Sunday, May 27, 2007

Profiting from Markets by Understanding How Cycles Determine Trends

``I know you won’t believe me, but the highest form of Human Excellence is to question oneself and others.” Socrates

ON the average, investors think the markets are a function of random events, hence gets easily swayed by ticker based actions. It is such reason why the common man’s interpretation of the financial markets are as gambling havens, simply because they mostly assimilate a gambler’s fallacy mindset or ``the tendency to assume that individual random events are influenced by previous random events”

For instance after a series of coin tosses, where 5 heads appear in a row, what do you think would be the next outcome?

Trend followers would bet that the next throw would still result to a head (due to its streak), while contrarians would bet on a tail (premised on the “running out of luck” or “law of averages”).

But the fact is since the coin tosses are a 50/50 odds proposition, the next outcome is independent of the results of the previous throws. Therefore, both bets were based on flawed grounds.

However, unlike a coin toss financial markets do not basically operate on random. Instead they operate on cycles. As Warren Buffett’s mentor Ben Graham once said, ``In the market is a voting machine but in the long run it is a weighing machine.” Yes, there may be instances where short-term randomness will dictate on markets, but as a weighing machine the likelihood is it follows a general secular trend.

Figure 3: Japan’s Nikkei 225 suggests of an incipient bull market

We love to look at the long term macro perspective and for bull markets cycles, long term returns are usually awesome, for instance in Japan the 20-year bullmarket lifted the Nikkei 225 from about the 2,000 level in 1970 until 40,000 or a return of 20 times!

Yet following the Nikkei Bubble bust, the next 14 years saw the Japanese benchmark on a general downtrend until 2003 or a loss of 80% from its peak. Today the Nikkei has broken out of its long term declining trend, has shown signs of convalescence and is apparently on an upward dynamic.

So the secular trend for the Nikkei 225 could most likely be on an advancing phase and such is why we have been bullish on Japanese Equities since 2003 despite its recent underperformance.

We believe that the market clearing phase has sloughed off enough malinvestments to merit renewed revaluations of the Japan’s asset markets.

Further, we also believe that the Japanese are likely to adopt to the globalization dynamics with necessary reforms, such as further liberalization of its markets and unwinding of its opaque web of keiretsu crossholdings, plus a shift to shareholder responsiveness while increasing economic ties with its neighbors are additional boosters.

In addition, we also think that Japan’s demographic challenges will allow its government to adopt policies which will increase migration flows and outsourcing trends. Lastly, we think that increasing rates for the world’s largest creditor nation will help repatriate resident funds invested overseas and bolster Japan’s financial asset markets as well as for the region.

This is in sharp contrast to the long term trends that one can see in the US interest rates markets, where the US 10 year rates appear to be forming a bottom and could possibly segueing into higher rates as shown in figure 4.

Figure 4: Economagic: 10-year Treasury Constant Maturity: shows of advancing rates

As I have shown this in the past, the US interest rates have depicted some 20-year cyclical patterns. US 10 year coupon rates advanced from 1953-1981 (28 years) and fell from 1981-2003 (22 years). The chart shows that if the cyclicality holds then future rates are likely to move higher than lower.

What could be the potential instigators?

Asia’s or Oil Exporting countries’ “reserve currency decoupling” of their “surpluses” from recycling into the US dollar/or US dollar assets, as evidenced by the recent moves by Kuwait to unpeg its currency from the US dollar.

Another is China’s fiery baptism into the emerging realm of Sovereign Wealth Funds by acquiring 9.9% or $3 billion stake of US private equity firm, Black Stone Group or possibly recent surges in the prices of food prices or agricultural products as a result of a global boom and aggravated by market distortions imposed by government policies promoting agricultural feedstock to produce biofuel.

Even Japan’s potential repatriation of resident investments overseas could likewise serve as a trigger.

The other major factor, the underfunded state welfare programs confronted by the present demographic trends could further raise inflationary pressures which eventually translate to higher interest rates.

Of course, one may argue that fears of deflationary bust from an overleveraged US financial economy would prompt the FED to drastically cut rates, but that would essentially be like throwing gasoline into the fire.

Or that a global deflationary depression could lead US treasuries (lower rates) into a new bull market as some analyst suggests. While we see such as a probable risk factor one cannot discount, I think that an implosion of the overleveraged US credit system in today highly “globalized” world has a potential to cause some serious delinkages or financial decoupling from US assets.

As I see it, the world is getting to be increasingly less and less US-centric as enumerated in my “History is not a closed book” series. Today we are seeing intensifying signs of US dollar “currency reserve decoupling”. In the future, the likelihood is that the “economic decoupling” thesis could gain more traction.

Further signs; Asia has fielded more candidates for the CFA or financial analysts exams than that from the US or UK or Canada as reported by the Financial Times. More writings on the wall?

