Sunday, April 29, 2007

Many of Mainstream Media’s “Reality” Represents Skewed Consensus Thinking and a “Black Hole of Risk Reporting”

``Let’s be clear: the work of science has nothing whatever to do with consensus. Consensus is the business of politics. Science, on the contrary, requires only one investigator who happens to be right, which means that he or she has results that are verifiable by reference to the real world. In science consensus is irrelevant. What is relevant is reproducible results. The greatest scientists in history are great precisely because they broke with the consensus.”-Michael Crichton

SINCE we got engaged into this endeavor, we realize of the indispensable function of information in determining our investing decisions. Yet, faced with the availability of a multitude of information in the cyberspace, our role is to ascertain the electrical engineering equivalent concept of “signal-to-noise” ratio or to distinguish the “level of desired signal” from “the level of background noise”.

In the investing sphere NOT all information are created equal. For instance, information disseminated in mainstream media signifies public knowledge; where the likelihood is that such published information has been reflected into the prices of the underlying securities or of the markets reported. Hence, the implications of the data presented are less likely to have a significant impact on the pricing UNLESS of course, if it comes with a “dramatic surprise”.

In my case, examining the relevance of the data or theory presented and its potential ramifications, its timeliness, the manner of which it was presented or the “framing” process, the “implied” biases reflected by its author and/or the publishing entity, aside from their credibility or reputation and most importantly the latent motivation or incentive for such article.

Remember, for the conventional news outfits, it is SELLING the news which counts more than simply conveying the information. Why do you think controversies or sensationalism mainly hug the headlines (whether it is your favorite broadsheet or prime TV news station)? Is it not there to catch your attention?

And since the business of mainstream media is to sell news, then it is quite obvious that the current or du jour “sentiments” underpin most of their articles. What you may believe as “reality” are most likely present fashions or trends and may yet be susceptible to change, whether it is comes from the Fox, CNBC, CNN, the USA Today or the New York Times, Manila Bulletin or Philippine Daily Inquirer.

Take for example, market Guru Jim Rogers’ experience. When interviewed in mainstream media in the late 1990s where he predicted the revival of the commodities and the China investing themes, his ideas were simply shrugged off and dismissed as “...anchors were still giggling with glee still advising to buy more dot-com shares.” Now, of course, everyone knows what happened next.

My own experience post 9/11 “day of infamy”, was when the PRO-war sentiment has dominated the airspace, your analyst, by taking the usual contrarian stand, joined the war debate by taking his conviction, a letter of rejoinder to a pro-war columnist in Businessworld. The financial genius columnist quoted me verbatim, albeit anonymously, in his column and promptly rebutted my arguments. I was no match against his eloquence though. But 6 years from the war, it is a wonder how media’s “reality” or sentiment has radically changed.

Another example was from last week, where we pointed to the inconsistencies of the article underscored by a “bias” quoted from an expert who was incidentally an authority from a top government bank. While the articles’ prominence, given by its frontpage treatment, could likely be indicative of the snowballing trend towards national awareness of the Philippine capital markets, the banker’s “risk-free” suggestion of their products lack the perspective of the risks provided for by eroding purchasing power via inflation. So aside from popular sentiment, you have “biased” opinions pervading mainstream media.

In short, news from mainstream media represents MOSTLY consensus thinking. And consensus opinions have proven to be glaringly wrong especially during major inflection points of any trend be it scientific, social, political or financial trends.

Let me quote Elliott Wave’s Alan Hall who enumerates past scientific “reality” by the consensus:

``Some ideas accepted by popular consensus that are now rejected:

-The flat earth


-The harmlessness of tobacco

-The link between electromagnetic fields and cancer

-The benefits and harmlessness of leaded gasoline additives, followed closely by

-The benefits and harmlessness of MTBE gasoline additives

-Nuclear Winter


And that’s the reason why contrarian analysts utilize so-called “Magazine cover indicators” to discover misguided but deeply entrenched popular beliefs and promptly bet against them.

Finally, mainstream media could also suspiciously serve as conduits for politically veiled agendas. For example, as in the war in Iraq, mainstream media seems ever so obsessed with the potential menace of H5N1 (whose pandemic reach is something we DO NOT DISCOUNT).

However based on present facts (of course such dynamics could change), the death toll from malaria, according to the World Bank, is about a million a year or 3,000 children a day far exceeds that of the much feared H5N1 virus.

While we certainly are NOT qualified to offer expert opinion on such matters, we quoted this previously from risk communications expert Peter Sandman (which continues to haunt us), ``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.

Lately Mr. Sandman provides for more explicit examples of such media covered hazard-outrage asymmetries (emphasis mine), ``As for high-hazard, low-outrage risks — smoking, driving without a seatbelt, obesity, and the like — media coverage tends to be scanty and dutiful. These are the stories that are simultaneously too serious to sensationalize and too boring to cover straight. They’re the black hole of risk reporting.

``There are certainly times when the media sensationalize serious risks, especially in “docudramas.” But in news, sensationalism is most common in stories with no serious implications for public health. “Flesh-eating disease” gets sensationalized; terrorism usually doesn’t.”

This leads us anew to question on the present dynamics...

While it is true that Malaria appears to be confined to low income countries while the H5N1 virus has pandemic potentials, could it be that the world has instead been overreacting to a “fear-imposed outrage”? Or could it be that such “sensationalized outrage” have been utilized as justification for more government “carte blanche” intervention?

And you can look elsewhere for the application of such mainstream media promoted popular consensus themes...

As German Philosopher Oswald Spengler once wrote (emphasis mine), ``The press today is an army with carefully organized weapons, the journalists its officers, the readers its soldiers. But, as in every army, the soldier obeys blindly, and the war aims and operating plans change without his knowledge. The reader neither knows nor is supposed to know the purposes for which he is used and the role he is to play. There is no more appalling caricature of freedom of thought. Formerly no one was allowed to think freely; now it is permitted, but no one is capable of it anymore. Now people want to think only what they are supposed to want to think, and this they consider freedom.”

