Sunday, July 29, 2007

A Nightmare on Wall Street; Currency Markets Turmoil

``Our main business is not to see what lies dimly at a distance, but to do what lies clearly at hand." Thomas Carlyle (1795-1881) Scottish Philosopher, Essayist

Early this week, I had been asked why despite the adaptation of a bullish stance I sounded quite tentative. Well, the answer from the hindsight is quite obvious. We have been saying all along that since developments in the US markets appear to have been directing the path of the its counterparts in the global arena, if the financial markets were to reflect on the developments in the real economy, then we are at a loss of pertinent explanations except that we find massive expansion in today’s credit cycle and excessive risk taking behavior, underpinned by the expansionary policies assumed by the world’s central banks as basically responsible for the recent activities in today’s global financial marketplace.

Yet, regardless of the intensifying risks, financial markets have had their extended shindig, which seemed to uphold the impression that any inflection point could only be found in the distant future. Meanwhile, bearish analysts had been seen fading in the limelight as markets conspicuously contravened their outlooks as indices scaled to new heights. On the other hand, momentum investing appears to have gathered more following.

But suddenly, we found some of our apprehensions may have turned into a reality.

Last week, we described the possibility that as the US dollar Index approached its 35-year low, assaults on any major support levels have usually been accompanied by violent reactions. While we pointed out several factors that may lead the US dollar to breakdown into uncharted waters, we also raised the possibility that the US dollar index could in all probability stage a massive rebound from its lows. MOST of what we projected last week materialized as shown in Figure 1.

Figure 1: Currencies illuminate Market Stresses

At the start of the week, the US dollar index (+1.07% w-o-w) breached slightly below the 80s to a record low but fiercely recoiled after its attempted breakdown faltered (see panel above center window).

This coincided with a huge spike in the Japanese Yen (+2.06% w-o-w; see main window), which behind the scenes could have conspired to aggravate the turbulent conditions of several institutions holding assets already suffering from the worsening subprime implosions in the US.

And while both the Yen and the US dollar index surged, global markets represented by the US S & P 500 (upper pane below main window) and our own Phisix (lower pane) were thrashed (red circles). The blue vertical line signifies the demarcation timeline of the recent volatility chronicles.

In a perspective, the decline seen in the US markets in the weekly context has almost been similar in magnitude to the one seen late February (recall the “Shanghai Surprise”?), albeit a Bloomberg report calls it the worst week since 2002 (in allusion to the S&P 500--see how selective referencing can make a powerful difference in a presentation?) with about US $2 trillion in global market value wiped out.

This week the Dow Jones Industrials fell 4.23%, the S & P dropped 4.9% and the Nasdaq was lower 4.66% compared to end February’s 4.22%, 4.41% and 5.85%, respectively. This means that YES, the S & P was in accordance to the description by Bloomberg report but NOT so with the Dow Jones Industrials or the Nasdaq.

Similarly, for this week the Philippine Phisix got shellacked by 5.78%, however compared to February’s shakeout where the Phisix dived by a nasty 7.35%, the mitigated circumstances could have been cushioned by the latest BSP’s motion to reflate.

Anyway, following the said bloodbath early this year, the Phisix followed through with two successive weeks of decline, down 1.29% and 1.21% for a cumulative loss of nearly 10% before recovering. This is not to impress upon you that the Phisix will do a February reprise simply because the factors contributing to the recent actions have been dissimilar. Although our message is that streaks whether to the upsides or downsides occur. And given that the recent selloff resulted to some minor technical wreck (Phisix broke 50-day moving averages), momentum suggests to us that the path of least resistance could either be down or sideways.

Pockets of Resistance: Belated Effect or Incipient Decoupling?

Nevertheless, during February’s volatility, much of the world markets apparently sympathized with the actions of the US markets. However today, we see some peculiar divergences or markets behaving independently from the general activities in the equities frontier. For instance, while most people attribute February’s volatility to China, which we vehemently argued against, China’s Shanghai Composite rocketed by 7.06% and Shenzhen flew 10.84% (!) over the week in defiance to the prevailing sentiment across the globe--this should equally dispel the much touted China’s correlation with that of the world’s equity markets.

In addition, most of South Asia’s (Pakistan +2.09%, Sri Lanka +3.25%, Bangladesh +2.66%) and East European markets have likewise seemed insouciant to the recent turmoil to even end the week significantly higher. Even neighboring Thailand managed to eke out a 1.53% gain over the week.

Either we will be seeing belated effects on these markets or these pockets of aberration could be representative of emergent signs of financial markets “decoupling” with that of the highly leveraged US and western markets.

Threat to Global Markets: Credit Contraction or Liquidity Shrinkage

``What deflation is, is falling prices precipitated by a credit contraction—by the inability or unwillingness of lenders to lend and borrowers to borrow…But, for now, a superabundance of money and credit is financing a leap in asset prices across markets and time zones.” Jim Grant, Grant’s Interest Rate Observer

Nonetheless, there are several differences between that of February’s volatility and today’s carnage.

One is that as a function of market internals, as we pointed out in our June 18 to 22 edition (see Introspection on the US Markets and the Phisix, Deterioration in US Market Internals), the deterioration in the US has gone broad based, as shown in Figure 2.

Figure 2: Barry Ritholtz: Weekly Performance of Dow Subcomponents

Courtesy of one of our favorite analyst Barry Ritholtz, Figure 2 shows that even the previously buoyant sectors of Basic Materials, Energy and the Industrials responsible for the elevation of the main indices in the past has now degenerated. So instead of an interim recovery, which proved to be ephemeral, almost all of the industry groups have presently joined in the selloff. In short, what we are seeing today is a broad market decline in investor sentiment and this does not bode well for the US markets.

Second, credit markets are manifesting signs of a contagion…

Figure 3: Paul Kasriel of Northern Trust: Recent Spike in Yields still Low compared to yesteryears

Since one of the main pillars ascribed to as having boosted US markets of late has been the de-equitization process or “equity supply shortages for investment” mainly as a consequence to a combination of corporate share buybacks plus leverage buyouts or private equity deals (which accounted for more than a third of all acquisitions in the US in the first half of the year-Economist), the sudden rise of risk aversion as shown by the rising yield spreads has effectively reduced the incentives for such activities.

To quote another favorite analyst of ours Mr. Paul Kasriel of Northern Trust (highlight mine), ``But now, credit to fund de-equitization is getting more expensive. Since June 12, the yield spread between high yield (aka junk) bonds and 10-year U.S. Treasury securities has increased by 150 basis points. Even with this recent widening, corporate credit-risk spreads still are relatively low. But should they continue to widen, this de-equitization factor that has been driving up stock prices will wane.”

With the ongoing housing recession spilling over to the subprime mortgages, which during its heyday have been then packaged and rated in different forms of structured finance instruments, and sold or distributed to a diverse class of investors, the present re-ratings or change in risk assessment has likewise affected institutional holders in far corners of the globe. For instance, two Australian hedge funds were reportedly affected; Absolute Capital Group (suspended withdrawals) and Basis Capital Fund Management (hired Blackstone to negotiate with bankers to limit losses).

Even credit default swaps or contracts used to speculate on a third party’s ability to pay on our domestic sovereign bonds were recently repriced, according to Oliver Biggadike of Bloomberg, ``The perceived risk of owning Philippine and Indonesian notes rose to the highest in a year. Contracts based on $10 million each of Philippine and Indonesian dollar-denominated debt increased $55,000 to $205,000, according to prices from JPMorgan Chase & Co. The difference in yield on the nations' 10-year dollar- denominated benchmark notes compared with similar-maturity U.S. Treasuries increased to 2.08 percentage points and 2 percentage points respectively. Both countries' credit ratings are below investment grade. High-yield, or junk bonds, are rated below Baa3 at Moody's Investors Service and BBB- by Standard & Poor's.” Subsequently, the sharp rise in yields has evidently boosted the US dollar relative to the Peso (the latter had a precipitous drop over the week down by 2.05% from 44.8 to 45.72 pesos against a US dollar).

