We're not out of the woods yet: David M. Darst

With his experience at two of the largest Wall Street banks, David Martin Darst, a Managing Director of Morgan Stanley, is well placed to explain the crisis in the US financial markets (Darst was also with Goldman Sachs). Chairman of the Asset Allocation Committee and Chief Investment Strategist of the Global Wealth Management Group, Darst is an authority on asset allocation and has authored books on the subject. One of his recent works, The little book that saves your assets, has been acclaimed as an encyclopedia on asset allocation strategies. On a recent visit to India, Darst met BT’s Rachna Monga. Excerpts from an exclusive interview:

Q. If individual and institutional investors pick up The Little Book That Saves Your Assets now, it would have brought them solace. What are the lessons to be learnt from the current crisis?
A. The recent crisis reminds investors of few things. It’s time they understand their own investment temperament. Some investors have patience but some of them also panic. It’s difficult to understand your own temperament, which takes time and patience. Another big lesson for investors is the need for diversification across asset classes—a judicious spread of assets across stocks, bonds, hedge funds, cash and real estate; and also the need for rebalancing across (such) asset classes.

The market environment in India and elsewhere has reminded investors about the need for portfolio protection through other asset classes such as options, cash, and managed futures, which are non-correlated. Institutional investors are like individual investors working fulltime. For them the biggest lesson is the need to stick to basic principles and learn the importance of simplicity. Sometimes institutions tend to think that with the help of resources they can get involved with complex strategies. Although some of the best institutions like Harvard, Yale and Stanford use sophisticated manoeuvres, they are also interested in keeping the complexity under control and keeping things simple and comprehensible.

Q. What could be the impact of the US Federal government’s bail-out of mortgage finance giants Fannie Mae and Freddie Mac, on home buyers in the US and on investors in these institutions?
A. The Federal government realised that we are in a global world and it’s important to protect the interest of foreign investors. Of course, one of the major reasons (for the rescue) is to protect the US housing market. But another big reason is to protect foreign investors and the integrity of the capital market. These institutions have a large number of investors from Asian countries like China, Taiwan and Japan and Russia. In 2007, China’s investment in these institutions was around $376 billion and Japan held $229 billion till 2007, making the two countries the largest investors.

The Treasury Department had been getting calls from worried investors in these countries and the Treasury Secretary said “we need to take action”. So, to me, it’s another step towards globalisation of the dollar, the capital market and integrity. For home buyers in US, we hope that by stabilising the two main buyers of mortgages, the mortgage rates, which haven’t really come down despite the Fed rate cuts since last year, will begin to come down. It has started happening over the past two days as rates have gone down a bit. The mortgage rates is just one of the problems in the US housing market. The (main) problem is the excess supply in relation to demand. Today, there is double the normal amount of houses in “inventory.”

Q. So, is the worst over for the US economy?
A. We would know the worst is over when three things happen. First, when house prices stop going down. Second, when the credit markets cool down—interest spreads between treasury and bank bonds have to narrow down and more credit needs to be disbursed by banks. Third, the profit estimates for US companies have to come down. We think US companies will grow in profits by 5 per cent but the consensus is that profits will grow 25 per cent, which is too unrealistic. So, we need to see the forecasts come down.

Q. Do you see Wall Street banks scaling back their Asian operations as a part of their restructuring exercises?
A. The whole industry sees Asian countries such as India, China, Japan, Korea, the Philippines and Malaysia as a marvelous growth opportunity. Our management has told me that, in a very controlled, healthy and gradual way, they would like to significantly expand the Asian operations. I think the whole industry is also interested in doing the same. But is it possible if everyone thinks so? The growth opportunities are huge. Over the next 40 years, India will add 697 million people, which is almost a 62 per cent growth. It took 2,000 years to grow one India and it will now take 40 years to achieve that growth rate. To put it in perspective—Europe has almost 700 million people, so you can say India will add another Europe in the next 40 years. It’s a big positive.

Q. In May, you were among the few who had a bearish outlook for US stocks, terming the rally in stocks as a classic bear market playbook. What’s your view now?
A. We don’t think we are out of woods yet. It’s important to play a defensive and offensive strategy. So, we still have a conservative, defensive posture. We would like to see more visibility on the issues of housing prices, credit markets and jobs.

Q. We would like to see the job losses—almost 70,000 a month—coming down.But how much of this pain will have to be borne by the rest of the world?
A. After several years of rapid growth across economies, we are slowing down. Our study of economic growth and inflation pattern during a 47-year period shows that whenever the US goes into recession, other economies such as Europe, Japan and emerging markets tend to follow. Now, we see the US getting towards the bottom and others are behind us. There are two ways a recession can spread—financially and economically. The financial impact would be felt through the tighter credit markets and loan write-offs. The economic impact will be the slowdown of exports to the US, which is not happening in a big way yet. But a strong dollar may start hurting exports in future. We are seeing the financial impact as central banks are tightening interest rates because of inflation worries. To my mind the biggest worry is protectionism and inflation because protectionism slows down global trade and inflation hurts valuation of stocks and bonds.

Q. Large investment houses in the US are advising investors to increase allocation to foreign stocks. But you seem to have a view that this may not be the right time to increase exposure to foreign stocks. Why is that?
A. It’s because of the possibility of other countries following the US into recession that we are underweight on foreign stocks over the short term. We like non-US stocks over a longer term. We have equal weightage on developed Asian economies and emerging markets as of now.

Q. So, how are you advising your clients to allocate their assets?
A. We are telling them to keep more than the usual cash component and be underweight on bonds. The interest rate outlook is uncertain and we are never going to have perfect certainty about it. Our recommendation for cash allocation is much higher than the normal cash component in a portfolio. And we have an underweight recommendation for bonds and are slightly underweight in stocks and alternative investments (or hedge funds).

Q. Do you think asset allocation will play out more since the US is headed towards recession, whereas that is not the case with other stock markets across the world?
A. Equities all over the world are beginning to behave in similar fashion and are showing higher correlation with each other. Therefore, in equities, you need to find diversification across sectors and not just countries. It doesn’t do any good to own technology stocks or bank stocks, let’s say, across Taiwan, Korea and India at the same time. These sectors across countries may get impacted by similar global factors such as software-purchasing agreements or by interest rates.

Q. What is the case for Indian investors to diversify abroad? Which markets have an opportunity for upside? 
A. Indian investors need to find sectors that do not exist in India. If you look at the Morgan Stanley Capital International (MSCI) emerging market index weightage, India doesn’t have a high weightage in sectors such as consumer staples and consumer discretionary sector (apparel & leisure, hotels & restaurants etc). So, investors should consider diversification through sectors and not just through countries.

Q. One chapter of your book deals with behavioural aspects of investing. Being a practitioner, how tough it is to keep the biases away when it comes to actual investment decision making for your clients?
A. It’s difficult to do so because anything to do with behaviour or psyche has a certain magic, enchantment, fear and greed attached to it. These are very ancient feelings in all of us. We can go to the moon or to the bottom of ocean but it’s so difficult to get insight into one’s psyche, heart or soul.

That’s why I say in my book that you need to have a guru or an Uncle Frank who knows you better and can tell you when you make mistakes. I have two gurus who happen to be my long-time friends. I can bounce off my investment ideas to them. They don’t necessarily know about it in detail but they know me, which is more important. So, if they find anything stupid, they tell me straightway. I turn to them when I am overly depressed or overly optimistic.