Sunday, January 28, 2007

Financial Globalization’s Pluses and Minuses

``We can chart our future clearly and wisely only when we know the path which has led to the present." - Adlai E. Stevenson (1835-1914)

When we talk about financial globalization, we talk about greater accessibility to financing, a deepening of capital markets, a broader scope of risk-sharing capabilities, a wider base of asset ownership, more array or selections of financial instruments, and increasing profile of financial markets, participants and institutions. And these have been unfolding right before our very eyes.

Just to give you a short clue, market participants today includes the emergence of the “sovereign funds” class or public institutions assigned by national governments to allocate sections of their excess reserves into the global asset markets. In other words, public funds have now morphed into quasi-hedge funds which now compete with private funds for the same purpose, to generate “ALPHA” returns.

I have shown you how closely correlated the movements of our markets have evolved with that of our neighbors or with global benchmarks. And in such context, as much as the benefits accrue, the risks have been increasingly interrelated or shared.

To quote IMF’s Managing Director, Rodrigo de Rato in his recent speech (emphasis mine), ``In the last decade, the global integration of capital markets has become even deeper. As a result, both the benefits of free trade and free capital flows and the risks associated with volatile capital movements have increased....We have learned that shocks in the financial sector can spread quickly to other sectors, and that the interlinkages between sectors must be taken into account.”

In today’s world where capital markets greatly overwhelm the exchange of goods and services, it is of no doubt the principal role played by the financial sector.

And it is on similar grounds, where as an Asian bull, I believe trends towards the “financial globalization” theme will drive the region’s assets (including the Philippines) over the LONG RUN to unprecedented heights;

>mounting trade surpluses which represent the wealth shift phenomenon,
>outsourcing and offshoring signifies a shift of the manufacturing capacity or increasing trends of industrialization,
>per capita convergence or the rising middle class,
>intensifying regionalization trends or lesser dependence on a single market or source of finance,
>growing consumer class,
>beneficiary of the science and technology revolution,
>favorable demographic trends,
>faster growth rates
>growing supply of skilled labor and
>rising productivity

Yet, in the face of these substantial auspicious circumstances, the Asian economies have not been adequately supported by its financial markets which are largely fragmented, underdeveloped and over reliant on the traditional banking sector as source for financing as shown in Figure 1.

Figure 1: IMF: Asia Underdeveloped Markets

The 2006 outperformance of the Philippine Phisix (+42.29% in local currency) and Indonesia’s JKSE (+55.3% in local currency) could be due to the extremely low levels of Market Capitalization relative to GDP, which in 2004 represented 34 and 30% respectively.

And this is one of the reasons why the present global structural imbalances thrive; Asia’s surpluses continue to be recycled into US assets, which tacitly supports the highly indebted US consumers as manifested by the exploding trade deficits, simply because its capital markets do not have the depth and sophistication to absorb all these excesses surpluses. And this will nonetheless change.

According to IMF’s Agnès Belaisch and Alessandro Zanello (emphasis mine) ``In the future, trends in regional trade and abundant liquidity are likely to serve as catalysts for stronger financial linkages throughout the region... A strengthening of regional demand and trade growth will independently stimulate Asian asset markets and tighten regional interconnections. Better-linked regional financial systems could provide funding and hedging instruments to support the region's trade activities. Overall, Asia's growing intraregional trade will catalyze greater financial integration and, in turn, be stimulated by it.”

In short, the trends towards further capital markets deepening and integration looks like a monumental and possibly “irreversible” force to reckon with. Such is the reason why I am bullish with non-bank finance services which I think should benefit significantly from this seismic transformation, aside from of course, the general asset classes of Asia.

In today’s globalized financial environment where money moves “freely” in search of yields real time, let me show you why foreign money should continue to pour into Asian assets. In the eyes of the widely followed BCA Research, real yields matter (or bond yields deflated by inflation indices)...

Figure 2: BCA Research: Searching for Yields

``The Chart compares real bond yields and the basic balance for key emerging markets. Countries with high real yields and strong external positions (emphasis mine) offer the best risk/reward profile for investors in domestic bonds—that is, those in the upper right area.” wrote
BCA Research.

As you can see in Figure 2, the Philippines alongside its ASEAN contemporaries have been labeled as good value in real bonds yields (domestic currency), with mature East Asian bonds in somewhat the lesser attractive class. Meanwhile, US and Australian bonds have been shown as the least attractive.

Now relative to RISKS I believe, the housing recession in the United States has been the biggest mystifying factor whose effects could undo yet all the present gains seen in the liquidity driven global financial markets.

Figure 3: Northern Trust: % changes of New and Existing Homes

Mainstream analysts have recently adduced to several positive data in the housing industry as signs of a bottom. I am highly skeptical of this.

Bottoms or tops, or major cyclical inflection points do not come without capitulation from either bulls or bears. Because markets are psychological in nature, they tend to shoot beyond the norm; that is why you have such phenomenon as Mania, Panics and Crashes. As the Wall Street axiom goes, Markets climb a wall of worry, and decline on a ladder of hope.

What gives the bulls the ammo for their continued exuberance is the absence of credit-related crisis or fallout from risky exotic mortgages or derivatives yet. However, it is too premature to discount such possibilities, as signs of incipient raptures could have emerged, from Bloomberg’s Caroline Baum, ``A few sub-prime lenders have gone belly up. Signs of additional distress are just starting to show up in larger home- loan companies. Last week, IndyMac Bancorp Inc., the second- biggest independent mortgage lender, said its fourth-quarter earnings would miss forecasts because of deteriorating credit quality in the home-loan market.”

This view appears to have been shared by the illustrious Yale Professor Robert Shiller of the Irrational Exuberance fame in his latest interview in Bloomberg (emphasis mine), ``Why hasn’t the weak the housing market affected retail sales? Or why hasn’t consumer confidence fallen’ more? Well the easy answer to that is it hasn’t really started falling yet. It’ s the rate of increase that’s been going down for two years now, and its just starting to fall....I mean cities are down 1-2%, its not happened yet, so I am interested in what’s gonna happen next year.”

This means mainstream analysts have been looking at the rate of change instead nominal figures in determining the scope of the retrenchment of the housing industry.

Despite the declining rate of change, as shown in Figure 3, the nominal price levels suggests that housing levels remains on the high side, ergo, the effects of the fallout has not yet been visible. In other words, market participants have been in a state of denial and have not capitulated, so the likelihood is that while there may be interim recoveries, the bottom in the housing industry in the US has yet to be found.

In addition, Mr. Shiller implies that as nominal price levels decline, things can get rather interesting or possibly, the ramifications would be more evident. And we must not forget that since markets functions as discounting mechanisms, where if such effects would be more apparent by next year, stressed or not, the market’s price signals should soon be reflective of these.

Further, as I have repeatedly mentioned, Derivatives, “Financial Weapons of Mass Destruction” to Warren Buffett, which have provided for expanded leverage and added liquidity in the markets, have now caught the attention of policymakers as potential catalyst to a major market crisis.

This is one of the major issues taken up in the
Davos Switzerland, where Zhu Min, the Bank of China's executive vice-president warned (emphasis mine), ``There is money everywhere. You can get liquidity from the market every second for anything. Derivatives are eight times global GDP and much of the money is flowing to Asia, where people have no idea what risks they are taking."

