Sunday, August 26, 2007

‘Scapegoating’ the Markets?

It’s finger pointing time again! In every crisis there’s got to be a scapegoat, and with the ongoing tremors felt in the global financial markets, the easiest blame always falls to where the stress is evident—the markets.

First, financial markets become the OBJECT OF SCORN for transmitting adversarial conditions to the real economy or to our ‘hapless’ neighborhood folks. Second, markets are DOWNPLAYED FOR THEIR CONTRIBUTIONS to the economy and worst of all, markets are even portrayed as AN ECONOMIC WEDGE to the society’s income class structure!

But do markets really deserve such blame or are these symptoms to other UNSEEN factors glossed over by such commentaries?

The investing public talk today about the US subprime blowout as is if it was a staple; your every morning oatmeal or ‘pandesal’ and coffee on your breakfast table. The notion is that the subprime woes CAUSES today’s market jitters.

In contrast, for us, the subprime imbroglio is only a strain to a deeper structural malaise bluntly dismissed by the mainstream.

Subprime loans are simply loans to people who are less financially qualified or have spotty credit histories. In the US, these imploding subprime papers represent the popping bubble in its housing industry that preceded it. Such instruments were mostly used in the acquisition of assets by the public in the belief that:

1.) monetary conditions would perpetually remain favorable or interest rates would remain always low or

2.) housing prices would continually rise which encouraged speculative “flipping” purchases, which became a vicious cycle even by those who can ill afford to make those regular mortgage payments or

3.) access to these loans to refinance or extract from existing equity to fund lavish lifestyles are immune from economic cycles

In sum, subprime loans were acquired NOT for productive purposes, but either for plain consumption or outright speculation.

Moreover, originators and other lending intermediaries took advantage of the sizzling hot love affair with the Housing boom and engaged the public’s appetite with more adventurous risk taking behavior through a reduction of lending standards.

Nonetheless, this expansive lust for risky assets essentially spread from lenders to investment banks and prime dealers, which packaged and repackaged such securities into highly complex levered forms of instruments, had them stamped with approval by established credit rating agencies and sold to financial institutions (hedge funds, insurances, pension funds, corporate treasuries etc…) around the world, who were then hungry for profits or to those who were eager to match returns with existing liabilities, in a world where rates of returns have diminished.

In short, in boom times risk was conventionally thought to have been “EXTINCT”.

Inflationary Policies and Not Markets are the Culprit to Inequality!

``There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose."--John Maynard Keynes, The Economic Consequences of the Peace (1919)

Figure 1: InvestU: Subprime Loans Explode from Greenspan Policies!

Now all of these rampant speculation and spendthrift ways wouldn’t have materialized UNLESS CONDITIONS PERMITTED THEM. In the words of Mark Twain, ``A banker is a fellow who lends you his umbrella when the sun is shining and wants it back the minute it begins to rain.”

It is the nature of BOOM CONDITIONS FUELED BY EASY MONEY POLICIES that such risky behavior exists in the first place. We previously discussed the Minsky Model under which credit cycles gradate from CONSERVATIVE “HEDGE” financing to wanton or BLIND GAMBLING (“Ponzi” finance). Or where streaks of successes eventually lead to greed, complacency to risk then evolves to future instability. Such patterns appear to repeat itself anew.

Figure 1 courtesy of Dr. Mark Skouzen of InvestU, depicts to us that as the US FEDERAL Reserves brought their interest rates to a four decade low, subsequently, the toxic subprime instruments ballooned!

According to Dr. Mark Skouzen (highlight mine), ``As Greenspan & Co. lowered the Fed Funds Target Rate from 6% to 1%, banks borrowed cheaply from the Fed window, and invested in risky mortgages. The subprime mortgage market took off like a rocket, from 2% to 14% of all mortgages over a five-year period (2000-2005). In 2003, the year of the great money flood, when the Fed cut rates to only 1%, the subprime lending went from 4% of total lending to more than 10%. That’s in one year!

``But there is no free lunch, as sound economists have warned repeatedly. At some point, the harvest time comes and the wheat must be separated from the tares. This is the crisis stage, where the boom turns into the bust. Now it’s harvest time, and we are weeping the effects of the Greenspan era.”

Oh of course, before we forget, we might add that subprime loans have essentially been BYPRODUCTS of Government Sponsored Enterprises (Freddie Mac, Fannie Mae). These institutional agencies handled most of the mortgage financing deals until they got entangled with accounting issues. This fundamentally paved way for the spawning of Wall Street’s version of Gremlins.

Figure 2 Consumer Debt Exploded On Fed Actions!

A favorite analyst of ours Mr. Doug Noland of the Credit Bubble Bulletin wrote of such evolution (highlight ours), ``Issuance of GSE debt and Agency MBS stalled abruptly in 2004. Yet at that point Mortgage Finance Bubble Dynamics were in full force. After all, Inflationary Biases had taken firm hold in real estate markets across the country and throughout the Wall Street mortgage finance machinery. Indeed, the Street didn’t miss a beat with the hamstrung GSEs. The evolution of market perceptions of Moneyness to include ALL mortgage-related securities encouraged an historic issuance boom in “private-label” MBS and ABS. Wall Street was quite keen to more than fill the GSE void with its own brand of top-rated "structured finance." And flood it they did.”

Figure 2 courtesy of reveals that household mortgage debts exploded during the advent of the millennium as the FED undertook its massive “reflationary” campaign to stave off the risks of deflation.

Figure 3: Derivatives Explode Simultaneously with Greenspan Policies!

In addition, financial creativity led to the introduction of innovative instruments such as derivatives. Mortgage instruments were likewise bundled with other debt papers (consumer and corporate debts) into such highly complex structures.

Paul Tucker, Executive Director and Member of the Monetary Policy Committee of the Bank of England, aptly describes this phenomenon (emphasis mine), ``This is the age of what I call Vehicular Finance. The key intermediaries are no longer just banks, securities dealers, insurance companies, mutual funds and pension funds. They include hedge funds of course, but also Collateralised Debt Obligations, specialist Monoline Financial Guarantors, Credit Derivative Product Companies, Structured Investment Vehicles, Commercial Paper conduits, Leverage Buyout Funds – and on and on. These vehicles can fit together like Russian dolls. By way of illustration – and, I fear, slipping for a moment into alphabet soup – SIVs may hold monoline-wrapped AAA-tranches of CDOs, which may hold tranches of other CDOs, which hold LBO debt of all types as well as asset-backed securities bundling together household loans.