Overall, prudent investors are concerned with long term trends while looking at potential risks that could upend such trends.

And while trends could be influence by some short-term randomness or gyrations they are likely to be dictated by cycles over the long term. And by cycles we can incorporate the business and economic cycles, by considering the Juglar cycle (7-11 years), Kitchin cycles (40 months or 3-4 years), the Kondratieff long wave cycle (50-60 years), and simply the financial markets cycle.

Jesse Livermore was Right, A Rising Tide Lifts Most Boats!

``Democracy, Communism, and Modern Portfolio Theory all rest on the same claptrap - that The People are geniuses and saints. All the theories agree - there is no higher source of wisdom, virtue, or pricing than the will of the heaving masses. If the voters want to do something foolish, who can tell them not to?” –Bill Bonner, Daily Reckoning

WE face arduous challenges in trying to communicate our long term views relative to the short-term expectations of the public.

As we have described in numerous times, the average investor have the natural inclinations to look for simplified explanations on the market’s action rather than understanding the underlying structural dynamics beneath its moves.

While we attempt to identify present trends as part of the long term cycle, the average investor desires to be told of media-hugging sensationalized activities as drivers of the markets or prices of securities.

The legendary trader Jesse Livermore had been absolutely right; the average investors don’t want to know whether it is a bull or bear market, they only want to be told of what they want or need to hear. And media alongside with mainstream analysis feeds on these popular “ad hoc” explanations, which are mainly “event” prompted.

Because sound scrutiny does not appeal, intuition based rationalization becomes the fundamental basis for decision making. It is of no wonder why most investors are bound to lose when the market cycle turns, as it has always been. Again the invaluable words of Mr. Livermore, ``The stock market never really changes that much. What happened before will happen again and again and again."

For instance, we persistently hear of arguments that our local markets are MICRO fundamental driven. Said differently, securities are believed to be priced according to its corporate fundamentals, i.e. cash flows, sales, earnings, dividends, enterprise value and etc.

And because it is supposedly micro fundamentally driven, the implied assumption is that the success in stock selection becomes a function of ability or talent. This reminds us of the behavioral finance school which identifies the common follies of investors called as the “cognitive biases” or in this case, specifically the attribution bias or the tendency to attribute success to one’s skills and failures to randomness.

We have long argued that aside from being macro or globalization propelled, because of the juvenile state of our stock market, the Philippine Stock Exchange have been mostly impelled by momentum trades by local investors over the broad market rather than valuation based investing; hence, the “rising tide lifts all boats” dynamics have even been more pronounced. In matured or developed markets, I would wholeheartedly agree that fundamental drivers are important contributors to the market’s direction, but not locally.

Why? The lack of local investor breadth has been one elemental foible. Yet where local investors have been actively engaged, they have been mostly guided by momentum driven or voguish explications from sell side analysts, whose economic interests are far divergent from the investor’s goals. To our experience, this lack of sophistication and comprehension of the financial market dynamics applies to even local institutions.

Second, there is also the issue of the paucity of publicly listed companies and the lack of more sophisticated trading instruments. The universe of publicly listed companies in the PSE is only about 260, which is far below our neighbors with Vietnam fast catching up on us with 109 listed companies from 30 companies at the start of 2006.

Figure 1: Number of Issues traded shows a “Rising Tide Lifts All Boats”

As shown in Figure 1, the booming Phisix translates to the rising incidences of number of issues traded. The accelerating trend of issues traded from a limited bandwidth depicts of the diffusion of issues gaining the attention from investors as the market advances.

In addition, where the stock market functions as claims on future cash flows, we see some issues frenetically being bidded up, whose fundamentals are backed by nothing but “stories”.

On some accounts, if one realizes the supposed actualization of cash flows from the purported plans, they would probably occur (if they materialize at all) at the peak of the market’s cycle. And astonishingly yet, these issues have greatly outperformed the market by a mile!

Evidently, the investing public has become less discriminatory and more daring with regards to imbuing risk appetite. This simply shows how the gullible public would ACT on justifying their actions using any pretext to eagerly join the bullish bandwagon.

Another, over the broader market, from the start of the year, the Phisix has gained by 15.4% as of Friday’s close. Nevertheless, advancing issues outnumber declining issues by a daily average of 59 relative to 52, respectively.

Lastly, sliced and diced based on the sectoral index performance, as shown in Figure 2, we prominently see the arguments in favor of a “Rising Tide lifts all Boats” dynamics.

Figure 2: PSE sectoral Performance: “Rising Tide Lifts All Boats”

The Manulife and Sunlife weighted All index (violet line), the Commercial Industrial (Pink line), Holdings (Red), Property (Blue), Services (Orange) and the Mining Index (Green line) are seen in conjunction headed higher, as the Phisix breaks into a new high.