Figure 4: Lazlo Birinyi/ Trend Investor: S&P’s Record Run

As I have been saying along, despite fundamental risks, global markets appear to be getting ahead of themselves. In spite of Friday’s 3% decline, which shadowed the activities in Wall Street, the Phisix has still been up 6.04% year to date! And by virtue of being overextended, the market could simply tumble out of sheer profit-taking.

This observation from Steven Lord of the Trend Investor (emphasis mine), ``In a nutshell, this is the current situation in U.S. equity markets. Although I am not bearish on the market per se, the current bull market is elderly by historical standards at 51 months, while the S&P has now booked the 928 consecutive days without a one-day, 2% correction. It is the longest such streak since before the Depression, or, more correctly, for as far back as we can get daily prices. It is an ominous fact, since most things on Wall Street eventually revert to trend. With earnings and the economy decelerating, the Fed unlikely to be much help unless things dramatically change for the worse, and markets perched at record levels on the back of one of the longest bull markets on record, we’re calling the chances for a good, old-fashioned correction as better than good.”

Figure 5: Emerging Market dissonance

In figure 5, one can see that emerging market debts (lower panel) appear to have “peaked out” and could be in the process of correcting, [via manifestations of lower highs and lower lows] while Emerging market bourses seems to continue with its upside momentum. However, the Morgan Stanley Emerging Market Index has yet to break the 925 hurdle to confirm its uptrend. Failure to do so could translate to a weakening momentum or a possible reversal.

Let me repeat, aside from all the negatives I’ve cited since (growing divergences, unfavorable market actions, fundamental, technical and sentiment risks), I think that our cost of capital have risen far more than the potential returns that can be gained from investing today, making the present day theme least attractive.

Say if one of the analyst is right on his prediction that the Phisix will gain 10% in 2007, with the Phisix already up 6%, this means your upside is now limited to 4% until the end of the year! But how about your downside risks? This is what I mean as the risk prospect has far outgrown your return potentials.

Of course, there will be selective opportunities within the market. We are after all in a long term bullmarket faced short-term risks.

Further, with eroding seasonal strengths, the manifestation of overconfidence through the bidding up of third tier issues signifies the accelerating speculative fervor. As such, it looks as if there are more fools or suckers out there than money to be made, which gives us another reason to be extremely cautious.

Yet, the market can still go higher predicated on a budding mania at work. As I have said to a favorite foreign client, acting on one’s portfolio reminds me of the Serenity Prayer which goes...

God grant me the serenity
to accept the things I cannot change;
courage to change the things I can;
and wisdom to know the difference.

There are things that we cannot change and things that we can act upon to effect changes for as long as we know our goals.

PLDT and A Resurgent Global Telecom Sector

Figure 6: PLDT and Dow Jones World Telecom Index

Finally, this is just an observation; PLDT which today represents 18.87% of the Philippine benchmark index, has taken most of the load in driving the Phisix to its present level since 2003.

Yet in figure 6, the patterns of telecom issues worldwide, represented by the Dow Jones World Telecoms Index (line chart) and PLDT has been growing its correlation since 2006.

While I may be guilty of
clustering illusions or seeing patterns when none exists, I think that following the tech bubble implosion in 2000 which included the telecom sector, the resurgent money flows towards the telecoms issues globally has further increased the global investor’s attention towards the Phisix’s major component.

A resurgent global telecom sector should constitute a significant impetus for local and regional telecom issues overtime.

Financial Globalization and Not Elections Will Determine the Path of the Phisix

``The whole aim of practical politics is to keep the populace alarmed -- and hence clamorous to be led to safety -- by menacing it with an endless series of hobgoblins, all of them imaginary.”—Henry Luis Mencken (1880-1956), prominent journalist

Almost everyone I talk to still believe that today’s market has been “local” driven in spite of the voluminous material evidence to the contrary.

In fact, I observed that in quite a significant number of comments, the upcoming election poses as a big factor of influence to the present activities in the market.

While I do not dispute that the forthcoming elections may have to some degree some influence, I do not think that it would be substantial enough to cause a ripple.

Recent events point to this:

In 2003, the Phisix climbed amidst a failed July coup which would have unnerved investor sentiment as in the 1987 and 1989 experience [see last week’s No Trend Goes in a Straight Line].

In 2004, the Phisix ignored the menace of political instability brought about by the rancorous contest for the chief of the land.

The Garci Scandal in 2005 managed to delay but was unable to wholly disrupt the ascension of the Phisix.

Simply put, the Phisix survived the most mephitic of the political environment on continued support from foreign capital flows. Foreign money remain as crucial determinants to the progress of the Phisix or to the Philippine asset class which seem to have been desensitized from domestic politics and much driven by “financial globalization” among other variables. Political tumults as in the case of Sri Lanka, Nigeria or Israel have not prevented global investors from bidding up local share prices as evidenced by their national benchmarks.

Unless political developments would have an impact on the capital flow framework as that of Venezuela or Thailand, they are unlikely to MATERIALLY affect the capital flow dynamics on our financial asset markets today. Hence, under such premises, the political election like in the past will most likely be discounted.

Of course, once the temporary setback in the markets should occur, an event which I expect to happen anytime soon, contemporary analysts will jump into the conclusion that these have been politically driven. You can count on that.

Building Your Nest Egg’s Prudently

``If you know the enemy and know yourself, you need not fear the results of a hundred battles.”--Sun Tzu

Lately, I have been astounded by the plethora of ebullient treatment the Philippines has been getting from various foreign research outfits and institutions. Imagine such remarks the “number ONE choice in the Far East”! It gives me goose pimples and makes me ephemerally feel like I am in a living in a prime investment haven.

It also marks a HUGE turnabout in mass psychology; an exoneration on my behalf. Back in 2002, when I turned bullish on the Phisix, such “reversal” theme was met with profound and revolting cynicism. The Phisix, as the consensus have it, was condemned to perpetual damnation. Nobody even wanted to discuss the existence of the market. Yet it was the best buying opportunity.

The Sage of Omaha, the world’s best stock market investor, Mr. Warren Buffett was absolutely right when he said that we should be greedy when everyone was fearful, and fearful when everyone was greedy. 2002 had been essentially, the pinnacle of FEAR.

Today, while I remain structurally bullish over the LONG-TERM potential of Asia’s financial markets and economic outlook due to the “wonders of globalization” and technology enabled macro developments, I have been alarmed by the sense of snowballing attachment to the gains of “yesterday”.

What has been seen as today’s triumphs have been projected to extend way into the future, which effectively discounts the risk elements attendant to the “subterranean” developments in the global financial and economic system.

In a list of cognitive biases, this is what is known as the Impact bias, where people have the tendency to overestimate how long they will emotionally benefit from present conditions.

And manifestations of such emotional attachments I can pick up even in my recent communications. For instance, because of the gingerly overtones of my outlook, a dear friend reacted to my pitch in displeasure, decrying of the loss of potential income for one’s “nest eggs”.

Nest eggs are basically built on portfolio allocations, principally designed upon one’s risk profile. Like any other financial markets, stock market investing comes with cost-benefit tradeoffs, where returns are hardly ascertained with consistent certitude especially over the short-term. As baseball Hall of Fame awardee, the witty Lawrence Peter “Yogi” Berra once said ``Prediction is very difficult, especially if it's about the future."