While Japan’s banking system is said to have little exposure on US subprime mortgages, according to the International Herald Tribune (emphasis mine) ``Japan's nine biggest banking groups have more than ¥1 trillion of combined holdings in products backed by U.S. subprime mortgages, the Nikkei English News reported.” That’s still equivalent to about a hefty US $8.418 billion but nonetheless a short change compared to the $600 billion subprime mortgage loans (as of 2006) in the US.

So with tighter credit standards self-imposed by the US financial entities arising from the subprime mortgage crisis, rising yield spreads have led investors to shy away from present deals, where according to the Economist (highlights mine), ``The mortgage malaise has, in short, led to a broader reassessment of risk. Until recently, issuers of high-yield (junk) bonds and loans were able to borrow at wafer-thin spreads over blue-chip credits. That gap is now widening by the day. As a result, more than 40 companies—many the targets of leveraged buyouts—have had to cancel, postpone or sweeten bond or loan offerings this month. This week banks pulled the sale of $12 billion in loans to finance the leveraged takeover of Chrysler. This has left some wondering if the golden age of private equity may be over. Shares in Blackstone, a private-equity firm that went public last month, are languishing 17% below their offer price.”

Effectively all these translate to one thing: Credit Constriction. If in the past liquidity or the availability to create, access and intermediate funds came with no apparent limit, today’s subprime busts have spurred a change in risk appetite which has reversed the course of investor’s expectations: investors now demand higher yields for commensurate risks taken.

Figure 4: Dr. Ed Yardeni: Assets of US Households

Lastly, the recent realignment in investor’s expectation could also affect the spending patterns of the US households which constitute about 75% of GDP.

Where total financial assets of the US households totaled US $42.522 trillion for the first quarter according to the Federal Reserve’s Flow of Funds, direct and indirect exposures to equities or via mutual funds and the real estate industry constitutes about 50% of the said assets, as shown in Figure 4 courtesy of Dr. Ed Yardeni of A broad deterioration in both asset classes could further restrict the financing options for the highly levered US households in the face of a contracting credit environment.

Under the Threat of Recession, The FED Will Likely Cut Rates!

``For practical central bankers, among which I now count myself, Friedman and Schwartz's analysis leaves many lessons. What I take from their work is the idea that monetary forces, particularly if unleashed in a destabilizing direction, can be extremely powerful. The best thing that central bankers can do for the world is to avoid such crises by providing the economy with, in Milton Friedman's words, a "stable monetary background"--for example as reflected in low and stable inflation.”-Ben Bernanke, Chairman US Federal Reserve, On Milton Friedman's Ninetieth Birthday

With a slowdown in earnings growth, stubbornly high energy prices and a potential slackening of US economic growth (recent 3.4% could simply be a bounce), it becomes doubtful for jobs creation to pick up and weightlift its economy out of its present junctures. In short, the recent adverse reactions in the financial markets increases the likelihood of risks for a serious potential headwind; a RECESSION in the US, a development which we have been concerned with since last year.

In essence, the risks prospects that the US financial markets will possibly live through extended periods of downside volatility in the light of the changes in investor’s expectations as reflected in the credit markets as well as the recent re-ratings in the equities market seems accelerating until proven otherwise.

Since the US markets has reasserted its leadership role for most of the global equity asset markets, then the possible persistence of market turmoil could likely be transmitted into the global markets including that of the Phisix, as recently countenanced. We should then extrapolate such development to our portfolio by keeping ourselves judiciously in a defensive mode rather than wishing away our optimism. Remember no trends go in a straight line.

In the meantime, while the US dollar’s bounce was said to be a “flight to quality”, the stark manifestations in the credit markets are unlikely to herald “quality” with respect to US fixed income assets being the catalyst for the recent market deterioration.

What could be construed instead is that the US dollar has simply “bounced off from its record lows” following a test on its critical 35-year support level or in short, a plain vanilla TECHNICAL REACTION. Yes, US treasuries prices sharply rallied or yields declined, but this implies economic weakness (main window), as shown in Figure 5.

Figure 5: 10 Year treasuries, Oil

US sovereign securities (upper pane above main window) as measured by the Morgan Stanley Dean Witter U.S. Government Securities Trust served as a recent shock absorber to the recent carnage. Yet, this brings us to the implied message.

As we have discussed in the past, if the US equity markets undergoes further selling pressures, or possibly the Dow Industrials infringe on 12,600 or a correction of MORE than 10%, then we submit to the position that the US FEDERAL RESERVE will respond in a typical fashion when faced with ALL previous crisis: the provision of liquidity stimulus by the LOWERING of interest rates. It is thus said that a US recession induced bear market could translate to a loss of over 40% of market value!

The US Federal Reserve will most probably risk the destruction of its currency than live up to the risks of a debt induced deflationary recession that which is politically unpalatable.

And importantly, should losses exacerbate in US dollar denominated assets, this could also prompt foreign investors to look for alternative avenues to park their investments. In short, given the present circumstances the US dollar is unlikely to function as a safehaven.

To take a little gloom away; on the other hand, if the US markets manages to hold off at the said levels and consolidate then we are likely to simply experience a normal healthy corrective phase. But present market signals do not appear to validate this view yet.

Meanwhile, deflation proponents argue that monetary responses by the US authorities will prove to be inadequate this time around to save the US economy. Maybe so. However, given the reaction of the oil markets amidst the current upheavals, which even surged by 1.6% to $ 77.02 per bbl (WTIC-see Figure 5), it would appear that if the US will undertake inflationary measures via more expansionary policies to stave off what it frets most, some assets are likely to benefit from it, which leads us to a conjecture that precious metals would most possibly surge.

If the recent market actions in our Phisix should be an indication, then the mining sector was the least affected down by 2.56%. This, in contrast to the Phisix, which was down 5.87%, led by the Property sector (-8.3%), Holdings sector (-8.22%), Industrials (-6.52%), All shares (-5.73%) and the Financial Sector (-5.04%). Another bizarre development was the unfazed FTSE Australasia gold index which was unchanged over the week, compared to its counterparts which took the selling brunt as gold prices recently were equally slammed by the US dollar/Japanese Yen rally.

Lastly, with Asia, oil producers and emerging markets holding MOST of the world’s foreign exchange reserves and could probably be the LEAST exposed to the highly leveraged financial dominion of structured finance and derivatives compared to most of its developed market counterparts, it is likely that “quality” could instead be found within its asset markets.

As such, it won’t be a far fetched idea for global investors to get a whiff of this, and migrate financial flows or the genuine “flight to quality” which should cushion these markets from external selling pressures and prompt for these markets to delink or decouple from the US.

Monday, July 23, 2007

Will the Fall in the US Dollar Affect the Carry Trade Currencies and the Global Markets?

``But when people discuss chance (which they rarely do), they usually only look at their own luck. The luck of others counts greatly. Another corporation may luck out thanks to a blockbuster product and displace the current winners. Capitalism is, among other things, the revitalization of the world thanks to the opportunity to be lucky. Luck is the grand equalizer, because almost anyone can benefit from it. The socialist governments protected their monsters, and by doing so, killed potential newcomers in the womb”- Nassim Nicolas Taleb, Black Swan, The Impact of the Highly Improbable

The US dollar trade weighted index tumbled anew to a multiyear low down .57% over the week to 80.12. This signifies a continuation of the US dollar’s softening against MOST global currencies, including our domestic currency, the Philippine Peso which appreciated considerably to its 7 year high or to its 2000 level at Php 44.8 against the US Dollar.