In essence, this age of Vehicular Finance has seen an explosion of the opaque derivative markets. Figure 3 courtesy of, reveals that coincidental with the surge in subprime and other household mortgage instruments, notional derivatives quadrupled in 2006 from 1998, with the gist of its growth coming from the period when the FED undertook its campaign to the flood the world with cheap money!

On the aggregate level, let us now refer to the FED’s Flow of funds to ascertain the pace of debt expansion in the US corporate sector.

Figure 4: US DEBTS to the Moon!

In figure 4 courtesy of, the red line shows the occasion when the FED began its resuscitation campaign.

Here we see, the financial and non-financial sectors accelerated their debt accumulation to the tune of 110% and 215% of the GDP as of the first quarter of 2007!

What a coincidence! The FED cuts rate to historical lows, and consequently the debts markets from both the corporate, finance and consumer levels flew!

Figure 5: McKinsey Quarterly: Global Financial Assets outpace Real GDP!

I have shown you this before. Figure 5 courtesy of McKinsey Quarterly shows how global financial assets have been growing at a nifty clip.

In 2005, global financial assets were about 2.8 times global GDP. Where have the growth sectors been? According to the chart in 1995-2004, the Compounded Annual Growth Rate had been in Equity Securities (9.4%) and Private Government Debt (9.4%)! Government and Private debt accounted for 41% of total financial assets in 2005 and expected to be 44% of total assets in 2010!

Again, this simply shows that the massive amounts of leverages had been a worldwide phenomenon and NOT limited to the US.

Oh, my ramblings and may not be enough though. Well, to add some MEAT to our presentation…guess on who said this?

``American consumers might benefit if lenders provided greater mortgage product alternatives to the traditional fixed-rate mortgage"

Well if you guessed former FED Chair Greenspan…then you are right! Bravo! The speech was delivered in February 23, 2004 to the Credit Union National Association meeting where Greenspan EXHORTED the public to go for Adjustable Rate Mortgages (ARMs)….the very problem we see sending ripples to global markets!

And I suppose those who listened to him or heeded his advice should now be asking for his scalp!

What are we then trying to show? In a word….INFLATION!

Celebrated economist Milton Friedman’s famous definition of inflation… “is always and everywhere a monetary phenomenon”.

Another prominent economist Henry Hazlitt’s explains further (highlight mine), ``Inflation, always and everywhere, is primarily caused by an increase in the supply of money and credit. In fact, inflation is the increase in the supply of money and credit. If you turn to the American College Dictionary, for example, you will find the first definition of inflation given as follows: "Undue expansion or increase of the currency of a country, esp. by the issuing of paper money not redeemable in specie."

Which leads us to ask, who does the ACT of inflating….the markets? Or who is responsible for the creation of the incentives 1) to produce and intermediate credit on a multiplier scale, 2) to relay signals to the business community 3) to setup the conditions for lower lending standards, 3) to allow credit rating agencies to pass off dubious papers as AAA ratings, 4) to exhort consumption binges for the households and 5) to stir up the gambling instincts or go wild on speculative orgies?

Or, perhaps a more germane question should instead be, are the markets simply REFLECTING on the volatility IMPOSED THROUGH it via furtive monetary policies?

Now if some families in New York or in California fail to pay their house bills (for one reason or another) and undergoes foreclosure proceedings which eventually affect our provincial farmer’s access to financing, then who should get the blame? Is it fair then to shoot the messenger?

In Defense of the Philippine Stock Exchange From Political Correctness

Now when markets become an instrument for POLITICAL CORRECTNESS we are compelled to respond.

Where the allegation is…

In rising markets, the rich benefits with a miniscule “trickle-down-effect” to our economy…

In falling markets, the poor ‘non market participant’ gets clobbered by losses transmitted by changes in financial conditions…

While the rich is implied to remain “rich” or “unaffected” by the reversals of financial fortunes…

Of course, the obvious implication here is that the financial markets including the PSE becomes an agent of “inequality”, where gains are limited to a select few while losses ripple across the country.

First, our response on the issue of losses

In absolute terms, a LOSS is a LOSS is a LOSS…regardless of economic status!

Let us put that in an OBJECTIVE perspective…

In 1997 as we previously described, the Phisix fell by 70% in the wake of the 1997 Asian Financial Crisis from 3,400 to about 1,000. Then, whether one’s investment was Php 100 million, 1 million or 10,000 pesos, in absolute terms a 70% write off is a loss of Php 70 million, Php 700,000, or Php 7,000 respectively!...

Regardless of how one views the RELATIVE VALUE of money or…

Regardless of the wealthy’s “reserve” status (besides how can we categorize or know about the depth of their vaults?).

What we want to emphasize is that, losses DO NOT DISTINGUISH between people attired in COAT AND TIE or those wearing only tattered SANDOS, SHORTS AND SLIPPERS. Anyway, should there be one?

Second, is the issue of categorization; how certain are we that the “wealthy” dominates stocks investing?

Are we talking of Peso investment volume per capita or the average net worth of the average investor? Does the PSE have a data on such demographic make up?

What's more, investing in the stock market is NOT an exclave reserve for the “rich” since a neophyte or practically anyone from any income stratum can buy stocks for less than P 10,000.

To suggest another angle, what if LOCAL INSTITUTIONS and not retail investors dominate the Peso volume of trades? How does one classify them? Are they still part of the cyclically “immune” much loathed “Elite” brigade?

How about FOREIGN MONEY, are they also part of the complicit team of “inequality drivers” too?

Anyway, RISING markets DOES have the tendency to attract a wide variety of investors, again regardless of social status (one can just look at China.)….

When lower income levels troop into the market, STATISTICALLY you can bring down the averages…oops, remember the Gaussian Curve?

Does a population of more retail investors AUTOMATICALLY EQUATE to “wealthy” class of investors dominating our stock market trades? Not necessarily I suppose...