To build on one’s nest eggs, invest only the amount you can afford to risk. To believe that financial markets operate in a risk-free environment will only subject you to massive financial losses, if not mental angst or trauma. Gains today may not be there tomorrow. Risks do exist and most of the time the worst risk resides within us. As investor Bernhard Mast warned, ``First of all, you have to protect yourself from yourself".

We can also learn from the core tenets of Buddhism, where in the Four Noble truths, the ``first cause of suffering is due to our attachment to sense pleasure or desire”. Desire for untrammeled financial gains or plain vanilla easy money is a certain recipe for suffering.

Sunday, January 21, 2007

Nothing’s Worrying the Markets

``Nature has given enough to meet man’s need but not enough to meet man’s greed.”-Mahatma Gandhi

I’ve been asked if the strong correlation of US markets and the Phisix still exists. Well, Figure 1 should give us the answer....

Figure 1 Phisix, Dow Jones Industrials and Dow Jones World

Correlations may not signify causation as it may well just be coincidental. Yet under the premises of liquidity driven financial markets, the Phisix (red candle) could most likely be “influenced” by mainly the fate of US dollar among other variables, in as much as the latter’s association had been with the US equity markets, represented by the Dow Industrials (black line superimposed) or with the world markets as in the case of the Dow Jones World Index (line-lower panel).

According to the Financial Times, ``US investors bought a record volume of foreign assets in November amid fears of a weakening currency, according to official data released yesterday....The record net $39.1bn (€30bn, £19.8bn) US investors put into foreign assets reflected both fears about the dollar and broader trends, according to Rick MacDonald of ActionEconomics.”

In addition, today’s “globalization” phenomenon, the accelerating trend of the integration of the world’s capital markets greatly enabled by technology, trends towards deregulation and return-seeking behavior borne out of “surplus” capital, as shown in Figure 2, has enhanced this interdependence.

Figure 2: Economist: Global Gusher

As to its main sources of liquidity, the explains (emphasis mine), ``First, average real interest rates in the developed world are still below their long-term average. Second, America's huge current-account deficit and the consequent build-up of foreign-exchange reserves by countries with external surpluses has also pumped vast quantities of dollars into the financial system. A large chunk of Asia's reserves and oil exporters' petrodollars have been used to buy American Treasury securities, thereby reducing bond yields. In turn, low bond-market returns have encouraged bigger inflows into higher yielding emerging-market bonds, equities and property, especially in Asia. Liquidity has been further boosted by the use of derivatives, and by carry trades.”

What this implies is that the policy dictates of today’s global central banks have churned out an explosive expansion “capital”. This why as I pointed out last week the world financial markets have massively outgrown GDP. Put differently, you have global banks collectively sowing the seeds of inflation, and these are being transmitted through different channels at varying degrees. As an example, you see them first in the inflation of global asset markets, then spilling over to producer-consumer prices and possibly or eventually to the labor market.

One measure of liquidity is known as the M3, a statistical monetary aggregate, which the US Federal Reserve has discontinued publishing since March of last year based on being “costly”. The M3 basically depicts of the pace of money and credit creation by the FED.

While it is one of the most helpful statistics in monitoring the activities of the FED, it does not completely reveal about the trends in monetary policy. We can use either the Bank Credit or the price of gold as alternative means of tracking such policies. Nonetheless, inflationary policies cannot be hidden from the market. It will eventually reflect upon the diminishing purchasing power of the currency unit which undertakes such policies.

Figure 3: M3 Reconstructed

The explosive growth of M3+Credit as reconstructed by shown in Figure 3, buttressed by an equally noteworthy acceleration of its rate of change (green line). Could this be the reason why gold (up $7.8 over the week) holds steadfastly at its present levels in the face of a selloff in oil and other metals? One must remember that gold has been in a bull market not only priced in the US dollar but against all major currencies.

Long time favorite analyst of mine John Maudlin brought up a very interesting Christmas carol from American billionaire real estate entrepreneur Sam Zell entitled, “Capital Keeps Falling on My Head”, which was sang to the tune of “Raindrops Keeps Falling on My Head”. You may watch it at

Here is a piece of the song, ``What lies ahead: we're old -- the western world is aging, we'll need income from our pension funds, where's it coming from? The yields we see won't fuel no party... And there's one thing I know -- To get things back to normal it's a long haul that's global. Yields won't improve 'til growth soaks up this liquid freefall. Capital keeps raining on my head. So much is out there that the world is out of whack. When will we see balance back? It's gonna be a long time 'til returns meet expectations. We need to be prepared for slim annuities..."

Mr. Maudlin further comments (emphasis mine), ``“Nothing's worrying me," is how B.J. Thomas ends the original version. That ending keeps playing in my head. Investors cannot be worried by much to look at real estate at 22 times projected future earnings. Or emerging market debt at little more than what you get for US government debt. Yields on all manner of investments have been compressed. How? As Zell says, "Illiquid assets have been alchemized into currency in play competing for returns."

Yes, nothing seems to be worrying the markets today. Yet, Mr. Zell message has been in the same light as ours, but forgets to add that the world is getting deeply more leveraged as increasing amount and rate of leverage are being utilized to squeeze out additional returns.

Gillian Tett of the Financial Times points out of the rapidly accelerating growth trend of ‘Structured Finance’, particular in the Collateralized Debt Obligation (CDO) market, which according to him “could make anybody blink” (emphasis mine)...``According to data released by JPMorgan this week, total issuance of CDOs - repackaged portfolios of debt securities or debt derivatives - reached $503bn worldwide last year, 64 per cent up from the year before. Impressive stuff for an asset class that barely existed a decade ago. But that understates the growth. For JPMorgan's figures do not include all the private CDO deals that bankers are apparently engaged in too. Meanwhile, if you chuck index derivative portfolio numbers into the mix, the zeros get bigger: extrapolating from trends in the first nine months of last year, total CDO issuance was probably around $2,800bn last year, a threefold increase over 2005.”

In another article Mr. Tett relates of how “frighteningly” such leverage multiplies in today’s financial markets (emphasis mine), ``the case of a typical hedge fund, two times levered. That looks modest until you realise it is partly backed by fund of funds' money (which is three times levered) and investing in deeply subordinated tranches of collateralised debt obligations, which are nine times levered. "Thus every €1m of CDO bonds [acquired] is effectively supported by less than €20,000 of end investors' capital - a 2% price decline in the CDO paper wipes out the capital supporting it.”

In essence, today’s market conditions have been increasingly dependent on the continuity of rising asset prices in support of these hastening and deepening trends of liquidity generation via leveraging.

Liquidity has been basically self-reinforcing; the larger the increase in one’s portfolio value, the more the access to larger leverage in order to generate marginal returns. Since extensive competition has driven down returns, low returns necessitate the use of more leverage. And the cycle revolves.

Even as economic fundamentals depict of a prospective downshift, these have been taken to mean as “good” for the financial markets, as Central Banks have been expected to deliver their roles as “financers of last resort”.

Valuations, no matter how high, relative to historical standards have been considered as “cheap”.

Credit spreads between once known as “risky” investment classes and “risk-free” government backed Treasury benchmarks has narrowed to record levels, implying that the degree of risks variance among diverse assets classes has substantially diminished.

Volatility indices are at record lows, suggesting that the world has become less risky!

Any news, either good or bad, has been justified as “good”. It’s been a “Brave New World” of highly leveraged asset-based economies out there! It has also basically been a high-risk low-return approach, where rampant speculation rules!