That’s why I don’t ask you to just trust me, read diverse “non-mainstream” opinions for your intellectual freedom.

Prudent Investor Suggests: Overweight the Phisix More than the Dow Jones Industrials!

``Much has been written about panics and manias, much more than with the most outstretched intellect we are able to follow or conceive; but one thing is certain, that at particular times a great deal of stupid people have a great deal of stupid money.”-Walter Bagehot, English Journalist (1826-1877)

The markets appear to be headed in the direction which we have been anticipating albeit in a much gradual fashion. Yes, contrarians need the crowd to bolster their prescient views or investment positions.

Following the dynamics of the US markets, the Phisix breached its minor resistance levels to a high of 3,350 but closed back to within its new support levels/previous resistance. The Philippine benchmark ended the week up 1.95%, as the Peso continued to set new milestone 6 year highs at Php 47.46 against the US dollar.

While we are aware that the market action risk increases in an environment where momentum gets overheated, any present market declines in spite of the traditional seasonal weakness could possibly mean a pause rather than a reversal.

Taking a cue from Mr. David Kotok of Cumberland Advisors, ``We would now say to “sell in May” if the Fed Funds futures market was demonstrating an expectation that the Fed was going to hike in the future. This is currently not the case.” In other words, while Mr. Kotok expects the low interest rate environment as conducive for equity markets investing, we keep my fingers crossed.

The US dollar (trade weighted index) fell to near record levels as the Euro surpassed its December 2004 high ($1.3667) to set a fresh record at $1.3682. The euro closed at $1.3634 up .26% for the week.

As previously shown, we think that the falling US dollar has been the ONE major pillar which has lead to money flowing out of the “orthodox” US markets to the non-mainstream markets as the emerging markets or even timber (from Jeremy Grantham, Chairman of Grantham Mayo Van Otterloo).

A friend asked me recently on a choice whether to maintain his portfolio of US investments in the US equity markets or the Phisix. My obvious response was that it would be best to keep ourselves diversified. However, Figure 1 shows how the Phisix performed over the past three years as deflated by the US DOW JONES INDUSTRIAL Index.

Figure 1: The PHISIX vs. THE Dow Jones Industrials

The upper pane accounts for the movement of the US dollar trade weighted Index, while the lower pane represents the Morgan Stanley Capital Emerging Free Index. The center window shows how the Phisix performs relative to the Dow Jones Industrial Averages such that if the Phisix is outperforming the Dow Jones Industrial then the chart shows of a rising trend, and vise-versa.

The purpose of the US dollar is to once again show its PAST and PRESENT correlation with that of the Phisix, emerging market index and of the Phisix-Dow Jones activities.

Again, it is quite evident that over a longer period, particularly in 3 years (as the maximum coverage for FREE use), the Phisix has largely outperformed the US Dow Jones Industrials in an environment where the US dollar has been falling and vice versa.

Presently in spite of the weakening US dollar, the Phisix has consolidated and has not been at par with its previous performances, hence the red diagonal triangle at the rightmost edge.

Our question is: has the present underperformance been an outcome of “overvaluation” or an “exhaustion” from the previous run? Or will the Phisix eventually come up with a similar “lagged” rendition as shown in many instances in the past?

So before coming up with our answer let us look at the broader picture.

Heavyweight contrarian Jeremy Grantham, Chairman of Grantham Mayo Van Otterloo, thinks that world assets are in a bubble, where he says (emphasis mine)

``Never before have all emerging countries outperformed the U.S. in GDP growth over a 12-month period until now, and this when the U.S. has been doing well. Not a single country anywhere – emerging or developed – out of 42 listed by The Economist grew its GDP by less than Switzerland’s 2.2%! Amazingly uniform strength, and yet another sign of how globalized and correlated fundamentals have become, as well as the financial markets that reflect them.

``Bubbles, of course, are based on human behavior, and the mechanism is surprisingly simple: perfect conditions create very strong “animal spirits,” reflected statistically in a low risk premium. Widely available cheap credit offers investors the opportunity to act on their optimism. Sustained strong fundamentals and sustained easy credit go one better; they allow for continued reinforcement: the more leverage you take, the better you do; the better you do, the more leverage you take. A critical part of a bubble is the reinforcement you get for your very optimistic view from those around you. And of course, as often mentioned, this is helped along by the finance industry, broadly defined, that makes more money when optimism and activity are high. Hence they have every incentive to support rising markets as they do.”

While we agree with Mr. Grantham that some parts of the world have shown lathered or frothy conditions we do not subscribe to the idea that every asset class is a bubble yet.

Of course we could be speaking from a “conflict of interest-finance industry” point of view.

Relative to the Phisix, the degree of bubble exposure depends on how much credit money has been linked to the Global credit chain, which has buoyed the present state of the market.

In the same circumstances, we can hardly construe Japan’s equity market as being lifted by strong “animal spirits” to the same degree as in the US or some OECD countries. Japan has been experiencing a NET outflow due to residents looking for higher yields abroad.

Like us, Mr. Grantham raises the question of an imploding bubble as a question of timing. Mr. Grantham wrote, ``Of course the tricky bit, as always, is timing. Most bubbles, like internet stocks and Japanese land, go through an exponential phase before breaking, usually short in time but dramatic in extent. My colleagues suggest that this global bubble has not yet had this phase and perhaps they are right.”

Yet in the face of these bubble fears, we are seeing a radical trend shift of money flows towards non US markets, Alan Murray recently wrote in The Wall Street Journal (emphasize mine), ``We are witnessing a crucial moment in history -- the movement of U.S. capital markets abroad."

Tim Hansen of the adds, ``Nine of the 10 largest IPOs of 2006 and 24 of the 25 largest IPOs of 2005 occurred in foreign markets.”

Deflationary “bust” advocates predict that a bubble implosion would result to a panic driven safehaven rush towards the US dollar and US treasuries, the premise being that the US as the most liquid and sophisticated market. Yet present day evidences have proven otherwise, as shown in Figure 2.