What we are trying to painstakingly point out here is…unwarranted POLITICALLY COLORED sweeping conclusions have been punctured with a lot of observational biases…

Nicolas Nassim Taleb, in his book Black Swan, the Impact of the Highly improbable, calls this kind of cognitive bias as the ROUNDTRIP Fallacy….

The flawed circular logic goes something like this, “the RICH profits from the STOCK MARKET, the STOCKMARKET is for the RICH”…

Or simply, the UNFAIRNESS of stereotyping!

Where the driver of my broker, invests in the market, I presume that he must also be “Rich”!

The third point is the issue of “market prompted inequality”.

For an economic class to assumingly reap the benefits from a collective activity it implies uniformity of actions, which is hardly the case.

One should realize that being rich and a rising market is NO guarantee of stock market investing success!

We should remember that every security yields a different price and varies in the degree of volatility…

Remember those “Greek” letters in “Alpha”, “Beta” and etc…

Then there are different perceptions and set of actions from different market participants on how to manage their portfolios…

Together these variables combine to facilitate the trades in the stock market.

But like every type of enterprise or even careers, there would always be winners and losers. Of course, rising markets are likely to produce more winners than otherwise and vice versa.

And this equation is UNIVERSAL to the investment spectrum…or in any other entrepreneurial endeavor….

Be it investments in tourism projects, schools, restaurants, computer shops, sari-sari stores, farming, or others.

Under ALL types of markets (financial or otherwise), the accurate anticipation of future events coupled with the corresponding action determines the success of an investor (regardless of economic status), unless the participant is a government sponsored entity such as the hybrid “sovereign wealth funds”.

``Like every acting man, the entrepreneur is always a speculator. He deals with the uncertain conditions of the future. His success or failure depends on the correctness of his anticipation of uncertain events. If he fails in his understanding of things to come, he is doomed. The only source from which an entrepreneur's profits stem is his ability to anticipate better than other people the future demand of the consumers. If everybody is correct in anticipating the future state of the market of a certain commodity, its price and the prices of the complementary factors of production concerned would already today be adjusted to this future state. Neither profit nor loss can emerge for those embarking upon this line of business.”- (highlight mine) Murray Rothbard, the Market, Man, State and the Economy

You see, under such conditions, even the “POOR”, which supposedly is a “victim” of the market fluctuations, can benefit from the stockmarket! One must remember, RISK TAKING IS ESSENTIAL TO WEALTH CREATION! In other words, markets provide the opportunities for ANY SOCIAL CLASS to benefit either from LUCK OR SKILLS, which in itself is a GRAND EQUALIZER.

On the other hand, to even entertain the thought of a “class struggle” presupposes the contrary; the “POOR” CANNOT BENEFIT from the markets. This seems to be dangerously discriminatory since it essentially DENIGRATES their capacity to think (anticipate) or even be lucky. So such assumption is UNDEMOCRATIC and sows the seeds of further INEQUALITY.

This leads us to the final point of our contention: The true source of Inequality.

Putting the blame on the markets for economic inequality is truly unfortunate and strays from the root of the issue.

As we have noted above, inflation is the core to society’s inequalities.

Again let me lengthily quote the illustrious economist Henry Hazlitt, in his book “What You Should Know about Inflation” (highlight mine),

``Inflation never affects everybody simultaneously and equally. It begins at a specific point, with a specific group. When the government puts more money into circulation, it may do so by paying defense contractors, or by increasing subsidies to farmers or social security benefits to special groups. The incomes of those who receive this money go up first. Those who begin spending the money first buy at the old level of prices. But their additional buying begins to force up prices. Those whose money incomes have not been raised are forced to pay higher prices than before; the purchasing power of their incomes has been reduced. Eventually, through the play of economic forces, their own money-incomes may be increased. But if these incomes are increased either less or later than the average prices of what they buy, they will never fully make up the loss they suffered from the inflation.”

``Inflation, in brief, essentially involves a redistribution of real incomes. Those who benefit by it do so, and must do so, at the expense of others. The total losses through inflation offset the total gains. This creates class or group divisions, in which the victims resent the profiteers from inflation, and in which even the moderate gainers from inflation envy the bigger gainers. There is general recognition that the new distribution of income and wealth that goes on during an inflation is not the result of merit, effort, or productiveness, but of luck, speculation, or political favoritism. It was in the tremendous German inflation of 1923 that the seeds of Nazism were sown.”

``An inflation tends to demoralize those who gain by it even more than those who lose by it. The gainers become used to an "unearned increment." They want to keep their relative gains. Those who have made money from speculation prefer to continue this way of making money instead of working for it.”

In other words, subsidies, bailouts (which includes the market’s expected FED cuts (!) or Bill Gross’ suggestion for Fiscal Policy rescue package or Willem Buiter’s proposal for the Fed to act as a “market maker of last resort”), social welfare, wars, price control, dole outs (aids, grants, etc…), taxes or other redistributive programs fundamentally TRANSFER RESOURCES FROM PRODUCTIVE TO NON-PRODUCTIVE activities are inflationary in nature, because they tend CONSUME capital.

Burned capital signifies “SUNK COSTS” from which taxpayers would have to shoulder at the end of the day, despite the other ephemeral options of borrowing and printing money.

Figure 6: American Institute for Economic Research: US Dollar’s Purchasing Power

Figure 6, courtesy of the American Institute for Economic Research reveals of what inflation does to the public—the LOSS OF PURCHASING POWER or it lowers the standard of living for its citizenry!

As an example, the US dollar’s purchasing power plunged by 95% since the FED came to being in 1913 that’s according to the US Bureau of Labor and Statistics. You can check on website’s INFLATION CALCULATOR via the provided link…where $100 today has the same buying power of only $4.75 in 1913!

Figure 7: BSP: Peso-US dollar Rate: The Peso’s Anguish

In the same context, see figure 7, the Philippine Peso’s foreign exchange value relative to the US dollar fell from 2.733 in 1960 to 51.3143 in 2006 (BSP-thanks Vina)! During the same period, the US dollar’s purchasing power lost 85%, which even AMPLIFIES the loss of the Peso’s Purchasing Power! Yet in contrast to the claims where a LOWER PESO will help jobs or the public simply has not been supported by evidence.

