As a Trustee of the Fraser Institute, Canada’s leading public policy think tank, I'd like to share with you a new study they recently released.  This new report, Economic Freedom of the World: 2011 Annual Report, measures the degree to which policies and institutions of countries are supportive of economic freedom.

The annual peer-reviewed report uses 42 different measures to create an index ranking of 141 countries around the world based on policies that encourage economic freedom. The cornerstones of economic freedom are personal choice, voluntary exchange, freedom to compete, and security of private property. Economic freedom is measured in five different areas: (1) size of government, (2) legal structure and security of property rights, (3) access to sound money, (4) freedom to trade internationally, and (5) regulation of credit, labour, and business.

Canada scores higher than the United States in this current report, but Canada now scores lower than it did a year ago. Many European countries also scored lower, reflecting the results of regulatory responses to global debt crises. These scores are important because measures of economic freedom year to year show the immediate and long-term consequences of regulations on the health of a nation's economy. Economic freedom is of critical importance for a number of reasons. It leads to greater investment, higher per-capita incomes and growth rates; it leads to less poverty and fosters improvements in the general living conditions of a society; it encourages cooperation, tolerance, and peaceful relations; and it leads to entrepreneurial business activity, which is the opposite of political allocation and crony capitalism.

I trust you will find this report of interest and I hope that you will share it with others who are concerned about the state of economic freedom at home and abroad. The Fraser Institute provides a useful public service: reporting objective information about the economic and social effects of current public policies, and offering evidence-based research and education about policy options that can improve the quality of life for all Canadians. The Institute is a non-profit organization and relies on charitable donations and research grants. You can find additional research from the Institute on a wide range of topics at www.fraserinstitute.org.

Economic Freedom of the World: 2011 Annual Report.

As Yogi Berra aptly put it, “It’s like déjà-vu, all over again.”  ‘If leverage got us into this problem, then more leverage will get us out of it,’ seems to be the logic of U.S. Treasury Secretary Tim Geitner and others with ‘iBank’ experience.

The latest idea to save Europe is to take the properly sanctioned EFSF asset base of roughly €440 BN and leverage it to over  €2 TN to effectively recapitalize European banks and bailout the entire Garlic Belt plus Ireland.  While I studied finance at university, I did not stick around to get a Ph.D., but perhaps I should have when it comes to how this would actually be “effected.”  One version involves the European Investment Bank (“EIB”) - when you need a lot of leverage and a lot of really smart people to do it, who better to call than the structured products dudes at an ‘iBank’?  Unfortunately, this effort is doomed because the 4 biggest backers are Germany, France, Italy and the UK.  The Italians, I suppose, might go for a CDO squared punt, but the UK would certainly not put its AAA rating on the line for this project.  So forget the EIB idea. 

A terrific blog post by Macro Man, has put forward another version of the same idea as shown in this complicated chart below:

Don Coxe's Strategy Journal is always a must-read for me. Coxe has the incredible gift of being able to distill decades of market experience and knowledge of history and the arts, into a thoughtful, prudent and sensible investment strategy.

His latest September 16th release is a wonderful example of his process. In particular, he tackles an issue that has enormous importance for many readers of this blog - a strategy for dividends.

Coxe has tweaked his model by adding dividend stocks to the fixed income component of his recommended asset allocation. He recommends "bullet-proof", dividend-paying stocks. That is, those that not only have good dividends, but also have a history of solid dividend growth. His initial allocation is 10%. Companies like Bristol Myers, Johnson & Johnson, Walmart etc. are these types of firms. Somewhat controversially, Coxe is not fond of stock buybacks especially in today's environment. On buybacks, he states:

"The justifications used for such programs are inherently contradictory: they are said to be returning money to stockholders, but they actually give funds only to those who want to sell their shares. If the companies also have generous stock option schemes for top executives, the programs could easily be construed as being, at least in effect if not in design, cover-ups about the real cost of such dilution, and as extra enrichment to the insiders by financing the purchase of their low-cost shares at higher prices. Dividends go only to those who choose to remain as partners in the enterprise. Stock buybacks go only to those who want out-in whole or in part-or those who are selling the stock short."

This, in most instances, makes sense to us.

His rationale for the dividend strategy is predicated on taking a 5-year view (a "private equity" approach). Do not worry much about the market-to-market volatility - which will be hard for individuals. He implicitly references the 1950s when pension funds valued their equity more on dividend streams to better match long-term assets and liabilities. Back then, dividend yields were higher than government bond yields, but that was a function of the belief that equities were inherently more risky and so they should pay out more. A lot has changed since then - tax policy of income versus capital gains and importantly, executive compensation (especially stock options). He suggests that company CEOs promoting dividend growth will attract a new investor class. In some respects, it reminds me of the income trust model once offered in Canada; the pitch was implicitly that it is not management's money so give it back to the shareholder - of course without the tax angle!

Ultimately, Coxe argues that it is the breakdown of the Capital Asset Pricing Model ("CAPM"). In this model, the "risk-free rate" is assumed to be government bond yields - those yields are now best described as "return-free risk". The Efficient Frontier that many allocators use to create and optimize portfolios based on CAPM are now inherently much more risky. This is compounded by the role of central banks in manipulating these yields that makes adapting one's investment policy to these new realities a necessity. Given the big sell-off this morning, now might be a decent time to start accumulating positions in these companies.

Jim McGovern

P.S. Given the wild state of markets today, you should also read Mr.Coxe's view on gold and his idea for government's use of their gold reserves - very intriguing!!

If you are an investor who prides him- or herself on bottom-up stock picking and prudent sector diversification, you must be frustrated.

That frustration is a function of extremely high correlations across and within equity sectors. Of course, you expect some correlation as factors like interest rates, commodity prices, etc. have directional impacts on markets generally. But since the 2008 credit crisis, correlations generally have been stubbornly high. The average correlation between S&P 500 sectors has jumped from 68% in June (when we thought it finally was going to fall in earnest) to 90% today - greater than the levels seen in the 08/09 credit crisis!

Source: Scotia Capital (Sept. 15, 2011)

This market feature is frustrating for both long-only and long/short funds. For long-only, the idea of diversification as a "free lunch" is mitigated along with the concept of being a "stock picker". For long/short or paired strategies, this state of affairs is equally frustrating as the "spread" remains stubbornly wide and is often quite "irrational".

So what can you do?

Interestingly, high equity correlations are also often correlated (not necessarily a causation) with high equity volatility. The VIX is the standard measure of equity volatility and, as the chart below shows, is also very elevated. Both the VIX and correlation indices are indicating that macro factors are driving the bus when it comes to returns. In the alternative space, this has managers like Arrow accessing higher than normal allocations to macro and trading strategies. The critical difference is that these strategies will involve varying degrees of bias, but ultimately they are designed to profit from volatility and correlation. Unfortunately, for inexperienced allocators, the macro space also has the highest dispersion of returns across managers - one has to use a special set of criteria when selecting this type of manager.

In the Arrow Maple Leaf Fund, which allocates to Canadian-based managers, Garrison Hill is one such manager. Michael Yhip recently noted that "This market has proven that you need to have managers that have the ability to invest in all markets, long and short and be able to deploy and withdraw capital very rapidly in order to make money. In addition, managers need to be capable of fundamental macro analysis in real time. Performance of our strategy will not be a function of just our market views, but also on our ability to interpret changing events and trade effectively. This market demands trading strategies".

We agree wholeheartedly.

Jim McGovern