Monday, March 31, 2008

Missing Rallies or Catching A Falling Knife?

The recent stock market activities has stimulated the urge for some to consider today’s rally as a possible turning point -that some of us may harbor the feeling of “missing the train”.

First, we do not have the power of clairvoyance as to really know when the market bottoms or peaks out. We do not also know where the short term market path will go, simply because we can’t read the emotional impulses of every market participants.

Even if my first lessons in the stock market had been in technical or chart reading, I eventually discovered that these are not foolproof, entirely depends on past performance (pattern and signal reading), and is a tool mainly utilized by brokers who are itching for trading churns and not measured risk reward output.

The chart above shows that during this bearmarket cycle, rallies have been significant (see ellipses) or V-shaped but they tend to give them away as the tide reverses.

New York Times’ Floyd Norris: For Stocks, It’s the Wild West, East ...

Can today mark the bottom? Maybe or maybe not. My impression is that for as long as the world markets continue to track the developments in the US and forced liquidations represent a significant driving force weighing down on global markets (see volatility chart from NYT's Floyd Norris), then a major bullish run on our markets or to any stock markets elsewhere will likely remain suspect.

Second, the important lesson I learned about the market is to understand the interplay of different cycles and try to project on how these are likely to impact prices of assets or securities and thus allocate portfolio according to our risk profile.

Yet looking at the how regional and other contemporary markets have performed none of which has yet revealed signs of conspicuous decoupling. All of them, World Index, Emerging Markets and Asia ex-Japan continue to manifest downside action and bias.

So regarding risk, a downside bias could still be the dominant driver, although global monetary conditions and idiosyncratic fundamentals may support or cushion the decline of individual markets.

My point is: to hinge on the idea of missing a train ride is tantamount to catching a falling knife.

We simply shouldn’t believe in “missing rallies” today simply because different cycles seem to converge and point towards greater downside risks than a precipitate recovery. Remember, bearmarkets draws in hopes of investors until they capitulate.

If a decision has been made to enter the market today, then the expectation should be geared towards the longer horizon since the risks is likely tilted towards more potential downside actions or the risks of a portfolio going underwater. For me, trying to bottom fish or picking market tops is a game of vanity.

We should get aggressive when the trend suggests of a complete reversal. This is like paying for an insurance premium, by buying high because they are likely to go higher and importantly because the risks are likely to be reduced.

Thus, conservative portfolio exposure and allocation is best recommended.

Sunday, March 30, 2008

How Surging World Rice And Food Prices Could Impact the Philippines

``Some argue rather forcefully that we’re now immersed in “debt deflation.” I understand the basic premise, but to examine double-digit growth in Bank Credit, GSE “books of business” and money fund assets provides a different perspective. To be sure, our Credit system continues to provide sufficient Credit to finance massive Current Account Deficits. And it is this ongoing flow of dollar liquidity that stokes both indomitable dollar devaluation and global Credit excess. Many contend that inflationary pressures are poised to wane as the U.S. economy weakens. I’ll suggest that inflation dynamics will prove much more complex and uncooperative. There is further confirmation of the view that the bursting of the Wall Street finance Bubble will have a significantly greater impact on asset prices than on general consumer pricing pressures.”-Doug Noland, End of the Era,

The Philippines once again hit the world headlines.

However, this time it is not due to its intense infatuation with “personality based politics” but for driving up prices of rice to milestone record highs as the world’s biggest buyer of grain.

The projected deficit or shortfall in the national stock level of the primary food staple has prompted the national government to drastically react by suddenly tapping into the world markets where it has been reportedly trying to secure some 1.8- 2.1 million tonnes from Vietnam and Thailand (Financial Times).

Figure 1: CBOT Rice futures at Record High

This week rice futures surged by over 30% (see Figure 1) to set fresh record levels at the Chicago Board of Trade. And this has been equally reflected in global rice benchmarks.

According to the Financial Times, ``Thai rice, a global benchmark, was quoted yesterday at Dollars 760 a tonne, up 30 per cent from the previous daily quote of about Dollars 580 a tonne, according to Reuters data. But some traders said the jump was not as steep, adding that Thai rice had already hit about Dollars 700 a tonne this week.

