Table: One Year Asset Class Valuation Conclusions and Recent Momentum

The following table sums up our conclusions (based on the analysis summarized in this article) as to potential asset class under and overvaluations at the end of September 2009, over a one year time horizon. Note that over views on valuation over a longer-term time horizon sometimes differ from our short-term views. As we repeatedly note, when discussing asset class valuation (or any forecast, for that matter), being specific about the time horizon is critical. Our longer term valuation views are contained in the Global Asset Class Valuation Analysis section of each month's journal.

We believe that asset prices reflect the interaction of three broad forces. The first is fundamental valuation, as reflected in the balance between the expected supply of and demand for returns. The Global Asset Class Valuation Analysis of each month's journal contains an extensive discussion of fundamental valuation issues. One of our core beliefs is that while asset prices are seldom equal to their respective fundamental values (because the system usually operates in disequilibrium), they are, in the medium and long-run strongly drawn towards that attractor.

The second driver of asset prices, and undoubtedly the strongest in the short run, is investor behavior, which results from the interaction of a complex mix of cognitive, emotional and social inputs - the latter two comprising Keynes' famous "animal spirits". We try to capture the impact of investor behavior in each month's Market Implied Expectations Analysis, as well as in two measures of momentum for different asset classes - one covering returns over the most recent three months (e.g., June, July and August), and one covering returns over the previous non-overlapping three month period (e.g., March, April, and May).

The third driver of asset prices is the ongoing evolution of political and economic conditions and relationships, and the degree uncertainty that prevails about their future direction. We capture these longer term forces in our economic scenarios.

The following table summarizes our current views about current prices compared to fundamental valuation estimates over a one year time horizon. Specifically, we reach conclusions about whether different asset classes appear close to fairly priced (in which case our rating is "neutral"), or whether they are under or overvalued.

The extent to which we believe over or undervaluation to be the case is reflected in the confidence rating we assign to each conclusion. We believe it is extremely important for the recipient of any estimate or assessment to clearly understand the analyst's confidence in the conclusions he or she presents. How best to accomplish this has been the subject of an increasing amount of research (see, for example, "Communicating Uncertainty in Intelligence Analysis" by Steven Rieber; "Verbal Probability Expressions in National Intelligence Estimates" by Rachel Kesselman, "Verbal Uncertainty Expressions: Literature Review" by Marek Druzdzel, and "What Do Words of Estimative Probability Mean?" by Kristan Wheaton). We use a three level verbal scale to express our confidence level in our valuation conclusions. "Possible" represents a relatively low level of confidence (e.g., 25% -- 33%, or a 1 in 4 to 1 in 3 chance of being right), "likely" a moderate level of confidence (e.g., 50%, or a 1 in 2 chance of being right), and "probable" a high level of confidence (e.g., 67% to 75%, or a 2 in 3 to 3 in 4 chance of being right). We do not use a quantitative scale, because we believe that would give a false sense of accuracy to judgments that are inherently approximate due to the noisy data and subjective assumptions upon which they are based.

An exception to this approach is our assessment of the future return to local investors for holding U.S. dollars. In this case, our conclusions are mechanically driven by interest rate differentials on ten year government bonds. To be sure, the theory of Uncovered Interest Rate Parity, which calls for exchange rates offsetting interest rate differentials does not often hold in the short-run, as the apparent profitability of the carry trade has shown (i.e., borrowing in low interest rate currencies to invest in high interest rate currencies). However, other research has shown that a substantial portion of these profits represents compensation for bearing so-called "crash" risk (see "Crash Risk in Currency Markets" by Farhi, Fraiberger, Gabaix, et al) -- as many who were long Icelandic Krona in 2007 and 2008 learned the hard way.

Our fundamental valuation estimates over a one year time horizon, as well as recent momentum, are summarized in the following table. We stress that these conclusions represent our assessment at a given point in time, which implies no forecast as to when any over and undervaluations will be reversed. Indeed, before such a reversal occurs, current over and undervaluations could actually become more extreme. That said, common sense suggests that more extreme situations are more likely to be recognized and reversed. An example of this would be a situation in which an asset class was deemed likely or probably overvalued, but where momentum data indicated an accelerating increase in prices. As so many authors have noted throughout history, trends that can't continue don't continue. Finally, conclusions about potential price reversals also have to be seen in the longer term context of the likely evolution of future political/economic scenarios and their implications for asset class valuations and investor behavior (see, for example, our monthly Economic Updates). This is also an important input into investment decisions, as we do not believe that the full implications of these scenarios are typically reflected in current asset prices and investor behavior.

| Table: Market Implied Regime Expectations and Three Year Return Forecast | Uncorrelated Alpha Strategies Detail | Global Asset Class Returns | Table: One Year Asset Class Valuation Conclusions and Recent Momentum | Market Phase Change Risk Analysis | October 2009 Issue: Key Points | October 2009 Economic Update | Product and Strategy Notes: Challenges Facing Investors in Venture Capital Funds; Improving Warning of Future Financial Crises; A New View on the Fundamental Drivers of Equity Market Returns; and The Long-Term Impact of the 2007-2008 Crisis on Financial Advisers' Compensation | Feature Article: Equal Risk Weighted Portfolios in 2007 and 2008 | Global Asset Class Valuation Updates Detail | This Month's Letters to the Editor: Oil and Gas Partnerships - Do they fit in your portfolio?; What's the best Asset Allocation Today; Is it Possible to Over-diversify a Portfolio?; PIMCO Heavy Weighting for Emerging Markets, II's thoughts?; Timber Followup |