What a difference a century makes. As the 19th century segued into the 20th, Carl Sandburg (1878-1967) wandered the country as a hobo. His personal experience of the gap between the rich and poor instilled in him a distrust of capitalism. After a stint in the Spanish-American war, Sandburg worked as a fireman by day and wrote poetry by night as a member of the Poor Writers' Club. Later, as a man with a family to support, he penned labor columns for the Chicago Daily News, honing his now legendary writing skills as well as his socialist views. In 1914 he published the famous "Chicago Poems" which celebrated the "course and strong and cunning" workforce of this city, which was:

Hog butcher for the world,

Tool maker, Stacker of wheat,

Player with railroads and the

nation's freight handler;

Stormy, husky, brawling,

City of the big shoulders.

Sandburg would scarcely recognize the sophisticated Chicago that hosted Undiscovered Managers' fifth annual Wealth Management Symposium in June. A long walk north of the Loop, the Gleacher Center of the University of Chicago School of Business nestles comfortably among gleaming office towers and posh hotels in a manicured section of this modern city. Several generations removed from the stockyards and steam engines of Sandburg's burly industrial city, golf-shirted, middle-aged portfolio managers filed past portraits of the university's Nobel Prize winners to attend lectures on the state of the capital markets.

Warnings Abound

The first three invited speakers offered, each in his own way, a sober view of the prospects for returns on capital over nearby years. Jeremy Grantham, chairman and chief investment strategist of Grantham, Mayo and Van Otterloo, presented reams of data supportive of his conviction that markets are not "basically efficient over time" and that one can profit from understanding that we live in a "mean-reverting" world.

Grantham says that professionals are too optimistic in expecting equity returns going forward to be 6% plus inflation. The spring rally left stocks 32% overvalued at 24 times 10-year real earnings; so he expects a nominal equity return of slightly less than 0% over perhaps seven years! The 20% rise in stock prices this spring is, he says, just a whopper of a bear market rally, in part reflecting the re-election dance of a popular President.

We must keep in mind that when the price of any asset rises faster than its long-term return, its expected future return necessarily tumbles. If a price doubles from its fair value, its future return is halved. Under the theory of regression to the mean, this inefficiency is usually corrected via a price change.

Efficient market theorists also miss the boat, according to Grantham, when they assume that high risk (especially when defined as high volatility) is rewarded by high returns. He displayed a chart dividing stocks into deciles according to their beta since 1965; the three highest beta deciles had the three worst returns relative to the market. Grantham concludes that you are rewarded for paying attention to value, and that high volatility actually penalizes performance.

Always on the lookout for opportunities to profit from market inefficiencies, Grantham currently sees relative value in international stocks, particularly the small-value category. In the United States, "small value" seems a much better buy than the large-cap universe. His GMO Global Balanced Fund is 20% underweighted in U.S. equities. In fixed income, they are 11% underweighted in traditional bonds and overweighted in "Other Fixed Income" instruments, such as Treasury Inflation Protected Securities (TIPS) and currency-hedged foreign bonds. In true "mean reversion" portfolios that permit it, they are short Japanese government bonds and the S&P 500.

John Brynjolfsson heads Pimco's Real Return Bond Fund. His presentation was titled, "Are We Sitting On The Dock Of A Deflationary Cliff?" In commenting on the state of the markets, he pointed out a number of realities that will weigh on economic growth and diminish vendors' ability to raise prices:

Rising taxes to support increased government activity, especially the rising cost of the social safety net.

Excess productive capacity all over the industrial world.

The need for companies to increase funding for pensions. (Their current return expectations of more than 9% are unrealistically high.)

Relentless incursion of China into developed countries' markets.

Aging populations, with their increased need and propensity to save.

Very heavy debt burdens of businesses, governments and consumers.

Brynjolfsson concludes that the United States is at the edge of a deflationary cliff; one false step, he says, and down we go. Because the consequences of a deflationary spiral are so awful, the Federal Reserve Bank has chosen re-inflation as the lesser of two evils. The Pimco strategy folks believe that the transition from 20 years of disinflationary policies to a reflationary future will be a long and bumpy road. They expect that monetary policy will be as easy as it needs to be for as long as it takes. Ultimately they believe the Fed will succeed-hence the attraction of TIPs as a defense against the prospects of a return to inflation. (Principal payments on TIPS are indexed to the CPI.)

Like Grantham, Brynjolfsson referenced the P/E ratio for ten-year "normalized" earnings on the S&P 500. In referring to that index as the "Pension Industry Standard Bearer," he noted that despite the three-year bear market it is still priced at an extreme, just under the 1929 levels. In raising the likelihood of continuing P/E compression, his chart also showed that downtrends of this nature have historically tended toward a full standard deviation below normal before a trend reversal got underway. His summary advice to investors is to work longer, save more, spend less and invest with a bias to preserving capital complemented with "smart risk plays." In other words, business as usual is not a winning strategy for the current environment.

Doug Noland, financial markets strategist at David W. Tice and Associates, was the symposium's third Cassandra. He manages the financial sector short positions for the Prudent Bear Fund. Noland's talk was "A Bubble Waiting To Burst, or Why The Bear Market Is Not Over Yet." He maintains that consumption in recent years has been artificially inflated by fiscal and monetary stimulation. Loans are being extended without appropriate credit controls, leverage is at unprecedented levels and speculation is rampant in equities, bonds and real estate. The credit bubble, Noland feels certain, will end in tears.