Two important notes, since Manulife (unchanged year to date) and Sunlife (+2.2%) has barely budged from the start of the year, the rising trend of the “All” index markedly exhibits of a broad market advance.

Second, the mining index has as previously identified broken above its crucial resistance levels (another bullseye for us!).

While it is true that several market cap heavyweights are key components to these disparate indices, there have been rotations within each benchmark to offset the stalled activities of the others.

In effect, Mr. Livermore was quite accurate with his assertions that the inclinations of a cyclical market is for broad market moves. Let me repeat, issues may not move simultaneously (except on parabolic stages) but may undergo rotation by the sector or by the units within the sector.

Of course, there have been some exceptions to the rule, where some issues continue to lag. However these exceptions could be construed as symptoms of greenness or immaturity of the advancing phase of our secular bull market which represents a very bullish long term signal.

Again all these evidences contravene the arguments that our markets have been micro “valuation based” boosted but rather lends credence to our contention that global inflationary bias has psychologically pushed investors into bidding up asset prices of emerging markets, as in the PSE, with a “reflexivity loop” of the “prevailing bias” of the markets influencing economic fundamentals.

Sunday, May 20, 2007

Another Bullseye! The Phisix Weaves Into A New Frontier.

``Elections are won by men and women chiefly because most people vote against somebody rather than for somebody.”-Franklin Pierce Adams (1881-1960) American Journalist

SO it’s all splashed over the headlines; the Phisix has finally joined its peers (global bourses) to set a fresh milestone high!

Yet, against the conventional wisdom where elections have been thought of as a menace to the markets, we unequivocally asserted that given the today’s credit-driven inflationary environment, political exercises would have minimal consequences to our financial markets.

The Election Drivel

In our January 22 to 28 edition article, Financial Globalization and Not Elections Will Determine the Path of the Phisix we said,

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

And no matter how media in cahoots with mainstream analysts portrays markets as being event-driven, the fact is that trends, and not events (unless it comes on a complete surprise or shall we say “shocks”) largely determine the market’s activities.

Take for instance the assertion that the markets “cheered” the elections or that “peace dividends” have equally caused the market’s elation.

Figure 1: Phisix on a CHEER mode since March!

THE week prior to the election proper, the Phisix had already climbed by 2.6% which essentially confirmed our “election spending” theory.

Here we conjectured that the lagging performance of the Philippine benchmark, which had been be traced to local selling, could have been a direct or indirect result of campaign fund raising via the stock market. Hence, if such activities have indeed weighed on the markets, in spite of discordant behavior of the other Philippine asset classes, i.e. firming Peso and the rallying bonds, aside from the buoyant asset classes of our neighbors of the US markets, the Philippine Stock Exchange (PSE) would recover at the eve of the campaign raising. AND IT DID SO!

If we take a gander at Figure 1, the Phisix is limned on an upside “cheering” mode even PRIOR to the elections. POST-elections simply AMPLIFIED such trend with a breakout gap from February’s high on Tuesday (the Day AFTER), and carved a fresh record at the week’s close.

To quote Sherlock Holmes in the crime novel “The Hound of the Baskervilles” ``The world is full of obvious things which nobody by any chance ever observes."

Furthermore, we argued that in a declining trend of the US dollar, foreign money would likely buttress our markets.

Over the past TWO weeks, where the Phisix climbed by an amazing 5.2%, foreign money flows heavily streamed into Philippine equity assets accounting for Php 5.224 billion or about 11% of the aggregate turnover. Moreover, the scale of influx was seen over the broadmarket, which essentially confirms our outlook that the fate of the US dollar has been a key pillar to global money flows.

As we have said before, media loves sensationalism because it has to sell what the public wants. Such is the reason too why market actions are explained away simplistically, where our “experts” join in to add “authority” on the subject matter even if premised on tenuous grounds. This is because, as mathematician author Nassim Taleb says, ``We favor the visible, the embedded, the personal, the narrated, the tangible. We scorn the abstract.”

Because market actions are oversimplified, what would have been the explanation if the markets fell after elections? “Disappointed by election results”, perhaps?

Now, if one considers the elections as the MAIN driver of our financial markets, would an opposition dominated Senate be favorable to the nation’s present political environment? Could it not translate to even more political tumult and instability rather than harmony? Or could it be indicative of an aggravated gridlock, where legislative activities would grind to halt? (I know; they appear to function more as a body of inquisition rather than of legislation, which provides its members ample room for political “showmanship”….or perhaps a public “spectacle”. Yet the public loves it.)

In other words, looking at the political dimension alone hardly suffices for the present bullish theme…IF politics had been the SOLE DRIVER. However, in reality it isn’t. Markets comprise of multitudinal dimensions and variables, therefore, in absence of any meaningful enlightenment, our “experts” speedily arrive at flaky justifications such as the “peace dividend” bunk.

In the same manner, we can see how politicians undeservingly seize the present developments as propaganda opportunities to snare credit.