Figure 2: World Federation of Exchanges: World Equity Markets Overtake the US

Since global markets have bottomed out in 2002, the share of US markets relative to world markets in the context of market capitalization has shrunk from 52% to 45% in 2006. This is because Asia has generated the best returns up 168% over the same period compared to Europe’s and MENA (Middle East and North Africa’s) 140% and the Americas at 90%.

And as we have previously pointed out, this dollar “decoupling trend” has not been limited to the equities market but also to bond markets where the Euro has displaced the US dollar for the second year in succession, or to Euro notes in circulation exceeding that of the US dollar or to the falling share of the US dollar as foreign exchange reserves, but retaining the majority, in the global banking system.

In addition, with the emergence of “Sovereign Wealth Funds” [SWF] or countries with foreign exchange reserves surpluses which assigns a separate national entity or public “fund” to manage or invest excess reserves, the likelihood is that these trends will be further accentuated.

Remember, in the recent past, excess reverses by Asian countries or Oil Exporting states have been recycled into US assets. Today, the thrust to diversify from the US dollar assets appears to be taking place via the medium of SWF into the global financial markets.

How much funds are we talking about? An estimate by Morgan Stanley’s Stephen Jen is that 24 of these funds hold some $2.3 trillion or about 5% of 2006 market cap with growth of about $500 billion a year! Now with public financial “funds” beginning to compete with private funds for returns, yields are going to be more marginalized than ever although risky assets could be more supported as liquidity flourishes.

However, could the financial instability side today emanate instead from the fundamentally altered world financial risk profile as Mr. Stephen Jen recently suggests? Perhaps. Apparently we are witnessing the emergence of new financial paradigms or evolutions in the financial system at work, although like the innovative financial products, these have not been stress tested and could be sources for volatility (such as politically induced ones). And that new paradigms or “different this time” axioms give us jitters.

Present developments tell us that in spite of the present lethargic economic state (real GDP of the US grew below market expectations of 1.3% on high GDP price index) US financial markets appear to be experiencing a prolonged bonanza (DJIA up 1.23% for the fourth consecutive week). However, as exhibited above the gist of the benefits has been moving away from US assets and into global markets.

Could such developments underscore the unintended consequences from the highly taxing Sarbanes-Oxley Act? Or could the US dollar’s woes have prompted for the exacerbation of such trend of outflows? I think more of the latter is the culprit.

For me, Mr. Doug Noland of the Credit Bubble Bulletin, has got the best answer among the analysts I monitor (emphasis mine), ``U.S. securities markets continue to lag much of the rest of the world. Yet there is an ingrained market perception that financial tumult/crisis is invariably instigated at The Periphery. Participants have been conditioned to believe that risks and excesses are greatest with the inherently fragile “emerging” markets. These markets have also tended in the past to perform as credible “canaries in the mineshaft,” warning of more generalized financial turbulence. So with emerging markets again trading well and crude and commodities on the rise, complacency with respect to the general liquidity backdrop has returned with a vengeance.

``Here’s where the markets could have it gravely wrong: the greatest vulnerabilities associated with the most egregious (ongoing) excesses today reside not at The Periphery but at The Core. Indeed, current global liquidity excesses are now exacerbated by heightened excesses and flows away from The Core, in the process masking heightened securities market fragility throughout The Core.”

Put differently, if the credit excesses have been due to the US (The Core) why would a bubble implosion or a panic driven run lead money back (from where it originated) and not towards the Periphery (global markets)? Could today’s developments instead serve as an initial manifestation of a deepening trend in preparation for such “tailed event”?

Further if capital outflows would translate to higher interest rates in the US, does it suggest that higher rates could stanch such exodus?

Mr. Axel Merk of Merk Investments debunks such myths (emphasis mine), ``It seems that ever since academics developed a theory of how interest rate differentials move currencies, the theory has not worked. Yet just about every textbook continues to teach it. Aside from the fact that expectations on future interest rates and inflation are more relevant than actual interest rates, there are simply too many factors influencing currencies to be able to focus in on interest rates. Why do some low yielding currencies, such as the Swiss franc, perform reasonably well, whereas many developing countries have weak currencies despite high interest rates?

``A good year ago, the U.S. joined the ranks of developing nations in paying more in interest to overseas creditors than it receives in interest from its own investments. As a result, higher U.S. interest rates mean higher payments abroad, further weakening the foundations of the U.S. dollar.”

So aside from speaking from the perspective of a “home biased” investor, our analysis leads us to think that risks for more declines in the US dollar could exacerbate outflows from US capital markets into the world. This perhaps validates why our 90 day treasuries have been lower than that of the US counterparts.

Given the above premise, I guess the “appropriate” suggestion for my friend would be to give weight more into Asian assets or to the Phisix than that of its US contemporaries.

Could Brent’s Premium Over WTI Imply a $70 above Oil prices?

``Those who have knowledge, don’t predict. Those who predict, don’t have knowledge.” Lao Tzu, Chinese Philosopher

At the start of the year despite being apprehensive over the prospective performances of global equities markets we remain buoyant on oil prices on two basic premises; one, Peak oil, where about 80% of global oil reserves are held by national oil companies, non-transparency, market distortion from government intervention and politically instability from resource rich countries has continued to placed a restrain on the supply side from adjusting to market requirements.

For instance, would you believe that despite being an oil exporting country starting May 21st Iran will be rationing its gasoline? Yes, the country is said to hold 10% of the world’s oil reserves but subsidies have kept its supply consumption high. Reportedly high consumption levels could have been corollary to the government imposed subsidies as some have undertaken to smuggle oil and sell it at global prices beyond its borders.

When we say peak oil we mean the end of “cheap oil”. While technology has enabled access to once prohibitively costly oil patches [e.g. deep sea], national policy restrictions have been a huge barrier in expanding supply access even with such added technology at hand.

