Fall of the Super-Rich – A Lesson in True Diversification? Read This New York Times Article

Editor’s Note: This is an article about issues discussed on financial television and in newspapers. This is not an investment article and no one should base any investing decisions or conclusions based on anything written in or inferred from this article. Investing is a serious matter and all investment decisions that should only be taken after a detailed discussion with your investment advisor and should be subject to your objectives, suitability requirements and risk tolerances. .

This week we came across an interesting article in the New York Times titled Rise of the Super-Rich Hits a Sobering Wall. This is an informative and analytical article that is a must read for many reasons. 

The article writes that “over the last two years”, the Super-Rich in America “have become poorer. And many may not return to their old levels of wealth and income anytime soon”.

It discusses the possibility that American Society might be on the verge of a structural change in income patterns. The most pithy quote is from Neal Soss, the Chief Economist at Credit Suisse who says “We have had a period of roughly 50 years, from 1929 to 1979, when the income distribution tended to flatten…Since the early 80s, incomes have tended to get less equal. And I think we have entered a phase now where society will move to a more equal distribution.”

What caught our attention is the comment of John McAfee, the founder of McAfee Associates, the anti-virus software company. The article describes how Mr. McAfee became worth 100 million dollars in the boom and how, due to the fall of his real estate and stock investments, his networth is now reduced to $4 million. 

Why did this happen and how did Mr. McAfee get hurt so badly? According to the article, Mr. McAfee got caught off guard by the simultaneous crash in real estate and stocks. As he said “I had no clue that there would be this tandem collapse”.

Mr. McAfee is not alone or even in a minority. We have no doubt that the majority of Americans, not just the Super-Rich, believed that Real Estate would provide a diversification from Stocks and vice versa. In fact, this was the professional advise provided by the majority of Financial Advisors in America.  Look at Mr. McAfee himself. The article states that Mr. McAfee “typically chose his investments based on suggestions from his financial advisers”.   

Of course, there were prescient Wall Street Strategists who warned against the perils of assuming diversification when in reality the asset classes were highly correlated. Richard Bernstein, then of Merrill Lynch, wrote a research piece in February 2008 titled “Uncorrelated” Assets are Now Correlated.

This boring sounding piece was one of the most significant pieces of research we read in 2008. It made the case that the rally in what are called “risk assets” had changed historical correlations during this decade. 

  • Bernstein pointed out Real Estate had become much more correlated to stock prices than in the past. 
  • He showed how physical assets like Gold and Art had gone from a negative correlation (meaning art & gold used to go up when stocks fell) to a positive correlation (meaning gold & art falls when stocks fall).
  • He also showed how hedge funds had become highly correlated with US stocks. According to Bernstein, the correlation between stocks and hedge funds had risen to 90% positive correlation in January 2008.
The consequence? When stocks fell sharply in 2008, hedge funds fell sharply too. The Super-Rich who had been overly invested in Hedge Funds lost an enormous amount of money and so did University Endowments like Harvard & Yale.

Bernstein also showed that Long-Term US Treasuries had gone from a +37% correlation in February 2000 to a -54% correlation in January 2008, a change of 91%. This would mean that US Treasuries could rally dramatically when stock prices fell sharply. That is exactly what happened in the second half of 2008.

Bernstein’s conclusion was that investors should look at bonds and cash as powerful diversifying assets. Had Mr. McAfee or his advisers followed Bernstein’s advise, Mr. McAfee would be a richer and a happier man today.

CNBC provided the same advise to its individual investor viewers that Wall Street advisors provided to their clients. During the boom years of 2003-2008, CNBC Anchors lauded the returns available from “risk assets” like US & European Stocks, Emerging Market Stocks, Commodities and Art. We recall that CNBC Anchors used to suggest investors diversify their assets but the diversification they suggested was into Foreign stocks, Commodities and Gold. At the same time, CNBC Anchors almost continuously derided investments in US Treasuries choosing to hype the fears of hyper-inflation. Clearly CNBC Anchors chose to not read Bernstein’s article.

Is it surprising then that the average American Individual Investor went in to the horrible 2008 crash loaded up in US Stocks, Emerging market stocks, Commodity ETFs and without the protection of US Treasuries? 

Like Bernstein of Merrill, there were smart, astute investors like Mort Zuckerman who told CNBC in 2007, as we recall, that “his assets are mainly in US Government Bonds and that is why he sleeps soundly”.But, Mort Zuckerman’s prescient comments were drowned out in the din of CNBC’s ebullient coverage of global growth & global liquidity and the stocks that benefit from it.

This is why we began writing about CNBC’s negative coverage of US Treasuries in August 2008 with the question Are CNBC Anchors on a Mission Against US Treasuries?

To our regret, not much has changed in CNBC’s coverage of US Treasuries since that article. Our “Friends N Fun” CNBC Anchors simply cannot bring themselves to speak well of Treasury Bonds. Then this week, CNBC imported an Australian Anchor who promptly became the lead singer of the CNBC chorus*. Is this global diversification CNBC style or another case of highly correlated views?

* See clip 10 in our article Interesting Videoclips of the Week (August 16 – August 22)

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