``Rice prices have doubled since January, when the grain traded at about Dollars 380 a tonne, boosted by strong Asian, Middle Eastern and African demand, and tight exportable supplies across Asia, according to the US Department of Agriculture.” (emphasis mine)

Nonetheless, rice relative to other major agricultural commodities is the least traded in the world since most of the major rice consuming countries are close to or have reached self-sufficiency levels. It is reported by the UN’s Food and Agricultural Organization (FAO) that annually “only 7% of the world’s production is traded across international boarders”.

That was then.

Price Inflation’s Accelerating Momentum

The dynamics are quickly changing.

Supplies are rapidly being depleted around the world. According to the Financial Times, ``Global rice stocks are set to fall this year to about 70m tonnes, the lowest level in 25 years and less than half the 150m tonnes held in inventories in 2000.”

Figure 2: The Economist: A Reversal of Long Term Declining Prices on Supply

Following 6 out of eight years where demand has surpassed supplies, inventories as measured by the stocks-to-use ratio has fallen to a precariously low level similar to that in 1976 with roughly over 70m tonnes of reserves at a time when population was about a little over 4.1 billion compared to today’s 6.6 billion.

Figure 2 from the Economist shows that despite the rising rice production over the decades, the recent price activities imply for a reversal of the long term declining trend, which also appears to reflect stronger increases in demand relative to supply.

Figure 3 from UN’s FAO shows of the world’s largest major exporters of rice.

In FAO’s 2007 Rice Market Monitor it noted that

``The 2007 forecast of global carryover stocks has also been lowered since September by 5 million tonnes to 102.4 million tonnes, which would represent a 1.2 million tonnes drop from opening levels. The expected decline suggests that production in 2007 would fall short of utilization and that drawing from world reserves would be needed to bridge the gap. The expected year-to-year contraction is anticipated to affect mostly the major importing countries, except Indonesia. Although as a group, the traditional exporting countries are foreseen to end their 2007 seasons with larger inventories, much of the increase would be concentrated in China. The situation in the other traditional exporting countries is less buoyant, since Australia, Cambodia, Thailand, the United States and Viet Nam are all anticipated to end the season with lower inventories.” (highlight mine)

Growing demand and production shortfalls have likewise led to major policy changes among nations.

Major exporters as Vietnam, India, Egypt and Cambodia (International Herald Tribune) have imposed restrictions (on a varying scale: Vietnam to reduce exports by 22%, India pegged new prices at $1,000 per ton, Russia imposed export duties) on rice exports. Thailand is yet in public discussion and risks following the same “protectionist” measures.

Next, present shipments are being consummated to comply with the recent contracts entered into by governments through state owned companies, with virtually no private contracts signed. Basically, governments have cornered both the buy and sell side of the trade equation.

So far, all these concerted restrictions have effectively taken off about a third of rice supplies in the international markets, reduced liquidity and thus, have contributed immensely to the ongoing price volatility in the world market.

Political Impact of Rising Food Prices

Figure 4: UN FAO: Surging Food Price Indices

No, this is not entirely about the issue of rice; it is about food in general…and on a global reach.

As you can see in Figure 4, global food prices have been surging almost across the board-as dissected per group (left) and as generally classified (right)- and the momentum of increases has recently accelerated.

Notes the UN FAO, ``In 2007, the FAO Food Price Index averaged 157, up 23 percent from 2006 and 34 percent from 2005. Except for sugar, prices of which declined sharply, international prices of other major food commodities rose significantly in 2007. Dairy, cereals and vegetable oils made the strongest gains, supported by tight supply and demand situation. In December, the food index averaged 184, the highest recorded monthly average since the start of the index in 1990.”

So as the food spectrum appears to be taking the heat from heightening episodes of “price inflation”, recent political events imply “inflation” getting rapidly unhinged in the broader segment of the world.

Since rice is a staple of more than 2.5 billion of the world’s population (mostly in Asia) this has political significance.

Recently riots have erupted around the world in Guinea, Mauritania, Mexico, Morocco, Uzbekistan and Yemen associated with soaring food prices (New York Times). Since rice is also a staple in Africa, small countries as Cameroon, Burkina Faso and Senegal have been suffering from social unrest (Financial Times).