Take for instance Mexico’s once prolific Cantarell oil field, one of the largest in the world. Last year its production dropped by a significant 20% from 2 million barrels per day to 1.6 million barrels a day. Some estimates have even placed the field to produce by less than 500,000 per day or an equivalent 75% drop in 2010, according to Petroleumworld.

Yet Mexico’s national oil company Pemex suffers from foreign investment restrictions embedded in its constitution from which its two past chief executives have failed to persuade members of the Congress to have this lifted. As a result Mexico, according to Wall Street Journal, may become an oil importer within eight years!

Of course the other factor major factor is the declining US dollar.

Lately, I stumbled across a very compelling argument posed by analyst Elliott Gue of the Energy Letters where he notes of the present disconnect between the benchmark crudes of the WTI (West Texas Intermediate) and Brent Crude which could translate to a significant impact on oil prices.

Figure 3: Energy Letters: WTI-Brent spread breaks!

The WTI crude is of higher grade sweet crude and is widely used in the US and benchmarked by US refiners while the Brent Crude is of a lesser grade sweet crude than the WTI but is commonly used in Europe and in Asia and likewise benchmarked by the refiners of the respective regions.

Figure 3 shows that in the past seven years WTI maintained an average premium of $1.72 relative to the Brent. However recently, the Brent Crude turned negative by a huge amount. Such negative spread reflects of the global demand supply imbalances which could possibly induce higher crude oil prices in the coming months.

Mr. Gue says ``When Brent trades at a significant premium to WTI, US refiners start refining more WTI (and other types of crude) and less Brent. This reduces demand for Brent and pushes up demand for WTI, putting downward pressure on Brent prices relative to WTI.”

Figure 4: US Gasoline prices reach Major Resistance Levels!

As we enter the major driving summer season in the US, a sharp drop in gasoline inventories has caused a spike in gas prices. Where the U.S. transportation sector accounts for 66% of all U.S. consumption, the recent spike in Gas prices hardly signifies a slowdown with its economy.

Figure 4 shows that in the past 3 years, each time gas prices reach the resistance levels, oil prices hit the $70 or more per bbl area, however today we see a virtual lag in the WTI prices. Technicians may see today’s actions as a sell based on previous price behavior over the past three years, but I wouldn’t bet on it.

While gasoline inventories have been dropping, crude inventories have stayed high due to low refinery utilization or bottlenecks in the supply chain as refiners reduced outputs due to maintenance related outages. However the refiners are expected to pick up the slack by completing their maintenance work soon, and should be expected to use up quickly the higher than average inventories.

On the other hand, global inventories of crude oil have dropped sharply, crude oil inventories fell to about 80.5 million barrels last February. Further, the IEA estimates that the combined supply in the US, Europe and Japan have declined at a rate of more than 1 million barrels per day during the first quarter of the year; a higher than average decline for the season.

In short, the negative spread reflects the quickening depletion of crude stocks abroad relative to the US, hence the negative spread. And this should imply for higher prices in the interim as US seasonal demand picks up and where supply imports by the US are expected to rev up in order to augment current stock levels.

Quoting Mr. Gue, ``But with US oil benchmark (WTI) prices below prevailing international benchmark (Brent) levels, US refiners are going to have trouble finding any oil to import; better oil prices are available internationally than in the US. Of course, there are certain oil supplies (such as Venezuelan heavy crude) that are relatively captive to the US market. However, with WTI prices so far under international levels, it will be tough for the US to attract additional barrels.

``It's simple economics: If the US is going to attract imports, US benchmark prices will need to rise toward international levels and WTI will have to close its discount to Brent.

``Moreover, as US crude inventories start to draw lower and the nation begins importing again in earnest, this will represent another wall of demand for the international crude oil markets. In other words, strong US gasoline demand will eventually represent a strong draw on global crude oil supplies. Those supplies are already tight, and OPEC shows no sign of letting up on its campaign to cut output.

So fill up your gas tanks as oil prices are due back to the $70 levels and above. On the hand, you may consider oil stocks as insurance.

Sunday, April 22, 2007

A “Tipping Point” for the Philippine Capital Markets?

``The highest use of capital is not to make more money, but to make money do more for the betterment of life - Henry Ford

WHEN I came across one of last Sunday’s front page headlines from the Philippine Daily Inquirer entitled ``Why Pinoy savers are turning investors”, it brought a smile on my face for validating what we have LONG anticipated; a concrete testament of the emerging transformation on the psychological acceptability of domestic capital markets investing by the local populace.

Front page headlines reflect on national consciousness such that when the concept of capital markets investing turns topical and gets ingrained into the national level (to reach a proverbial “Tipping Point”), we should expect such trends to further deepen.

In Malcolm Gladwell’s marvelous bestseller the “Tipping Point”, this development could be classified as one of the key “principles of an epidemic”--the “Stickiness Factor” or the longer the idea/disease stays the more it is likely to get propagated.

The inherent strength of ANY capital markets basically lies with its domestic investor base or the so-called “home bias” rather than on foreign portfolio money. Unfortunately, local investors have in the past been geared towards a “US dollar bias” which resulted to the low penetration level of participants (demand side) or our much maligned state of the domestic markets which has been likewise reflected in the state of our national economy. This apparently is changing.

Technicians are wont to believe that they alone capture the directions of the markets by reading the psychological aspects from historical market action. In contrast, by understanding the Misesean standpoint of “Human Action”, where the late great Ludwig von Mises said ``Mans striving after an improvement of the conditions of his existence impels him to action. Action requires planning and the decision which of various plans is the most advantageous”, we asserted that prevailing global dynamics would work for this psychological shift among the local investing mindset.

In particular, we have long argued that our underappreciated, as epitomized by the low penetration level by local investors, and underdeveloped capital markets would mainly benefit from the “global liquidity” driven financial market activities, aside from deepening financial integration or globalization trends, as seen by the current symptoms in the APPRECIATING PESO, RISING PHISIX and RECORD LOW INTEREST RATES. And that such reported “savers turning into investors” signify our own version of “searching for higher yields” syndrome.