All these are manifestations of the outgrowth from the inflationary policies thrown to us by global central banks. As the leverage mounts, the risks become increasingly systemic. The world has never encountered such degree of leverage, and exploding growth in innovative financial instruments has not been stress tested.

We could never size up the potential scenario arising from the possible unwinding of this ‘house of cards’. It could be a combination of “debt deflation” and collapse of the faith based paper money system. Unless of course, a miracle occurs and economic growth upends the amount leverage in the system.

So far, the world financial system appears to have the capacity and room to absorb all these yet. Party on!

No Trend Goes In A Straight Line!

``Throughout all my years of investing I've found that the big money was never made in the buying or the selling. The big money was made in the waiting.” Jesse Livermore

As I’ve noted in the past, markets are mainly emotionally driven, despite the thought that we act rationally in its face, the painful truth is...we don’t. Since markets are hardly about equilibrium, as they constantly change, expectations can be overestimated in the short run and underestimated over the long run. In short, nothing is fixed everything is fluid and dynamic, governed by expectations.

Irrationality means that we are hardwired to frequently use “rules of thumb” or mental short-cuts in our thought processes particularly in decision making, often falling into traps of cognitive biases. Recency or Anchoring biases, overconfidence, rationalization, framing, loss aversion, regret theory are part of such “cognitive illusions” or the illusions of knowing.

There is also the phenomenon called as the “emergence”. Josh Wolfe of Forbes describes it as, ``Emergence is a fancy way of saying that the whole is greater than the some of the parts. Ant colonies, brains, cities, behavior in markets all exhibit this phenomenon of emergence where the constituent components give rise to higher order.” Put differently once we attain a certain level we tend to seek more.

And seeking more is what news headlines are all about these days as analysts pile atop each other declaring the bullish outlook for the Phisix “Philippines one of Asia’s top 3 investment sites” orStock prices seen rising further in ’07”.

As I have said in the past, market tops are usually characterized by “euphoria” and global markets including the Phisix could go vertical or parabolic before “topping out”. Let make a recent example of Saudi Arabia’s Tadawul All share index as shown in Figure 4.

Figure 4: Bloomberg: Saudi Arabia’s Tadawul All Share Index

As you can see in the chart, the final phase or “blow out top” of the Tadawul Index was marked by a nearly 90° ascent.

From about 2,500 to a little over 20,000, the Tadawul index leapt by nearly 7 times in three years before the harrowing collapse of late. Today, it drifts at around the 7,000 levels which essentially translate to over 60% of losses from the peak, in spite of the supposed intervention by Saudi’s Prince Alwaleed bin Talal. The scale of correction is almost equal and opposite to the degree of the trend that preceded it. The Lesson: The higher and the faster the rise, the steeper and harder the fall.

Of course, the structural dynamics of Saudi’s Tadawul is starkly different than the Phisix, of which the latter has followed closely the movements of major Global indices. Another is that the pace of volatility has not been as dramatic as that of Saudi’s bourse which had only 78 issues of publicly listed companies. Lastly, the financial market dynamics has been more “regional” oriented, the Phisix and Philippine asset class in general has had more correlation with the financial asset classes of its neighbors.

This is not to even suggest that the Phisix will do a Tadawul. The lessons are clear no trend goes in a straight line. Even the Philippine cycle shows the same patterns.

During the Phisix’s last bullmarket cycle which was from 1986 until 1997, the Philippine benchmark encountered two major mid-cycle corrections, triggered by the failed coup attempts of 1987 and 1989 as shown in Figure 5 (arrows).

Figure 5: Phisix: Reviewing the Last Bull cycle

Yes, the Phisix flew by over 10 (read my lips T-E-N!) times before the massive correction took place in 1987. And in both instances, the Phisix gave up over 50% of its gains during these mid-cycle retracements which lasted by about a year each.

As stated above, market trend dynamics are never linear.

Today, the Phisix has gained by only about 200% from its low in 2002, which makes its current advances relatively inferior compared to the Tadawul and Phisix 1986 experience to merit the same degree of horrifying adjustments.

In other words, if the Phisix should correct in tandem with global markets, I do not expect the same extent of damage seen in our previous examples.

Figure 6: Phisix subsectors: Mines Diverge

As for industry specifics, if one where to assess on the recent actions of the market, the mines and the general market moved independently of each other in 2006, which makes a worthwhile case for portfolio diversification, see Figure 6.

The mining index (orange line) took the first semester by storm, while severely underperforming the second semester rally by a big margin against the broadmarket issues.

This means that while it is possible for mines to diverge with the general market even when the PHISIX corrects, given the narrow breadth of our underdeveloped market, the opposite case of the rising tide lifts all boats could also occur. As Edwin Lefevre wrote, ``In a bull market, all stocks go up. In a bear market all stocks go a general sense.” I think this applies especially to less advanced and sophisticated markets as ours.

Well, candidly, I wouldn’t exactly know how the market would turnout when a correction transpires. Sorry, but I have no predictive powers of a clairvoyant, unlike some of my contemporaries. Instead, I heed the advices of the battletested and successful investment or fund managers as the legendary John Templeton, who said ``The best time to invest is when you have money. This is because history suggests it is not timing which matters, it is time.”

And based on time, in the context of market cycles and probabilities, since I think we are in a secular long term bullmarket, positioning gradually based on how the market progresses or how the interim cyclicality unfold should make one’s returns at least at par with the index.

Over the short-term, I think the Phisix as well as most global markets are in high-risk low-return sphere. I would rather be cautious and selective. Be careful out there.Posted by Picasa

Sunday, January 14, 2007

Global Risks Rise Amidst Market Euphoria

``There are a terrible lot of lies going around the world, and the worst of it is half of them are true.” Winston Churchill

FORECASTING markets, particularly over the short-term, is an incorrigibly tricky pursuit. Variable gyrations and wildly random pendulum swings characterizes the market’s volatility whose directions over the short term are as good as a “throw of dice”. Curtly said, your guess is as good as mine. In the words of Benoit Mandlebrot, author of the Misbehavior of Markets, ``All is not hopeless. Markets are turbulent, deceptive, prone to bubbles, infested by false trends. It may well be that you cannot forecast prices. But evaluating risk is another matter entirely.”

And risk evaluation and assessment is what distinguishes us from the rest of the domestic playing field, simply because our paramount aim has been to preserve capital, aside from maximizing profit opportunities and containing losses.

Of course, we try to heed on Warren Buffett’s invaluable advice of reading and applying on Ben Graham or Phil Fisher’s principles in relation to the “macro” stuffs, and don’t engage in equations with “Greek” letters on them, especially on “technical grounds” as some others do.

Figure 1: Guardian: World Economic Forum: Complex and Interconnected Global Risk Environment

I have interminably argued that today’s market landscape has dramatically shifted, such that the “Globalization” platform phenomenon backed by the “technological telecommunication and information revolution” has tremendously increased the interconnectedness or the correlations of our market’s movements with that of the world’s. In doing so, our domestic market have now been subjected to the ebbs and flows of global capital, sharing with it, as much of its benefits, the risks of an “increasingly complex and turbulent complex world” as shown in Figure 1.

Notes the World Economic Forum in their Global Risks 2007 (emphasis mine) ``In an increasingly complex and interconnected global environment, risks can no longer be contained within geographical or system boundaries. No one company, industry or state can successfully understand and mitigate global risks.”