Figure 2: World Equity Markets on A Bull run!

Where the international financial markets have shown intensifying correlation due to increasing dynamics of financial markets integration, according to Standard & Poors (emphasis mine), ``Based on monthly returns over the past five years, the S&P 500 and the MSCI-EAFE, which tracks developed markets, registered a correlation of 0.85. (A perfect correlation is 1.0.) Similarly, the MSCI-EM index, which represents emerging markets, sported a 0.78 correlation with the "500." Mid and small-cap U.S. stocks also had correlations of at least 0.77 with developed and emerging markets, as well as larger U.S. blue chips”, a 77% to 78% correlation can hardly be assessed as “insular”, it would be downright misleading to impute the domestic market’s record breaking run to “micro” activities, as shown in figure 2.

The chart shows how the world markets have been performing synchronically through the Dow Jones World Index ($DJW-Main window), iShares MSCI Emerging Markets Index (EEM-above window), JP Morgan Fleming Asia Equity (JPAIX-upper below pane) and the Fidelity Southeast Asian Fund (FSEAX-bottom pane) which all have been in a winning streak!

So while indeed several administrative reforms helped boosted the fundamental outlook for the Philippine asset class, it would be inappropriate to read through this as its main driver, since an ocean of liquidity has bolstered global asset classes of diverse nature and in different geographical zones. One must remember that foreign money flows represents a majority of our trades in the Phisix or even in other asset classes.

China’s Financial Liberalization + Global Excess Reserves =Phisix 10,000?

Figure 3: Economist: Asian Hoarders

And speaking of global liquidity, Figure 3 from the Economist depicts of the foreign exchange reserves rich countries which come mostly from Asia and other emerging markets and has signified improvements on their respective economic and financial outlook. In my view, the massive surpluses are indicative of an inflationary boom.

According to Bloomberg analyst Andy Mukherjee (emphasis mine), ``The bloated and growing Asian foreign-exchange reserves are being increasingly financed by an expansion in the monetary base. Base-money growth in China was 21 percent in 2006, double the annual average of 2004 and 2005. It was about 20 percent in Korea in 2006, six times the average in the preceding two years, according to a World Bank report last month.

``Unmistakably, Asia is contributing -- along with petrodollars and Japanese carry trades -- to a surfeit of global liquidity and a mispricing of risk....Standard & Poor's, which raised the credit rating on eight out of 34 emerging-market sovereigns and lowered its assessment on just one in the 12 months through August 2006, is talking about the need to redefine the ``emerging market'' label, and in certain cases, even eliminate it.”

Yes, these excess savings are likely to provide a floor for risk asset classes, where according to Morgan Stanley’s Stephen Jen (emphasis mine), ``This ‘real’ liquidity arises from a mismatch between world savings and investment rates. World capex has surprisingly been too low to absorb all available savings. Annually, there are some US$800 billion worth of ‘excess savings’ from oil exporters and Asian exporters to chase after assets.”

Another buoyant development likely to boost the global equity asset markets could be the recent liberalization actions undertaken by China to allow its residents to invest overseas via the qualified domestic institutional investors (QDII), which is meant to ``allow for an 'orderly outflow of funds' from the mainland and ease pressure on the yuan to appreciate, Hong Kong Monetary Authority chief executive Joseph Yam said.”

While at the onset the estimated QDII licenses covering 18 commercial banks have an aggregate quota of only around US $14 billion, where 50% or about $7 billion would be allowed to invest overseas, this should translate to a minimal impact over the interim.

However, looking at the bigger picture, this reflects a very important breakthrough as the enormous amount of Chinese savings has far reaching potential impact once totally deregulated, according to JP Morgan (emphasis mine), ``the Chinese savings pool of RMB36 trillion (more than US$4.6 trillion) has proven to be too big for the domestic stock market (market cap only RMB 15 trillion, with RMB 6 trillion floatation). EM/Asia stands to benefit the most as Chinese investors would want to have a natural hedge against renminbi appreciation, and Asian currencies are likely to appreciate over the long run along with renminbi to provide the hedge.”

So there you have US$800 million of excess “public” savings plus a potential US $2.3 trillion from Chinese resident investors that could be invested in today’s rapidly integrating world financial markets whose equity market cap according to the World Federation of Exchanges, is about $50.623 trillion end of 2006. And the noteworthy part of it is that a substantial share of these could be invested within the region (Asia’s market cap of US$11.838 trillion or 23% of the world).

Just imagine even if a fraction of the said amount would be invested in the Phisix, such would drive the Philippine benchmark to parabolic heights!