``But food protests now crop up even in Italy. And while the price of spaghetti has doubled in Haiti, the cost of miso is packing a hit in Japan”, reports the CNN.

Meanwhile, sporadic violence in Egypt has prompted President Hosni Mubarak to require the army to “bake” or ramp up bread production (! As you can see, desperate problems call for desperate measures.

In 2007, we saw a prelude to this antsy over food such as the "Tortilla Crisis" in Mexico, the "Pasta Protest" in Milan, and riots and stampede in China over cooking oil. Today we are simply witnessing the aggravation of such “food inflation” tensions.

Present And Prospective Policy Responses

Naturally, the typical response to politically charged events by governments is likewise “political” in nature or as we long described- the treatment based solution directed to appease the short term demands of voters or the populace than over structural reforms.

The Philippine government has not reached a point that requires its 200,000 strong military personnel to operate as bakers or farmers, but we are closely getting there.

So aside from the frantic buying in the overseas market to shore up local stockpiles whose import bill is projected to rise to P 60 billion with Php 21.7 billion serving as rice subsidies through the National Food Authority (Philippine Daily Inquirer), the government plans to relax or ease tariffs import duties similar to oil.

Currently tariffs for rice and corn stand at 50% and 40% (!!!), according to the Philippine Daily Inquirer. Imagine the astounding amount of subsidies or “safety nets” granted to our farmers (meant to protect them from external competition) throughout the years and yet they have remained “poor”, uncompetitive and “unproductive”!

The government is also reportedly planning to allow for greater private sector participation for importation and to expand rise production expenditures to US $68.5 billion, while the social welfare services intends to issue rice coupons to the depressed “poor families” sectors of the society (reuters I wonder how many of these “redistribution” goodies would genuinely end up with the needy and not to “poor” relatives and associates of those in charge—of course at the expense of taxpayer’s money.

In addition, for public display of government in action or what I call the “superman effect”-people love to see superheroes rescue the victims (e.g. falling from buildings or emancipation from the clutches of the antagonist/s) and not by the unappreciated preventive actions-aimed against “profiteers”, the government intends to “toughen up” against “hoarding” (Philippine Daily Inquirer). Are we seeing more opportunities for extortion or corruption?

If all these measures don’t meet their desired end, the probable next line of action would be bigger subsidies at the expense of the fiscal conditions, imposition of price caps or ceilings or rationing or forced appropriation of private properties-all of which means more inflationary policies, market distorting measures and more socialism of the marketplace.

All this suggest the prospective impairment of the country’s balance sheets which will all be reflected in our reduced purchasing power. The fate of the Peso will depend on who among the relative currencies would be inflating more. As we have pointed out in the past see February 18 to 25 edition [Surge of Food Prices Presage Armed Conflicts!], rising food prices have coincided with armed conflicts and the rise of tyrants and despots. Could we risk the emergence of a new dictator?

Nonetheless, if there will be any political cause that that could unseat the present administration, it is not from the angle of “truth” but from “hunger”. Thus, expect more rescue packages at the expense of the taxpayer.

Rising Food Prices Is A Complex Issue But Driven By Mostly Unintended Consequences

``What we commonly find, in going through the histories of substantial or prolonged inflations in various countries, is that, in the early stages, prices rise by less than the increase in the quantity of money; that in the middle stages they may rise in rough proportion to the increase in the quantity of money (after making due allowance for changes that may also occur in the supply of goods); but that, when an inflation has been prolonged beyond a certain point, or has shown signs of acceleration, prices rise by more than the increase in the quantity of money... As a result, the larger supply of money actually has a smaller total purchasing power than the previous lower supply of money. There are, therefore, paradoxically, complaints of a ‘shortage of money’.”-Henry Hazlitt, (1894–1993) libertarian philosopher, economist, and journalist; The Velocity of Circulation

We came across an article where a local expert from the academia lectured on the present predicament attributing the crop of problems to “productivity”. We are likewise told that we require “investments” in research and development, the “right” irrigation, “adequate comprehension” of the needs of the farmers to reach a sustainable increased productivity.

While we basically concur with the premise of “productivity” as the root of most economic problems, the fundamental problem of the argument of “productivity” is one of abstraction, similar to politically abused terminologies of “honesty” or “truth”. To quote Ludwig von Mises in Liberalism, ``The concept of productivity is altogether subjective; it can never provide the starting-point for an objective criticism.”

