There was a lot of talk at IMCA's 2010 New York Consultants Conference about whether Modern Portfolio Theory (MPT) and the Efficient Markets Hypothesis are dead, wounded or still functioning after a swoon. How do you regress to normal returns–meaning companies must start to grow again–after a severe, sudden contraction of the economy that cannot recover to previous levels of growth until jobs are robustly being added? According to Nouriel Roubini, the U.S. needs 150,000 a month just to sop up new talent–that doesn't count re-employing the 25 million unemployed or underemployed in the U.S.
This may sound overly simplistic but, if a primary driver of our economy is consumption, at around 71% of GDP, and those 25 million people are not consuming they way they did before, and employed consumers are still reticent to spend, fearing they, too, will lose their jobs–then where would the growth in corporate earnings come from that would make securities prices regress to the mean, that is, upward?
Andrew Lo opened his talk at IMCA in January by asking, "Who needs a hug?" After all, the assembled 800 or so brokers, investment advisors, executives and journalists, most of whom had heard Nouriel Roubini, the New York University's Stern School of Business economics professor, speak about the potential for a double-dip recession and "anemic" recovery. Even as he began to impart his thinking about the difficult lessons of the past two-and-a half years, Lo was a bit more upbeat than "Dr. Doom,"–as Roubini is frequently called–conveying to the assembly the "Creation Myth of Financial Professionals: In the beginning (1964), Harry Markowitz and Bill Sharpe said, 'Let there be beta,' and it was good."
In addition to his role as Chairman and Chief Investment Strategist at the quant investment management firm AlphaSimplex Group, LLC., Lo is the Harris & Harris Group professor of finance at MIT's Sloane School of Management and director of MIT's Laboratory for Financial Engineering.
As he began his talk, Lo pointed to "Gaps in traditional wisdom," and literally blasted away the traditional portfolio theory in his presentation, complete with startlingly loud bomb blast noises and accompanying pictures. "We got hit by the mother of all financial dislocation." He spoke compellingly about his theory that the investment thinking that is the bedrock of investing is not irrelevant–but incomplete. More diversification is necessary.