This comes even as the foreign entities reported a record buying binge of US assets ($126.1 billion) last May, which was more than enough to cover its twin (current account, budget) deficits. Said differently, when positive news is insufficient to buttress sentiment from its present lethargic trend, this could possibly denote of more turbulence ahead for the US dollar.

Figure 1: Gold and Carry Trade Currencies

As observed last week, even currencies that served to fund the du jour cross border asset arbitrages or the well known CARRY trades have seen a reversal as shown in Figure 1.

The Swiss franc at the lower panel has recoiled from its recent lows and appears to be testing its key resistance levels (red circle).

Meanwhile, the Japanese Yen at the upper panel; seems likewise to be in a rebound phase (blue circle). The Yen jumped .74% this week to 82.53.

Two issues to consider with the Japanese Yen. First technically, the Yen’s price action seems to be shaping out a looming trend reversal. The red channel lines above indicate of a falling wedge reversal pattern. A break above the upper trend line or nearly around 84.5 could possibly pave way for a massive rally in the Yen.

Second is that the Yen’s role in the “carry trade” has been an important feature in today’s levitated and highly leveraged markets.

The infirm yen had been partially prompted by Japanese retail investors seeking higher returns overseas by reducing their “home bias” and investing in Uridashi bonds or “foreign bond denominated in non-Yen currency issued in the Japanese market by a non-Japanese issuer” (Deutsche Bank Private Wealth Management).

Another is that the present “stable or low volatile conditions” have provided incentives for institutions to capture higher returns by taking on more leverage to arbitrage in the spreads of currency yield curves. In figure 2 courtesy of the IMF, institutions have been shown to take short positions on the Japanese Yen and the Swiss franc while profiting from the yield differentials of the Australian Dollar, Mexican Peso and the Brazilian Real.

Figure 2: IMF: Global Stability Report: Institutional Currency Positioning (percentile rank)

According to the latest Global Financial Stability Report issued by the IMF last April, ``One measure of the shift toward carry trade shows that institutional investors (so-called “real money”) have positioned themselves strongly in favor of carry trades over the past six months—funding in Japanese yen and Swiss francs and investing in high-yielding assets in other currencies—to an extreme percentile position (assessed over 1994–2007).

Mr. Bob Lenzner columnist for the Croesus Chronicles at cited Merrill Lynch estimates of about US$ 1 trillion worth of yen carry transactions.

To put in a wider perspective, given the global bond ($58 trillion 2005-McKinsey Quarterly) and equity markets ($50 trillion 2006-World Federation of Exchanges), such exposure would represent a rather small share to present itself as a major risk factor to the world capital markets.

However, drastic moves could spark a financial market turmoil in a particular market that could ripple across other asset classes as in the previous cases of May 2006 and the latest February 2007 “Shanghai Surprise”.

Back to Figure 1, the blue arrows in the upper chart depicts of the previous 2 instances of the Yen spikes. On the other hand, the EEM or the iShares Emerging Market Index in the lower pane above the center window, represented by the red arrows indicates of the coincidental downward volatility-possibly in response to the abrupt closing of several Yen carry positions.

Mr. David Kotok of Cumberland Advisors estimates the mark down as a result of a surging yen to world bond and equities market in 2006 at around $7 trillion and for this February, the losses were assessed at around $ 2 trillion.

Mr. Kotok qualifies the diminishing impact of the Yen’s upside spike as a “step function” where the financial markets gradually adopts with the expectations for its eventuality. In Mr. Kotok’s words, ``The step function is geometric and not arithmetic. The impact lessens each time an event occurs.”

Going against the tide in Asia, Japan’s yen has been the only currency experiencing losses amidst its massive trade surpluses. The Yen is down about 1.8% year-to-date. Yet, one must remember that Japan holds the second largest foreign exchange surplus, but paradoxically corollary to its monetary policy, again due to government intervention, depressed interest rates have spawned factors leading to resident based outflows and institutional yield arbitrages that has distorted its currency value levels, making it the world’s most “undervalued currency” according to the Economist.

In other words, while the global financial markets may be anticipating for an eventual rebound in the Japanese Yen to reflect on its fair market value, and thus a rise in yen may result to a much diminished impact, this does not eliminate the risks where an unheralded upside explosion by the Yen may trigger some upheavals in the marketplace.

And since the Yen carry has financed many of the present leveraged positions elsewhere, a Yen ‘shock’ could amplify adverse reactions in the other asset classes experiencing distress, such as the mortgage markets in the US and could become a contagion.

So as the US dollar presumably proceeds with its downside ordeal, it would be worthwhile to keep an eye on the movements of the Yen and consequently how the other markets react to it.

It’s always better to be safe than sorry.

US Dollar Index At 35 Year Support Level; Gold is Your Best Friend Now

``Nixon Administration officials were convinced that cutting the dollar's tie to gold and devaluing it against other currencies would increase our exports, slash imports and give us a fabulous round of prosperity. Instead, unhinging the dollar from gold gave us more than a decade of debilitating inflation, catastrophic increases in the price of oil and record-high interest rates.”-Steve Forbes

Going back to the US dollar Index, we noted last week that as the US dollar plumbs to its critical juncture, gold and the precious metal group are likely to benefit from the erosion of the US dollar’s value.

Figure 3 35 year price action of the US dollar Index

In the past 35 years, figure 3 courtesy of and, the 80 levels of the US dollar index (shown by the red horizontal arrow) has been the bailiwick of the US dollar bulls where thrice (1992, 1994, 2005) they were successfully able to repel the US dollar bears. Obviously this will be the fourth attempt.

Last Friday, with the US dollar at 80.12, we apparently stand at the crossroads.

With that in mind several questions pop up…. Will the bears muster enough force to BREACH for the FIRST time the ALL important 35 year threshold level? If the support gives, will the decline be orderly? Will the assault on the 35 year support levels be violent or are we going to see a nasty bounce off from the 35 year support levels? Will the global FIAT money based system face tension for the first time since the gold window was closed in August 15, 1971? Or could there be a US dollar crisis?

Most of the signals APPEAR to point towards a successful breakdown of the US dollar index, such as the continuing saga of US subprime, structured finance and housing jitters, rising interest rates across the globe, outperformance of Global economy relative to the US, and rampaging commodity prices.

Meanwhile in the context of Gold, which closed on Friday at the TOP of the resistance channel in figure 1, a successful upside breakout next week, could lead it to a test on its previous May 2006 high at $720, and potentially, lay siege on its all time high at $850 back in 1980 anytime soon. Perhaps, by first quarter 2008?

Echoing the activities of Gold is the world mining indices. Lately, when gold prices attempted to move higher, global mining indices stagnated or simply did not follow gold’s price actions. Some analysts pointed to rising operating costs, which depressed profits, as the main reason for its deviation.

However, as of Friday, almost in synchronicity, we see global mining indices surge such as the AMEX Gold bugs, FTSE AustralAsia, FTSE Africa, FTSE Gold Americas, Japan’s TSE Mining index and Canada’s S&P/TSX capped Gold Index.

We are unsure if the Philippines counterparts will follow suit. Given the historical perspective, their correlation with global mines appears to be low. However a knock on effect from the floundering US dollar and the recovering gold will likely continue to influence global mines. And with that being the case, given the growing exposure of Philippine mining industry to the international arena, the probability could be tilted towards a spillover from the international field to the local mining index.

Simply said, if the global mining indices will continue to validate the movements of the prices of the precious metals then one can expect foreign money to pour on into the local mines very soon.