By logic, we should have been one of the top exporting countries by now if PRICE ALONE, as reflected by the currency, had been the key measure of success…but where (see Figure 8)?

In practice, as any entrepreneur knows, price, while important, is NOT the only factor that shapes business transactions. Consider labor cost, China’s export might is often attributed to its low labor cost, but this is not entirely accurate, because Africa has even cheaper labor costs, so they should have been the export leaders, but not- because they suffer from other aspects of impairment such as the lack of infrastructure to security to governance concerns which increases the cost of doing business.

So after four decades of peso devaluation which area of trade have we then topped? Yes, you guessed it right again…human exports! Why? Because of our depressed standards of living as a consequence to the enormous purchasing power gap relative to the developed world prompted the LARGE SCALE EXPORT OF OUR CITIZENRY instead of goods of services! Essentially, an arbitrage of income disparities even in the Labor markets!

Figure 8: Exports Benefit from Lower Peso?

On the other hand, instead of the increased market share and profits via efficiency and productivity gains aided with lower prices, as our neighbors, what we saw is the opposite: MOUNTING HOMEGROWN INEFFICIENCIES aggravated the loss of competitive edge for our enterprises, which reduced our standards of living, discouraged productive risk taking ventures which thereby brought about the present outbound migratory trends.

The financial markets are to blame? In all 47 years until today, the domestic financial markets remain a small segment of the economy (see below: Stock Market: Boon or Bane to the economy?).

So, again despite the tremendous loss of purchasing power transmitted via the declining PESO-US dollar exchange during the past 47 years, why is it our economy remains uncompetitive and still mired in poverty?

In effect, the issue of inequality is LARGELY an OFFSHOOT to persistent government interventionist activities and does NOT emanate from the markets. The markets or financial conditions simply reflect on such policies, whether internally generated or from external influences.

To quote Milton Friedman anew, “There is no FREE LUNCH”.

Stock Market: Boon or Bane to the Philippine Economy?

``But innovation, in Schumpeter’s famous phrase, is also “creative destruction”. It makes obsolete yesterday’s capital equipment and capital investment. The more the economy progresses, the more capital formation will it therefore need. Thus, the classical economist-or the accountant or the stock exchange-considers “profit” is a genuine cost, the cost of staying in business, the cost of a future in which nothing is predictable except that today’s profitable business will become tomorrow’s white elephant.”- Peter F. Drucker, Profit’s Function, The Daily Drucker.

Admittedly, the Philippine financial markets are small relative to its neighbors, to say the least UNDERDEVELOPED, since we principally rely on the banking system for most of its financing needs, as shown in figure 9.

Figure 9: IMF (2006): The Need to Develop Stock and Bond Markets

It is why the IMF argues that we need to develop our local markets (stocks and bonds) as a vital part of our economic development. Remember, the lifeblood of an economy is the financing sector.

However, to project our market’s past into the future, and use this as basis to censure Philippine markets as some burden to the economy obviously disregards today’s evolving trends.

For instance, we have consistently pointed out that the Phisix, the Peso and its bond markets have closely tracked the movements of world markets. To wit, foreign money has been a principal driver of our markets today. All these suggest to us that our financial markets have been undergoing transitional integration following the “financial globalization” model, which is why we remain structurally bullish on the domestic markets.

Going back to basics; how does a market work?

According to, ``A market is a social arrangement that allows buyers and sellers to discover information and carry out a voluntary exchange of goods or services. It is one of the two key institutions that organize trade, along with the right to own property.” In short it is place to conduct exchanges to satisfy one’s needs.

Our community marketplace, where we usually source the food for our daily meals, is a basic example of a functioning market. Here, suppliers of chicken, beef, fish, vegetables and others consumer staples congregate to meet buyers who trade their supplies for money.

Prices of the items traded fluctuate daily depending on demand and supply as well as other factors driving the exchange mechanism (competition, profits etc…). Credit is likewise a part of operations depending on the arrangements of the economic agents.

If such marketplace is indispensable to one’s community, then the financial markets do not DIFFER from its functionality except for the products that it exchanges—financial securities.

Going to a broader perspective, if financial markets are a bane to the economy, then why have economies that have espoused varied degrees of the capitalistic model worldwide, from former communist countries of China and Vietnam, to Eastern Europe as Slovenia or Estonia, to Africa like Kenya or Nigeria or to Latin America as Peru or Costa Rica, necessitate having stockmarkets?

Historically, stock markets around the world have had important contributions to the national economy, let me cite D. W. Mackenzie in an article published at (highlight mine), ``Stock exchanges played an important role in the development of the industrial West. Initially, these stock exchanges were informal and unsophisticated. The London Stock Exchange developed in the eighteenth century. The stock market in Amsterdam emerged in the seventeenth century. The financial system of Belgium began in the fourteenth century, but the Brussels Stock Exchange opened in 1801. These early stock markets developed into sophisticated institutions with formal rules. These early stock markets in major cities began to direct capital investment throughout the West and in parts of Asia. Statistical studies indicate that the economic development of Belgium was driven by the development of Belgian financial markets, including the Brussels Stock Exchange. Financial development in Belgium began with the country’s independence in 1830, and was accelerated by the liberalization of the Belgian stock market in 1867. This pattern was paralleled in many nations. Statistical studies show that well-developed stock exchanges have enhanced long-run economic growth, increased capital investment, and raised productivity throughout the industrialized world.”

So in essence, the stock market functions as a channel to REDIRECT SAVINGS into investments or an important part of the capital formation process, it also serves as an ALTERNATIVE ROUTE FOR RAISING OR ACCESSING CAPITAL, it works to PROVIDE LIQUIDITY for company owners as well as for public investors, it LOWERS THE COST of capital, and importantly PLACES PRICE MECHANISM from which the investors values a company or an enterprise.

Stock market investing, unlike the currency markets is NOT A ZERO SUM WIN-LOSE outcome because it has value added components such as dividends, aside from the actual ownership in the company itself.

