Tuesday, February 27, 2007

Epicenter China? The Return of Volatility on an Unwinding Yen Carry?

China stocks tumbled the most in 10 years! Global indices seem to be feeling tremor while at the same time the Yen rallies across the board! Are we seeing the return of volatility via an unwinding YEN CARRY or is this merely a head fake? We'll see.

Gold Watch: Gold Breaks Out in Yen!

We have been bullish on gold premised mostly on the flawed structural conditions of the global monetary system. Where no country wants to have a strong currency, gold flourishes as neutral currency against these circumstances.

As such, gold’s rise has not been solely against the US dollar but against all major currencies. Gold's performance against key currencies during the past two years in the table above borrowed from one of my favorite analyst John Maudlin.

The latest rebound of gold in the US dollar is also a worldwide phenomenon, and thanks to Fullermoney.com, we may have a clue on where gold maybe headed for. According to Fullermoney.com, ``This is the first breakout against a reserve currency following the May-June 2006 correction.” Yes, Gold prices breaks out in Yen prices! Will Gold in US dollar follow suit?

Sunday, February 25, 2007

The Phisix Knocks On History

``Global finance is a dark hole. There are more investors in more countries moving more money into more securities in more other countries than ever before. Herd behavior sometimes overwhelms the natural tendency of markets to self-correct, often harmlessly to everyone but overeager investors. Large losses in one market could trigger selling in others. Confidence and spending could weaken. What's unnerving about the global money bazaar is not what we know; it's what we don't know.”-Robert J. Samuelson, Storm Cloud at the Global Bazaar?

So what else can I say? As the Phisix continues to hug the limelight, I have been watching in awe as it energetically set another milestone; a fresh TEN year high!

Based on present conditions, the momentum going forward appears to be insuppressible as the torrent of foreign money inflows have now been AUGMENTED by considerable money flows from Philippine residents.

We are just a few points shy from an important breakthrough; the ultimate barrier erected in February 3, 1997 at 3,447.6 is merely 58.23 points distant from Friday’s close! Beyond this level represents uncharted territory. And this dam could be broken anytime soon. Even possibly by the time you’d be reading this. While I am delighted to witness the Phisix approach my long term goal of 10,000, the prevailing rhapsodical sentiment represents much of a cause of concern in my view.

The Phisix surged 1.67% over the week, and is up an amazing 13.64% from the start of the year. Market internals continue to manifest record breaking upon record breaking developments.

Figure 1: Local Investor Peso Volume Turnover: Surging Momentum

This week has a different theme though. Where in the past local investors mainly played the supporting role to overseas money, this week they apparently were in control. And as the market continues its upward trek, money from resident investors has gradually been increasing as shown in Figure 1, with the recent volume at its strongest level since the inception of the rally in 2003. For this week, domestic investors had a commanding majority (55.77%) of the aggregate transactions!

You see, when the locals are bullish they tend to fiddle with speculative “illiquid” or highly volatile issues. As testament to the speculative proclivity of the local market participants advancing issues hit another record high (421 over the week)!

And because local investors have been generally ecstatic, trading activities are expected to blossom as they frequently take on short-term positions. Again as evidence to this, total daily trades eked another week of record transactions; the average-an astounding 13,878!

Gadzooks, we are today witnessing another spike or more indications of growing overconfidence! The market is indeed getting quite euphoric.

While this week’s foreign inflows had been the weakest since the start of the year, a tepid Php 959.393 million, the breadth of foreign money flows or issues bought up at the boards have been at the highest level since the cyclical turnaround in 2003! In short, foreign money has also joined the locals in the speculative frenzy.

The penetration level of local investors has been extremely low, despite the recent run-up. According to the estimates of the PSE president last year, as we mentioned previously, only about 1% of our population have investments in the domestic equity market.

Present events indicate that this has been evolving. Where the hunt for higher returns have been a key factor in determining investments worldwide, in the light of further advances of the Phisix and the other Philippine asset classes, we are now witnessing a similar spillover effect to the local domain.

Where the once “risk-averse” public have gradually come to psychologically and socially accept that stockmarket investing as a genuine and legitimate investment channel (instead of gambling arena), this implies a strong support for the Phisix (and the economy) over the long term. I would like to emphasize LONG TERM!

The back of the napkin calculation tells us that if the penetration level of local retail investors would treble or reach 3% of the population or 2.55 million, where each participant would transact P 1m worth a year (P 100k traded 10 times) or in over 240 days (20 trading days/mo. x 12 months), daily volume would translate to about P 10.625 billion a day! Considering the present share of foreign investors of about half of today’s volume, our aggregate daily peso volume should be at around P 20 billion! And this does not yet include local institutional investors. You can just guess estimate the level the Phisix would be in at P 20 billion a day-around 8,000!

From the start of the year, our daily volume averaged about Php 4.462 billion where local investors constituted 45.27% of the accrued transactions or P 2.02 billion. I think this roughly falls in line with the estimated penetration level of local retail investors as quoted by the PSE president.

In other words, while nominal volume has grown, the penetration level has NOT YET grown enough to surpass the levels cited by the PSE president. Over the long run this should serve as ANOTHER BULLISH case for the PHISIX, as we have said before.

HOWEVER, over the SHORT-TERM [pardon my insistence with timeframe references, which in my view signifies a crucial factor in determining absolute returns] with the severe lack of understanding, today’s market participants have been mostly drawn by the prospects of EASY MONEY and by SOCIAL PRESSURE rather than risk-reward/cost-benefit factors.

As an example, some market participants insist of being “cerebral” in their approach towards the market when their influence centers affecting their investment decision making process spring from the analysis emanating from information from either mainstream news/ analysts [momentum or fad based] or stock forums. If successful investing in markets means being “ahead of the curve”, how does one gain from the knowledge or information the public already knows? What distinguishes “noise” from “true” drivers?

There have even been the “personality occults” variable. Because of the relative successes of pushing up of several issues based on the JOCKEYING by some key market personalities, these have been interpreted by some punters as having the magic of “King Midas’ golden touch”, where the future direction of the share prices of some issues on the market is wholly dependent on the “blessings or not” of the market’s version of “King Midas”. In short, stock market “jockeys” and not business viability to some are deemed as critical factors in determining their investment returns! Incredible.

