The year 2008 was a remarkable year in the capital markets. The S&P 500 Index, which posted its worst year since 1931, was only one of many disappointments, as virtually all risky asset classes produced breathtaking losses. Hedge funds failed to hedge (not to mention that one fund had pulled a $50 billion fraud for the ages). The strategies of many of the best active stock pickers of the past two decades massively under-performed the plunging indices. Confidence in anything—for institutions and individuals alike—vanished. More than anything else, 2008 proved to be the exception to many of the investment "rules" once thought to be cast in stone. In this issue, we review this extraordinary period through the dual lenses of our global tactical asset allocation (GTAA) and Fundamental Index^® strategy focus areas with an eye toward the future.

Global Tactical Asset Allocation

The challenges and opportunities facing asset allocators were self-evident in 2008. Over the past 12 months, most asset classes experienced their worst returns ever or, for those with a long enough history, since the Great Depression years of the 1930s. Indeed, this misfortune fell on 10 of the 16 key asset classes we closely follow.

Within this overall dreadful 12-month stretch were three distinct subperiods as shown in Figure 1: the conventional bear market of January through August, the "take no prisoners" market of September and October, and the "sorting through the carnage" market of November and December.

In Stage One, the first eight months of 2008, in contrast to the later blood-letting, fully 7 of the 16 asset classes managed to post positive returns. Among those that escaped losses were Treasury Inflation-Protected Securities (TIPS), emerging market bonds, commodities, and core bonds. None of the equity categories produced positive returns; losses ranged from -3% to -22%. An equally weighted portfolio of these 16 assets classes would have returned -2.2%—a loss, but hardly a debilitating impairment of capital.

Then came Stage Two, the September/October 2008 crash, which changed the picture drastically. Simply put, these two months were a Take-No-Prisoners market. All 16 asset classes fell. That had not happened before in any single month, let alone any two-month span in the past 20 years. Furthermore, the losses were astonishing: 13 of the 16 asset classes lost more than 10%, and half lost more than 20%! For 12 of the 16 asset classes, their performance was the worst two-month stretch of performance in the past 20 years or more. From TIPS to emerging market equity, asset classes were devastated. The benefits of diversification and relative value decisions were a no-show.

This lockstep free fall had a remarkable effect on most asset allocation strategies. Students of Markowitz's efficient frontier can tell you that the diversification effect is mathematically captured through the correlation coefficient. In the 20 years ending 2007, the average cross-correlation of the 16 asset classes was 0.27.[1] In 2008, the average more than doubled; for the year, these assets were highly correlated at 0.58.[2] And, during the take-no-prisoners market, the correlation often seemed to approach 1.00!

But September/October opened up the door to recoveries in November/December 2008. Crises bring opportunities. Indeed, the global meltdown of fall 2008 produced, in our opinion, severe price dislocations in several markets. Many areas of the bond market sold off more relative to their historic risk profiles than equities did. Markets that were "four sigma events" for stocks were "eight sigma events" in other markets. Some categories appeared to be pricing a deep depression, whereas equities were pricing only a moderate recession. Consider the following:

• Emerging Market Bonds. On October 24, 2008, the spread offered by emerging market bonds over U.S. Treasuries was 9.6%—the widest spread since the 11.6% witnessed in the Long-Term Capital Management sell-off of August 1998. What makes this immense risk premium remarkable is that the asset class is now 60.3% investment grade, whereas back in 1998 it was only 10.8% investment grade![3]
• TIPS. By the end of October 2008, the 20-year TIPS yield was 1.39% lower than the nominal 20-year Treasury yield on October 27, implying an annual inflation of 1.39% for the next two decades. Such a level of inflation has not been seen since 1926-1945, an era encompassing five years on the gold standard, followed by the Great Depression and World War II!
• Convertibles. Driven by the severe unwinding of the entire convertible arbitrage hedge fund strategy, the Merrill Lynch Convertible All Qualities Bond Index fell more than the S&P 500 during the September/October implosion. Granted, the conversion features were essentially worthless, but these securities are still bonds that carry all of the benefits of being higher in the pecking order in the capital structure!

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