Allow us to quote more of D. W. Mackenzie (highlight mine) ``Financial markets are important in capitalism because they redirect resources towards the satisfaction of the most urgent consumer demands. As Ludwig von Mises noted “it is above all necessary that capital be withdrawn from particular undertakings and applied in other lines of production … [This] is essentially a matter of the capitalists who buy and sell stocks and shares, who make loans and recover them, who speculate in all kinds of commodities” (Mises 1922 [1936] p121). A study by Borsch-Supan and Romer (1998) finds that competitive financial markets reinforce product market competition by cutting off funds to unproductive companies, but only in the face of competitive threats. Borsch-Supan and Romer also find that government regulation and ownership are important causes of low capital productivity, both directly and indirectly through limitations of competition. For example, the trade protection of the German and US auto industries and Deutsche Telekom enabled these companies to earn high profits, despite low productivity. Many less developed nations are now emulating the West by forming more sophisticated financial markets. One study (Agarwal 2001) of nine African nations indicates that stock exchange development has led to increased economic growth. Another study (Aragarwal 2007) of twenty-one developing nations shows that the development of stock exchanges increases private investment and economic growth. This study indicates that stock exchanges contribute to economic development by stabilizing productivity and liquidity shocks.”

To add, Mr. Rodrigo de Rato, Managing Director of the International Monetary Fund, in his latest speech likewise underscored the significance of financial markets development in the age of financial globalization to the national economy (emphasis mine), ``it is no coincidence that the countries—in Latin America and elsewhere—where financial market development has been the most advanced are also those that have been among the most successful economies. The causality runs both ways. As macroeconomic policies have become more credible, and confidence grows that inflation will remain low, demand for financial services increases. As financial markets grow, the availability of credit increases, spurring faster noninflationary growth. And as financial markets become more sophisticated, and risk management and hedging become easier, economies become better able to manage volatility.”

As you can see, for many reasons cited above, financial markets including the stock markets signify an integral part of capitalism, hence the sine qua non presence to any economy that aspires to move up to the ladder of economic prosperity.

It would be better for us to face up with these unfolding trends especially in the light of the massive technological advances which have largely underpinned today’s accelerated integration process.

Denying their significance or restricting our insights to the past paradigms simply leads to misdiagnosis, faulty assumptions and eventually, misleading and unjust generalizations.

Monday, August 20, 2007

In A Bear Market, Doun’t Count on Lady Luck

``Lucky fools do not bear the slightest suspicion that they maybe lucky fools-by definition, they do not know that they belong to such a category. They will act as if they deserved the money. Their string of successes will inject them with so much serotonin (or similar substance) that they will fool themselves about their ability to outperform the markets (our hormonal system does not know whether the successes depend on randomness)”- Nassim Nicolas Taleb, Fooled by Randomness

As a saying goes, ``When it walks like a duck, quacks like a duck, it must be a duck!” And so it was.

Everything came so swift and furious that practically swept the floor from the bewildered public. The intensity of the carnage even landed in the FRONT PAGE of national broadsheets!

While it came to a surprise for most, it was not as much for us (except for the degree of decline) since we have seen such risks snowball. We began to play the role of AESOP’s “THE BOY WHO CRIED WOLF!” as early as the last week of July (see July 30 to August 3 edition, “US Mortgage Crisis Contagion: There is NEVER One Cockroach!” and “Technical View on the Phisix: The Path of Least Resistance is Down”), although needed more confirmations until last week, when central banks collectively moved which served as the clincher for us to essentially declare a contrarian cyclical BEAR MARKET call.

Well, based on the news account, these are some of the comments on the latest bloodbath from our industry’s bigwigs, “as if they don’t have value at all…”, “thrown fundamentals out the window”, “they’re getting cold feet”, “difficult to differentiate between a bear market and a deep correction…you should be buying right now because there are values out there. Stocks have come down 20-30 percent from the peak” and “it was a case of “emotion taking over””.

In fairness to these “highly-paid-to-be-bullish” personalities, they might have been quoted out of context. To our experience, media quotes from analysts are usually based on what the media or the reporter DESIRES to present (framing) and NOT exactly the message conveyed by these analysts. We had been an unwitting victim of such circumstance and stands as the reason why we refuse to be a part of these journalistic circuses.

However, in the face of such “frame”, obviously such comments reflect a BIG sense of DENIAL. Now considering their stature, academic backgrounds, network privileges and importantly liberal access to information, research materials and resources, they should KNOW better.

Yet we understand why they “tunnel” or ``neglect of sources of uncertainty outside the plan itself” (NNTaleb-Black Swan) simply because they operate under the economic and financial incentives that buttress the entities which sustains them. Succinctly, our industry makes money when we are bullish.

Self-development author Robert Ringer in his article “Beware of False Perceptions” hits the nail on the head (highlight mine), ``Action is the starting point of all progress, but an accurate perception of reality is the foundation upon which a successful person bases his actions. A false perception of reality leads to false premises, which in turn leads to false assumptions, which in turn leads to false conclusions, which, ultimately, leads to negative results…Which is why it’s incumbent upon you to become adept at distinguishing between reality and illusion. A false perception of reality — regardless of the cause — automatically leads to failure. An accurate perception of reality doesn’t guarantee success, but it’s an excellent first step in the right direction.”

Or we might say their lack of awareness of ignorance, to quote J. Kruger and D. Dunning in “Unskilled and Unaware of It: How Difficulties in Recognizing One’s Own Incompetence Lead to Self Inflated Self-Assessments” (highlight mine) ``In short, the same knowledge that underlies the ability to produce correct judgment is also the knowledge that underlies the ability to recognize correct judgment. To lack the former is to be deficient in the latter.”

Let us now delve with the facts; on the account of the global shakedown, the PHISIX was down 12.12% for the LARGEST weekly decline we’ve seen during this cycle. It has been FIVE consecutive weeks since the Philippine benchmark has started to unravel and has lost about 25% from its recent high of 3,820. Year to date from a huge positive return has now turned NEGATIVE down 3.29% as of Friday’s close.

In addition, if the week that ended in Aug 2 was one remarkably huge negative market breadth at 4 decliners for every one advancers; this week’s activities was even more amplified at 5.8 to 1 (29 advancers to 551 decliners)!