Yet, the gullible public has generally ignored the important truisms of a “rising tide lifts all boats” scenario, or as the legendary trader Jesse Livermore discerningly advised, “In a bullmarket all stocks rise in general”. In its eagerness to speculate [NOT invest] the investing public would consume every story Hook, Line and Sinker on even dubious themes as grounds for their bets.

One must be reminded that while management is indeed essential in determining the success of any business, it is also the long term viability of the business model that matters and not some “castle in the air” models, where short term gains or price-driven momentum advances have been the apparent priority.

Stray no further and recall the Technology bust or the Dot Com Bubble in 2000, where share prices of questionable, capital consuming, non-profitable business paradigms were bidded up to stratospheric levels only to end up nowhere resulting to huge losses by gullible investors (again, people get what they deserve).

In the domestic instance, the 1999 BW Resources Fiasco should refresh our memories. From about 60 cents, the company Greater Resources was transformed to BW Resources which raced to about 107 per share, (premised on a chimera or a fantasy business model-it even topped the market cap of San Miguel, the largest market cap at its peak then!) which was “jockeyed” by known market players allegedly with the support of the political leadership.

At the end of the day, the bubble imploded and its shares prices were brought back to planet earth (from 60 cents to 107 pesos back to 60 cents). Some of the jockeys and the principal of company themselves got nastily burned while many gullible investors, who bought into the fad mostly at the top, today still holds on the issue with enormous losses in the HOPE of its revival (of course, in a reconstituted real estate company).

The important lesson here: People have very short memories. For failing to learn from the mistakes of the past, we would most likely see a repeat of a similar fate...someday. Again in the valued words of Jesse Livermore, ``The stock market never really changes that much. What happened before will happen again and again and again."

Liquidity Driven Global Equity Mania

``The closer you are to the truth and the facts, the more of an edge you have. The further you are, the more risk and higher probability of a telephone game of distorted information and stacked assumptions—each precariously dependent on all the priors.” -Josh Wolfe Nanotech

Well, much of the present euphoria has actually been the same phenomenon worldwide, as global equity assets persist to outperform.

Analyst Gary Dorsch, recently observed that bubbles have been brewing in Shanghai Tokyo and London, in a Kitco article he wrote (emphasis mine),

``But what disturbs Chinese government officials are signs of a speculative bubble in the stock market. Investors opened 50,000 retail brokerage accounts a day in December and mutual funds raised a record 389 billion yuan ($50 billion) last year, quadruple the 2005 amount. January turnover was five times early 2006 levels. Beijing is now ordering banks to prevent retail borrowing for stock investments....

``The Chinese stock market has now become the most expensive in Asia, trading at 40 times 2005 earnings, compared to 16 in Hong Kong. The high P/E ratio is supported by expectations of 25% earnings growth for 2006 and 2007, from the possible new tax policy and new accounting standards starting from 2007. However, if 2006 corporate results fail to meet strong expectations, Chinese investors could easily dump inflated stocks, and send the overall market into a tailspin.”

Well it’s not just in China, in Vietnam, the rush into equities have spawned a nationwide mania, writes the Financial Times (emphasis mine),

``After watching the formal stock market's main index soar by 249 per cent over the last 13 months, Vietnam's emerging middle class is in the throws of stock market mania and students, civil servants and state enterprise managers with cash to spare are all rushing to buy shares and dreaming of windfall profits....

``Until recently, Vietnamese tended to put what savings they had into more traditional assets such as gold or real estate. But in the past year the number of trading accounts in the Vietnamese stock market has almost quadrupled from 32,000 to about 120,000.

``Brokerages are mushrooming, with 56 now licensed, up from 16 early last year. All kinds of companies are trying to get a bite of what they see as a lucrative business with one state garment maker, Vinatex, recently declaring it would open a stock-broking arm.

Figure 2: Bloomberg: Ho Chi Minh Index

Speculation knows no boundaries. Figure 2 shows of how success relatively attracts more money, the Vietnam Ho Chi Minh Index up 332% in about two years have been enticing novices and punters to take on “dreams” of a windfall.

Once again to quote the Financial Times, ``“It's a frenzy," says Jonathan Pincus, the UN's chief economist in Hanoi. "All the chatter in Hanoi is about people investing in the market. I don't know if anyone knows what these companies are worth, but they are buying the paper." Well one should know of what comes after manias.

At least here in the Philippines, there has been to a lesser degree similar evidences that would YET suggest of a manic intensity with a similar degree, although we are definitely headed into that direction. As I have been saying repeatedly, Manias can last longer and intensify more than one could ever imagine.

Well of course global liquidity is the main reason for all these.

For instance, we mentioned that marketplace liquidity has been growing even locally. Recently, a publicly listed broker CITISECONLINE <COL> announced that it would begin offering margin facilities to its clientele base backed by a P 200 million bank loan.

Anyway, what I am trying to say is that rising collateral values, increasing pressure from clients, attempts to gain market share and the prospects of more commissions would eventually lead brokers to offer margin facilities to their clients as the upward trend of the Phisix gets more entrenched.

Such facility will add to more liquidity in the marketplace as levered money gets recycled back to the markets in search of better returns. With levered money, volatility of asset prices increases and so as with the risks associated with it.

This, in effect, is what we’ve been seeing in the world marketplace.

Figure 3: The Grandich Letter: US Margin Debts at 2000 levels

In the US markets, margin debts have buttressed the present lofty levels of its equity markets, another potential pin that may cause a serious dislocation. Peter Grandich of the Grandich Letter remarked, ``When stock market players get giddy, they tend to feel it’s a one-way street up and getting highly leveraged is just a way to make more money. They attempt this by borrowing heavily against their existing holdings in order to get more equity exposure. You’ll notice we’re now back to levels last seen in 2000. To those who say the stock market peaked then – good eye.”

Since the US markets have generally been highly correlated with our local market, as well as the rest of the other emerging markets, any disorderly unwinding triggered by these highly levered positions could pose as a significant threat to the present momentum.

Homogenous or Divergent Emerging Markets?

``Venezuela, Nigeria, Iraq, Iran!” Everyone is supposed to be terrified and pay up for oil. But, the horror story is not raising risk premiums on risky assets such as emerging market bonds. Nobody seems bothered by the inconsistency.” Andy Xie

Given that emerging markets which is said to have an .85 correlation with developed markets, according to a report from Bloomberg, a correlation of 1 indicates lockstep movement, the activities of the developed markets particularly that of the US has served as a very significant gauge in assessing the risk-return dynamics and determining portfolio allocations.