In the absence of a domestic commodities market, then the best recommended alternative would be an adequate exposure to the mining industry as insurance to the possibility of a vehement reaction to the US dollar’s breakdown. Remember gold stands not as your ordinary commodity but your alternative currency.

Well, for as long as the market’s response is orderly this should actually not be limited to the mines.

We must also not forget that the Philippine stockmarket cycle has been moored to the fate of the US dollar. Since the Phisix’s cyclical troughs in 2002, a declining US dollar has greatly boosted foreign portfolio flows into the country, from which so far has driven our Phisix to record territories. And our Phisix has largely played out closely alongside with the activities of its emerging market peers, responsive to the actuations of the US dollar.

Our bullish premise is conditional to the orderly and smooth decline of the US dollar index plus an equally upbeat or low volatility in the US equity market, as similarly reflected in our peers or the emerging market class and in our neighbors, the Asian markets.

Surging Food Costs in US Belie Muted Inflation Indices

``Since the general exchange-value, or PPM, of money cannot be quantitatively defined and isolated in any historical situation, and its changes cannot be defined or measured, it is obvious that it cannot be kept stable. If we do not know what something is, we cannot very well act to keep it constant.” –Murray N. Rothbard, America’s Great Depression

A declining US dollar is inflationary. And despite muted inflation indices in the US we can take note of some conspicuous divergence.

Figure 4: CRB Foodstuffs on a Tear!

We have been bullish agriculture primarily because of the investment cycle (growing demand in the face of limited and underinvested supply) and the inflationary bias undertaken by the world’s monetary institutions. In addition, we have governments intervening to create hideous distortions to the marketplace such as biofuel subsidies.

In figure 4, courtesy of CRB, the CRB Foodstuff sub-Index which comprises butter, cocoa, corn, hogs, lard, soybean oil, steers, sugar, Minneapolis wheat and Kansas City wheat is now at its highest level ever. This means that the prices that underpin the stuffs that Americans eat have been rising significantly too! Yet, inflation figures shown by the government remain compressed.

This also means that inflation figures had been largely understated or manipulated for self serving purposes. To quote Antony P. Mueller, in the Myth of Price Stability, published in 2004 at the (highlights mine),

``Price indexes necessarily average out the extremes; they are unable to signal the more subtle price movements and they leave out relevant items such as asset prices. This way, it is not only the general public that is being deceived, the central banks themselves are falling victim to their calculations like the joke of the statistician who drowns while crossing the water that he had thought was easy to wade based on the arithmetic average of its depth.

``Currently, for example, the depreciating value of the dollar is already visible in oil, real estate, precious metals, domestic services, health care, tuition, or even when calculated against other fiat monies such as the Euro. In this perspective, there is inflation taking place and it has been taking place for quite some time at a remarkable pace. However, when counting in a considerable portion of computer storage capacity and imported gadgets, the picture changes and the perspective of a deflationary trend could be diagnosed by that yardstick.

``The great cheat of the stabilizers consists in spreading the illusion that a stable or a moderately increasing price index would imply economic stability and would have no effect on the capital structure. Neither do monetary policy measures publicized under the heading of stabilization imply a constancy of purchasing power. Such measures rather mean that old distortions are covered up while new ones are being created.

Governments in all forms can hardly be trusted.

Record Baltic Index Reveal Signs of Vibrant Global Exports?

``Firmer currencies also would help Asia kick its addiction to exports. The best way for the region to raise living standards is to move upmarket -- away from the cheap export model of the past toward greater entrepreneurship. Weak exchange rates leave fewer incentives to make that transition.”- William Pesek Jr., Bloomberg Asian Analyst

Another indicator that allows us to be bullish is the continuous surge of the Baltic Dry index, an indicator which reflects on the trading activities of raw materials or of basic commodities.

The Baltic dry index is an index which covers dry bulk shipping rates. According to the Baltic Exchange, the index provides:

``an assessment of the price of moving the major raw materials by sea. Taking in 40 shipping routes measured on a timecharter and voyage basis, the index covers supramax, panamax and capesize dry bulk carriers carrying a range of commodities including coal, iron ore and grain.” (

Figure 5: Baltic Dry Index and Crude Oil confirming robust global growth?

Figure 5 courtesy of manifests of the vigorous activities in global arena, resulting to high freight “dry bulk” rates and oil prices, which lend credence to our belief that the global economy remains resilient in the face of the softening US economy.

Moreover, according to Dr. Ed Yardeni global exports story continue to remain vibrant. To quote at length Dr. Yardeni,

``Let’s review some of the latest developments in the global exports story:

(1) According to the IMF, world exports rose to a new record high of $13.5 trillion in the 12 months ending March. They doubled since the start of the decade.

(2) World exports were up 11.5% y/y through March. This growth rate is highly correlated with the y/y growth in non-gold international reserves held by central banks, which is a good measure of global liquidity. This measure was up 21.3% through April, suggesting there is plenty of liquidity available to finance the global export boom.

(3) The BRICs have among the fastest growing export sectors with y/y gains of 15.8% for Brazil, 11.6% for Russia, 18.2% for India, and 25.9% for China. (My comment: Brazil’s real and India’s rupee has far outpaced the Philippine Peso’s advance yet they have been sporting massive export gains!)

(4) The EU is also exporting at a rapid rate with a gain of 20.0% y/y with Germany up 18.0%.

(5) The US has clearly benefited from global trade as exports have risen to a record high of $1.08 trillion over the past 12 months through May. This has been one of the major offsets to the housing recession. More specifically, capital goods industries have enjoyed boom times with their exports totaling a record $425.6 billion over the past 12 months.

(6) Of course, the US has been a big market for foreign exporters with our imports totaling a record $1.89 trillion over the past 12 months, but that’s just 14% of the world exports.

(7) US capital goods industries with record or near-record exports over the past 12 months include aircraft ($42.1 billion), jet engines ($17.9b), excavating machinery ($11.1b), agricultural machinery ($5.5 b), oil & drilling equipment ($12.5b), and generators ($9.8b).”

A caveat is that all these are past data.

However, shipping remains as the key transport used for exports, and thus, the said freight index could help serve as a leading indicator for the health of global trade. According to Christopher Hancock of Penny Sleuth, ``Shipping still serves as the world’s economic circulatory system. This business connects the world in ways technology never will. Roughly 90% of the world’s exports are still transported by ship (highlight mine).”

This means that if we are to compare the enumerated activities with that of the Baltic Chart, the recent vivacious export performances by global economies appears to have been corroborated by the tight shipping activities which resulted to the high prices seen in the world’s shipping index.

In addition, the recent record close by the Baltic Index could further indicate of the salutary growth clip the world could be experiencing today.

Again for as long as there won’t be any ‘shocks’ that could perturb the financial markets, under the conditions stated above we are likely to see more upside gains based on the present reactions of the several leading market indicators, as well as with the current momentum.

Don’t forget your mental stops.

Sunday, July 15, 2007

Phisix: Back to our Bullish Stance! But Keeping Vigil on the US Dollar Index.

Phisix: Back to our Bullish Stance! But Keeping Vigil on the US Dollar Index.
-US Markets: Presidential Cycle behind Recent Rally?
-BSP Reflates! Locals seen to Add Fuel to Fire
-US Dollar Index Sits At Multi-Year Lows, Risks of Disorderly Unwind Heightens

``Accept the premise that my method is no better than theirs, and yours no better than mine. It doesn’t matter anyway; methodology isn't the primary element of successful trading. The key to success lies in two simple words: money management. There will be losing trades with every methodology. The secret is to have smaller losses on the losing trades and larger relative wins on the winners. To put it another way, "trade picking" ability, while important, is secondary; money management is primary.”- George Kleinman, editor of Commodities Trends, How to Become a Successful Trader

In the past issues we have noted of our interim neutrality stance towards the Phisix stemmed from the ambiguity provided by the dithering US equity markets, which has accounted for the negative factor, relative to the plight of the cascading US dollar, which represented as the positive factor. This push-pull dilemma apparently got resolved this week.