In essence, the polemics of whether we are in a correction or BEAR market is all about semantics or definition in the eyes of the observer. In the US, a normal correction is perceived to be at the 10% level, where something beyond it is accounted as the “gray area”, while 20% or more becomes a bear market. So, if we go by their definition then evidently we are in a BEAR Market. Of course, we expect the bulls to argue otherwise.

Yet as last week’s discourse, bear market cycles are typical occurrences within a secular trend. The Phisix can lose 50% to 60% as in the past cycle (1987 and 1989) yet proceed with its secular bullmarket trend. These are the defining features of ANY market cycles. (Caveat: I am not implying that Phisix will fall 50-60%, I am saying that we should NOT dismiss the risk of such outcome, especially under present hostile conditions.)

Nonetheless, to aver that market trades “without fundamentals” or trades in “an emotional state” during a panic selloff represents an entirely biased view. It presumes that investors have gone irrational, ONLY when it comes to a DOWNSIDE.

When the market moved up, or even panicked up, does it mean that our investors rationally priced securities under the conditions of “fundamentals” sans speculation?

How is it that we have “cult stocks” flying over based on fantastic stories but with negative assets or cash flows? Yet the public with the help of media bought into this grand tomfoolery. Now, Newton’s Third Law of Motion comes into play, where ``For every action there is an equal and opposite reaction.” In short, we simply get what we deserve.

As we have always argued, the human mind sets prices in the markets, where values are determined subjectively in combination to one’s perceptions of utility or usefulness, scarcity and time preferences. Thus, the market simply responds to the stimulus that directs such expectations.

Again it pays to HEED the all important lesson by Edwin Lefèvre, a.k.a. Jesse Livermore, in the book Reminiscences of A Stock Operator (highlight 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 all go up...I speak in a general sense. But the average man doesn’t wish to be told that it is a bull market or a 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 doesn’t even wish to think.”

Especially with emphasis to our juvenile market, going against the tide is a recipe for portfolio catastrophe.

In our field, what intrinsically matters is the OVERALL APPROACH to one’s portfolio under the prevailing conditions. For instance, at the present turn of events, does one hold on to losses and endure the agony of diminishing price values-to simply HOPE and wait out until the cycle reverts to its secular trend, or does one learn to absorb losses to preserve capital for future undertaking? I have explained to you last week the mathematics of Cutting losses.

A choice is always about a tradeoff on something or some events, known as opportunity cost or economic cost. At present, it looks more likely a choice between capital preservation and the opportunity to lose more than to gain (again I hope I would be wrong).

Getting emotionally attached to the markets can be highly stressful, where conflicting expectations of “not wanting to be left out” and “facing losses” have been today encompassed by the “inability to accept mistakes”. No amount of information will supplant the inherent biases by speculators who will seek everything to justify their losing position regardless of the market’s action. That’s why BEAR MARKETs are described as “descending on a ladder of HOPE”, because hope and illusion and NOT rationality and the acceptance of reality becomes the order of thought.

It is also why HUBRIS or overconfidence exacts a heavy toll on the speculative public who come to believe that their streak of wins becomes an everlasting trait or that the markets function to oblige them without prudential risk assessment.

When it is all left to Lady Luck, in a bear market, then she may have as well turned on them.

Global Markets: An Advent to the Minsky Moment and the Kindleberger Paradigm?

``The object lesson is that whatever convincing arguments politicians may advance to justify yet another piece of draconian legislation, you can be certain that the authorities will misuse and abuse it for totally different and repressive purposes.”-Martin Spring, analyst

Well if you think the equity markets are simply undergoing a normal corrective phase then think again.

Figure 1, tell us that in spite the previous collective central bank actions to mitigate the emergent strains of financial stress, we are seeing these developments spread to almost the entire spectrum of the financial market universe.

Figure 1: The Problem Looks like System-wide Deleveraging

This has not been solely confined to the subprime space as we also now see a massive unwinding in the Carry Trade phenomenon, where as the Japanese Yen breaks out massively from its resistance level (horizontal line) seen in the main window, as the Australian Dollar, seen in the upper pane, a key beneficiary of the carry trade, collapses. The Australian Central Bank had to even intervene to shore up its currency last week!

Coincidentally as the Japanese Yen spiked way beyond its key resistance level, we also note that the JP Emerging Markets Debt fund (upper window below center) or an index of sovereign bonds from emerging markets have simultaneously accelerated its declines, alongside the Dow Jones World Index (lowest panel). The vertical line underscores the timeline of seemingly synchronous activities.

So what appears to be a synchronized deterioration in market action from corporate bonds to sovereign bonds, to money market instruments to derivative markets to the currency markets seems symptomatic of a financial system wide phenomenon called “DELEVERAGING”.

Christopher Wood, a respected strategist at Credit Lyonnais Securities Asia who recently scoffed at the interventionist activities of global central banks made a piquant remark which I quote (highlight mine), ``The grim analogy that most resembles securitisation run amok is a body ravaged by a spreading cancer”.

The clear and present danger is the vulnerability of today’s Fiat Based Currency system to inflationary abuse, fraud and to excessive leveraging and speculation, which American Economist and the Father of Financial Instability, Hyman Minsky described as the Ponzi Finance model, (we touched on this, see March 5 to March, US Markets: Risks of Ponzi and Speculative Finance).

Minsky’s model actually basically depicts of the credit cycle underpinning the business cycle, where credit transforms from a function of HEDGE financing (ability to pay principal and interest) to SPECULATIVE financing (ability to pay interest only, which needs a liquid market to enable refinancing and debt rollovers) and finally to PONZI Financing (basic operations cannot service both interest and principal and strictly relies on rising asset prices to service outstanding liabilities).

Minsky’s model likewise accompanies the loosening of credit standards by lenders, intermediaries and regulators as a consequence of a boom, aside from financial engineering that allows for more credit creation and intermediation.

Mr. Martin Wolf of the Financial Times has a fitting boom-bust cycle interpretation of the Minsky model (highlight mine),

``The late Hyman Minsky, who taught at the University of California, Berkeley, laid down the canonical model. The process starts with “displacement”, some event that changes people’s perceptions of the future. Then come rising prices in the affected sector. The third stage is easy credit and its handmaiden, financial innovation.