On the surface the “proposed solution” looks so downright simple, easy to address, quite plausible and pragmatic to the point that it does not require an expert to make such prescription. But after all these years, our question remains, if such has been the case then why today’s quandary?

To quote the Economist (highlight mine), ``Robert Zeigler of the International Rice Research Institute, one of the driving forces behind Asia’s 1960s “green revolution” in farming, says that governments are now reaping the results of years of neglecting agricultural research, irrigation and other means to aid farmers.”

From the hindsight, everything looks easily explained. The problem here is the operating belief that current conditions can be sterilized or seen from amongst the limited variables operating under laboratory “cultured” settings.

Besides, given that we "supposedly" know what to do, these experts imply that throwing “tax payers” money to all these supposed problems will resolve the problem. You could add to the above the call for subsidies for higher quality seeds or funding for scientific cross breeding of existing strains of rice, but it seems none of these will be enough. Why?

The fact is the world is not as simple as we may perceive it to be, as there are many unforeseen factors that have contributed to the present environment such as evolving geography or climate dynamics, the intermittent occurrence of plant diseases or viruses, strained water supplies, the loss of arable lands due to natural causes as desertification or to even a sharp decline of Honey Bee population, which have been an instrumental component of pollinating world’s major crop production (!

Knee Jerk Government Policies And Side Effects

Most importantly aside is the unintended effects from government policies.

Since global governments have practically corralled the rice markets, price signals have essentially been distorted. One can’t argue that this is signifies a “market failure” since the global rice markets have now morphed into an exclusive intergovernment activity. The recent volatility of rice prices seems to manifest of such aberration.

Yet, the present measures adopted by governments signify knee jerk reactions and does not guarantee of a sound resolution to the brewing disparity.

Governments reacting via the "superman effect" have now opted to either conserve its resources by closing its markets (for exporters) or by throwing vasts amount of taxpayers money to secure its desired outcome (for importers), without the necessary structural reforms. More protectionism and socialism would consequently lead to more resource allocation imbalances. All band aid remedies may temporarily alleviate pressures, but exacerbate or even extend the day of reckoning when it materializes. It is not the question of if, but when.

The fact that the Philippines have shielded its farmers with towering walls of tariffs over the years, which have not improved their lots (they are still marching on the streets!), seem to represent sufficient evidence of government policy failures. This has kept the incentives away from investors (remember capital investment would come from either private investors or you the taxpayer) who our expert say ought to have invested in the industry (R & D, irrigation, “aid to farmers”, high quality seeds etc…).

Since the Philippines has no organized market platform for its agricultural produce (commodity spot and futures market/s) that could have instituted pricing efficiency or delivered price signals enough to generate whether a given line of production is profitable or not, or a means from which to determine the profitable redistribution of resources to the areas in need, or a coordinative function of prices across the production and consumption structure, the present system still depends on the old traditional ways reliant on the functioning ‘cartels’ for financing and distribution, and kept our farmers in poverty bondage despite the so-called safety nets.

With inadequate infrastructure, the lack of price signals, limited access to financing, and deeply embedded ‘cartelized’ system (apparently the main beneficiaries of the subsidies), who in the right mind would invest or plunk capital into a losing proposition? Moreover, the depressed prices of the past years further worsened these conditions (see figure 2 earlier).

This is not an insulated development though, the aggregation of collective government policies aimed at providing so-called safety nets via subsidies, have induced the cycles of overinvestment and underinvestment. The agricultural subsidies of US, the Common Agriculture Policy of Europe and the rice subsidies of Japan have had an important hand in the present disequilibrium of supply and demand.

Moreover, recent mandate to promote the use of biofuels such as the US Energy Policy Act of 2005 have spurred meaningful impact to global agricultural prices.