In other words, global economic trends have militated on local investor actions, notwithstanding, the activities in the Philippine asset classes in general.

Again we see this development under the rubric of Malcolm Galdwell’s third principle of an epidemic—the Power of Context, external or environmental influences play a far greater role than what we conventionally expect of them.

While the article served to highlight on the du jour accelerating trends, we’d like to make illuminate on some seemingly discrepant views covered.

First, the article quotes an official who says that “markets don’t move in the same direction” where he directly cites stocks and bonds moving inversely, as raison d’ etre for portfolio diversification.

Today’s markets have exhibited that some “textbook” concepts have ostensibly become “inapplicable” to a degree or even perhaps have turned “obsolete”.

Figure 1, from the IMF shows that global financial markets have been increasingly correlated in terms of performances gauged from different dimensions.

Figure 1: IMF (Global Stability Report): Growing Correlation Among Asset Classes and Across Borders

This is something I have shown in the past but would like to repeat to reemphasize on the point of correlation.

On the left panel of the chart is the Correlation of Asset Classes with the main US equity benchmark, the S & P 500, and its corresponding Broad market volatility while on the right panel is the Global Speculative Default rates.

The noteworthy aspect is that bonds or fixed income instruments and most especially commodities have in the past been NEGATIVELY correlated; today we are seeing a radical SHIFT where bonds and EVEN commodities or in fact ALL asset classes have been shown to be POSITIVELY correlated! All of the yellow bars signify positive correlation with that of the S & P 500 (right most yellow bar).

On the other hand, the right panel shows where emerging markets and OECD regions have had historically divergent spreads to reflect on the so-called “risk premia”. Today, such default rates have astonishingly disappeared or have even CONVERGED!!!

Again this is reflective of the prevailing perception of “sustainable” LOW RISKS environment where a country’s currency yield and economic growth factor has apparently taken precedence over other risk variables. In the same dimension we have previously showed that 90-day Philippine treasuries rates lower than its equivalent in the US.

From which again we ask; have investors come to price US treasuries as “riskier” than Philippine contemporaries? Has the emerging market class reflected significant improvement enough to classify its assets as equal or near equal to its developed market equivalent? Or has a new paradigm emerged? Or has this phenomenon simply exhibited a pricing misalignment? The future provides the answer in today’s juncture.

This from the IMF’s Global Stabilization Report (emphasis mine), ``...rising correlations in returns across asset classes have meant that the volatility of the overall market basket has not declined as much as the volatility of its component parts—indeed, by some measures it has increased. Insofar as markets have become overly complacent, they may not yet have priced in this covariance risk, which could lead to the further amplification of any volatility shock. For instance, the recent market sell-off in late February 2007 illustrated how seemingly minor, unrelated developments across markets quickly led to the unwinding of risk positions across a wide range of financial assets.”

In other words, traditional justifications for employing the conventional Portfolio Diversification model would simply be impertinent under present circumstances, where risks as well as rewards have been increasingly shared. So before listening to your financial advisor, who would advocate the traditional models of diversification, ask them of how to go around the risks of intensifying financial assets interlinkages.

The second issue which I wish to deconstruct comes from the statement ``This is the difference between a bank depositor and an investor—depositors can expect guaranteed principal and interest while investors can expect principal risk and yield.”

The implied premise is that bank depositors are “risk free” while investors are exposed to “principal risks”.

While this is TECHNICALLY true, that depositors can expect “guaranteed principal and interest”, the argument does NOT deal with the aspect of the depositor’s equivalent of PURCHASING POWER risks, as natural consequences of inflationary policies. This effectively translates to the risks of the erosion of the purchasing power of the depositor’s principal or an investor’s equivalent of principal risks in spite of guaranteed returns.

In the last issue we have dealt with Zimbabwe from where in 2006 their consumer prices indices have astoundingly soared by over 1,700% a year and yet where similarly its stock market has spectacularly spiked by over 12,000% in spite of an economic standstill (literally speaking).

What this means is that under such hyperinflationary environment, or translated to the currency’s massive loss in purchasing power, has compelled the general public to seek safe haven into the only most liquid asset, i.e. the stock market, which has acted as medium of insurance against the drastic fall in the value of its currency.

Since “guaranteed” fixed income instruments are almost equivalent to cash holdings, the loss of purchasing power translates to a loss in value for the depositor’s principal. While the nominal value of the currency remains, it buys increasingly less amount of goods or services in the marketplace.

Figure 2: Gavekal Research (Brave New World): Building an Efficient Portfolio in Our Brave New World

Put in a different perspective, fixed income instruments do well under disinflationary or deflationary environments as they increase the real value of the underlying currency’s purchasing power, while other assets as tangible assets or commodities normally serve as an insurance against a loss of purchasing power, as well as stocks under “hyperinflationary” mode as in the Zimbabwe or Germany’s 1920s Weimar experience. In the context of risks, even the US dollar which was once the Filipino’s favored asset class has shown of its vulnerability.

In Figure 2 courtesy of Louis Gave of Gavekal Research, the Gavekal team outlines a suggested portfolio allocation under FOUR different economic conditions.

In short, in this mortal world NOTHING is EVER “RISK FREE or GUARANTEED” (except for death and taxes). It is only the degree of risks that differs that which is determined by the nation’s primary economic activity.

Profitability and NOT Vanity Matters

``What feels good or is psychologically appealing is not necessarily profitable.” F.J. Chu

Just A little reminder. Our bullish stance has NOT in anyway been designed to SELL you stocks. If my main economic incentives had been the case, then I would have taken the “micro/corporate” fundamental analysis or “technical” analysis or “insider” route as channels to stoke our reader’s imagination or fire up their adrenalin.

Or I would have utilized my own “call center” version by conducting telephone campaigns instead of this lengthy episodes of writing (where personal phone calls has bigger probabilities for a close--spent nearly 15 years in the field of sales and marketing), or could have opted to work as a full time sell side analyst for a broker who would be willing to pay us enough to cover our basic needs or lastly consider the option to SELL this newsletter service to the public.