Would you believe that due to the tsunami of worldwide liquidity which has practically distorted the pricing of different asset classes, emerging market debts have now been priced MORE than the US corporate debts?

According to a report from the Tom Stevenson of the Telegraph (emphasis mine), ``Globe-trotting investors have become so immune to risk that they are happy to accept lower yields on emerging country sovereign debt than on equivalently-rated US corporate bonds, one of the world's largest fixed-income investors said yesterday.”

In what was traditionally considered as riskier investments, investors typically asked for higher yields to compensate for the risks undertaken, as measured relative to “safe” US Treasury bills, where the difference or the spread represented as the premium. As the perception of risks grows or increases, so does the spread or the premium. That was then.

Today comes in a different context; the reasons investors have priced emerging market debts higher could be due to higher growth prospects, improving fiscal conditions and lesser supply relative to the demand of the issued sovereign debt instruments, according to Mr. Stevenson.

Generally this implies that global investors appear to be immune to the political risk spectrum which could translate to financial risks. In addition, this underscores the one track determination in the quest for higher returns. The desperate search for yields has essentially blinded investors into mispricing or discounting such risks. How could one underestimate the political risks considering the emerging tide of leftist leaders being elected in Latin America or of growing geopolitical tensions in the Middle East or of the recent attempts to impose capital control in Thailand?

And largely because of the hunt for yields and the attempts by fund managers to diversify their portfolios to assets which are lesser correlated to developed markets, the S&P came up with a new investing index, as an offshoot to the emerging market class, the S&P/IFCG Frontier Markets Composite Index, which accounts for 22 emerging markets that are too thinly traded or too small, according to a report from Bloomberg. Naturally such exotic themes as we previously discussed continues to outperform most indices considering their high risks nature.

Now comes the highly respected independent research BCA Research, whose recent outlook tells of the surfacing of a lesser degree of homogeneity or divergence among the emerging market class.

Figure 4: BCA Research: Emerging Markets are No longer Homogenous

According to BCA Research, ``The correlation among emerging equity markets and equity sectors has fallen dramatically in recent weeks. This has largely been driven by fundamental factors such as varying valuations in different segments of the equity universe, as well as diverging country trends in inflation, interest rates and cyclical growth profiles. We expect these divergences to persist heading forward.”

Could the present outperformance of the Phisix translate to internal strength of the Philippine asset classes in the eyes of foreign investors? I doubt so, but we will see.

Philippine Mining Momentum Gains; Gold’s Potential Mania

``Truth, like gold, is to be obtained not by its growth, but by washing away from it all that is not gold." - Leo Tolstoy

The recent resurgence of major commodities such as gold (+2.14% w-o-w), silver (+4.43%) and crude oil (+2.14%~above $60!) appears to have given some traction to the newfound vigor in our mining industry.

As previously discussed in our January 15 to 19 edition, [see No Trend Goes In A Straight Line], the mining sector have been behaving divergently from the Phisix markets since 2006, where it first led the gains during the first half but following the May selloffs, the rally within the sector stalled.

As the Phisix underwent a massive run-up since July, except for some speculative issues, the mines either stagnated or underwent several occasional selling pressures. As the mines failed to pick-up with the general market, a sectoral rotation occurred where many speculators who had been previously bullish with the mines took turns shifting to the other sectors by dumping the mining shares. The wave of selling pressures practically left most of the mining majors to trade in a range while the general market ascended.

I have also noted that because the mining issues had missed the July-Dow inspired rally that they looked LESS vulnerable to a potential exogenous inspired correction or could be deemed as LESS risky when compared to the general market, which has risen significantly.

And that since the market operates in a “Rising Tide Lifts All boats” scenario, the probability looks favorable for the mines to benefit from a forthcoming sectoral rotation. But since I am no clairvoyant and nor am I a seer, I do not KNOW when this shifting should transpire.

Figure 5: Phi-Mining: Breakout looks Strong

With the recent price action of the mining majors as shown in Figure 5, it appears that the rally could get extended, as the momentum looks quite strong and could represent as the inception of the sectoral rotation trend towards the mines.

Yet there could short term risks facing gold prices and the mines, if one would consider the present positioning by investors in the Commodity Futures market, according to Jeff Clark of Growth Stock Wire,

``Commercial short interest in gold is now at a level that typically occurs at short-term tops in the market. According to a report from the Commodity Futures Trading Commission, the commercial net-short interest in gold futures and options is 177,000 contracts. That’s higher than the 172,000 net-short position we saw when the gold market peaked last May. And it’s higher than the 140,000 and 119,000 net-short positions that occurred during the September and December tops.”

So while we may face certain selling pressures in gold prices over the interim which may affect the activities in our mining sector, possibly sectoral rotation could provide for a support.

Let me further add that when investing in themes we try to avoid timing the markets because essentially it is hard to ascertain the tops and bottoms of the cycles, instead the prudent approach is simply to sit and wait until the cyclical shifts becomes evident.

And because we look at themed investing as a long term proposition, this germane outlook from BCA Research on Gold makes us want to keep our long positions of gold until the mania unfolds.

BCA Research as shown in figure 6, opines that Gold is playing out a reprise of the 1970-1980 cycle pillared on four factors (emphasis mine),

``First, global liquidity settings will remain plentiful because inflation will stay low. Second, investor demand for gold will rise in response to higher gold prices after an extended bear market. Third, central bank selling could take time to re-emerge after the wave of liquidation in recent years. Finally, Chinese and Indian private sector gold demand should improve as their wealth and incomes rise.”

While I don’t share the view that inflation will stay low as global monetary authorities continue to pump immense liquidity into the financial system and don’t think much can be done with Central bank selling [they could likely be buyers instead of sellers in the long run], I generally think that gold will eventually go beyond US $1,000.

While we think somehow that investing in mines could serve as a proxy to gold investing since we don’t have a gold market, it is important to realize that not all mines are of the same quality. As such we want to remain invested in mining companies which have the following criteria, as expounded by Craig Walters of the Sleuth.com (emphasis mine);

Evaluate the Level of Sales and Earnings: Many risky exploration companies exist in the marketplace today that have no real sales or profitability. They may have been clever enough to attract lots of cash in the hopes of making a large discovery, though. Unless your risk tolerance is extremely high, you’ll want to own the companies that are actually generating cash flow from selling gold.