Mr. Kevin Kerr for the Daily Reckoning makes this noteworthy comment on the unforeseen impact of the recently enacted law (underscore mine),

``Then the political light bulb came on – dimly, but it came on. The idea was to turn a key staple of our food supply (corn) into fuel and thus create a panacea for the energy problem. This was a miracle, right? Wrong. Ethanol is nothing new; it has been around since cars first rolled out of Detroit. Ethanol from corn comes at a very high price. Not only does it require several steps to turn corn into ethanol, but it requires acres more of land, fertilizer, fuel, water, etc. At the end of the day, the only thing that widespread ethanol use is doing is destroying more of our natural resources while perpetuating the myth that we are doing something about our energy problem. It’s almost criminal…

``It has become so absurd that farmers are becoming careless, throwing aside less-profitable crops like cotton and wheat.

``In addition, being overlooked are prudent farming methods like crop rotation and not growing corn on corn, or the process of growing a different crop the year after you grow corn in a particular field. The environmental statistics are staggering, too.

``In Wisconsin, for example, local rivers and tributaries have been dropping rapidly due to all of the extra water consumption - millions and millions of gallons.

In short, subsidies have fostered a seismic shift of activity towards these mandated crops at the expense of other agricultural produce. Reduced acreage allotted for other crops have diminished supplies which have caused higher prices for the latter. Moreover, the lack of prudent farming methods are likewise contributing to inferior yields and the inordinate usage of water, which has been turning out to be a long term strain on agricultural productivity (or lesser future output).

Moreover, monetary policies have had a substantial impact to the price of commodities. As we have long argued negative to low real rates tend to stimulate the public to seek a substitute “store of value” in lieu of a currency which it perceives to be losing purchasing power (or buys less quantity via higher prices).

Figure 5: Jeff Frankel: Commodity Prices and Real Interest Rates

Mr. Jeffrey Frankel provides us with the empirical evidence, see Figure 5, of how real interest rates are strongly correlated with price directions of commodities. This alternative explanation from Frankel (highlight mine):

``The theoretical model can be summarized as follows. A monetary expansion temporarily lowers the real interest rate (whether via a fall in the nominal interest rate, a rise in expected inflation, or both – as now). Real commodity prices rise. How far? Until commodities are widely considered “overvalued” — so overvalued that there is an expectation of future depreciation (together with the other costs of carrying inventories: storage costs plus any risk premium) that is sufficient to offset the lower interest rate (and other advantages of holding inventories, namely the “convenience yield”). Only then do firms feel they have high enough inventories despite the low carrying cost. In the long run, the general price level adjusts to the change in the money supply. As a result, the real money supply, real interest rate, and real commodity price eventually return to where they were. The theory is the same as Rudiger Dornbusch’s famous theory of exchange rate overshooting, with the price of commodities substituted for the price of foreign exchange.”

We have earlier been suspecting that some asset class would benefit from the recent monetary developments. Could soaring rice prices signify as the elected “store of value” for the Filipinos?

By and large, this phenomenon has not been unexpected to us, since we have been saying all along the inflationary pressures will continue to mount and reflected in disparate ways as governments inflate the system to avert a financial storm.

Possible Market Implications

What this means to markets?

It means agriculture and resource based industries remain as compelling investment themes for as long as governments will undertake socialistic tendencies to inflate the financial system to serve its political objectives.

As earlier discussed, distortive monetary policies coupled with increasing administrative regulations are likely to entail unintended effects that would be manifested in the market prices of commodities.

Moreover, demographic dynamics such as urban migration and infrastructure development will further add strains to the present disequilibrium aside from the ongoing global wealth redistribution process.

Yet, there could be other factors such as changes in weather and other imponderables that may elevate this progression in spite of the deflationary chapter in some industrialized economies.

Figure 6: US Global Investors: Share of Food in Headline CPI Inflation

On the negative side, higher food or commodity escalates the risk of social unrest which ups the security and political risks dimensions for investors; especially in least developed countries, where a high percentage share of Food relative to headline inflation as shown in Figure 6 courtesy of US Global Investors, may destabilize the peace and order situation or elicit the recurrence of dictatorship rule.

In addition, more social safety nets are likely to threaten fiscal discipline and wreak havoc or impair the balance sheets of national governments as the future need to pay off present subsidies by more taxes grows.

Since most governments will be undertaking currency debasement programs, the currency that debases least will likely rise, but all paper currencies will most probably fall against tangible or hard assets.

The relief is that the food basket of the Philippines CPI such as rice, meat, corn and flour comprise around 13.5 percent of the CPI basket, according to the central bank (Philippine Daily Inquirer).