Aside from technical developments in the US markets, these efforts by China to liberalize have possibly led to the “capitulation” of one of my bear favorite analyst Richard Russell. CBS Marketwatch analyst, Mark Hulbert quotes the Dow Theorist practitioner Mr. Russell (emphasis mine), ``We saw something that is extremely rare [on April 20 and April 25], in fact I can't remember ever having seen this before. What I'm referring to is that on those two dates all three Dow Jones Averages, and -- closed at simultaneous historic highs. To me, a fellow steeped in Dow Theory for over half a century, this was like a clap of thunder... My take on the situation is that the stock market (and the Dow Theory) told us that an unprecedented world boom lies ahead."

Short Term Risks: Overheated Markets and a US dollar bounce?

Yes, despite the exuberant outlook, risks abound. Aside from the factors of excessive leverages and speculation, structural imbalances, asymmetric carry trades and untested novel financial instruments, short term risks include an overheated global equity markets following its recent sizzling hot streak. In addition, a potential rebound or rollover of the US Dollar (represented by its trade weighted index) from its recent lows could heighten volatility, as shown in figure 4.

Figure 4: BCA Research: US dollar Poised for a Rebound

Notes the widely followed independent research outfit BCA Research (emphasis mine), ``The U.S. dollar has moved into oversold territory, and according to our capitulation index a bounce is likely. Furthermore, speculators are short the currency and sentiment has been declining for the past 18 months - both measures are often good contrarian indicators. However, the bigger question for the dollar is whether there are fundamental reasons for currency strength. Currently, the global macro backdrop still supports a soft dollar. The U.S. remains the weak link in an otherwise solid global economy and further growth redistribution (via an adjustment in the currency) is likely needed. Still, any signs of improvement in the U.S. housing market as the year progresses would result in an unwinding Fed rate cut expectations and provide support for the currency. Bottom line: Betting on the dollar can be justified purely on technical grounds, but improvements in the U.S. housing picture would add momentum.”

Finally, the breakout from its 10 year range by the Phisix signifies our bullmarket is in a PRIMARY TREND, which places my Phisix 10,000 at a very attainable target.

Most of the questions I receive today allude to what issues are likely to move during this bullmarket phase of the cycle.

Over the past two weeks as the Phisix gained by over 5%, where advancing issues dominated the market with 548 against 432 decliners and 505 unchanged issues, local investors appear to be dithering as foreign money went into a shopping spree.

Because in bullmarkets it is a general rule that ALL stocks go up, previous heavyweight laggards as San Miguel and SM Investments substituted the previous heavy cap favorites in PLDT and the Ayala Group in pushing the Philippine benchmark to its recent record highs. This clearly shows that past performance does not equate to future actions, as the favorites underperformed against the former laggards.

Yet, the average investors can hardly grasp that in a bullish cycle, stocks either go into a rotation or move up simultaneously especially at cyclical peaks. The public believes that micro forces drive the local market when evidences tell us that the present cyclical advance is hardly a “micro” thing.

I’d like to repeat a very important message (which I have practiced) from Jesse Livermore, in his investing classic, Reminiscences of a Stock Operator (emphasis mine), ``I never hesitate to tell a man that I am bullish or bearish. But I do not tell people to buy or sell any particular stock. In a bear market all stocks go down and in a bull market they go up...I speak in a general sense. But the average man doesn’t wish to be told that it is a bull or bear market. What he desires is to be told specifically which particular stock to buy or sell. He wants to get something for nothing. He does not wish to work. He does not even wish to have to think. It is too much bother to have to count the money that he picks up from the ground.”

Believe me, it is a basic rule which works.

Saturday, May 12, 2007

Hit by a Black Swan, My Computer Crashed!

For all this time we had been looking at the possibility of “black swan” risks or tail event risks (low probability but high impact events) that could harm our portfolios, unfortunately I got afflicted by a nasty one, but this time outside the realm of financial investing-my computer crashed!

Add to my woes is the HUGE possibly that my entire 5-year collection of financial market data, ebooks, analysts’ articles including my own have been obliterated!

Even while I was warned early this year by some friends on the exigencies of having a backup, I kept postponing the decision in anticipation that a limited access to financial sites would expose me to lesser risk of contamination.

How I was wrong.

After allowing my son to dabble on my computer Wednesday night, particularly burn some downloaded music on his CD, my windows failed to start on a corrupted window file last Thursday. After failing to successfully restart several times, I tried the systems recovery option. Then the entire system went haywire.

The lesson learned is that black swans exists even beyond the financial realm and that it pays to keep ourselves insured in whatever undertaking we do. Failure to ACT is a damning experience.

Now with shortages of references and limited access to our much required data, I am now constrained to take a “forced vacation” from my posts.

"Election Spending" Theory Validated, Phisix 3,400 Next!

The Phisix ended the week with a bang (up 2.6% week-on-week)! It closed at its highest level at 3,364.61 since the latest February "Shanghai Surprise" that stalled the upside momentum. And it comes roughly 35 points away from our 3,400 breakout target.