``The fourth stage is over-trading, when markets depend on a fresh supply of “greater fools”. The fifth stage is euphoria, when the ignorant hope to enjoy the wealth gained by those who came before them. The warnings of those who cry “bubble” are ridiculed, because these Cassandras have been wrong for so long. In the sixth stage comes insider profit-taking. Finally, comes revulsion.

Essentially the culmination of the Minsky Model is the ensuing COLLAPSE of the Ponzi finance system, prompted by the drying up of credit even to creditworthy borrowers and a Panic. George Magnus of UBS once coined this as the “Minsky Moment”. In other words, the house of cards built upon by too much credit fundamentally falls under its own weight and the repercussions constitute a massive selloff to pay down obligations which results to a system wide panic. Some of signs these we are indeed seeing today.

The important question facing us investors is that “are we facing the crossroads of the Minsky Moment”? Will the present actions by global central banks be sufficient enough to mitigate the unraveling of current highly leveraged conditions?

Another of our favorite independent analyst, the once bullish BCA Research has manifested a whiff of alarm in their latest outlook as shown in Figure 2.

Figure 2: BCA: FED Rate Cuts Imminent?

This from BCA Research (emphasis mine), ``Illiquidity has spread beyond subprime-related markets. Banks are wary about lending each other money. Speculative-grade corporate bond issuance has ground to a halt and the asset-backed commercial paper market has seized up, even for high-quality investors. It is when even high quality borrowers lose access to capital markets that alarm bells ring for central bankers. Our financial stress indexes are higher than they were in 1998. True, policymakers do not wish to be seen as bailing out poor investments. Nonetheless, in the end they have no choice if credit markets begin to freeze. Bottom line: unless market liquidity improves in the coming days, the Fed probably will provide an inter-meeting rate cut. The Bank of Canada will likely follow suit, given similar financial strains. The ECB will likely wait to see if Fed action calms the markets.”

So interim reactions by the global financial market will essentially determine the chain of responses from global monetary authorities, if today’s purported measures of elixir don’t work.

To further illuminate on the anatomy of a crisis, we’d like to quote Charles P. Kindleberger on his 1976 book Manias, Panics and Crashes anent the “ONSET of a CRISIS” p.92 (highlight mine),

``Causa Remota of the crisis is speculation and extended credit; causa proxima is some incident that 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 that leads to a significant actor to unload. Prices fall. Expectations are reversed. The movement picks up speed. To the extent that speculators are leveraged with borrowed money, the decline in prices leads to further calls on them for margin or cash and to further liquidation. As prices fall further, bank loans sour, and one or more mercantile houses, banks discount houses, or brokerages fail. The credit system itself is shaky, and the race for liquidity is on.”

Doctors diagnose the ailments of their patients based on exhibited symptoms. The patterns seen in the Kindleberger Crisis paradigm and the Minsky Model uncannily parallel a brewing crisis at hand. Could it be a full blown financial crisis? We don’t know and we hope not. Yet we are uncertain if this juncture will simply just breeze over.

Some institutions think that we are at the levels of maximum “uncertainty” and advocate the Rothschild maxim of “buying when there’s blood on the street”. We doubt so.

In determining whether it would be the propitious time to invest, there is supposedly the distinction between risk and uncertainty from which we may consider when evaluating. To borrow from economist Frank Knight’s (Risk, Uncertainty and Profits) definition, which we will quote economist Nouriel Roubini in his blog (highlight mine), ``In brief, “Risk is present when future events occur with measurable probability” while “Uncertainty is present when the likelihood of future events is indefinite or incalculable”…Risk can be measured and priced because it depends on known distributions of events to which investors can assign probabilities. Uncertainty cannot be priced by markets because it relates to “fat tail” distributions and extreme events that cannot be easily predicted or measured.”

Learning from the recent events, the initial stand by the mainstream market participants was TO DISMISS the contagion risks from the US mortgage crisis citing its limited share to the overall markets and as share to the GDP. Suddenly, the credit spigot seemed to have been turned off, where from one markets to another, global financial markets essentially felt the tremors escalate, sold off steeply and then central banks stepped in with liquidity injections and NOW the FED’s discount rate cuts.

In other words, what was initially viewed as a “contained” problem turned out FAR from mainstream expectations. Markets reacted way beyond what participants expected. Many got hurt and this has YET TO SHOW. Consequently, the financial industry beseeched to be bailed out and appears to have gotten what they wished for. Question is, has the present bailout been adequate?

Given the huge underestimation by Wall Street, and given the embryonic symptoms of a financial crisis, these represent the prospects of an “incalculable outcome” or “uncertainty” in the Knightian terminology. Remember, financial crisis have far reaching effects. Take the impact to the Phisix in 1997 as shown in Figure 3.

Figure 3: Asian Financial Crisis: Phisix lost 70%

The Phisix in 1997 to 1998 REACTED VIOLENTLY to the Asian Financial Crisis. In over one year and a half, the Phisix fell by nearly 70% from 3,400 to 1,076. As you can see the overall trend was DOWN but had a couple of bull traps in between the general trend. This is where “knife catchers or bottom pickers” thought they had “timed” the market’s bottom when they actually were false dawns. One can just feel the pain of miscalculation.

We don’t know if another crisis would occur. We sincerely hope it does not. The point is, when we are faced with a LIMITED upside relative to the risk prospects with an immeasurable downside or earning opportunities is limited relative to greater opportunities for losses, we simply don’t take the trade.

While we can’t control what happens to the financial markets or economies, we have CONTROL over our portfolios.

We don’t mind buying higher for as long as the “uncertainty” prospects abate. So far this hasn’t been the case.

US FEDERAL RESERVE Is Financial Markets Sensitive!

``By definition, the center is the provider of capital , the periphery the recipient. An abrupt change in the willingness of the center to provide capital to the periphery can cause great disruption in the recipient countries. The nature of the disruption depends on the form in which capital was provided. If it was in the form of debt instruments or bank credits , it can cause bankruptcies and a banking crisis..."-George Soros

When the seminal bouts of financial stress began unveiling late July, we took the stand that monetary authorities were likely TO INTERVENE with corresponding policy measures (see July 23 to 27 edition Under the Threat of Recession, The FED Will Likely Cut Rates!).