Examine the Company’s Reserves: The amount of gold a company has is measured by its reserve level. The higher the reserve, the more gold that can be translated into sales and earnings. It’s important to pay close attention to a company's proven and probable reserves numbers. This will clue you into the possible amount of gold the company can reasonably expect to extract and turn into a product for sale.

Location: It’s important in real estate, and it’s important in gold investing. Well, it’s not so much the location per se, but the politics that control it. It's better to pay a slight premium for gold in a politically stable area than to risk having a dictator seize your company’s mine, leaving your investment worthless. Obviously, gold plays in North America are among the safest in which you can place your money from a political perspective.

Funding: It’s important to look for gold companies that are able to self-fund their operations. That is, they are generating positive operating cash flows, and hopefully positive free cash flow as well. A gold company might have to tap the equity and debt markets from time to time to fund major new projects, but we don’t want to invest in companies turning over sofa cushions to stay alive.

While some mining firms may be in a hot streak for other reasons than the above, we’d like to get a good night sleep and position on issues that “won’t turn sofa cushions to stay alive”.

Sunday, February 18, 2007

Year of the Fire PIG: Lucky Pig Or Pork Loin?

``Every investment is a form of speculation. There is in the course of human events no stability and consequently no safety." -- Ludwig von Mises

Kung Hei Fat Choi!

As we enter the New Year of the FIRE PIG, a yahoo article tells us that this year could be expected to be a turbulent one, with possible incidences of epidemics, disasters and violence. The yahoo article quotes a Hong Kong feng shui master Raymond Lo ``Pig years can be turbulent because they are dominated by fire and water, conflicting elements that tend to cause havoc”.

However, despite the bleak outlook, most of the soothsayers, says the article, think that world economy will continue to boom, yet advices people to be cautious about their investments (duh!).

Another astrology link tells us of an opposing view, that Year of the Pig will be lucky! According to Chineseastrologyonline.com, ``The Chinese see that pigs eat food all the time, enjoy sleeping all day long and worry about nothing during their entire lives. Therefore, pig is a lucky animal.” Maybe FOR the Chinese denizens of the Mainland; China’s bourses in Shanghai (+12.07% y-t-d) and Shenzhen (+37%.67!) have been on FIRE since 2006 and are thought to be in a “bubble” by some analysts, while Hong Kong’s Hang Seng (+3.02%) hasn’t been far behind.

Well, what concerns us is this very important Wall Street “piggy” maxim, ``Bulls, Bears Make Money, Pigs Get SLAUGHTERED!” Which means whether the market is in advance or decline, it is the “greedy” suckers who essentially gets creamed...ALWAYS.

Now speaking of greed, all, if not most of you, are now aware that the Philippine Stock market, once a PARIAH, is today’s CYNOSURE.

It certainly has been a twist of fate, and a most significant vindication on my behalf. (While turning bullish on the market in 2002, the years of drought have depleted most of my resources which almost compelled me to reluctantly shift careers...I was essentially saved by the proverbial BELL! Sorry to my batchmates who had earlier expected me to join them in their field).

The record breaking developments of the Philippine financial markets as seen in the Phisix and the Peso have now been splashed into the MAIN headlines (and NOT just the business headlines) of the front pages of the major local broadsheets. What used to be a function of plainly business interests has NOW BECOME a FUNCTION OF SOCIAL SENTIENCE! As I have repeatedly argued, the financial markets bear the important facets of social phenomenon aside from the “commonly known” economic, financial or corporate dimensions. The present breakthroughs are very important indications of transformation because it HIGHLIGHTS the evolving phases of the stock market cycle or the cyclical phases of any financial market.

In addition, as signs of complacency, low regards to risks, and prospects of easy money, I continue to receive queries on which issues to speculate on by vulnerable retail investors. For you who read me, you’d know that my usual response to these, “I am NO SOOTHSAYER or CLAIRVOYANT to know or identify which stocks will be tomorrow’s darlings, as I CANNOT READ THE MINDS of the collective thousands of investors.” Yes sorry, but I cannot live up to your “excitement expectations” of me because my concern is about ABSOLUTE RETURNS and not of faddish themes as mainstream analysts are wont to do.

I have long given up on the “excitement themes”, particularly betting on Jai-Alai (well, honestly it closed more than I had to give it up) or Horse Racing, and believe me the financial markets are NOT of the same class if ONLY to be based on time frame preferences.

The public in general has this misplaced notion that such activities are one and the same. To such context, we might say that the degree of assumed risks EQUALS to the degree of expected returns. While the average investors put to risk 100% of their capital to generate 10% returns, prudent investing means the reverse, risking 10% of capital to generate 100% returns. In other words, people get what they deserve.

While chart reading may yield some clues, they serve NO guarantees, and are NOT foolproof of the momentum you and I would like to expect. Charts function as a tool in my view, and have not been the ultimate determinant of my investing decision making process.

Chartists who declare that they read psychology, and operate SOLELY on such premises, in my view, simply are instruments of brokers whose aim is to churn accounts in conflict to our goals. Furthermore, the portrait of price action operates SINGULARLY on a historical context, where if to paraphrase the Sage of Omaha Mr. Warren Buffett, ``if past history was all there was to the game, then the richest people would be librarians.” In the markets, the reality is that previous performances are NOT surefire signals of tomorrow’s action.

Moreover, the concept of price action as a standalone analysis misses out the psychological premises in the field of economics (Austrian) such as the HUMAN ACTION and of IRRATIONALITY of the markets in the variegated outlooks of behavioral finance/economics, George Soros’ Theory of Reflexivity, Multi-fractal analysis of Benoit Mandelbrot and the dynamics of Booms and Busts as conveyed in the book Manias Panics and Crashes by Charles Kindleberger. In other words, pattern recognition based on price action, for me, serve as a ONE dimensional and oversimplified approach to investing, which may NOT be the optimal way to generate superb returns.

By the way, for your information, my mentor started me out basically as a technician, owing my first lessons to the book of Alexander Elders “Trading for a Living”. How time has changed.