Unfortunately, I have deliberately not engaged in such activities as my intent is to specialize in this field of undertaking, which to my mind has vastly enormous potentials (remember bullish non-banking finance?).

Where our actions are a matter of choice, our bullish perspective emanates from our interpretation of market signals operating under our comprehension of the functional dynamics of the Philippine asset classes in relation to the global financial markets as contributing factors in determining absolute returns.

Bluntly said, our view stems from mainly the horizon of a trader-investor and NOT as your typical “sell side” analyst nor as a broker. Although candidly, I am a licensed agent in behalf of a broker, nevertheless, I am NOT paid to be bullish.

This means that divergences in our market outlooks or opinions should not be construed as conflict of interest on my behalf. As we have noted before, differences in economic outlooks, valuation appraisals, technical readings or market opinions or investing/economic/political philosophy pave way for exchanges in the marketplace and are natural and salutary elements of well functioning markets.

Our goal is NOT to be proven vaingloriously right but to be proven humbly PROFITABLE. ``For we are taking pains to do what is right, not only in the eyes of the Lord but also in the eyes of men.”-2 Corinthians 8:21

World Equity Markets on A Bullish Juggernaut, Phisix to Follow?!

``If you board the wrong train, it is no use running along the corridor in the other direction.”- Dietrich Bonhoeffer German theologian

WHILE the domestic stock market appeared to have partially responded to our forecasts of a “global contagion” influenced domestic meltup, this only came after wild swings during last week’s activities.

The Phisix was up 1.17% amidst streaking hot Asian indices as the Peso streaked to a new six year high at Php 47.51 against a US dollar.

The wild swings in our market has been coincidental to an apparently much wilder roller coaster activities in China, whose composite indices fell by over 4% last Thursday but ended the week still with significant gains, the Shenzhen up 5.85% (!!!) and Shanghai 1.87% after an equally strong rebound on Friday.

As we have previously noted, despite the uninspiring or tepid fundamentals, global markets have justified the present loose (inflationary) conditions as beneficial for equities and the rest of the asset classes. This has been greatly aided by the continuing swoon of the US dollar (as measured by the trade weighted index).

And such asset friendly financial market conditions means that in spite of credit (mortgage) growth slowdown seen in the housing sector in the US, there have been signs that more leverage taking activities have shifted to the other sectors.

Let me quote another favorite analyst Mr. Doug Noland of the Credit Bubble Bulletin, ``It appears obvious to me that rampant Credit excess runs unabated. Household debt growth may be moderating, while corporate borrowings are likely expanding at low double-digit rates. But it is the growth in financial sector borrowings that holds the key to liquidity puzzle. The leveraging of existing securities (there’s $45 TN of Credit market debt outstanding) – by hedge funds, in broker/dealer and bank “trading accounts” – is likely a major source of current liquidity excess.”

And such excess liquidity has certainly fired up the US markets to a blast-off stage...

Figure 3: US Equity Markets in OVERDRIVE!

We have previously shown how the US Dow Jones Industrials have served to inspire global indices. This time the uptrend has accelerated into a broad market run, as shown in Figure 3, where the S&P 500 (main window), the Nasdaq (highest pane), Russell 2000 (above pane) and Dow Transports (lower pane) have ALL conspired to surge beyond their recently established highs (blue arrows).

Such broad based advance can hardly be deemed as an “isolated” event. And in my view taking a bearish stand against such a vigorous “momentum” would be suicidal for one’s portfolio. Of course, over the short-run the markets may retrace, but given the present pace of advances, the odds are that the emotional impulses will continue to spur prices into a maximum overdrive.

As we have previously presented, the global financial markets have mostly tracked the directions of the US markets.

Last Tuesday, April 17th the widely followed Canadian independent research outfit BCA Research, came up with their own bullish outlook as emerging markets broke out as shown in Figure 4.

Figure 4: BCA Research: Emerging Market Equities: Breakout!

Notes the BCA Research (emphasis mine), ``...many EM currencies are likely to appreciate further against the U.S. dollar, which will help bring down EM bond yields. In turn, this provides a bullish equity environment. Lower interest rates will further stimulate domestic demand, benefiting domestically oriented sectors and helping encourage P/E multiple expansion. Emerging market banks tend to perform particularly well during times of a falling U.S. dollar, and banks in Asia and Eastern Europe currently appear attractive.”

And such variables COULD HAVE fueled the bourses of our Southeast Asian neighbors to almost simultaneously SET new RECORD highs, as Indonesia, Malaysia and Singapore (except Thailand-still hobbled by political direction on its capital flows), as shown in Figure 5, as well as most of other East Asian neighbors as Taiwan, China, Australia and Korea (Hong Kong and New Zealand at resistance).

Figure 5: With Jakarta Hitting FRESH Record Highs, How Long Before The Phisix Catches Up?

With Indonesia’s Jakarta Composite Index (red candle) on a winning streak into FRESH record highs, the odds are that over the near term (possibly in a week or two), the Phisix (blue line) could likely breach its very own 10-year hurdle following the global juggernaut.

The Economist wrote a dampener following Indonesia’s recent foray to new bullish grounds (emphasis mine), ``Three times since the start of the year it has suffered sharp falls, partly as a result of contagion from problems in other markets (although to be fair, most other Asian markets have suffered similar fates). But Indonesia remains a high-risk market, and it is inherently vulnerable during bouts of global or regional market turbulence. Moreover, the very scale of the JSX Composite Index's gains also makes a corresponding downward correction that much more of a worry. In the 24 months to March, Indonesian equities rose by around 80%, compared with a median of around 45% in ASEAN. Valuations may also be on the high side. The average price-earnings (P/E) ratio of the JSX is currently 20.2, lower than China (22), New Zealand (22.5) and Japan (26.6) but higher than in most other Asian markets. In Singapore the average P/E ratio is 15.3, and in Thailand it is 10.4, although this probably indicates that political instability has lowered valuations.”