With the US market’s electrifying breakout from its key resistance levels, particularly Dow Jones Industrials (+2.17% week-on-week) and the S&P 500 (+1.48% w-o-w), our main tentativeness have been set aside, as we are LIKELY to see momentum flow tilted in favor of the bulls.

Figure 1: USD-SPX-Phisix correlation

The upper window pane of the chart shows of the US S & P 500 bellwether which recently bolted convincingly out of its resistance level (blue arrow), while the Phisix at the lower panel appears to be levering up for a thrust over the 3,800 zone, although, the Philippine benchmark could back up first to gain enough pivot room for the all important test on the resistance level at 3,822.

US Markets: Presidential Cycle behind Recent Rally?

Amidst the variegated concerns of a deflating housing industry, an equivalent tension over the possibility of a contagion from the subprime mortgages anxieties, and the softening of the US economy, the paradoxical vibrancy seen in the US equity markets could be resonant of the Presidential stock market cycle following next year’s slated US Presidential elections.

The Presidential Stock Market Cycle according to, ``A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a new U.S. president. According to this theory, after the first year, the market improves until the cycle begins again with the next presidential election.”

Figure 2: Script Right on Cue!

In figure 2, courtesy of the, the best returns have been historically found during the third year of the Presidential cycle. And today’s US market performances appear to be right on cue!

To quote (highlight mine), ``What history suggests to us is pretty much crystal clear. In the last half century, there has only been one third year of the Presidential cycle period that has witnessed negative results for the S&P. The average third year cycle performance since 1955 is 18.4%. Again, in the wonderful world of make believe as per "what if this happened in 2007", an 18.4% increase for the S&P in 2007 would mean a target of 1,670. Again, we present all of this completely in the spirit of learning to accept and be at peace with whatever happens in the financial markets, and in the spirit of acknowledging the lessons of history, regardless of our personal outlook or beliefs.”

If we go by the data presented above, then 1,670 as a target for the S&P translates to another 7.5% gain from Friday’s close, considering that on a year-to-date basis the S&P is already about 9.5% higher.

Of course when we talk about statistical average, in simplest form it means that to arrive at an average number requires that about half of the time the S&P has performed above this average and vice-versa.

With the momentum today strongly favoring the bulls following the impressive breakout, our immediate guess is that the index could go higher perhaps until sometime mid-August before a major slowdown or a correction ensues.

Of course, to avoid being literal, no trend goes in a straight line: which also means despite the tendency of US markets to advance there could be one, two day or even a week’s correction interspersed during the coming month or so.

While we aren’t interested in exact figures, what interests us is how the US markets plays out during the last half of the year.

If any corrections especially going into the traditional or seasonal lean months of September-October will be benign or mild then the last quarter could probably see a sturdy bounce to reflect on the Presidential cycle’s usual performance.

If the global market’s correlation to the US markets holds, then the most likely scenario is that world markets including that of our Phisix will continue to strongly outperform.

Anyway all these are just plain conjectures. Statistical patterns or seasonalities are hardly enough reasons why one should be invested.

BSP Reflates! Locals seen to Add Fuel to Fire

As these positive developments unfold, world markets seem to have similarly celebrated the latest shindig.

In all of Asia, only Sri Lanka’s All Share index fell (-2.38%). The biggest gainers were Korea (+5.48% w-o-w), China’s Shanghai Composite (+3.52%), Indonesia’s JKSE (+3.35%), Thailand’s SET (+3.21%), Taiwan’s Taiex (+3.08%), Singapore’s Strait Times (+2.6%) and Hong Kong’s Hang Seng (+2.52%). While the Phisix joined neighboring Malaysia’s KLSE as two of the “lagging advancers” up .72% and .79%, respectively.

While the Phisix registered NET foreign buying, most of these emanated from the highly successful second round offering of the PNOC-Energy Development Corporation (+15.79%).

However, over the broadmarket, excluding special block sales, we observe that foreign money has been Net sellers based on nominal amount (Php 629.5 million), and on the number of issues traded (Net 34 companies encountered outflows this week).

We are unaware if the recent action taken by foreign investors has been related to the recent announcement by the Philippine Central Bank (Bangko Sentral ng Pilipinas or BSP) to recalibrate its monetary tools by suspending tiering system for bank placements and by lowering overnight interbank borrowing and lending (from 7.5 and 9.75% to 6 and 8%, respectively).

Figure 3: NSCB: Declining Philippine Inflation Rate

IT is said that such actions were considered “neutral” and aimed at “preempting inflation” as benchmark oil crude prices (WTIC and Brent) appear to be headed towards the record $80 levels.

However, our reading of this is that BSP acted to REDUCE THE YIELD SPREAD for Philippine assets relative to our neighboring counterparts or relative to our contemporaries in the emerging markets asset class.

In other words, we are predisposed to view BSP’s twin monetary actions with an UNSTATED goal of lessening the INCENTIVES for massive portfolio inflows from overseas investors.

Given today’s INTEREST RATE DRIVEN global capital flows dynamics, the implied effect is to PUT A BRAKE towards the rapid appreciation of the Peso.

In figure 3, the National Statistical Coordination Board ( shows of the Philippine inflation rate in sharp decline almost in conjunction with the steep rally of the Philippine Peso vis-à-vis the US dollar in 2005 until the present.

While in most instances, it would be a cognitive folly to attribute a correlation as causally linked, here we can probably say that the rising Peso has perhaps contributed to the decline in inflation rates (as measured in consumer prices).

As previously shown in March 26 to March 30 edition, (see History Is NOT A CLOSED BOOK: The View from IMF-chart provided by Gavekal Research), the rising Peso could have prompted for increasing trends to import capital goods, and this could have translated to lower consumer prices or a greater purchasing power for the Peso. So how bad could a rising Peso be?

Yes, since every action has a consequence and not all consequences will be positive. The rising Peso has to some degree affected our export sector.

However, Morgan Stanley’s Stephen Jen calls this muted effect on the export sector by rising currency levels in Asia as the “Ballast Effect”, where essentially, currency values becomes subordinate relative to the snowballing regionalization trends in the global trading dynamics and a more sophisticated financial markets.

To quote Mr. Jen, ``The notion of declining trade elasticities with respect to exchange rate movements in recent years has been well-documented, particularly for developed countries. What this means is that, with globalization, the export demand curves have steepened, i.e., it now takes bigger price adjustments to induce a unit of change in real trade. Several possible explanations have been proposed by academicians. First, as countries move up the product ladder, products become more differentiated (the ‘heterogeneity’ argument) and therefore less price-sensitive. Second, currency hedging may have retarded the responses in real trade as exchange rates change. Third, global demand (the ‘income effect’) has been so robust recently that the slope of the export demand curve appears steeper, when in fact the export demand curve has ‘shifted to the right’ due to the strong income effect.”

Thus, the BSP has done the unthinkable and unorthodox. But seemingly a lot better approach compared to those advocating the institution of rigid capital controls, as knee jerk reaction to the present trends. Capital controls are most likely to lead us to retrogress economically and financially as markets become heavily distorted by intervention. Recall Thailand’s bungled efforts backfired? Where they ludicrously repealed most of what they have imposed in less than a week!

