - specifically the Dow Jones Industrial Average. Here they are.

The DJIA Derby is a three horse race. The favourite to win over the next five years is "Hard Times", which assumes a U-shaped recovery for the global economy. In other words, things aren't going to get worse, but they are not going to get better either for an appreciable period. The magnitude of debt is the cause of the recession and all the US and UK governments have done so far is increase the size of the problem. It takes years for them to reduce their budget deficits (and total debt) to a reasonable proportion of GDP. Meanwhile, rising inflation will cause a hike in interest rates and that, together with higher taxes to pay off the government debt, will make a significant dent on any resurgence in consumer expenditure. All in all, the US and UK economies stutter between growth and stagnation.

This scenario parallels the one that prevailed from 1966 to 1982 when the DJIA oscillated between 700 and 1 000 on no less than five occasions. Likewise, in the foreseeable future, it will oscillate between 7 000 and 10 000 as a mixture of good and bad flags provoke greed and fear alternately among investors. In this type of market, the best strategy is to trade in and out of stocks and catch the highs and lows of the DJIA.

The second horse in the race is a young stallion called "New Balls Please" which has some heavy-duty punters such as Obama, Bernanke, Brown and Darling. The recovery is V-shaped and all the indicators start turning positive later this year. In 2010, the property market turns, car sales pick up and unemployment falls.

Nevertheless, it will be a new game requiring new balls. Firstly, credit will not be easy to obtain for a long time. Secondly, the banks will be more heavily regulated and will no longer be able to gamble depositors' money on the derivatives market. Thirdly, the East will catch up to the West and probably lead the recovery. Fourthly, a new technological wave will power the next boom, as the emphasis shifts from improving the flow of information to improving the use of energy and moving away from fossil fuels.

This scenario is equivalent to the one that America experienced between 1942 and 1966 when the war started turning in the Allies' favour. US government debt at the time was more than 100% of GDP and fell continuously thereafter on account of the acceleration of economic growth in the 1950s. The DJIA went up 10 times from 100 to nearly 1 000. The breaking news in "New Balls Please" is that the DJIA has already launched itself in an ascent to 100 000 and this is the perfect time to get in for a long-term investor.

The third horse is a sneaky outsider called "Forked Lightning". In this scenario, the worst is yet to come because of some unexpected shocks to global stability at a time when confidence and stability are already fragile.

The shock could be the eruption of a trade war between China and America/Europe, a military conflict over Iran's stated objective of developing a nuclear capability, swine flu turning really lethal or a national bankruptcy much larger than Iceland. The markets just plunge.

The reason for the name "Forked Lightning" is that in this scenario, the DJIA repeats its dramatic behaviour between late 1929 and mid-1932. It peaked in September 1929 at 381 before dropping to just below 200 at the end of November. It thereafter recovered to 294 in mid-1930 before free-falling to 41 in mid-1932 (losing 89% of its peak value). In modern times, the DJIA fell from 14 164 in October 2007 to 6 547 in March 2009 before recovering to its current level of 9 000. In "Forked Lightning", the DJIA would establish a new low (below 6 000) in the next couple of years. Hence, the best strategy is to be in cash and bonds.

So what are the odds on the three horses? At the moment Chantell Ilbury and I give a 60% probability to "Hard Times", a 30% probability to "New Balls Please" and a 10% probability to "Forked Lightning". Given the recent recovery in Wall Street, the market appears to be attaching higher odds to "New Balls Please" and a zero chance to "Forked Lightning". Let's say 50-50 "New Balls Please" to "Hard Times".

We differ with the Wall Street bookmakers because there are no positive flags fluttering in the breeze at the moment. Things are less ominous, but they're not looking up. In the end, you as the reader must make up your own mind and place your bets accordingly. Remember buyers and sellers have exactly the opposite scenario in mind when any transaction takes place on the stock exchange. That's why the investment game is so interesting!


The beauty of round numbers

2009-07-23 07:44
Clem Sunter

You are 10 years old, living in New York in 1916. Your father establishes a trust for you and puts in a variety of blue chip shares worth $10 000. He then whisks you off to the Amazon jungle because he is a keen botanist. You are essentially cut off from the world because you develop an interest in botany too while you work alongside him. All the dividends on the shares in the trust are remitted to you as living expenses.

Twenty six years later in 1942, you make your first return visit to New York and check up on the value of your trust. The lawyer who looks after it says that it is still worth $10 000, having risen to just over $30 000 in 1929 and fallen to $4 100 in 1936. You are relieved you missed the drama and are reassured that your trust still has its capital intact. Back you go to the isolation of the jungle.

In 1966, after another twenty four years you decide to celebrate your 60th Birthday in New York and ascertain the latest value of the trust. To your delight it has multiplied nearly ten times to close on $100 000. That makes you very happy as you trek back to the jungle for your final stint. You reflect on how different the result was for 1942 to 1966 compared to 1916 to 1942, despite the fact that the intervening periods were similar in numbers of years (24 versus 26).

Finally, you retire hale and hearty and come back to New York in 1982 sixteen years later. You pay a visit to the same legal firm expecting another substantial increase in the value of your trust. This time the lawyer has a resigned expression as he tells you that your trust has not appreciated at all. It is still worth about $100 000.

So in light of the fact that you have been a fairly successful botanist, having discovered a couple of brand new plant species and made a fortune out of one of them as a medicinal herb, you decide to leave the capital in the trust. At the ripe old age of 93, after seventeen years of luxurious retirement in Long Island, you think it is time to take one last look at your father’s trust. Lo and behold, its assets amount to $1 000 000 making you, as the sole beneficiary, a millionaire at the end of the millennium (or worth $66 000 in 1916 terms).

Even though your father has been dead for a long time, you want to give him a hug for reaching this important milestone. Once more, you can’t help noticing that the two periods, 1966 to 1982 and 1982 to 1999, were similar in length (16 versus 17 years).

The morals of the story

So what are the points you should take away as an investor?

  1. I specifically chose these years on the grounds that they mirror the behaviour of the Dow Jones Industrial Average – the blue chip benchmark of Wall Street. At some time in 1916 it was 100, in 1942 100, in 1966 just shy of 1 000, in 1982 1 000 and in 1999 10 000. That is the beauty of round numbers: you remember them.
  2. These figures show that capital appreciation on the stock exchange goes in waves. When some financial adviser smoothly says to you that if you hold shares for long enough, you are bound to win over other investment options the answer is: it all depends on when he says it. The long run can be very long if you get the timing wrong.
  3. Right now we are ten years into a period of no capital gain similar to 1916-1942 and 1966-1982. The DJIA after zigging and zagging is still below the 10 000 level established in 1999. Obviously, you could have made money if you were a shrewd trader like Goldman Sachs, but for normal mortals it is a risky business.
  4. The good news is that the DJIA at some stage will begin a long-term ascent towards 100 000, ten times the current baseline of 10 000. The bad news is that the beginning of the ascent (when it crosses 10 000 on the way up for the last time) may take place at a much later date than the market gurus are currently suggesting.
  5. A hundred times your money in 83 years sounds a lot, but expressed in compound growth rates the result appears quite modest. For the record, between 1916 and 1999 the botanist’s annual capital growth on his portfolio was 5.7% in nominal terms and 2.3% in real terms (after allowing for inflation of 3.3%). Based on historical charts, his annual dividend yield would have averaged around 4%. Nearly two-thirds of his overall monetary gain from the trust was therefore attributable to the dividends that he consumed over the years on living expenses.

This shows just how important yield is in the scheme of things.




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