Yet, the peculiarity was that Friday’s rally came amidst a severe correction in the US markets (Thursday), massive corrections in commodities and a rallying USD Index. To my mind, the latest underperformance (by the Phisix) has engendered Friday’s rare 'un coupling'.

Further, the week's rally came amidst the pinnacle of the election campaign period, where the CONVENTIONAL EXPECTATION was that elections would bring about “uncertainties”. Ironically too, the remarkable rebound flies in the face of “lackluster” forecasts by mainstream analysts in support of the conventional wisdom. We asserted otherwise.

In the past, we argued that foreign money and global dynamics are far stronger drivers to our markets than political events.

We likewise theorized that today's underperformance had been most likely prompted by election spendings or of political aspirants raising funds via the financial markets during the campaign season (and NOT JITTERS), where we audaciously forecasted that at the eve of this political exercise, the stock market would recover.

Our predictions had been premised on the grounds of divergences with the relative vigor of the financial markets of our neighbors and the US markets, aside from conspicuous dissonances of the Pesos’ strength vis-à-vis the US Dollar (the traditional safehaven for local investors) and higher bond prices relative to the weak stock indices.

Friday’s close appear to have validated our view with oomph. And most importantly, likewise proved the conventional wisdom as an ILLUSION--election jitters are a myth under today's conditions.

Apparently as the ticker says we have been proven RESOUNDINGLY RIGHT; our next paradigm would be the continuing bullish momentum towards our 3,400 target and beyond. Of course, this would be achievable depending on the external environment which means a continuity of the present upbeat trend barring any significant shocks most likely sourced from overseas.

The US market’s Friday rally which recovered most of its losses would certainly be an added booster for the Phisix for the earlier part of next week. With 35 points away breaking the 3,400 looks quite imminent.

Sunday, May 06, 2007

Election Spending A Drag to the Phisix?

``All great deeds and all great thoughts have ridiculous beginnings.” Albert Camus (1913-1960) French philosopher

AS the global equities melt-up continues only two countries in Asia suffered losses last week. Unfortunately so, our Phisix had been one of them down 1.2%, aside from Sri Lanka (-1.32%).

Compared to our neighbors, even Thailand’s SETI which had earlier been trammeled by the recent fiasco on capital controls had broken out of its tight range to climb 3% over the week and surge past the 700 levels, as shown in Figure 1.

Figure 1: Lagging Phisix an Election Related Issue?

The center window shows of the bedraggled Phisix (line chart and down blue arrow) against a reanimated SETI (candle and red up arrow). At the above pane is Indonesia’s index represented by the $IDDOW (DJ Indonesia Stock Index) and Malaysia’s $MYDOW (DJ Malaysia Stock Index), all of which are treading on record grounds.

Year to date, among our neighbors Malaysia’s KLSE leads in terms of nominal benchmark returns up 22.82% followed by the Indonesia JKSE (+12.62%), our Phisix (+9.92%) and Thailand’s SETI (+5.38%).

With the Phisix lagging both the US Dow Jones Industrials (as previously discussed) and our neighbors, two nagging questions come to our mind. One, what ails the Phisix? And second will the Phisix eventually join the global shindig or be caught with the corrective headwinds?

We are aware that foreign money had mainly driven the local market since 2003.

For this week, foreign money accounted for 56% of the week’s aggregate turnover. However, foreign money flows shows of a measly net Php 194.25 million worth of inflows compared to the previous week’s Php 1.2 billion. The degree of foreign money inflows have tapered off since the second week of April, ironically even as the US dollar continues to cascade, in terms of its trade weighted index and relative to the Philippine Peso.

Furthermore, this week we observe of some net foreign selling on many index heavyweights, such as Metrobank (-5.51%), Ayala Corp (-3.25%), Ayala Land (-4.11%), Globe (-1.21%) and BPI (-2.29%), as responsible for most of the decline of the Phisix. Based on the market float, the combined weightings of these 5 heavyweights constitute 32.77% of the Phisix as of Friday’s close. But, on the other hand, foreign money inflows remain buoyant over the broader market.

So here we see some mixed signals, foreign selling on select index heavyweights, but supportive of the broad based market.

In addition, we also notice that even as the Phisix has traded sideways since the second week of April, the broad market has been on a bearish bias for the fourth consecutive week, as indicated by MORE declining issues than advancing issues. We construe this as symptoms of bearishness from LOCAL investors.

In other words, over the past four weeks, foreign money remains largely defensively positive (net inflows) with occasional bouts of select selling (as last week) but the locals appear to be the major drag to the Phisix. In fact, repeatedly over the last three trading days, as the Phisix sprinted to over 20 points in gains on the record territory gains of the US Dow Jones, mid session selling dampened the trading sentiment to end the day’s session mixed. This ambivalence leads us to suspect that despite the sanguine micro environment and “bullish” global backdrop, the extent of local selling could be ELECTION related.