Moreover, if today’s subdued inflation rate (measured by consumer prices), has been corollary to the rising Peso then in essence, its consequent gains has been more publicly widespread (if the index is to be believed) compared to the propping up of select industries by government intervention at the expense of the society in general.

Putting these into a philosophical dimension allow me to quote the trenchant words of Professor Gary North,

``We all wear two hats: a consumer's hat and a producer's hat. As consumers, we want producers to compete. As producers, we want protection from unfair competition. What is unfair competition? Successful competition.

``People vote with their money as consumers. They often vote in a polling booth as producers. As consumers, they want liberty. As voters, they want controls, or more to the point, control. Control over them. You know. Competitors.

``Spending is about liberation from controls on us. Voting is about the imposition of controls by us.”

The latest action undertaken by the BSP is almost synonymous to the UNSEEN motion to “reflate” the economy.

The lowering of interbank transaction rates effectively reduces rates available to the public across the board. And by the doing so, the public could be spurred to redirect their savings towards more entrepreneurial activities or drive them into the open arms of the domestic stockmarket.

With today’s highly inflationary environment, in terms of surging money and credit growth and intermediation: falling US dollar, bursting-to-the-seams trade and current account surpluses in Asia and oil exporting countries, exploding derivative markets etc…, most conspicuously evident in the global financial marketplace, it is less likely to see a marked constriction of capital flows although the BSP’s move could have SOME effects.

Again we can probably anticipate some intrinsic tradeoffs; a slight decline in foreign money participation but increasingly more local players into the market.

This also implies that as locals join the bandwagon we could probably envisage greater and more volatile activities in the broader market. This means that there could be an increase in the activities in the second and third tier issues, which should also suggest the latter’s outperformance relative to the Phisix.

Perhaps, given the current outlook, positioning a portion of one’s portfolio to speculatives may help increase yields over the immediate term.

US Dollar Index Sits At Multi-Year Lows, Risks of Disorderly Unwind Heightens

The last of the issue of concern is the US dollar.

Figure 4 : NYBOT: Components of the US Dollar Index

Figure 4 is taken from the New York Board of Trade, where the largest component according to its weighted order is the Euro (57.6%), followed by the Japanese Yen (13.6%), British Pound (11.9%), Canadian Dollar (9.1%), Swedish Krona (4.2%) and the Swiss Franc (3.6%).

While a falling US dollar has so far benefited global equity markets, what brings us to worry is that at present the US dollar index closed at a multiyear low.

Because a currency pair is a zero sum game it explains that the plight of the US dollar equals to a record high in the Euro, a 26-high in British Pounds, a 30 year high in the Canadian dollar, 2 ½ year high in the Swedish Krona and interestingly, a indications of significant rallies from “carry trade funding currencies” of the Swiss Franc and the Japanese Yen. In short, the US dollar has weakened almost across the board.

With Iran recently asking Japan to pay in Yen for its oil sales, we risks seeing a furtherance of the decline of the US dollar index, as major exporters

1. Depeg or delink from the US dollar as a currency anchor as Kuwait, or

2. Establish or increase exposure to Sovereign Wealth Funds to augment returns by utilizing surplus or excess forex reserves to diversify into NON-US dollar assets or finally and most importantly,

3. Be required to be paid for export sales of products or services in non US dollar currency.

Effectively all these construe to a weakening demand for the world’s reserve exchange currency.

Foreign central banks portfolios account for about a quarter of the total US treasuries outstanding, with similar degree of significant exposures into other US dollar denominated assets.

With the present decline in the US dollar index, these redound to enormous losses in the price value holdings of these institutions. And added losses could signify a litmus test on the loss taking appetite for these international institutional banks.

So far the US dollar’s decline has been orderly. And the benefits reaped from the global financial markets have been an offshoot to such gradual clip of decline.

However, if anyone from these institutions should undertake the initiative to sell on its holdings to cut losses or for some other reasons beyond our comprehension, such an action could risk a domino-effect panic selling binge that could trigger a US dollar crash, which could easily roil the financial markets and spoil our fun.

I think at such critical times it would be best for one to have sufficient exposures to precious metals in your portfolio, as insurance, especially if a US dollar panic turns into a gold/silver buying spree panic. Oh please if you are contemplating mines as a proxy to metals, only mind those with proven reserves.

Also best be reminded to keep those mental stops active.

Fischbowl: Shift Happens, Did You Know (Version 2.0)?

``Everyone takes the limits of his own vision for the limits of the world.”-Arthur Schopenhauer (1788-1860), German Philosopher

Major developments unravel at the margin.

The following YOU TUBE presentation by Karl Fisch of Arapahoe High School together with Scott Mcleod of Dangerously Irrelevant blogspot, succinctly depicts of the ongoing seismic “exponential” technology-enabled growth transforming the world today.

As Nassim Nicolas Taleb wrote in his “Black Swan, The Impact of the Highly Improbable”, ``History and societies do not crawl. They make jumps. They go from fracture to fracture with a few vibrations in between. Yet we (and historians) like to believe in the predictable, small incremental progression.”

Apparently because of the lack of sensation, mainstream media hardly covers on such trends.

While we don’t write to convince skeptics, especially those who have been “tunneled” towards mainstream media and IVY league personalities as their only ACCEPTED sources of information, eye-opening books like Thomas Friedman’s “World is Flat”, Alvin and Heidi Toffler’s “Revolutionary Wealth” and to the extreme futurist Ray Kurzweil “The Singularity is Near: When Humans Transcend Biology” have elaborated deeply on these evolving trends at varying degrees.

According to analyst John Mauldin ``I think that we underestimate the accelerating pace of change we are going to see in the next 15 to 20 years. We will see more change in the coming decade than we saw all of last century. Think back just 20 years and realize how much things have changed. Then double that pace through 2020. The opportunities and displacement are going to be huge.”

Likewise, we believe that the drive towards the Phisix 10,000 would be underpinned mostly by these defining transformations.

Watch and Learn!

Sunday, July 08, 2007

The Prudent Way To Profit From IPOs!

``I guess it's true that some people simply don't have the stomach to think big thoughts, let alone take big actions. The ultimate nightmare for such people is waking up some fine morning only to discover that they're going in the opposite direction from where the mainstream is headed. To people with a lemming mentality, acceptance is more important than money, dignity, or purpose. Which is unfortunate, because success and the desire for acceptance are mutually exclusive objectives.”-Robert Ringer, Making Ripples

The Prudent Way To Profit From IPOs!
-Prevalent IPO Fallacies: Confirmation Bias and the Greater Fool Theory
-Fundamental Analysis or Rationalization?
-Market Cycles Determines IPO Activities Over the Long Run
-IPOs Over the Short Term: "It’s the Market Sentiment, stupid!"; Lessons

The Prudent Way To Profit From IPOs!

As the Philippine benchmark, the Phisix, continues to set fresh record highs, a stream of Initial Public Offering (IPOs) have been set to take advantage of the public’s burgeoning appetite for Philippine securities. And with several scheduled to list in the coming weeks, we get a flurry of queries on these.

With the prevailing perception that IPOs represent the quickest way to earn money, such desire to secure allocations occasionally creates a friction between clients and their brokers on the former’s access to available IPO shares.

It should be understood that member-brokers of the Philippine Stock Exchange are prorated shares in accordance to the allocation as determined by the candidate company undergoing the IPO process under the supervision of the Philippine Stock Exchange (PSE).

It is then the brokers who assign the distribution of the partitioned shares to their clients. Plainly put, given the traditional role, the brokers have the discretionary power to ration IPO shares to their clients according to their priorities.

Amidst the prevailing buoyant sentiment exuded by the market, the reality is that NOT everyone can be pleased.