The essential reason that credit has gotten out of control, says Noland, is that lending is no longer dominated by the regulated banking system as it had been for generations. In that environment, leverage was limited by law and excesses were self-correcting (loan defaults reduced a bank's reserves which reduced its lending capacity). The explosive growth in the last 25 years of a poorly regulated securities-based credit system loosed an unlimited supply of lendable funds. Because of this distortion, the demand for loans seems to have lost its influence on interest rates; debt has doubled in the last five years while interest rates have plunged. The economy has become so dependent on consumer loans that the Federal Reserve is actually hostage to the system's need for liquidity; by accommodating the credit bubble for fear of unleashing a deflationary decline in demand for goods and services, it is only making the credit bubble worse and its future consequences more drastic.

Our present asset-based lending system is self-reinforcing; swelling credit drives up the market price of assets, which permits greater loans. Freddie and Fannie are classic examples. It is an "anchorless system," Noland maintains, and once it has gathered momentum there is no way to stop it until it explodes.

Will the Fed successfully turn us away from the deflation threat? It is impossible, says Noland, for the Fed to generate inflation that is more or less evenly spread over the economy. Some sectors will see inflation (health care, education, natural gas, homes in California) while others will suffer deflation (manufacturing, technology, homes in Dallas). The dollar will continue to weaken because the credit bubble is worse in the U.S. than elsewhere; hence we will suffer commodity inflation and we will import inflation in manufactured goods.

Our real economy (output of goods and non-financial services) is just not competitive in a global sense. The Fed is helping increase the global supply of dollars in the face of a shrinking demand for them; eventually we will have to exchange goods for goods (eliminate our trade deficit) which could be the beginning of the end of the Fed's dangerous game. Noland recommends (in addition to his fund) avoiding dollar exposure and being long in high-quality foreign bonds and gold. For reams of charts and data, see www.prudentbear.com.

Does Anybody Care?

You remember Cassandra from Greek mythology. She had fantastic powers of prophesy and accurately foretold many calamities. But Apollo was jealous of her, so he arranged that anyone who heard her predictions would not believe them. Hence, they succumbed to every disaster despite her timely warnings.

I was reminded of this curse of Apollo during afternoon breakout sessions at the Undiscovered Managers Symposium. Each group of about a dozen attendees (mostly independent portfolio managers/financial planners) were encouraged to share in an informal setting how they were receiving the presentations and how the information might or might not influence the way they were structuring client portfolios. I only experienced one of these groups, since they were conducted simultaneously, so my observations may not be reflective of the larger group experience.

Nevertheless, for what it is worth, I would note two impressions from the group of which I was a part. First, how little we discussed the material presented by the featured speakers; the impression I got from participants was that this was gloomy and depressing stuff, hence nothing one would want to dwell on. And second, that these well-paid portfolio managers seem to have altered their style very little since before the bear market began three years ago.

I heard a consensus developing around the idea that stocks are the asset class of choice for the long run and the recent 40% plunge in large-cap prices was more or less the sort of noise a professional advisor must put up with from time to time. The advisor's real job, they seemed to agree, is to keep clients from bailing out of equities in a bear market so they can enjoy the long-range benefits of a 60% to 80% exposure to stocks; 50% was considered "very conservative."

Another consensus was a general fear of any style that smacked of "market timing." Most even shunned "tactical allocation" strategies, other than perhaps to slightly favor small-cap or value in the hopes of edging out an index benchmark. There was a great deal of concern about style drift, a dislike of "concentrated" equity funds as poorly diversified and a religious avoidance of long-term bond maturities. In general, it seemed to me that the advisors I met with were concerned about neither inflation nor deflation, recession nor slow growth, high valuations nor the possibility that the U.S. stock and bond markets might be inhospitable for the next few years.

Complacency Or Discipline?

Grantham listed some core beliefs of modern investment professionals that he believes helped set the stage for bubble pricing in stocks and bonds and that help explain why this condition persists despite continuing economic malaise:

Benchmarking

Career risk/momentum

Belief in market efficiency ("Fama Effect")

Stocks always win (Siegel effect)

Anti-market timing (Ellis effect)

These convictions were certainly evident in my breakout group; a fervent adherence to a working assumption that "the market" will continue to reward broadly-diversified, high-equity-allocation portfolios with returns of 7% plus inflation over time, and that one wanders from the prescription at one's peril.

Compared with the raucous nature of free-market capitalism in Sandburg's industrial Chicago, it struck me that there was something unnatural about the calm disdain accorded the speakers' data and their assessments of economic and market risks. Maybe in the 100 years that separate the old stockyards from this upscale academic setting the capital markets have really become gentrified. Maybe because so many workers are now also owners of capital, the struggle between wages and profits will be orderly and polite. Or could it be that the efficient market theory has lulled many of us into a false sense of security, a complacency of the well-fed. Are we so comfortable, wrapped snugly in our academic theories, that we don't notice that the temperature is dropping and the wind is picking up?

Is it the personal advisor's job to maintain a disciplined 70% equity allocation appropriately balanced across the style box and wait for stocks to win in the long run? Or is it to do our best to understand the interplay between the economy and securities prices in the public markets and make judgments designed, for example, to help retirees maintain their lifestyle with real returns on their accumulated savings?

I think I'll go down to the library and see how things turned out for Cassandra.

J. Michael Martin, JD, CFP, is president of Financial Advantage in Columbia, Md.