Remember there is NO one HOLY GRAIL for financial market’s investing. Quants and their Nobel Laureates ilk have likewise designed sophisticated mathematical-probability modeled trading programs that basically underestimates statistical “FAT Tail” or low probability high impact events. The 1998 LTCM fiasco clearly comes to mind. Yet many of today’s hedge funds operate on such paradigms and are levered to the hilt in order to generate above par returns.

We might as well also remember that TODAY’S FAVORITES/WINNERS MAYBE TOMORROW’S LAGGARDS and vice versa. It is RANDOMNESS over the short run that dictates on the market in spite of the declarations of your most loved prime time analysts.

Because markets reflects of a social spectrum, the recent successes of the Phisix will surely attract more of the numerous skeptics in the long run, while at the same time enhance the risks taking appetite of the general investing public. It is no less called than the SURVORSHIP Bias where people see only [or are drawn] to the winners. A befitting quote from Ex-US President John F Kennedy’s underscores such phenomenon, ``Victory has a thousand fathers but defeat is an orphan”.

Local business analogies would be mini boom-bust episodes of the “pan de sal”, “lechon manok”, shawarma, “pearl shakes” [zagu] and etc...

Since the state of the present Philippine market cycle is essentially in a bullmarket or in the advancing phase over the long run, the general premise that one should consider is that of the Rising Tide Lifts All Boats (RTLAB), although not equally. Yet under a more torrid circumstance, as Wall Street says, Even Turkeys Fly in Strong Winds (ETFSW), which means that even the weakest showing stock today will be boosted as general sentiment will buoy the issue regardless of fundamentals or story.

Considering yet the narrow breadth of the supplies of listed companies, the speculative tendencies of the public will mean more issues being bidded up regardless again of fundamental outlook, and more upside volatility in the frantic state to pile up on winners.

As we tackled in our Jan 29 to Feb 02 edition (see The Phisix is UP 9%, It’s EASY Money Out There!), of the snowballing exuberance, the Phisix surged to a 10-year high (up 2.7% w-o-w, +11.7% y-t-d!) late this week. The SURVIVORSHIP Bias has NOW lured investors to the a RECORD BREAKING number of trades, averaging about 11,500 a day for the week, while daily traded issues spiked to an average of 172 a day! The market appears to be getting really ecstatic now.

If the past would RHYME if not repeat itself, then you could be looking at an interim TOP. Yet, as a client texted me earlier on the supposed consolidation of the PHISIX and the US benchmarks, my response was the market hasn’t revealed signals of stress yet, which proved to be a lucky observation considering that both the PHISIX and the US benchmarks took on NEW highs at the latter segment of the week.

Figure 1 stockcharts.com: Confirming Averages

In figure 1, the great run of the US benchmarks has expunged all sorts of previous divergences. Today, the Dow Jones Industrials (black-red candle), Utilities (lower pane) and Transports (line chart behind) have chimed to signal that the upside momentum, according to the Dow Theory, has strengthened in spite of the litany of “wall of worries”.

Further, major headlines as a social indicator could mean the public has, for the interim, jumped on ONE side of the trade and this could translate to a short-term profit selling event, nevertheless this comes in the face of the rising US benchmarks which has so far greatly inspired the mighty rally seen in the Phisix.

As you have known, I have been NEUTRAL to BEARISH on the interim on the Philippine equities and the Peso considering the frenzied momentum relative to the exogenous risks presented. Although, I have not recommended to anyone for that matter to SELL yet, considering that the premises of irrationality could translate to EVEN MORE UPSIDE MELT-UP, which could even be aggravated by the accelerating upside momentum in the US markets.

On the other hand, I have asked those who have been unable to resist the ITCH or the “social” pressure to jump into the market with caution, investing only the amount of which one can afford to risk or assume upon a position of risk which one can afford to sleep upon.

While the market may encounter a counter trend soon, AS ANY CYCLE DOES, the long term trend remains accommodative towards one’s mistakes. But that doesn’t mean that one should ride roughshod over the market. Reckless behaviors equate to ignoring the risk equation which frequently results to either poor returns or even at worst; gut wrenching losses.

What I have repeatedly suggested to you is to TIGHTEN YOUR STOPS and await for the next cycle before undertaking an overweight position. After all, successful investing is all about patience, and discipline, without it PIGS get slaughtered and sold to the market.

Parties Never Last, Hangovers Do!

``The market, like the Lord, helps those who help themselves. But unlike the Lord, the market does not forgive those who know not what they do.”- Warren Buffett

The risks remain out there in spite of the snowballing sanguine expectations.

Figure 2: IMF: Philippine Peso and the VIX Index

In figure 2, courtesy of the IMF, the Philippine Peso (dotted line) has appreciated amidst the backdrop of a RECORD low volatility, low signs of anxiety and high-risk appetite conditions as represented by the VIX Index.

Figure 3: IMF: Appreciation pf Regional Currencies Against the US Dollar

And as I have likewise pointed out in the past, the rising Peso has been a regional phenomenon as shown in Figure 3, again from the IMF. Growth in forex reserve surpluses, increasing rate of (portfolio) investment flows, surging remittances, greater official cooperation, regionalization trends and/or increased economic and financial integration have served as the key impetus, aside from of course, as beneficiary to the global carry trade and a structurally weakening US dollar.

Figure 4: IMF: Rollover and Exchange Risks in Public Debt

The Philippine financial markets seems to be pricing in conditions where the low key reporter Clark Kent turns himself into Superman! Yet, all these could be illusory or smoke and mirrors as global inflationary policies heavily distort risk pricing activities by investors whose goal had been no less than to hunt for expanded returns, no matter the risks involved.

While there is no question that the present efforts of reforms instituted by the incumbent administration has significantly improved the country’s finances and fiscal position, a boatload of work remains to be done.

In Figure 4, the IMF reminds us that the Philippines remains as the region’s MOST VULNERABLE relative to Debt to GDP risk, Exchange Rate risk and Rollover exposed debt to GDP. Wrote the IMF (emphasis mine), ``As a result of recent reforms continued robust growth, and the more appreciated exchange rate, staff expect NFPS (Non-Financial Public Sector) debt to have fallen below 80 percent of GDP by end-2006, compared to 100 percent at end-2003. External debt is expected to have declined by a similar order of magnitude. Nonetheless, the Philippines remains vulnerable to a sudden reversal in global risk appetite, as rollover and exchange risk remain high.”