However, because of this bottleneck, several companies undergoing IPO have tried to accommodate small retail investors through a special arrangement or via the “small investors program”, where retail investors can directly or indirectly subscribe from the company or through a designated non-broker conduit.

Anyway, despite the hubbub generated by the IPOs, our assertion, once again going against the conventional wisdom, is that buying IPOs for short term gains is a SPECULATIVE undertaking, unworthy of the anxieties that emanate from securing shares to subscribe. Moreover, as we will show the best returns from IPOs DO NOT COME from short term gains!

To quote Porter Stansberry of Stansberry & Associates (highlight mine), ``Speaking of IPOs... Buying them is a fool's errand, if you don't get the broker price – which you can't get unless you've got tens of millions of dollars in your account or you're plugged in. Market studies show that, on average, buying IPOs on their first day of trading is one of the worst ways of investing.”

Prevalent IPO Fallacies: Confirmation Bias and the Greater Fool Theory

IPO’s by definition means the first sale of stock by a company to the public ( or specifically a private company’s channel to raise capital by the sale of its shareholdings to the investing public.

The procedures of the IPO itself requires the company to disclose all attendant risks that the prospective investor could likely assume, as indicated in the preliminary prospectus or the “Red herring”.

However, since the main thrust is to raise money by the sales of its shares, then obviously the plus or the selling points and NOT risks get to be emphasized. The likely analogy is that of the fine prints usually found in contracts, which are hardly ever read by the contract signatories which only come into their awareness when a conflict occurs.

And naturally, in order to generate public interest for the raise funds via the IPO route, the company undertakes a marketing campaign. Media blitz, Road Shows, and other related activities are conducted here and abroad. But since the core of MOST of the offerings are designated for overseas investors, so does the thrust of the marketing campaign.

In other words, good publicity combined with warm reception from the international investing community frequently lead to a “buzz” in the local sphere which prompts for a surge in the local market participant’s demand for the IPO.

AND MOST importantly, in the backdrop of spiraling prices in the market, as signified by the ecstatic Phisix, as well as elevated prices of companies belonging to the same industry, further reinforces the impression that such investments are impervious to risks. Subsequently, the average investors thus draw a conclusion that the prospective IPO would inarguably go nowhere but UP…especially over the short term!

Here, as we have noted before, the fallacy where average investor equates rising prices as representative of “fundamentals” is much pronounced. In addition, their perspectives have been apparently shaped by projecting the recent performances as tomorrow’s outcome, known as the “Recency Bias” or the “rear view mirror” syndrome.

As an example, let me cite you the common threads asked of us on the upcoming IPOs:

1. What do I think about the IPO?
2. How will the market receive the IPO?
3. Will there be opportunities to make short term gains?

Where our natural response is that we can’t see how IPOs perform over the short term as they are most likely to be DETERMINED BY THE PREVAILING SENTIMENT UNDERPINNED BY THE MARKET CYCLE, and that over the short-term the RISKS DIMENSIONS ARE FAR GREATER with respect to the market’s general dimension…unfortunately we get the Rodney Dangerfield treatment-“we get no respect”, simply because our answer DOES NOT FIT what they had actually expected to hear!

The first question was never really of any relevance or importance because it was a question designed to lead to a discussion on the known “fundamentals” as they have most probably gleaned from either the media, their social circles or from broker reports.

What these prospective investors would like to hear is a confirmation of their belief, where we recall Julius Caesar invaluable words, ``Men in general are quick to believe that which they wish to be true.

And our expected role as a person from within the industry was to actually validate on such views! And to talk of something beyond what is expected was tantamount to blasphemy!

As a student of the financial markets we understand this fallacy as the confirmation bias or where one looks for circumstances to confirm one’s beliefs, or ( ``the tendency to search for or interpret new information in a way that confirms one's preconceptions and avoid information and interpretations which contradict prior beliefs.”

In essence, people simply want to believe what they need to believe regardless of the validity of the basis of their beliefs.

The second issue is to deal with expectations particularly that of the short term dimension.

Basically, except for the insiders, information disseminated from an IPO company are usually almost evenly distributed, where both long term investors and short term speculators obtain similar data and profile as dispensed by the company through their prospectus.

What distinguishes the investors from the speculators is the time frame expectation in terms of holding on to a security or in this case the IPO.

In the norm, like long term investors, speculators often cite “fundamental” reasons to justify their actions.

However unlike the long term investors, instead of the rating securities based on valuations, they are predisposed towards tuning into the surrounding hype and the prevailing market action from which, they assume, would allow them to sell to a BIGGER SUCKER once the IPO gets listed.

This investing approach is commonly known as the Greater/Bigger Fool Theory or from (highlight mine), ``the assumption that they will be able to sell it later to "a bigger fool"; in other words, buying something not because you believe that it is worth the price, but rather because you believe that you will be able to sell it to some one else for an even higher price.” In short, this approach essentially epitomizes gambling. You go into a position in the hope that someone else will subsidize your bets.

Likewise, the average speculator never ruminates about the other side of the trade, i.e. if there is a willing seller there should be a willing buyer at an agreed price. If they sell, who would be the buyers?

What if, despite the media sensation and present buoyant conditions, a significant majority of the IPO subscribers turn out to be short term punters, where most expect to unload of their holdings upon the company’s initial listing date? And in contrast to expectations, when the company debuts in the stock exchange, a paucity of investors or “Greater Fools” surfaces instead. The likely scenario is that the IPO share prices would DROP towards its offering price or could even trade below them!

And since falling prices runs counter to the average speculator’s mindset, especially by those who cannot accept their mistakes, this would entail a sudden departure from a short-term perspective to a “long” only position. Our spurned punter then turns into a buy-and-hold investor!

To put in categorical perspective, does anyone ever recall of how major telecom player Digitel Telecommunications Philippines which listed on November 27, 1996 at Php 3 per share NEVER popped beyond its offer price (as shown in figure 1)?

The company’s share prices even lost more than 90% of its value (a low of about 26 centavos) during the trough of the recent bear market! Today, DGTL trades about HALFWAY from its 1996 offer price!

Figure 1: Digitel Communications: Never Seen the IPO Sunlight!

This is not to say that the conditions we cited above had been applicable to Digitel; that would be speculation on our part.

But the fact is DGTL’s listing came at the peak of the bullish cycle (Phisix reversed in first semester of 1997), where its unfortunate timing resulted to its failure to breach its listing price and consequently suffered a loss for both the investors and speculators alike, especially by those who were in denial about the state of the market’s cycle.

Could these happen again? Of course it can…or it will, if and when the market cycle turns.

As finance guru Jay Ritter says of the investing in IPOs, ``The IPO market is never in equilibrium. It's either too hot or too cold. Buy in the cold periods.”

Fundamental Analysis or Rationalization?

The third fallacy goes with the “fundamental” excuse to justify one’s activities.

As we have noted above, the average investors most probably in the league of speculators or momentum traders tend to use “fundamentals” to justify entry positions and exit based on “intuition”.

Take for instance an investor obsessed with the Price earnings ratio. Let us assume that company ABC presently priced at 10 pesos per share has earnings of Php 1 per share, which effectively translates to a Price Earning ratio of 10. The company expects an average earnings growth rate of 10% a year.

Because our average investor/speculator thinks that such PE ratio is “cheap”, Company ABC is then added to his/her portfolio at current prices.

Then for no apparent reason, sometime in the future, the share prices of Company ABC is bidded up to Php 11 per share. Our investor/speculator having seen a 10% gain decides to take profits because he/she “feels that the price has risen and therefore subject to fall”.

If going by the “fundamental” reasoning, an earnings growth of 10% implies earnings per share at Php 1.1. So at the market price of Php 11, essentially the PE ratio remains the same. So why did our investor or speculator sell?