No, we don’t think this is about election jitters. Instead we suspect this to be about election spending. The Philippine Stock Exchange (PSE) could have been utilized as conduit, directly or indirectly (mutual funds, UITFs), for fund raising activities in the upcoming elections.

Since the PSE’s payout procedure is Transaction + 3 days, going by this line of reasoning, we expect the “election fund raising” dynamics to culminate by Tuesday as the elections are scheduled for next Monday, May 14th.

And if our analysis is accurate, then we should see a sentiment reversal, possibly as early as the latter half of the coming week or after the elections. Of course, this would all depend on the prevailing global sentiment then.

So in answer to the two questions we earlier posed, we think that the divergences or the underperformance of the Phisix relative to its neighbors and the US Dow Jones Industrials, as possibly due to Election spending related and the probability is that as global markets remain buoyant, the likelihood is that the Phisix should regain its footing.

Stay Long the Phisix and the Peso.

Systemic Risks Rises as Leverage Mounts

``Causa remota of the crisis is speculation and extended credit; causa proxima is some incident which snaps the confidence of the system, makes people think of the dangers of failure, and leads them to move from commodities, stocks, real estate, bills of exchange, promissory notes, foreign exchange—whatever it may be—back into cash. In itself, causa proxima may be trivial: a bankruptcy, a suicide, a flight, a revelation, a refusal of credit to some borrower, some change of views which leads a significant actor to unload. Prices fall. Expectations are reversed. The movement picks up speed,”-Charles Kindleberger (1910-2003) historical economist, author of Manias, Panics and Crashes.

WHILE we remain optimistic over the Philippine capital markets over the long term, several significant headwinds or systemic risks possibly posited by excessive leverage threatens the global financial markets. Since the extent of local leverage have been minimal, it would be safe to say that Philippine asset markets have not attained “bubbly” conditions. What worries us is the extent of foreign “leveraged” or chained credit exposure underpinning the Philippine asset markets.

In the past we have noted of how the world financial markets have taken up way too much leverage to shore up asset values in the search for diminishing returns. And today, we are seeing much of this “leveraging” take place in private equity buy-outs, hedge funds to even margin debt taken up by mainstream or individual investors.

In the US, according to estimates by Bridgewater Associates Inc., a Westport, Conn., hedge-fund company (emphasis mine), ``borrowing by hedge funds and margin loans to individuals added up to $4.9 trillion in 2006, compared with $1.8 trillion in 2002. Hedge-fund borrowing and other financing tools were valued at $1.46 trillion last year, up from $177 billion in 2002.”

Notwithstanding, loans to companies acquired by private-equity firms jumped by about 5 times to $317.3 billion in 2006 from $51.5 billion in 2002, according to Reuters Loan Pricing Corp.

Derivatives have been used largely by hedge funds and private investment pools for institutions and wealthy individuals to go around margin restrictions by mimicking the effect of purchasing stocks and bonds at lesser upfront capital. Of course derivatives come in myriad varieties not limited to stocks or bonds but also to commodities and even to the weather.

By taking up more leverage investor’s portfolios accentuate gains when the value of the underlying assets rises. However when the invested assets fall, unlike stocks holdings where losses could translate to floating paper losses, in swaps, the hedge funds or the counterparty of a derivatives dealer (usually investment banks) would be required to pay the equivalent amount of losses in value plus the agreed upon fee to underwrite the contract.

The danger lies when losing wagers would require investors to raise significant cash and by doing so unload illiquid assets that may create pressure on today’s highly correlated asset classes.

Aside, there is also the question of the erosion in lending practices that could lead dealers to relax on collateral requirements. As in the US subprime experience, lax credit requirements has led to numerous defaults.

According to Randall Smith and Susan Pulliam, writing for the Wall Street Journal (emphasis mine), ``Wall Street itself is one of the biggest users of leverage. Last year, the nation's four largest securities firms financed $3.3 trillion of assets with $129.4 billion of shareholders' equity, a leverage ratio of 25.5 to 1, according to research firm Sanford C. Bernstein & Co. In 2002, those same firms financed $1.59 trillion of assets with $72.7 billion of equity, a ratio of 21.9 to 1, it said.” At 25 to 1, a 5% decline in value is more than enough to eviscerate its entire equity capital.

Mr. Warren Buffett in last week’s Berkshire Hathaway’s annual stockholders meeting again reminded the public of the dangers of derivatives, Bloomberg quotes the Sage of Omaha (emphasis mine), ``The introduction of derivatives just made any regulation of leverage a joke. It's an anachronism,'' he said. Because of them, ``there will be some very unpleasant things that happen'' in the financial markets. ``We may not know exactly where exactly the danger begins and at what point it becomes a super danger.”