Given the recent predicaments, the present leadership is faced between the perils of the proverbial devil and the deep blue sea.

Tuesday, March 25, 2008

Groping For A Market Bottom

Many have been calling for a market bottom.

A market bottom, according to Economist’s Market.view can be identified by the following signs (highlight mine):

``Bear-market bottoms usually require three things. First, they require the existence of forced sellers, to have driven prices down rapidly. Secondly, they offer some clear appeal on valuation grounds. Third, they need a catalyst, an event which, while gloomy, might conceivably mark the worst moment of the crisis.

That’s the way it has been in 2003, observes Market.view,

``All the requirements were in place in early 2003. Pension funds and insurance companies had become forced sellers of equities for solvency reasons. The dividend yield had risen sharply from its pitiful level during the dotcom boom; in the UK, it was higher than the yield on government bonds for the first time since the late 1950s. Finally, the onset of the Iraq war proved the catalyst, perhaps due to the sheer relief that all the uncertainty was out of the way. Equities duly rallied, sharply.”

Today, there are some signs of the reemergence the same pattern. According to Market.view,

``And there is a plausible case for saying all three elements are in place this time. Not, however, for equities but for investment-grade corporate debt. First, there have been forced sellers; notably hedge funds and specialist vehicles like conduits. Second, spreads over government bonds seem to offer a return that compensates for a very high level of defaults. Third, the collapse of Bear Stearns could conceivably mark the worst moment of the crisis.

And importantly, global fund managers who are overweight cash are at extreme levels, possibly indicative of a looming reversal, adds market.view (emphasis mine),

``Sentiment is also pretty gloomy at the moment, usually a bullish sign. According to Merrill Lynch’s monthly poll of fund managers, a net 42% of asset allocators are overweight cash, a record level. Since slightly more are underweight equities than bonds, that might suggest the stockmarket is a better bet. However, it is hard to argue that there have been forced sellers of equities; shares have held up rather better than corporate bonds. And equity valuations are only decent by historical standards, rather than compelling, even if one discounts the fact that profits are high relative to GDP.”

While it may possibly be true that the present levels of cash could serve as a contrarian indicator, the chart of global money managers who are overweight cash (in %), courtesy of the Economist and Merrill Lynch plus the S & P 500 weekly by, appear to indicate otherwise-- that bear markets have, in the past, sucked out excess cash from global fund managers- from which the bottom has been marked by low levels of fund managers with available cash!

Since "Bear markets descend on a ladder of hope", maybe this attracts the phenomenon called the catching of "falling knives" or "bottom fishers" deplete their cash levels.

This also means that mere sentiment may not precisely reflect inflection points because general market trends can lead to protracted sentiment excesses. This noteworthy excerpt from Dr. John Hussman,

``Presently, the level of advisory bullishness is not much below where we would expect it to be, given the market decline that we've observed. That's often the case early in bull or bear markets. High bullishness in early bull markets is typically not a negative, because the initial advance is generally very powerful. Likewise, high bearishness is typically not a positive early in bear markets, because the initial decline is often fairly deep.” (emphasis mine)

Barry Ritholtz observes of “rampant bottom callers” or of many articles declaring to an end to the “bear” market or a market bottom.

These are likely to instead signify the “Denial stage” of the psychological cycle operating within the markets as shown above.

Besides, the present rally seems to be in reaction to the gamut of Central Bank measures; US Federal Reserves expanded TAF or the TSLF, the 75 bp cuts, reduced reserves of GSE to expand mortgage acquisition, Fed bypass of lending procedures the activation of depression era laws to “salvage” Bear Sterns and BoE and the ECB’s liquidity provision and more, aside, from the technical oversold conditions.

The notion is that all these measures will be sufficient panaceas to the present problem. We doubt so.

What’s more, today’s forced selling seems to be a function of liquidity induced problems borne out of some material insolvency within the financial industry. The peak of forced selling would most probably occur once the ‘critical mass’ of losses surface, which is not likely to be anytime soon.

Of course, valuations matter- that’s why we see some selective opportunities. But gains of the past will possibly not be repeated this year; you’d have to have a longer horizon aside from positioning defensively.

As for an event driven catalyst, this can possibly be seen only from the hindsight.