All this goes to show that for as long as the world continues on its path towards the evolution of greater economic and financial interdependence, its markets, business environments, national and macro economies, aside from political, social and cultural dimensions are likely to evolve towards encompassing more developmental convergences, relative to risks and benefits.

With no less than the recent ASEAN meeting in held in our Cebu to corroborate on this perspective, according to China’s Xinhua/People’s Daily Online (emphasis mine), ``In the signed document, ASEAN leaders reiterated their conviction that "an ASEAN Charter will serve as a firm foundation in achieving one ASEAN Community by providing an enhanced institutional framework as well as conferring a legal personality to ASEAN."

Figure 2: McKinsey Global Institute: Record Cross-border Capital Flows

In addition, as testament to a world of greater integration, global capital flows have reached record levels where the Compounded Average Growth Rate (CAGR) has steepened to an average of 10.7% per annum during the last 15 years compared to 4.3% during 1980 to 1990 period, as shown in Figure 2, where in such environs the emergence of the global investors class has evolved.

In its 3rd Annual Report, McKinsey Global Institute, noted that (emphasis mine), ``In 2005, worldwide cross-border capital flows, which include foreign purchases of equity and debt securities, cross-border lending, and foreign direct investment (FDI), increased to more than $6 trillion, the highest level ever. Since 1990, cross-border capital flows have grown 10.7 percent annually,10 outpacing growth in world GDP (3.5 percent), trade (5.8 percent), and financial stock (8.7 percent). Advances in technology and the deregulation of financial markets around the world have enabled this growth and given rise to a growing class of global investors. Although investors in most countries still show a marked preference for financial assets of their home country, roughly one in four debt securities and one in five equities today is owned by an investor outside the local issuing market—for instance, a US investor buying Thai equities, or a German investor buying US bonds. National financial markets are increasingly integrating into a single global market for capital.

Plainly stated, much of the world’s developments matters for us today than the “wisdom of conventional thinking” would have it. To paraphrase New York Times’ columnist Thomas Friedman in his bestseller, the WORLD is indeed becoming FLAT.

For us, business or financial models or paradigms and market analysis would have to deal with the instrumentalities of present realities rather deluding ourselves of insularity.

To be get ahead of the curve, one has to learn how to adopt on the strategies or approaches underpinned by the present trends and risks, otherwise lose out to either obsolescence or competition.

Which brings us back to our risks analysis, the World Economic Forum (WEF) through their Global Risk Network identifies 23 global risks subdivided into the segments of economics, environment and geopolitics, The Guardian quotes the WEF warning (emphasis mine), ``Expert opinion suggests that levels of risk are rising in almost all of the 23 risks on which the Global Risk Network has been focused over the last year, but mechanisms in place to manage and mitigate risk at the level of businesses, government and global governance are inadequate."

The WEF enumerates the five major economic risks namely, an oil price shock, a plunge in the US dollar, a hard landing in China, budget crises caused by ageing populations and a crash in asset prices, which has been ``more acute than at this time last year”.

It also cited worsening instances of the four out of five environmental risks, particularly climate change, loss of fresh water supplies, tropical storms and inland flooding.

Aside from the incremental escalations in six geopolitical risk factors, specifically, international terrorism, WMD, war, failed states, instability in the Middle East and a retrenchment from globalisation. The WEF warns that if such factors tip into a degree of intractability, ``the environment for business and society could be changed beyond recognition."

True, today’s financial markets have been discounting much of these factors, in fact, the world equity markets appear to be exceedingly ebullient.

While some domestic technical “experts” have claimed in consonance to my view that today’s market has been quite overheated, following a semblance of retracement, the Phisix and the global markets rallied sharply at the end of the week which once again took queue from the actions in the US markets, despite the asymmetric or discordant signals from the broader financial markets (rallying US dollar and gold, declining bonds, copper and oil.) as shown in Figure 3.

Figure 3: Dow Jones at Critical Juncture

Here says that while the Dow is in critical juncture following the string of record high closes amidst its astonishing climb in a backdrop of a litany worries, it has to yet hurdle its three-year trading channel to steer clear of technical obstacles, which incidentally could also prove to be its decisive bump.

Figure 4: Phisix, Dow Ex-Japan Asia Index and the Morgan Stanley Emerging Free

However, if you take a gander at figure 4, the Dow Jones 1800 Ex-Japan Index (black line superimposed), a benchmark consisting of 1,800 companies throughout Asia, the Morgan Stanley Emerging Free Indices (black line lower panel), a benchmark of the broad universe of emerging markets “developing economies” benchmarks and the Philippine Phisix, the movements including short-term fluctuations have been almost similar to the extent that the recent retracements or even the “timing” at the end of the week rally appears to have been “orchestrated”. No conspiracy theory here, just a depiction of the congruity by global markets.

And to consider the Philippine setting, today’s market activities have been envisaged by massive outperformances of companies with little fundamentals. Formerly dormant companies with little or no operations have been taking the centerstage accruing mouth-salivating gains that have been attributed to corporate stories of potential backdoor listings, Mergers & Acquisitions and/or plain vanilla “push” by certain interest groups.

The recent easy gains have ostensibly lured vulnerable retail investors, the last among the investing group to get involved, to undertake aggressive moves in the broader market.

Such conspicuous froth have been simply reflective of an outgrowth of an accelerating speculative mindset, where one could even hear arguments stating that “nothing in the local arena poses as significant threat to present conditions”. Posted by Picasa

Markets Make Opinion

``The Masses have never thirsted after truth. They turn aside from evidence that is not to their taste, preferring to deify error, if error seduce them. Whoever can supply them with illusions is easily their master; whoever attempts to destroy their illusion is always their victim.” -Gustave Le Bon, The Crowd

As we have noted last week, “Markets make Opinion”, where “experts” and journalists in complicity draw up to form what is known as the “conventional wisdom”, a simplified explanation for market causalities.

First, the public including local mainstream experts have the tendency to be guided by the “recency bias” or the “rear view mirror” or “anchoring” syndrome, where they extrapolate the most recent past and project them into the future.

Second, the lack of perspective, our experts have been inclined to cite whatever headlines in order justify today’s market’s action. In behavioral finance, such is called “rationalization”.

Third, as we noted last week, it’s all about incentives; the merrier the market, the appearance of a more risk-free environment encourages “experts” to amplify the short-term risk appetites of the average investors.

Yet flurries of short-term trades or overtrading are manifestations of the folly of overconfidence; one of the major reasons why the average investors are left to hold the proverbial empty bag when the cycle reverses.

Nonetheless, such pressures for short-term gains come irrespective of potential risks. Typical brokers encourage investors towards more technical approach to the market, in order to whet their appetites for greater turnovers.

Anyway, Figure 5 is a chart from the normally Panglossian research outfit, the Taipan group which dissects upon the effects of an economic slowdown combined with a declining trend of corporate earnings in the US to the possible performance of US markets in 2007.

Figure 5: Taipan Group: The Coming Earnings Crunch

Let me quote Steven Lord, editor of the Trend Investor of the Taipan Group (emphasis mine), ``The above chart, tracking the earnings of the S&P 500 since the middle of 2003 and applying estimates through the third quarter of 2007 from Thomson Financial, shows the steady decline in year-over-year percentage gains. Companies in the S&P have expanded earnings at a double-digit pace for the last 13 consecutive quarters -- or for the last three years....This leaves the stock market, perched as it is close to record levels, with only one way to move higher -- multiples have to expand. In other words, for stocks to rise significantly from here investors will have to pay “more” for a dollar of earnings in 2007 than they did in 2006, via a re-rating of the market’s overall P/E ratio. With earnings trending down and the economy slowing, awarding a higher P/E ratio is the only way for the market to rise from here. While not impossible -- at roughly 15, the market is hardly overvalued on a P/E basis -- it is clearly a higher risk strategy than we have seen for the past few years.”