Figure 2: Bank of England’s Financial Stability Report: Rising Risks

It’s not just Mr. Buffett, recently the Bank of England in its Financial Stability Report notes of rising risks due to complacency and debt expansion, as shown in Figure 2.

The BoE warns, ``The changes are relatively modest, though several are judged to have edged up. Perhaps the most notable news is an increase in the interrelated low risk premia and corporate debt vulnerabilities, with signs of a further expansion of risk-taking in global capital markets. As conduits for much of this activity, the potential impacts of LCFI distress and infrastructure disruption are also assessed to be slightly higher. The likelihood of a disorderly unwinding of persistent global imbalances is judged to have fallen slightly since the July 2006 Report, as US domestic demand growth has eased and growth in the euro area has increased.”

On the other hand, the New York Federal Reserve sounded the alarm bells on the explosive growth of hedge funds which poses as the “biggest risk of a crisis since 1998”, notes the CNN (emphasis mine), ``Recent high correlations among hedge fund returns could suggest concentrations of risk comparable to those preceding the hedge fund crisis of 1998," according to a paper written by Tobias Adrian, capital markets economist at the central bank.

``Similar trading strategies can heighten risk when funds have to close out comparable positions in response to a common shock," the economist Adrian wrote.

As the market climbs on concentrated levered positions, this heightens volatility risks as well as systemic risks.

Since we cannot control the macro environment, and can only work with our portfolios, it would be best to position only with the amount of risks we can sleep on and to tighten our stops (given the limited investing options in the Philippine market setting).

Philippine Mining Index: Reliving The March to 9,000!

``If a man will begin with certainties, he shall end in doubts; but if he will be content to begin with doubts, he shall end in certainties.” Francis Bacon (1561-1626)

TODAY’s bullish landscape has prompted some analysts to claim that economic “decoupling” from the US as reasons behind the ebullience.

While it is true that the global economy and the global financial markets have been outperforming its US counterparts, I remain a skeptic on the “economic decoupling” driving-the-global-financial-markets premise simply because global financial assets classes have grown significant correlations with that of the US.

In my view, outperformance does not equate to decoupling, it is a low or negative correlation that signifies one. February’s “Shanghai Surprise” was a vivid example; when US markets corrected using China’s tremors as an excuse, world markets simply mimicked the developments of the US markets. Had there been low or negative correlation, global markets could simply have ignored such event or got least affected, yet that was hardly the case.

Instead, in my opinion, the “US dollar decoupling” premise seems more circumstantially evident as the declining value of the US dollar has coincided with (most possibly a causal relationship) massive capital flows towards ex-US assets.

Anyway, the recent economic slowdown in the US has been discounted by the financial markets as “the Periphery” or particularly emerging markets have taken the load of the world’s growth as shown in Figure 3.

Figure 3: BCA Research: Emerging Market’s Domestic Demand Boom

According to one of our favorite independent research outfit, BCA Research, domestic demand growth from emerging markets have alternatively functioned as an engine of global economic growth (emphasis mine),

``Similar to the U.S. during this period, emerging markets are now the main source of global growth with very vibrant and dynamic economies. Consequently, emerging market currencies are remarkably strong, which is helping drive down inflation and interest rates in the developing world to levels lower than would otherwise be the case. In turn, purchasing power for emerging market consumers and corporations is being boosted, fueling domestic demand growth and benefiting stocks levered to this part of the economy.”

This has likewise been supported by Industrial production growth outperformance by emerging markets relative to G7 as shown in Figure 4.

Figure 4: US Global Investors: Industrial Outperformances by Emerging Markets driving Commodities

According to the US Global Investors (emphasis mine), ``Emerging economies industrial production keeps its steady pace, maintaining demand for base metals, as exemplified with copper. Strong global economic growth is the critical driver behind the commodity price appreciation; historically commodity related equities follow commodity prices.

Figure 5: Philippine Mining Index Near 1997 high!

In our October 11 to 14, 2004 edition (see Philippine Mining Index: The March to 9,000-levels), we forecasted the Philippine Mining index then trading at the 1,900 level to reach at the 9,000 levels a 1987 high (to be exact July 21 1987 high of 9,185) over the coming years.

Today the Phimine hovers above its 2006 high and closed at 6,104.66 as of Friday and is about 400 points away from its 1997 high (March 21 high of 6,502.71).

With strong global growth fueling demand for supply restrained commodities, as evidenced by recovering industrial metal and precious metal prices, aside from the benign environment conducive for emerging markets assets, we find ample support to sustain the rise in commodity related equities similar to the view of US Global Investors.

In addition, in charting vernacular, the huge bullish J.LO (coined by Wall Street with reference to Jennifer Lopez’s derriere) “rounded” bottom, represented by the green blocked arrow, as shown by Figure 5, lends us even more support on the grounds that the 9,200 barrier will be a realizable target in a not too distant future.

Stay long the mines and commodity related issues.