Because the actions taken to enlist one’s position had been simply an effect of “rationalization” or ( ``the process of constructing a logical justification for a flawed decision, action or lack thereof that was originally arrived at through a different mental process.” (highlight mine)

This is the sort of convoluted reasoning is so widespread in the marketplace. It is the same kind of misaligned thinking that usually leads to portfolio disasters, simply because market participants manifests the lack of focus and discipline in their investing approach and allow ticker directed impulses to dictate on their decision-making process.

Market Cycles Determines IPO Activities Over the Long Run

If the function of the IPO is to raise capital for a private company by selling its shares to the public, then obviously the best time to facilitate such activities is when the markets are RECEPTIVE. Accommodating conditions allow for the company to sell their shares with relative DISPATCH at the same time get MORE value for them. So our question, when is this?

Figure 2: PSE: IPO TRENDS follow Market CYCLES!

Figure 2 gives us an indication of IPO activities. IPO activities (bar) tend to rise as the Phisix (line) goes higher and vice versa.

During the peak of the previous market cycle (1994-1997), companies that went public ranged from 13 to 22 a year. When the market cycle reversed as shown by a declining Phisix (1997-2002), the number of companies that took on the IPO road slowed to less than 5 a year.

Today as the Phisix transits deeper into the advance phase of the contemporary market cycle, we hear of more and more companies considering the IPO path. To quote the Philippine Daily Inquirer, ``Several companies are also raring to list shares. There’s Northwind Power Development Co., which operates a wind farm in the northern province of Ilocos Norte; ethanol fuel producer San Carlos Bionenergy Inc., based in Negros Occidental province; PNOC Alternative Fuels Corp., a biofuel unit of state-owned Philippine National Oil Co.; and Enerfuse Holdings Inc., also a biofuel producer.”

It’s a brewing IPO fever. And such is what to expect, upcoming hysteria from the IPO landscape as the Phisix goes higher!

IPOs Over the Short Term: "It’s the Market Sentiment, stupid!"; Lessons

Our earlier premise was that IPOs represent as “one of the worst form of investment” over the short term because it is usually treated as an alternative form of gambling.

This is premised on the difficulty of predicting market sentiment on the inaugural day of the company’s listing, where we painstakingly described above of the attendant perceptive fallacies commonly adopted by the “crowd”.

Figure 3 tell us that despite the all the rationalization about fundamentals, market sentiment weighs HEAVILY on the performance of an IPO company on its launching season.

Figure 3: Fundamental driven IPO Successes??? In your Dreams!!!

Since the onset of the millennium, the largest IPO offerings (in pesos) according the PSE to date had been (in pecking order):

1. SM Investments (Php 250 per share, listed on March 22, 2005, offer amount Php 28.75 billion),
2. PNOC Energy Development Corporation (Php 3.2 per share, Dec. 13, 2006, Php 16.696 billion),
3. First Gen (Php 47, Feb. 10 2006, Php 8.503 billion),
4. Manila Water (Php 6.5, Mar. 18 2005, Php 4.845 billion),
5. National Reinsurance (Php 3.8, April 27, 2007, Php 2.424 billion) and
6. Banco De Oro (Php 20.8, May 21, 2002 Php 1.852 billion).

The reason for this list of the IPOs is to put into perspective the so-called “fundamentals” usually broached by the average investors. The largest IPOs consist of the companies with known “fundamentals”.

And because the common assumption is that fundamentals drive IPO successes over the short run, we take into consideration of 3 issues that has operated in different time frames or in distinct stages of the market cycle as shown in Figure 3.

First is Banco de Oro, listed in 2002 at Php 20.8 per share, as shown by the leftmost arrow, represented by the black candle chart. The superimposed green line is the Phisix, while the red trend line denotes of the interim trend of the Phisix during the listing date.

BDO suffered a decline below its offering price during its debut to close at Php 20.75 and even lost a further 25% to a low of Php 15.5 three months after! This came as the Phisix slumped to its cyclical nadir in 2002.

After a year BDO even fell further to its ALL time low at Php 14.75. When the Phisix manifested signs of recovery, BDO broke above its offering price only in November of 2004 or more than two year after it listed!

Today, BDO is about 246% above its IPO price. Was BDO then, a showcase of “fundamentally-driven” short-term success?

Second is utility stock Manila Water, seen in the blue line whose listing date is similarly marked by the red arrow.

I purposely chose to chart MWC over SM Investments (not shown in chart), where both had almost simultaneously listing in March 2005, because UTILITY firms are often reputed abroad as “defensive” issues which usually outperforms on a countercyclical basis or during market or economic downtrends. Unfortunately so, as the chart indicates MWC did not manifest or operate as Utilities are known to function when the Phisix corrected.

Anyway unlike SM which traded immediately BELOW its offering Price during its debut, MWC for the first two days closed on a slight PREMIUM. However, as the chart shows, the declining Phisix (falling red trend line) once AGAIN weighed heavily on the two “fundamental” firms.

Remember at this stage of the cycle, the Phisix has already been navigating on the advance phase (drifting at the 2,100+ level after a steep run up). But the offering came at such a bad timing (both in March) which was coincidental to the massive corrective wave (also in March) and led to a dismal start.

Relative to the offering price, MWC fell or lost 14% to a low of Php 5.6 per share three months after, while SM fell to a low of Php 191 per share or a loss of 23% six months after!

Could SM and MWC serve as examples of “fundamentally” driven short-term success??? Obviously not!

When the Phisix bolted out of its previous high during the last quarter of 2006 or about one and a half year after the listing of MWC and SM, both companies breached their offering price levels to trade at a premium today of 96% and 80% respectively.

The recent best one day performer among the IPOs has been the listing of Pacific Online last April 12, 2007 where its share prices stormed by over 50% above its offering price of Php 8.8.

I won’t exactly categorize this issue as of the same “fundamental” caliber relative to the securities cited above, would you?

The rightmost chart shows LOTO, as signified by the violet line, in conjunction with the overtly bullish sentiment exuded by the Phisix (rising red trend line and downward arrow). So far LOTO trades about 73% above its offering price.

ALL other IPOs or secondary offerings from listed companies during this year have traded conspicuously ABOVE their offering prices simply because the Phisix has been on a tear up 26% year to date!

Such OVERWHELMING evidences basically demolish the argument that “fundamentals” drive stocks higher over the short-term! Not in the Philippine setting, anyway.

Some important lessons gleaned from the aforementioned experiences are:

1. IPOs are NO different than the REGULAR listed issues. They operate under the auspices of the market cycle in all time frame dimensions (short, medium or long term).
2. IPOs are NOT exempt from risks.
3. Recent activities DO NOT guarantee an IPO’s success.
4. While corporate fundamentals count, market sentiment MOSTLY determines the short term success of IPOs. But since short-term movements are hard to predict, it’s anyone’s guess how the IPOs perform over the short-term.
5. The best returns in an IPO experience does NOT arrive by second guessing what an IPO does during its listing date but by comprehending on the whereabouts and conditionality of the present phase of market cycle and by taking appropriate action based on these circumstances.
6. Like all forms of prudent investment, an enforceable exit strategy or contingent plan should be employed.
7. Benefit from a RISING trend by nursing one’s gains while reducing losses and finally,
8. Avoid falling for perceptive fallacies; conduct your own detailed investigation on the merits of the investment.

In 1992, the controversial presidential campaign slogan coined by Democratic Party Strategist James Carville which was carried by ex-US President Bill Clinton became widely used today...It’s the economy, stupid!

Allow me to paraphrase this quote in the context of IPOs over the short term, “It’s the Market Sentiment, stupid!”