Higher price multiple implies for richer valuations which makes today’s approach to the equities market clearly a higher risk strategy as Mr. Lord warns. Yet momentum remains tilted towards an acceleration of prices regardless of economic realities, where multiples could even reach bubble-like proportions as in 2000.

Markets can stay irrational longer than you can remain solvent says the illustrious economist John Maynard Keynes. Yes, today’s market environment may even surprise hard-core technicians that prevailing euphoric sentiments could lead to parabolic or sharply vertical moves; a speculative blowoff top in spite of present risks.

Considering the high-risk proposition of today’s market climate, it is probably best to simply keep your present positions and avoid overtrading and anteing up heavily by chasing prices.

Since the market has palpably been rotating it would be of lesser risk to employ risk capital to issues that have lagged, and hope for a contagion, i.e. if the itch to join the bandwagon trade becomes irresistible. Here position sizing greatly matters.

Moreover, one must keep in mind the basic market tenet that NO TREND GOES IN A STRAIGHT LINE. Such that while I remain bullish with the SECULAR or long term trend cycle of the Phisix, current conditions have raised the risk profile for investors to warrant a more cautious approach to the market.

It is also recommended or advisable to employ the practice of TIGHTENING of your STOPS in case the market does unwind. Remember, the steeper the market climbs, the harder its potential fall. Posted by Picasa

Unifying Global Stock Markets; Asia Looks Next!

``Over the next three to five years, we will become global and more diversified. The next logical spot is Asia. At some point we want a position in the Chinese market and in the Indian market."--John Thain, CEO of The NYSE Group

In its 3rd annual report the McKinsey Global Institute estimates that the Global Capital markets-equity securities, private and government debt securities and bank deposits reached US$ 140 trillion in 2005 representing about 316% of the Global GDP as shown in Figure 6.

Figure 6: McKinsey Global Institute: 2005 Global Financial Assets

Global equities which accounted for about 31% of the financial pie contributed the most growth among these assets in 2005, according to McKinsey, ``Equities accounted for nearly half of growth in global financial assets in 2005, increasing by $7.1 trillion. Although Japan had the largest single gain in equity markets, with an increase of $1.5 trillion, equities’ growth was broad-based. The eurozone saw its stock of equities increase by $1.2 trillion; the United States by $650 billion; and the United Kingdom by $550 billion. Equities also accounted for more than half of emerging markets’ growth in financial assets—with growth of $2.2 trillion.”

As global equities are expected to reach $59 trillion in 2010, the race towards the industry’s consolidation has apparently intensified.

At the end of 2006, two major stock exchanges, the New York Stock Exchange (NYSE), the world’s largest stock exchange in US dollar terms and the Euronext- Continental Europe’s largest bourse which runs Paris, Armsterdam and Lisbon, obtained the respective approval by their shareholders to a merger of giants. Last week, the European regulators formalized the approval of the US$15 billion merger.

Following the failed takeover offer by the Macquarie Bank, the London Stock Exchange (LSE) received a bid by NYSE’s key rival, the NASDAQ in March of 2006. As the NASDAQ negotiated its way through the takeover deal, it worked to accumulate LSE shares, which today accounts for a hefty 28.75% of England’s bourse. Having been spurned twice, NASDAQ’s active offer remains in abeyance even as the LSE options dissipate following the finalization of the NYSE-Euronext merger and Deutsche Börse withdrawal from the bidding contest. A resolution to this takeover offer could be realized this year with a growing likelihood of its completion.

Even in the futures market we are witnessing the same thrust: In 2006 the Chicago Mercantile Exchange (CME) proposed to acquire Chicago Board of Trade (CBOT) that would create the world’s largest futures exchange in a deal worth about $8 billion. Presently awaiting regulatory approval and the endorsement from the shareholders the merger is likewise expected be completed by 2007.

With the revolutionary advances in the field of communications and information technology-the advent of on-line electronic trading platforms makes it possible for real-time electronic transactions regardless of the geographical distance.

Grounded on this premise, the major exchanges appears to be in a rush to integrate financial services, to diversify and expand their market coverage, reduce transaction (bookkeeping, clearing and settlement) costs by achieving the economies of scale, to eliminate further inefficiencies by way of human intervention, provide for financial depth by attracting global investors (to augment the demand side), traders and listing companies (to increase supply side), to improve on liquidity by easily matching buyers and sellers, and finally, adapt to the ongoing changes in marketplace by being accessible to the growing significance of institutional investors [pension funds, hedge funds, mutual funds and insurance companies] as compared to retail investors in the past.

With the global trade and economic structure presently favoring Asia, as evidenced by its exploding foreign exchange reserves and rapidly rising per capita and middle class, its largely fragmented and underdeveloped financial markets makes it a potential ground for an explosive expansion. According to McKinsey Global, ``Perhaps more surprising is the fact that Asian countries have the largest links not with Japan or Hong Kong, but with the United States, the United Kingdom, and the eurozone, underscoring the lack of an integrated Asian financial market.”

Under such vein, NYSE’s CEO John Thain said in an interview last December at CBS that Asia “is the next logical step” for expansion. Mr. Thain opines that demutualization as prerequisite prior to any possible alliances (instead of acquisitions), and that entities will be “kept separate with no regulatory crossovers”. Mr. Thain was said to be eyeing Japan, China and India.

At the onset of 2007, NYSE’s Mr. Thain wasted no time into taking concrete action with his plans. In a rapid fire succession, he recently stitched up an alliance with Tokyo, joined a team of investors which included investment bank Goldman Sachs and private equity firm General Atlantic to acquire 20% of the India’s largest stock exchange the Mumbai based National Stock Exchange and even Australia’s ASX caught up on the speculative excitement as the next potential deal for NYSE. On Friday, the Australian Stock Exchange jumped 4.5%.

Today, the Philippine Stock Exchange, despite its miniscule capitalization and traded volume relative to global standards or its peers, will be an inescapable part of the ongoing global trends to unify financial market exchanges, such that in the future it will a party to any potential alliances, or consolidations by mergers or acquisitions, as well as, take into account the realization of cross-border listings, after progress on regulatory hurdles would have been met and expanding trading facilities to possibly include other asset markets.

In the future, you and I would be able to possibly trade US, European or any neighboring countries stock listings that could be accessed by the local trading platform at our very homes.

All these will not happen overnight but is part of the ongoing seismic shift in the financial realm. This is just one of the many steps towards the Phisix 10,000! Posted by Picasa

Sunday, January 07, 2007

Are Unit Investment Trusts (UIT) Good Investments Today?