Last week, using the Zimbabwe experience we wrote on how monetary processes or inflationary policies can distort market prices and even climb amidst deteriorating economic conditions. And as global asset markets trek higher on grounds of loose money conditions which allows for more inflationary (leverage) undertaking, consumer price inflation continue to manifests itself in varying degrees most notably in Canada (highest in 8 months), China (highest level in more than two years on jump on food prices driving concerns over “exporting inflation”) and the UK (highest in 14 years, which prompted Bank of England governor Mervyn King to write Chancellor Gordon Brown for an explanation).

This makes us likewise recall billionaire philanthropist George Soros’ ``Theory of Reflexivity” where he says that the prevailing bias may impact not just market prices but also the fundamentals, from which becomes a self-fulfilling prophecy and eventually leads to a boom-bust sequence.

While the bears could be right where sometime in the future a liquidity crunch may ensue which could put a grinding halt and possibly reverse the present trends, for the moment market actions have NOT been favorable to undertake positions against the present trend, as the global money machine appears to be working in full throttle.

As always, it pays to consider a contingency plan under potential TAIL EVENTS from which the practical ways would mean risking only the amount one can afford by “position sizing” and by strictly “enforcing your stops”.

When our short term view matches our long term outlook, we tend to become emphatic on our calls.

Remember markets may remain irrational more than we can remain solvent and designing portfolio profitability should always factor in such anomalies.

Sunday, April 15, 2007

Global Liquidity Conditions Should Buoy The Phisix

``You can't do well in investments unless you think independently. And the truth is, you're neither right nor wrong because people agree with you. You're right because your facts and your reasoning are right. In the end, that's all that counts. And there wasn't any question about the facts or reasoning being correct.”-Warren Buffett

JUST as I recommended a “Buy” following the conspicuous appearance of a turnaround, the door slammed shut on my face.

Momentarily, yes, the MOMENTUM which I have expected to have carried over seems to have faltered, and that the ticker says that my short term outlook could be wrong.

As student of the financial markets, we are taught to accept and endure mistakes as an integral part of investing, and to avoid from engaging ourselves in defending vanity, as market guru Peter Lynch has taught us, where he says, ``The list of qualities [an investor should have] includes patience, self-reliance, common sense, a tolerance for pain, open-mindedness, detachment, persistence, humility, flexibility, a willingness to do independent research, an equal willingness to admit mistakes, and the ability to ignore general panic.”

However, before conceding to such omission, the overriding question is that has the facts CHANGED enough to merit our retreat?

This analyst began his crusade as a technician, long before graduating ourselves into a macro observer. Where in reality the market militates on a diversity of forces, to my mind, rigidly looking at the technical aspects in determining one’s investing decisions has been rather ONE-dimensional, operating in the misplaced assumption that technicals captures the entire breadth of investing psychology. Technicals are preferred tools of brokers whose economic objectives are mostly distinct from investors.

Besides, in the markets, it is not about being right but being profitable that truly counts. In whatever investing style one undertakes, success has been a matter of adhering to discipline.

So far our successes have stemmed from looking at several dimensions, most importantly with respect to macro developments in conjunction with multifarious market signals and market cyclicality over a longer span of time horizon. As you perhaps noticed, we rarely engage in short-term predictions.

With regards to technical aspects, looking at the Phisix today shows some signs of bearishness as revealed by a semblance of “topping” formation of a “Head and Shoulders” pattern. However as mentioned above, we will also assess on the other facets to determine the probability weightings with regards to the market’s outcome over the interim.

We will not belabor the significance of the Phisix’s strong correlation with global equities, in the face of escalating trends of global financial integration as discussed ad nauseam. However, Figure 1 shows that with reference to the developments with MOST global markets, the Phisix appears to have momentarily “DIVERGED” from the general trend.

Figure 1: Divergent Phisix or a BLIP?

When making comparisons against global indices, we use established benchmarks for the purpose of shortening our presentation. It would be exacting and tedious if not downright confusing to show each and every 17 Asian, 18 European and 12 American bourses in one outlook.

For instance, our point is to PROVE that following the “Shanghai Surprise” at the end of February, markets in GENERAL have been recovering, where some indices have even set new record HIGHS.

The Dow Jones World index at the bottom pane and the JP Morgan Fleming Asia Equity at the upper pane has both been treading on record territories aside from depicting conformity with the apparent inspirational “leader”, the Dow Jones Industrial Averages (center line chart), as shown by the blue arrows.

It is noteworthy to emphasize that EACH “undulance” or the peak and troughs from the major to the minor ones appears to have been in CLOSE UNISON. Our question is, if the Phisix has played out a mostly similar rhythm with the rest of global equity bourses since 2003, could this “divergence” last or is it merely a blip?

Now let us examine the recent activities. The holiday-abbreviated Phisix have been the worst performer in a mostly buoyant Asia (down 2.34% over the week). Vietnam (-2.03%) followed next, with Japan (-.69%), New Zealand (-.49%), Bangladesh (-.29%) and Taiwan (-.03%) which showed minor declines, while the rest of the playing field registered SIGNIFICANT GAINS.

Considering that foreign money have DOMINATED trading activities and had been the MAIN CATALYST towards “significantly” most of the Phisix’s advances since 2003 could they be instigators of the present decline?

Foreign money unusually accounted for a LOW of 28.61% of the week’s turnover; this had been due to the humungous special block sales at San Miguel last Friday. And YES while Thursday’s (Php 58.097 million) and Friday’s (Php 10.064 million) declines had been spearheaded by foreign selling, over the week foreign money STILL registered (Php 1.069 billion) of NET foreign INFLOWs. In short, the degree of the outflows had been INCONSEQUENTIAL compared to the degree of the inflows over the week.