As a reminder, market trends or cycles are long drawn out processes and not simply one or two time events.

Sunday, March 23, 2008

In A Crisis, Be Aware Of The Danger But Recognize The Opportunity

``Hope and denial do not constitute a successful investing strategy. More money is lost by people listening to their emotions and ignoring facts than is lost because of just about any other influence.”-Bill Fleckentstein, MSN Money Contributor

ON the road to vacation, I chanced upon a rather queer article from a veteran stock market analyst on a business broadsheet. The narrative incited for local market participants or the purported “weak” hands to “panic” so as to “end” this dreadful bear market. Obviously, the bizarre straw man argument undeservingly nitpicked on the domestic players when it is the foreign participants mainly responsible for the recent carnage.

While the essay appeared to be a “reverse psychology”, which was meant to do otherwise, it signifies pretty much of a deeply entrenched state of denial-the inability to accept the persistence of the present conditions. This seems to reflect signs of impatience and deepening frustration from a supposed market expert. As German-Swiss author poet Hermann Hesse in his novel Steppenwolf wrote, ``All interpretation, all psychology, all attempts to make things comprehensible, require the medium of theories, mythologies and lies."

As discussed in last week’s Phisix: “Fear Is A Foe Of The Faddist, But The Friend Of The Fundamentalist”, since the Philippine financial markets has not evinced signs of a reversal from its internal or “local” cycle but rather has been reacting to the impact of bubble implosions (real estate and securitization) abroad, we are likely to be undergoing a typical “corrective” countercyclical phase than of a secular turnaround.

The point is to understand the underlying cycles driving our markets than speciously look for momentum and sentiment driven reactions and rationalization. To wit, the spate of foreign driven selling has been prominently impelled by “forced liquidations” of institutions in a frenetic effort to raise or shore up capital or meet margin requirements as lenders tighten up or fulfill investor redemptions, which translates to selling of the most liquid and even safest papers.

To quote the Economist (highlight mine), ``The fear is that the financial markets have entered a negative spiral with being forced to sell bonds and loans, whether or not they believe the borrowers will eventually repay. The problems are exacerbated by the demise of the securitisation market, and fears about counterparty risk. Both those factors are making banks less willing to lend—even to worthy borrowers. They will become even more cautious the deeper America’s economy tips into recession.” For example, Louis-Vincent Gave of Gavekal Research notes, ``tax-free AAA municipal bonds started to yield more than the equivalent US government bonds. Given the tax differentials, this makes no sense at all.” (emphasis mine)

As you can see the consequent fear and the forced offloading, which signifies a hoarding effect is a natural consequence of the breakdown in the securities market, has distorted the pricing of securities in the world financial markets. And under a globalized environment, we are feeling the heat of such contagion, so as in most parts of the world.

Secondarily, “adjustments on effective valuations” emanating from the perceived economic slowdown in the wake of the evolving debt crisis is another variable from which global markets appear to be exhibiting.

This cyclicality is best illustrated by the description of Citibank’s Credit strategist Mark King of the four phases of a credit cycle (hat tip: David Fuller). Quoting Mark King (underscore mine)…

`` Phase 1: Long credit, Short equity

``This phase immediately follows the bottom of the credit bear market. Spreads fall sharply as companies complete the process of repairing balance sheets, often through deeply discounted share issues (as we saw for Insurance and Telecom companies back in 2002-03). This, along with continued pressure on profits, keeps equities weak.

``Phase 2: Long credit, Long equity

``The next phase begins as profitability turns and equity prices start to rally. Credit spreads fall even further as corporate cashflow rises strongly. We call this an immature equity bull market. For the present cycle, this phase began in March 2003 and finished in the middle of the 2007.

``Phase 3: Short credit, Long equity

``The credit bull market is over, balance sheet leverage increases, spreads rise, and investor appetite for credit wanes. Financial market volatility rises. As we progress through Phase 3, the equity market eventually decouples from credit and continues to rise. This is the mature equity bull market.

``Phase 4: Short credit, Short equity

``This is the classic bear market, when equity and credit prices re-couple and fall together. It is usually associated with falling profits and worsening balance sheets. Concerns about insolvency plague the credit market, while broad profit concerns plague the equity market. A defensive strategy is most appropriate - cash and government bonds are the best performing asset classes.