``Information is the currency of the Internet. As a medium, the Internet is brilliantly efficient at shifting information from the hands of those who have it into the hands of those who do not...The Internet has accomplished what even the most fervent consumer advocate usually cannot; it has vastly shrunk the gap between the experts and the public. The Internet has proven particularly fruitful for situations in which a face-to-face encounter with an expert might actually exacerbate the problem of asymmetrical information-situations in which an expert uses his informational advantage to make us feel stupid or rushed or cheap or ignoble.”-Steven Levitt and Stephen Dubner in Freakonomics

Prior to the Christmas break, I was asked if Unit Investment Trusts (UIT) would be a good way to go, for the coming year. To my understanding, UITs operate like mutual funds in the sense that it holds a portfolio of securities. But unlike mutual funds they have been designed for a specific length of time and structured as a fixed portfolio. I was particularly asked, which among the bank’s locally offered portfolio namely, the Peso denominated fixed income, equity or combination of (balance fund), I would recommend, considering the bank’s bullish outlook for the coming year.

To the surprise of the client, my response was to buy US dollars (relative to the Peso) or US dollar short term fixed income instruments and Precious Metals or its proxy (mines) instead.

It is not that I seek to purposely become a contrarian, but my interest considering today’s ambiguous investing climate, is to preserve capital or minimize losses and optimize profits, yet much of today’s optimism comes in the light of a global downshifting of economic growth or a heightened risk environment.

It’s all about Incentives

During the holiday, I came about a very insightful book of which I am in halfway, by Steven Levitt and Stephen Dubner, called “Freakonomics” which essentially deals with how people respond to incentives; to both negative and positive stimulus, something like getting penalized for committing mistakes or receiving awards for a job well done.

Similar to the Austrian School of Economics “Praxeology” which basically deals with the study of human conduct, Mr. Levitt and Dubner wrote (emphasis mine), ``An incentive is simply a means of urging people to do more of a good thing and less of a bad thing. But most incentives don’t come about organically. Someone-an economist or a politician or a parent-has to invent them.”

For instance, in the environment where a country’s currency is rising, mainstream economists would demand for government intervention in support of the export industry, or politicians in response to a public’s outrage would act to impose restrictions or regulations such as the recent “Anti-billboard law”, or a parent would ground their child based on current misbehavior.

And in many instances, as Freakonomics team cites, an individual or the public or society responds to such incentives in manners which have not been anticipated, wherein, as the Freakonomics team says “the conventional wisdom is often wrong”.

Let me cite possible analogies in the local arena; while Economics 101 tell us that rising currencies are essentially bad for exports, why are there “substantially” numerous if not greatly significant cases of Asian, European and Latin American countries with rising currencies YET accompanied by years of rapidly GROWING exports?

Or the Freakonomics team quotes risk communication expert Peter Sandman in New York Times (emphasis mine),``The basic reality is the risks that scare people and the risks that kill people are very different...When hazard is high and outrage is low, people underreact, and when hazard is low and outrage is high, they overreact.” An example would be the dread of death from terrorism than from heart attack.

In the Philippine setting, could the recent Anti-Billboard law as a consequence of a once-in-10 year event, i.e. Typhoon Milenyo’s direct hit to Manila, reflect an overreaction to a low-hazard-high-outrage circumstance?

Since there are three basic forms incentives, moral (how the people would like the world to function), social and economic (“how it actually does work”-Freakonomics), I would relate to the latter with respect to this field of endeavor.

In such light, the economic incentives for brokers, bankers, fund managers and investors are divergent. Brokers earn by commissions, thereby our incentive is to encourage market participants to trade more. Bankers, on the other hand, earn by fees, whereby to entice the public for more placements opportunities by offering more products, while fund managers earn by a combination of fees and profit-sharing scheme, where the purported incentive is to earn from more placements and investing profitably (return based).

While the investing public seeks to grow their money through the incentives of “rate of returns”, it is incumbent upon them to understand the incentives of the intermediary they deal or transact with. Simply because the investing public’s incentives more often than not varies and could, in fact, be in conflict with their intermediary’s interest.

So it would be natural for bankers or fund managers or brokers to promote their product line or services regardless of the return outlook because it is their “economic incentive” to do so.

The Wisdom of Conventional Thinking

Now relative to the “wisdom of conventional thinking”, today’s investor sentiments emanating from the recent buoyancy in global equity markets could be depicted through this newspaper heading...

Figure 1: SCMP: December 30 Headline: “20,000” Roaring Through

The headline above from South China Morning Post reveals of the conspicuously bullish overtones by Hong Kong’s Hang Seng Index (+34.2% year-to-date) which recently carved fresh record highs, like almost any other benchmark indices all over the world.

For money managers, these are known as the “Magazine Cover or Newspaper Headline” indicators, a contrarian signal. Since the “incentive” of the press is to “sell its media to the public”, it usually does so by conveying recent developments backed by a STRONG consensus view. In other words, they vend information which caters to mostly what the public wants to hear about.

This reminds me vividly of the yearend 2004 where several magazines as the Economist declared the “Death” of the US dollar following two successive years of rout. In 2005, the US dollar simply proved the consensus wrong by rebounding mightily across the board.

Figure 2: Phisix At 3,000 level backed by Strong Peso on Massive Foreign Inflows

At the start of the year, I forecasted that the conditions of the Peso and the region would reflect on the Phisix see January 2 to 6 edition, (2006: Global Liquidity and the US Dollar to Drive the Phisix), ``It is apropos to view the recent strengths in Asian bourses as well as in the Phisix to the incipient signs of the US dollar strength reversal. This essentially serves as the bullish case for the Phisix.”

As shown in Figure 2, the Phisix ended the year up 42.29% for its best performance in over a decade, with gains of almost the same intensity as the inception of the bull run in 2003 (+41.63%) and for its fourth consecutive year of advance in synchronicity with global equity markets.

Figure 3: Declining Yield Spreads of on Major USD Philippine issues

Apparently, the massive inflows from foreign money came at the heels when I became alot cautious calling for extra vigilance in the latter half of the year from the same outlook, ``On the later semester of the year I would be extra vigilant/cautious for any possible signs of weaknesses that may arise in the US or from China.”

Yes, while it is true that weakness in the US did materialize, the subsequent effect to the financial markets was instead a “melt-up” on the account of expectations of a “Goldilocks” outcome backed by a more extra loose money environment.

The Peso gained 7.69% in 2006 to Php 49.03 per US dollar supported at the margins by these massive portfolio investments into the Phisix, the Philippine debt instruments in both local and dollar denominated issues as shown in Figure 3 and other asset classes. Of course, remittances have been a factor, yet as we argued before, it is the unseen working at the margins that have shifted in favor of the Peso.

As evidence to this, remarkably, the spread of the 10-year Peso Philippine denominated Treasuries and the 10 year US dollar denominated Philippine Treasuries has narrowed to only 34.9 basis points as Friday (Jan 05), from 278.4 basis points at the end of 2005 (Dec 29th).

The thinning of the spreads astonishingly reflects on the enormous money flows into Philippine assets mostly on the grounds of a global low risk premia and low volatility aside from the moving out of the risk spectrum in the stretch for yields mentality.

Of course, local analysts and experts will construe these as mostly reform based since they hardly comprehend the dynamics of the macro cycle which the local media would unsparingly carry up. To quote again Mr. Levitt and Mr. Dubner, ``Journalists need experts as badly as experts need journalists. Every day there are newspaper pages and television newscasts to be filled, an expert who can deliver a jarring piece of wisdom is always welcome. Working together, journalists and experts are the architects of much of conventional wisdom.”