Moreover, during Thursday and Friday’s retracements noticeably foreign selling had been concentrated on FEW or SELECT issues, as measured by two successive days of selloff and relative to the respective volume turnover; namely PLDT (-6.25%), MEGAWORLD (-1.37%), RIZAL COMMERCIAL Bank (-9.8%), UNIVERSAL ROBINA (unchanged) and PNOC EDC (unchanged). The rest of the Phisix components have either shown minor outflows or to the contrary of our expectations, INFLOWs amidst the carnage.

Now in the perspective of the broader market, the spread between foreign inflows and the outflows or the “NET inflows” had been the LARGEST since advent of 2007, which includes the depressed sentiment of Thursday (40:29) and Friday (51:25). This certainly is not a convincing sign of a reversal of sentiment by foreign investors, is it?

Moreover, the fact that the Peso climbed to its HIGHEST level since 2001, breaking out from the Php 48 level against the US dollar to close at PHp 47.905 to a USD, implies that more Pesos are being bought relative to the US dollar.

What this simply tells us is that foreign money has NOT initiated last week’s decline but local players.

Figure 2: Studying Elections 2004; Election Jitters suggests a buy?

So our next question would be what has prompted local players to such panic driven selloff?

PERHAPS election day jitters. As the national and local election day approaches, one should expect this major political variable to preponderate over the airspace and nonetheless serve as an excuse or justification by mainstream analysts to explain on the activities of the market.

Figure 2 likewise shows us that learning from the last electoral experience, in 2004, possible election jitters COULD HAVE triggered (we forgot the conditions which lead to this) a short-term decline, from April 28 to May 19th where the Phisix lost 9% (see blue circle). Yet over the following months Phisix worked to regain all such losses and by September had been trading above its April high. Could it be that local investors today are figuring out the same scenario today?

Yet, as the same experience shows, a knee jerk selloff under a bullish backdrop presents as BUYING opportunities instead of selling on crowd following “sentiment”.

Figure 3: US Dollar driven Phisix

Over the years I’ve repeatedly argued that the Phisix had been mostly driven by the US dollar dynamics.

The Phisix has sizably OUTPERFORMED when the US dollar as measured by the trade weighted index backslides. In Figure 3, it is conspicuously shown that as the US dollar declines (signified by the red trend lines at lower pane), the Phisix rises sharply (red trend lines at center window).

Notice too that when the US dollar staged a substantial rally in 2005 as denoted by the blue trend line, the Phisix has traded mostly sideways, as represented by the blue box.

Well, with the US dollar breaking DOWN from its CRITICAL support level, it could be expected that such added liquidity should serve as support to global asset classes including that of the Phisix and to other Philippine asset classes.

Dr. Ed Yardeni of the Oakwood associates underscores our view of such accommodative stance in favor of global asset classes (emphasis mine), ``...foreign central banks are already increasing their purchases of US Treasuries and Agencies to avert a precipitous drop in the dollar. The growth of FRODOR--foreign official dollar reserves--rose to 20% y/y last week, up from 13.3% late last year, and the highest since January 2005. In other words, the latest bout of dollar weakness is once again causing central banks to pump up the pace of global liquidity, which is why commodity prices are taking off again. Indeed, the CRB raw industrials spot price index is now a whopping 32% above its previous cyclical peak during the global boom of the mid-1990s! The IMF’s data show that non-gold international reserves rose to a record $5.15 trillion in January, more than doubling since the start of the decade. Emerging nations held a record $3.71 trillion in international reserves in January, up 24.8% y/y. International reserves held by industrial countries were unchanged at a record high $1.44 trillion, 6.3% above a year ago.”

So AGAINST a backdrop of combined bearish indications from the technical viewpoint and potential seasonal (remember Wall Street’s longstanding axiom “sell in May and go away”?) weakness to even possibly localized anxiety as the “election jitters”, we should view ANY selling amidst a weakening dollar (on continued premise of global search for yield) as prime conditions for BUYING OPPORTUNITIES.

Of course, anything can happen to the markets over the short-term, but given the strong correlation of the US dollar and the Phisix, as well as the internal dynamics of the Phisix (dominant foreign buying), it is likely that the present divergence may well be a blip.

And it is also important to remind ourselves that ANY risks that are most likely to emerge could EMANATE from exogenous factors, as evidenced by the May 2006 shakeout and the recent February “Shanghai Surprise”. As they may be caused by events in the US, such as withdrawn liquidity from the subprime mortgage fallout or geopolitical policies and reactions thereof (as protectionist measures against China or a military strike on Iran) or a US dollar crash, or possibly (to a lesser degree) in China or other emerging markets (which may cause a domino effect) or unwinding of the of carry trades, however, present day markets appear to have discounted such developments FOR THE MOMENT.

The Significance of the Phisix 3,400

``Investing should be dull. It shouldn't be exciting. Investing should be more like watching paint dry or grass grow. If you want excitement, take $800 and go to Las Vegas.”- Nobel Economist Paul Samuelson

WHEN 3,400 was mentioned as a benchmark, the significance for this is the “concept of round numbers” as propounded by the legendary trader Jesse Livermore (Reminiscences of a Stock Operator), where he says that a round number crossed for the “first time” should likely keep the momentum going further.

In technical lingo, the Phisix has drifted above the 3,400 level from January 31st to February 5th in 1997 whereby its watershed level was reached at 3,447.6 on Feb 3, 1997. The other “high” was in January 4th of 1994 at 3,308.37.

Figure 4: A Breakout of 3,400 Validates the Path to 10,000?

This means to say that it is NOT the first time for the Phisix to reach the 3,400 level. But should it reattempt to do so, it implies that a sustained breach of such threshold level SHOULD SPUR the Phisix to a much significantly higher level.

And MOST IMPORTANTLY, a sustained breakout connotes of the validity of the underlying PRIMARY STAGE of the Phisix bullmarket (nominally based and not inflation adjusted) which I think buttresses our assumption that the Phisix will conservatively reach 10,000 over the present cycle (barring a global depression) see figure 4.

In addition, in a WORLD OF DIMINISHING RETURNS, a Phisix at 3,400 relative to Friday’s close translates to 5.67% return, so absolute threshold levels basically sets your portfolio returns.