Some monetary figures and experts overconfidently claimed that the FED will NOT intervene because the housing recession had been assumed to have little effect on the economy and the financial markets.

On the other hand, we suggested that the performances of the financial markets are likely to be the key barometers monitored by the US monetary authorities, despite their vehement denials (they are purportedly not to influence asset markets). And to us, it seemed that this sector mattered more than economic figures, since…

1.) Financial assets comprise the CORE source of funding to the consumption patterns for the US households which make up about 75% of the US GDP.

2.) The global financial markets have DWARFED the global real economy (exchanges of goods, widgets and services) and lastly…

3.) The activities in the US markets have been TRACKED CLOSELY by global markets, which similarly could influence the general global economic momentum.

Under such construct, our projections were weighted on the performances of the US financial markets, in contrast to most experts. Here we asserted that a significant decline in the US markets will compel the FED to trigger its Rescue Package, (see July 30 to August 3 edition, A 10-15% Drop In the US Markets Will Probably Activate The Bernanke Put).

Recently in view of the upheavals in the market largely influenced by the spreading of credit drought, global central banks INITIATED such operations by injecting more than $300 billion of money “created from thin air’ to the increasingly distressed financial sector, where the US FEDERAL RESERVE even accepted mortgage backed securities as collateral in exchange for loans.

We even suggested last week that the FED will use its remaining tools under duress which proved to be prescient…``The FED has two more tools left at its disposal the discount rates and the Federal Funds rate and would be used soon.”

Thursday August 16th appears to have been the crux of the FED’s decision to trigger the NEXT DOSE of the Bernanke Put…

Figure 4: New York Times: A Day of Wild Market Swings and Global Anxiety

According to the New York Times article by Jeremy W. Peters and Louis Uchitelle (emphasis mine), ``At one point during the trading session, major stock indexes were down more than 10 percent from their peak last month — the threshold for the market’s fall to be considered a “correction.” But by the close, the overall market had escaped that territory, powered by a rush of buy orders in the last hour, leaving Wall Street not far from where it ended the day on Wednesday.”

So essentially what happened was the Dow Jones Industrial benchmark crossed over our projected frontier. The intraday trend of the Dow Jones Industrial in Figure 4 from the New York Times, shows of how the main index TRANSGRESSED the 10% threshold…down a little over 340 points during the mid-session!

But in the final hour, the key benchmark got a reprieve from a barrage of late hour buying orders (from the PPT/President’s Working Group perhaps?) to close down by only 15 points! With central banks apparently pumping up the financial system, it isn’t a remote probability to have the US government propping up such key indices.

Nevertheless, the mixed close on Wall Street did not DETER Japan’s market to a swan dive last Friday down by as much as 5.42% at the close, as shown in Figure 5!

Figure 5: Nikkei’s Swan Dive

Other key Asian markets fell but was able to reverse much of their losses likewise during the final hour. Hong Kong’s Hang Seng Index seen in the topmost pane, the Dow Singapore benchmark (upper pane below center window) and our own PSE following Japan’s collapse in a free fall.

In the meantime, European markets were trading in the red likewise early last Friday, while US futures were initially in deep losses. Then the unexpected happened, FED announced its discount rates cuts before the opening and saw its markets flew as the bells rang!

Again, the Fed’s timing of the discount rate cuts (before the opening) as well as last hour activities in the US markets on Thursday COMPOUNDS OUR SUSPICION of government’s stealth but revealing efforts to levitate the financial markets.

Nonetheless, in support of the recent monetary actions, we note of a volte-face on its priorities.

Early last August 7th the FOMC declared that the predominant risk had been inflation, although they noted that the risk to the economy has grown (highlight mine)…``Although the downside risks to growth have increased somewhat, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected.”

On Friday August 17th the FOMC stated that deteriorating market conditions has shifted their risk concerns from inflation to economic growth (highlight mine)…``Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.

I recall William Poole President of St. Louis Fed, who recently declared that it would take only a “financial calamity” to impel the FED to act. The following day, the FED admits of a shift in gears in support of the markets. This implies burgeoning risks for BOTH the US economy and the financial markets.

In the light of such admission, how does one become bullish when the monetary authorities themselves are apparently reacting to the escalating risks through the recent anodyne treatments in the hope that such would restore the balance?

In the first place, wasn’t it their encouragement through their expansionary policies to enter into inflationary excesses which has caused this problem? It’s like feeding more drugs to addicts.

Yes, some features of the latest policy actions could buy some time for the FED, Asha Bangalore of Northern Trust notes of the important variables accompanying the latest rate cuts (highlight mine),

``Why did the Fed change the discount rate and not the federal funds rate? Discount rates are established by each Reserve Bank's board of directors, subject to the review and determination of the Board of Governors of the Federal Reserve System. Today’s change in the discount rate was an official request from the Federal Reserve Banks of New York and San Francisco. There is no special significance to the fact that it was requested by only two banks. In addition to lowering the discount rate, the Fed modified the term of the loan. The Reserve Banks’ usual practice is to make funds available overnight through the primary credit program. Today’s announcement noted that financing is available for long as 30 days and it is renewable by the borrower. The Fed also increased the range of assets that will be acceptable as collateral under this arrangement compared with that of open market operations. These provisions indicate that the Fed strongly believes that addressing the problem of liquidity is the top most priority. The Fed has chosen this route given the difficulty in estimating what banks’ demand for excess reserves are on a regular basis…the Fed has erred on the side of supplying too many reserves rather than too few, with the daily effective federal funds rate trading below the FOMC’s target of 5-1/4% in the past several days. In sum, this innovative procedure under exceptional circumstances has given the Fed flexibility and bought time to evaluate the situation.”

Essentially what we see from the FED are two factors, first a telegraph that they are open to provide a BID on risk assets to support the markets, and second, if the present nostrums don’t do its expected job, they’d throw the kitchen sink to the markets to prevent economy from going under regardless of risks of “moral hazard”.

Once again it appears that based on political incentives, monetary authorities are responding by effecting treatment based solutions than preventive ones. As such, they are unlikely cures for today’s imbalances.