And this is what I’ve been saying all along. Today’s tsunami of capital has prompted both the private and public institutions, particularly the emerging trend of state investment companies to manage excess reserves, into expand their investing universe, to even consider illiquid and exotic themes, in order to squeeze out returns in a world faced with diminishing returns due to extensive competition and adaptation of similar investing approaches.

Furthermore, the introduction of innovative instruments such as derivatives, structured products and other forms of sophisticated trading strategies has compounded this outlook. As we have discussed before, in order to expand returns more leverage are being applied to magnify returns.

For instance, in our past issues we delved about the added liquidity brought about by the provisions of the carry trade arbitrage, where according to the Financial Times, ``households in Latvia and Romania have developed so much enthusiasm for borrowing in yen.” This means the carry trade has now turned increasingly global and more widespread to include unsophisticated households.

As record short positions have been taken against the “funding” currencies of the Japanese Yen and the Swiss Franc, demand for high yield instruments as the New Zealand’s dollar have caused a surge in the bond issuance of KIWI, adds Peter Garnham, Gillian Tett and David Turner of the Financial Times (emphasis mine), ``To take one out-of-the-way corner of global finance, the amount of bonds denominated in New Zealand dollars by European and Asian issuers has almost quadrupled in the past couple of years to record highs. This NZ$55bn (US$38bn, £19bn, €29bn) mountain of so-called "eurokiwi" and "uridashi" bonds towers over the country's NZ$39bn gross domestic product - a pattern that is unusual in global markets.” Incredible.

While this has so far reduced the volatility in New Zealand’s currency or any asset beneficiaries of the carry trade by way of offsetting the risks via hedging through derivatives, the world has been consistently adding tremendous amount of leverage which may at one point pose as a systemic risk or destabilize the global financial markets and the world economy.

Derivative trades, like any typical trades work on two ways, a buyer and seller, while such aims to reduce risks by dispersion one thing we shouldn’t forget is that there is always someone on the other side who will absorb the risks.

And I think this phenomenon is adding to the speculative inflows into our region and our local asset class.

Table 1: Guinness Atkinson’s Asia Brief: Asia’s PE

Aside from China and Hong Kong which had been mentioned earlier, on a year to date basis here is how the region fared: New Zealand +3.07%, Australia +5%, Taiwan -1.82%, South Korea +1.0%, Thailand +1.2%, Indonesia -.62%, Japan/Nikkei +3.77%, Singapore +8.4% and Malaysia +15.13%.

As you can see in Table 1, relative to PE ratios, the Phisix is situated on the HIGH end among its regional contemporaries in 2006. Whereas its earnings growth is expected to outperform the region for 2007 and 2008, the present gains appear to have almost consumed the expected growth rate. The same dynamics can be said of with the outperformance of Malaysia and Singapore, as well as, China. This essentially means that today’s star performers appear to be more richly valued relative to its peers.

Like your analyst, the Guinness Atkinson team remains bullish on Asian assets over the long term where they noted that (emphasis mine) `` it is the outlook for Asia’s domestic demand that is a key issue for future investment prospects and strategy. It also helps us understand why Asian central banks have been reluctant to allow too rapid a rise in their currencies while local demand remains fragile. Inflation in the region is subdued (including Indonesia where it has fallen sharply in the last couple of months to 6.6%) and should remain so until domestic demand picks up.”

Figure 4: Daily Wealth: Emerging Markets as Expensive as Ever!

Finally in figure 4, Daily Wealth Dr Steve Sjuggerud thinks that emerging market stocks are overbought, overvalued and way extended after having breached twice the Book Value of its underlying assets.

In other words, as our markets continue to head higher, the risks of sharper adjustments by way of precipitate correction increases. Parties never last, hangovers do.

Interview on CNBC with Warren Buffet and My Comments

``Wall Street likes to characterize the proliferation of frenzied financial games as a sophisticated, prosocial activity, facilitating the fine-tuning of a complex economy. But the truth is otherwise: Short-term transactions frequently act as an invisible foot, kicking society in the shins." - Warren Buffett

I’d like to thank my pal Raul Policarpio for passing on to me this very interesting subject, a summary of the life of the world’s second richest man....

There was a one hour interview on CNBC with Warren Buffet, the second richest man who has donated $31 billion to charity. Here are some very interesting aspects of his life:

1) He bought his first share at age 11 and he now regrets that he started too late!

2) He bought a small farm at age 14 with savings from delivering newspapers.

3) He still lives in the same small 3 bedroom house in mid-town Omaha, that he bought after he got married 50 years ago. He says that he has everything he needs in that house. His house does not have a wall or a fence.

4) He drives his own car everywhere and does not have a driver or security people around him.

5) He never travels by private jet, although he owns the world’s largest private jet company.

6) His company, Berkshire Hathaway, owns 63 companies. He writes only one letter each year to the CEOs of these companies, giving them goals for the year. He never holds meetings or calls them on a regular basis.

7) He has given his CEO’s only two rules. Rule number 1: do not lose any of your share holder’s money. Rule number 2: Do not forget rule number 1.

8) He does not socialize with the high society crowd. His past time after he gets home is to make himself some pop corn and watch television.

9) Bill Gates, the world’s richest man met him for the first time only 5 years ago. Bill Gates did not think he had anything in common with Warren Buffet. So he had scheduled his meeting only for half hour. But when Gates met him, the meeting lasted for ten hours and Bill Gates became a devotee of Warren Buffett.

10) Warren Buffet does not carry a cell phone, nor has a computer on his desk.

11) His advice to young people: Stay away from credit cards and invest in yourself.


While I do not know about the authenticity of this article I would like to share my insights on this interview:

1. My icon shows of a regimented way of living which reflects on his investing philosophy.

2. His aversion to credit cards is a sign of discipline. Why pay for the financing charges on unproductive expenditures?

3. While he may not be as sociable by way of avoiding the high society crowd, his contribution to the investing world, his invaluable shared insights makes him one of the world’s well respected and greatly admired persons.

In 2006, a lunch date auction with Mr. Buffett for charity purposes raised US $620,000. In other words, one person shelled out US $620,000 (€341,000) just to have lunch with him! Would anyone pay for the same amount to have lunch with any of the other members of the “high society” crowd?