Increased Portfolio Risks Plus Unfavorable Cost-Return Analysis

Figure 4: IMF: Sub-Saharan Africa: Trading Volumes

Arguing incessantly that today’s highly globalized financial landscape have been a manifestation of the above du jour thematic investing psych, figure 4 from IMF shows that money flows towards “exotic” themes, such as the Sub-Saharan region, have been dramatically expanding, as fund managers with a torrential “leap of faith” towards a protracted placidly rated risk environs; go for every “nook and cranny” with regards to any asset classes in the mission to seek above average returns.

Since I believe that today’s directional path of money flows are inexorably moored towards the fate of the US dollar [US dollar index -9.01% in 2006], we might as well consider the recent actions which may be as well be indicative of the directions of the Phisix and related Philippine assets.

I have argued in November 27 to December 1 (see Falling US Dollar Fuels Rising Oil Prices) outlook that aside from “demand-and-supply” factors the prices of oil or other commodities could be determined by the gyrations of the currencies where they are predominantly traded in, i.e. US dollar. For instance as oil prices recently swooned, media outlets took the quick-and-easy version of a warmer weather attributed to its actions. Nevertheless, oil’s decline came about as the US dollar massively rallied.

Which brings us to the unseen, could the inverse relationship of commodities and the US dollar signal a demand contraction and a rise in risk aversion similar to the case last May?

Figure 5: IMF US Housing Indicators

In the US, as shown in Figure 5 from IMF, Housing Stats continue to manifest steep deterioration. The OFHEO Price Index (blue line), Housing Starts (red line) and Total Existing sales (green line) appears to have “peaked out” (green blocked arrow) during the latter portion of 2005.

Warns the IMF (emphasis mine), ``The shift in recent years toward more risky mortgages may make segments of the mortgage credit markets more vulnerable to the deceleration in housing prices. Innovations in the origination of mortgages have allowed a widening range of borrowers to finance more expensive homes at a given income level. These include mortgages for subprime borrowers, mortgages with high degrees of leverage, and mortgages that feature sharply rising monthly payments, resulting in “payment shock” (Figure 10). More than half of mortgages originated in 2005 and 2006 are estimated to contain provisions that will eventually lead to a sharp rise in payments, even if the level of market interest rates does not change.

``Furthermore, as shorter-term interest rates have increased in recent years, rising payments on conventional adjustable rate mortgages will add to payment shock. Although the overall level of home equity remains high, a recent study suggested there may be significant pockets of home purchasers with low or negative equity; that is, mortgage debt in excess of the value of their homes. This may owe to several factors, including falling home prices in some regions, mortgages that initially allow for a buildup of debt over time, and the fact that some homeowners may have overpaid for their homes at the speculative height of the market, facilitated by overly liberal underwriting. Thus, homeowners with small or no equity cushions in their homes may find the payment shock difficult to manage.”

The good news is that so far the housing recession has been contained to within the industry premises. However, as the IMF warns, adjustments to subprime mortgages, which could have a significant impact and may translate to more tightening of belts by the US consumers, which has been the single most important engine of growth on the demand side for the global trade structure.

Figure 6 Commodities take a Drubbing

Meanwhile, commodities appear to take a drubbing as shown in figure 6. We can observe that both oil and copper, commodities widely used in the economy, which have coincidentally peaked in May of 2006, as with the benchmark CRB, trailed the peak of the US Housing industry by about 3 quarters. Noticeably, a broad spectrum of commodities went into a sharp and accelerated decline last week.

Lest be accused of the logical fallacy of “Cum Hoc, Ergo Propter Hoc” [With this, therefore because of this], we are curious to know if the inflection point seen above are correlated, since they broke down almost simultaneously? And if this could be reflective of the lagged effects of the above stated US housing recession? Or does this effectively represent a diffusion of the weakening of the US economy into the global economy?

Writing prior to the recent rally of the US dollar Chief Economist Paul Kasriel of Northern Trust last December to give us a clue, ``This weakening in copper prices corroborates the slowdown in the pace of U.S. manufacturing activity – it appears as though manufacturing output peaked in August 2006 – and the recession in housing. The decline in the dollar price of copper is all the more indicative of faltering goods-producing activity in the U.S. inasmuch it has occurred at the same time that the foreign exchange value of the dollar has been falling. All else the same, the dollar price of an internationally-traded generic commodity would be expected to rise as the foreign-exchange value of the dollar fell. The fact that the dollar price of copper has declined along with the fall in the dollar implies that the price of copper has declined in terms of other currencies, not just the dollar. This could suggest that manufacturing activity globally is slowing.”

So as Mr. Kasriel asserts a possible candidate could be a US-led global manufacturing activity slowdown, which is not a good news at all.

Figure 7: Inverse Relationship between the US dollar and Emerging Markets

In addition, the IMF in its unusually cautious “Global Financial Stability” tone admonishes (emphasis mine)``A transition from the current state of low volatility to one in which volatility returns to historically more normal levels would likely not be straightforward. The task has been made more difficult by the rapid growth of some innovative instruments and the build-up of leverage in parts of the financial system. Carry trades have grown and the unwinding of those trades has potential to cause perturbations in markets. A “volatility shock”—perhaps caused by a downward shift in growth expectations or by renewed inflationary pressures—could precipitate portfolio adjustments and raise underlying volatility.”

A benign decline of the US economy is more likely to lead to an incremental decrease of the US dollar index. However, a greater-than-expected incidence of the housing industry and auto manufacturing recession, which may spread to the general economy or the sudden emergence of adverse developments, such as “volatility shocks”, unwinding of carry trades, hedge fund collapse, geopolitical uncertainties-as possible catalysts, emanating from elsewhere could lead to a rush into “safehaven” instruments as the US dollar.

Thus likely, as shown in Figure 7, the inverse correlation between the US dollar and emerging market equities have been quite strong over the past year. To wit, as the US dollar rallies emerging market equity indices tend to decline, while emerging market bourses rally when the US dollar index is on a downshift.

Figure 8: IMF: Correlation of Asset Classes with S & P 500 and Broader Market Volatility

Moreover, the IMF Chart in Figure 8 shows that various asset classes have been in a trend towards increased correlation. Increased correlation suggests that the objective of diversification, which is “to reduce risk by spreading portfolio holdings”, effectively diminishes.

To quote the IMF, ``If these positive correlations were to persist, or even to rise, in a sell-off, the traditional diversification benefits of investing in a wide variety of asset classes might be less than investors expect. The possibility that the correlations may persist underscores that investors may eventually demand higher risk premiums.”

What this implies is that going forward considering the hefty advances of the Global Equity Indices (“priced for perfection”), as well as the Phisix, considering the record low volatility, tight credit spreads, extreme optimism (newspaper cover), the diminution of seasonal strength, the non-confirmation of Dow Theory (see December 4 to 8 Dow Theory: The Emergence of a Divergence?), technically overbought conditions, mean reverting cyclicality and tendencies of the financial markets, rising correlation among diverse asset classes, conflicting messages by the bond and equity markets, the recent massive decline of broad based commodities, a rallying US dollar, an inverted yield curve, rising potentials for “volatility” shocks (while the Euro is down lately, the Yen is up- further increases in the Yen could unnerve the widely utilized Carry Trade) and uncertainties towards the ripple effect of the present slowdown in the US suggests of Increased Portfolio Risks. Of course, aside from our oft mentioned “Fat Tail” or Sigma risks.

This coupled with the rising cost of our capital over potentials returns on our invested capital makes the investing in the local UITs a less palatable proposition today. Sometime in the middle of 2007 could be a good entry point. Posted by Picasa