1. Since it is so incredibly difficult to make predictions and properly discount future assumptions, it seems to me one key is flexibility. People talk about the inherent advantage of the institutional investor, be it a pension fund, mutual fund, insurance general account, etc., because they have access to types of vehicles or securities that Average Joe investors do not. However, what is rarely discussed is the complete lack of flexibility that institutional investors face. The cost to transition hundreds of millions of dollars between asset classes is not insignificant in most cases, so flexibility becomes something that may be ideal but is absolutely not feasible.

2. Because institutional investors are lumbering (see #1 above) and generally have medium-to-long term time horizons, agency theory comes into play here as well. Investment management shops obviously want to cater to the huge institutional dollars, and what types of strategies tend to play the biggest role in any asset allocation? Large Cap US Equities. How can a manager make the most money for himself? By managing Large Cap US equities and employing a low turnover approach, thereby incurring fewer transaction costs and thereby having higher capacity to manage even greater and greater sums of money. But in order to manage that type of strategy, you inevitably end up making fairly explicit forecasts about what the future holds and then discounting back to present. While that strategy has worked reasonably well for a few asset managers, it tends to be more of an on-again, off-again type of approach that has little predictability and repeatability in terms of performance. BUT it makes the asset managers more wealthy than if they employed a more flexible approach that had more limited capacity…and therein lies the agency rub.

I’ll stop my rambling now.

So, that A rated bond or ‘classic’ growth stock may not grow to the sky in a straight line.

This is one of the problems I have with projections out 20-30 years. The path of growth is not linear- as you point out. Regards.

Robert Samuelson wrote a book called The Great Inflation and it’s Aftermath. http://tiny.cc/z9H9V

Basically you can explain a great deal the US stock market history of the 40 years by the spike in interest/inflation until the mid 80′s and the subsequent decline. Since you need an interest rate to value any cash flow, the decline in interest rates made all cash flows more valuable.

The thing that is odd and sort of ties this together is the last year. After interest rates crossed the 4% level things started blowing up. The amount of debt that can be financed at 3% to 4% is enormous. That is, as everyone knows, on of the root causes of the housing bubble. Anyway, starting last year, treasury interest rates continued to decline and all other rates went through the roof.

I was looking at this chart yesterday. _ http://tiny.cc/eCZzF The interesting thing to me was that when the system blew up, treasury rates continued to decline and all non guaranteed debt rates went through the roof.

Most of this is obvious and everyone knows the reasons. The one thing that seems novel is thinking of this as the continuation of a very long secular trend — or secular cycle. I don’t want to get overly political, but the decrease in inflation/interest in the 90′s to the present was a function of productivity/technology and Foreign/Chinese imports. Anyway, one effect of these policies was a huge rise in asset values, especially in the FIRE (finance, insurance, real estate) sector of the economy at the expense of our industrial and manufacturing sectors. This was also a redistribution of wealth from the rust belt to the coasts.

It is much more complicated then the hand full of influences I mentioned, but the one thing i haven’t seen discussed a lot is the connection of the current catastrophe to the long term decline in inflation/interest rates since the mid/late 1980′s. If you think about it, declining interest rates increase the value of financial assets and are an enormous tailwind for finance. I suppose if you had just looked at the curve, it would have been obvious that the trend couldn’t continue. Prior to the blowup, there were lots of people financing long term assets with short term, low interest rate liabilities. That was a big part of the basic playbook for structured finance, hedge funds, etc.

The reason that the yield spread exploded is well known. Here is a snippet from Irving Fisher. http://capitalvandalism.blogspot.com/2009/01/deflationary-spirals.html