Further as stated above, Bill Gates became a devotee or protégé of Warren Buffett, to the point that Mr. Gates is now a board of director in Mr. Buffett’s flagship Berkshire Hathaway and a beneficiary of Mr. Buffett’s $37 billion donation to the Gates Foundation.

Could it be that winning the respect of the world’s richest man is considerably worth more than that of the “high society crowd”?

4. It is the embodiment of Humility at its finest!

5. Mr. Buffett loves Coke [drinks five cherry cokes a day (!) according to CNN], his Berkshire Hathaway is Coke’s second largest shareholder according to fundinguniverse.com!

6. Mr. Buffett loves to play Poker [so does Mr. Gates]! The Billionaire recently went BROKE in a Texas charity tournament last December, according to MSNBC.

Do you have what it takes to emulate Mr. Buffett? I don’t.

Sunday, February 11, 2007

SubPrime Jitters and the LUDIC Fallacy

``Fools ignore complexity," said Alan Perlis, the US computer scientist, "Pragmatists suffer it. Some can avoid it. Geniuses remove it." The world's central bankers, who are fretting about the growing complexity of financial markets, are clearly not fools. But unless a genius comes along with a solution, they will have to be pragmatic about complexity, and all of the risks that it entails.”-Financial Times, Where is the Risk?

I had been asked by a client if the recent developments in the US subprime mortgages market could signify as a possible catalyst that could upset the present momentum in the financial markets.

Subprime loans are basically loans to consumers who do not qualify for prime rate loans and have impaired or non-existent credit histories, therefore are classified as a higher risk group likely to default. As such, subprime loans are charged at higher rates compared to the prime loans.

``They made up about a fifth of all new mortgages last year and about 13.5 percent of outstanding home loans, up from about 2.5 percent in 1998, according to the Washington-based Mortgage Bankers Association” notes a Bloomberg report.

Rising incidences of defaults and foreclosures have led to a wave of mortgage lenders going under. Since December of 2006 ``about 20 lenders have gone kaput”, according to Mortgage-Lender-Implode-A-Meter.

Present developments have likewise led to the an increased loan loss provisions by the world’s third largest bank by market value, the HSBC Holdings Plc, aside from suffering from a management shakeout, while US second largest subprime lender New Century Financial Corp said that it probably lost money last year and had to restate earnings for 2006, where its stock prices tumbled 36% last Wednesday.

While of course we remain vigilant over the fact that the latest housing boom in the US has been the biggest since 1890, according to Yale Professor Robert Shiller of the “Irrational Exuberance” fame as shown in Figure 1.

Figure 1: NYT: Largest Housing Boom Since 1890

The consequent fallout could rather be nasty. As we previously quoted Mr. Shiller [see Jan22to 26 Financial Globalization’s Pluses and Minuses] saying that while the present decline in the housing industry had been seen largely in the context of the RATE of change by mainstream analysts, nominal housing prices remain at LOFTY levels. And at such high levels, it would be unusual for a manifestation of a bottom as activities remain vibrant aside from indications that the bulls remain HOPEFUL.

Since ALL markets are essentially psychological, the embellished description by the elaborate Josh Wolfe of Forbes on the US present day housing dilemma seems clear enough, ``But it’s not until you see a middle-class family on the cover of Newsweek with their bags outside of a church that we’ve seen full capitulation. Like a pendulum, when things go to excess they revert.”

Mr. Shiller recently twitted mainstream analysts in his latest commentary at the Wall Street Journal for not being able to predict the occurrence of the recent US housing boom, and as consequently questions them for their ability in finding a bottom, yet he wrote to remind us that the present risks shouldn’t be papered over (emphasis mine),

``We are left with a deeply uncertain situation, but one in which it would seem that a sequence of price declines continuing for many years has some substantial probability of happening. Traditional finance theory has trouble reconciling even a semi-predictable sequence of price declines with basic notions of market efficiency. The situation we are facing is a reminder of the glaring inefficiencies and incompleteness of existing markets for residential real estate, and may be regarded as evidence that institutional changes will be coming in future years to fundamentally change the nature of these markets.

Let me remind our readers that today’s Globalization has NOT been limited to trade and migratory trends but also to the financial markets.

Figure 2: Stockcharts.com: Global Correlation

Where money flows have been enabled by the click of the mouse, and where global inflationary policies, which have resulted to an ocean of liquidity, have collectively altered the risk environment as evidenced by record low spreads and interest rates, almost simultaneous advances in diversified asset classes, historically low volatility and strong risk-taking appetite; the world’s financial market have shown unprecedented correlativeness.

As evidence, look no further and compare our own Phisix (red-black candle) in Figure 2, with that of the Dow Jones Industrial Averages (black line), and the Ishares MSCI Emerging Market Index (lower panel). Quite simply, world markets appears to have moved as one, which suggests that as much as the present market gains from the dynamics of global interrelatedness, the fundamental risks have been equally shared, as we have explained in our January 8 to 12 edition (see Global Risks Rise Amidst Market Euphoria).

To quote the recent Emerging Market Report by the Institute of International Finance or the world’s only global association of financial institutions (emphasis mine), ``There are a number of risks to the projections. They include: increasing geopolitical tensions with potential effects not only on the real economy but also on market sentiment and risk appetite; uncertainties about the duration and severity of the ongoing housing slump in the United States as well as its impact on the rest of the economy; and the ever-present potential of the huge global current account imbalances igniting a disorderly adjustment, especially in the event of a sharp weakening in U.S. growth. Realization of any of these and other major risks could bring about a sharp adverse turn in the global financial environment now characterized by ample liquidity, low volatility, and strong risk appetite.”

Going back to whether the spate of adverse developments in the US will spillover to its financial markets and spread globally, recent market actions tell us that such effects have been rather benign or subdued, so far.

Figure 3: Stockcharts.com: Dow Jones Mortgage Finance and Philadelphia Bank

In Figure 3, the Dow Jones US Mortgage Finance Index (red-black line), whose components include the Government Sponsored Enterprises (GSE) as Freddie Mac and Fannie Mae, aside from the Philadelphia Bank Index (black line) has apparently shown minimal collateral damage arising from the recent developments.

Considering that the present state of the markets which has been largely overbought and overextended, the recent activities merely reflect profit-taking instead of a PANIC driven strain of action. Put differently, the damage has not been MATERIAL enough to convincingly manifest of a TREND REVERSAL.

There are two important matters to distinguish here; one is a plain correction which simply implies profit taking but a continuation of the underlying general trend and the other is an inflection point which indicates of a general trend reversal. Taking on the necessary action depending on which circumstances emerge is very important in determining your portfolio returns.

Investors who rely mainly on the assumption of fundamentals as drivers to the markets, ignoring market psychology, could get surprised or stumped with losses by the extraordinary resilience of a trend. In the words of market savant billionaire philanthropist George Soros in his book, the Alchemy of Finance, ``Markets are almost always wrong but their bias is validated during both the self-fulfilling and the self-defeating phases of boom/bust sequences. Only at inflection points is the prevailing bias proven wrong.” This goes to show that even if the markets are deemed fundamentally wrong they may remain or stay wrong until a certain point. Or as marquee economist John Maynard Keynes once warned, ``the market can stay irrational longer than you can remain solvent.”

Yes, defying a trend can usually be hazardous to one’s portfolio.

As you know, I have remained skeptical of the present rally on largely the account of a general downshift in the global economy, as shown in Figure 4, whose ramifications are to a large extent unqualified and whose outcome could be uncertain.

Figure 4: IIF: Worldwide Economic Growth Slowdown

Unlike the consensus who believes that today’s financial markets looks insuperable, deservingly risk free and incorporates permanency to present conditions, the inflationary dynamics has, in my view, distorted the way risks have been priced in, in as much as how assets have been valued at.

Further, boom-bust cycles have been determined by massive credit expansions from which today’s marketplace have been structured, in the words of the illustrious Ludwig von Mises, ``The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market”.

In principle, this makes little difference from what has occurred in the Great Depression in the 1930s to Japan’s recent bout with deflation. Of course, this is in sharp contrast to Milton Friedman-Anna Schwartz’s theory [US Fed Chief Bernanke’s icon] that it was government’s failure to liquefy the system that caused such conditions.

In fact, in terms of the scale and magnitude, today’s money and credit creation has been unprecedented.

I might add too that today’s financial marketplace is undergoing the greatest experiment of all time, the FIAT MONEY Standard or the US dollar “DIGITAL and DERIVATIVES” standard system.

American Jurist Oliver Wendell Holmes Jr. once said that ``A page of history is worth a volume of logic.”

In the John Law 1720 experience, the excesses of fiat money dynamics caused a reversion to the gold standard; it may or may not be the case today. In human history ALL experiments with paper money have been etched in epitaphs.

The great depression led to the US Government’s revocation of the public’s ownership rights of gold and the adoption of protectionist policies.

In addition, while there have been indeed massive changes in today’s economic and financial frontiers such as a combination of deregulation, technology enabled integration, greater participation of nations to trade and the inclusion of a huge pool of labor supply into the world economy, which has contributed to what is known as the era of disinflation, the collective government/central bank’s action has been to sow the seeds of inflation in the financial system.

The public’s perception that inflation remains muted lies on the chicanery of price index manipulation meant to promote and preserve the political power of the ruling class, regardless of the form of government. In Zimbabwe, for example, its national government comically and laughably declared inflation as illegal amidst hyperinflation or inflation gone berserk! Quoting New York Times (emphasis mine), ``For the government, “the big problem about Zimbabwe is that the one thing you can’t rig is the economy,” said one Harare political analyst, who refused to be identified for fear of being persecuted. “When it fails, it fails. And that can have unpredictable effects.” Well, governments can rig anything except for purchasing power.

One must be reminded that these massive changes globally may well just be the initial impacts of the adjustments operating under a greatly expanded economic universe which should translate to rising inflationary pressures overtime as demographic trends and entitlement programs continue to exert pressures on the fiscal state of collective governments.

This is not without precedent, however. Historian Niall Ferguson identifies globalization trends prior to 1914 which ended with the advent of World War I. Operating almost in the same template, the financial markets had been equally complacent then and risk insensitive. Let me quote Mr. Ferguson at length,

``To be sure, structural changes may have served to dampen the bond market’s sensitivity to political risk. Even as the international economy seemed to be converging financially as a result of exchange rate alignment, market integration, and fiscal stabilization, the great powers’ bond markets were growing apart. The rise of private savings banks and post office savings banks may help to explain why bond prices became less responsive to international crises. An investor whose exposure to long-term government bonds was mediated though a savings account might well have overlooked the potential damage a war could do to his net worth, or might well have missed the signs of impending conflict. Yet even to the financially sophisticated, as far as can be judged by the financial press, the First World War came as a surprise. Like an earthquake on a densely populated fault line, its victims had long known that it was a possibility, and how dire its consequences would be; but its timing remained impossible to predict, and therefore beyond the realm of normal risk assessment.

He warns of the risks that history could repeat itself.

Aside from risks of a long known possibility but whose “timing is impossible to predict” also comes of risks from something beyond what is conventionally known. It is called the Black Swan problem, where swans had been assumed as white until black swans where found in Australia....or risks associated with RANDOMNESS.

To borrow the words of the erudite author Nassim Taleb which he calls as "ludic fallacy" or "the attributes of the uncertainty we face in real life have little connection to the sterilized ones we encounter in exams and games".

The real world is complex, fluid and dynamic. This is in contrast to what is commonly known, or perceived as, or what we know, and could pose as one of the "sterilized" risks probabilities. We maybe overestimating on what we know and underestimating the role of chance. Most of the blowups emanate from unexpected events. Trying to figure or mathematically model all variables is an impossible task; while we try to assimilate risks prospects, the more scenarios we build on, the more questions that comes in mind.

I am not certain if the present ruckus in the subprime markets will diffuse to the general markets. Signs are that the impacts have been minimal; yield spreads in major public and private instruments benchmarks have been little changed, US dollar has even declined, while gold and oil staged strong rebounds. In other words, no relative signs of stress yet.

However if major participants to the subprime mortgage markets find themselves facing a liquidity squeeze enough to provide for a meaningful impact on the Credit and Derivative markets, then there is a likelihood of a contagion to the general financial sphere with systemic repercussions. It would be best to deal with these once the signs of stress or dislocations become more apparent.