The credit cycle as defined by Citibank’s Mark King suggest to us that the US is most likely in Phase 4, as shown in Figure 1.

Figure 1: St. Louis Fed: Panic in Wall Street-Fed Pushing On a String?

3-month Treasury rates have plummeted close to zero or to three fifths of one percent (blue line), even as Fed funds is now at 2.25%. If Fed rates (red line) historically track the performance of 3 month treasuries (as far back to 1982) then they appear to be signaling Fed rates at one percent or below. Wow, such panic seems written all over Wall Street! But the stock market hasn’t demonstrated the same degree of fear. So our guess is that one of them (stock market or bond market) could be wrong.

But the question is how much more room can FED policies adjust before the market responds favorably? In other words, conventional policies appear to be losing traction even as FED rates are approaching zero. Hence, the risk of “Pushing on a String” or Fed’s policies pushing on one end does not appear to produce the desired movement at the other end. For Keynesians it is known as the “Liquidity trap”, where the next step would probably be our version of TSLF or Total Socialization of Losses of the Financials or Bernanke’s Helicopter Money.

Likewise the 5 year Treasury Indexed Note (green line) or TIPS is now at negative yield territories, where to quote Bill Bonner of the Daily Reckoning, ``These TIPS provide protection from both enemies – inflation and deflation. The feds won’t default. And the TIPS adjust to losses in consumer purchasing power – as calculated by, well, the feds themselves. But so great is the demand for this kind of protection that investors are willing to give up all hope of a current yield in order to own them.” (emphasis mine)

All this goes to show how global investors have indiscriminately dumped most assets and gravitated or shifted towards safehaven issues in search of a protective shelter from the prospects of both defaults or deflation and inflation.

Nevertheless, based on the Mark King’s Credit cycle, the US and other heavily levered developed economies appears to be in phase 4 as the credit losses deepens, while the Philippines does not share the same fundamentals.

On the contrary we seem to be situated in between the Phase 1: Long credit, Short equity and the Phase 2: Long credit, Long equity of the King credit cycle as evidenced by repairing of balance sheets, greatly reduced leverages, exploding foreign exchange reserves, declining fiscal deficits, falling yield spreads, rising cash flows…all of which seem to suggest that fundamentally we do not share the same flaws as the external influences affecting us. Thus, instead of fear and denial, today’s credit crisis ought to be seen in the light of opportunities which may be lurching at the corner. After all, it is all a matter of perception.

In a speech in Indianapolis, April 12, 1959, former President John F. Kennedy (1917 - 1963) conveys of the best lesson one can learn from a crisis, ``The Chinese use two brush strokes to write the word 'crisis.' One brush stroke stands for danger; the other for opportunity. In a crisis, be aware of the danger - but recognize the opportunity.”

Voyaging The Unexplored World With Incomplete And Outdated Signposts

``I think there’s also a very real possibility that a lot of trouble could lie ahead. And at least my view, since we’re in uncharted waters, and I don’t think there’s a way to make a probabilistic judgment about where you are in that spectrum, I think we need to take these risks very seriously and I think that we should – from a policy perspective – take whatever measures we can find that we think are sensible to try to reduce that risk.”-former Treasury Secretary Robert Rubin quoted on WSJ blog

Next, we also find the recurring talks of the nominal measures of bear markets or of how the Philippine markets will react as the US enters into a recession. The idea is that US recessions or bear markets assume some quantifiable depth or duration dimensions that allows for the extent of the market stress to be identified. Such is premised on the assumption that historical performances are likely to repeat itself with near exactitude. The fallacy of this “appeal to the tradition” is where certain analyst projects the traditional-seen via lens of the “averages” or “median” of past activities-as the potential outcome for our market.

Figure 2: Declining Duration of Recessions

As shown in Figure 2, courtesy of, over the past 100 years US recessions have been in a decline in terms of duration (days) or have become shorter. To quote Bespoke, ``For example, three of the first four recessions during the 20th Century lasted longer than 600 days. During the last four recessions, however, only one has been longer than 250 days (the longest was 487).” Some say that the average recession lasted by about 11 months while a severe recession extends up to 16 months (

While indeed the general trend has been down, you’d notice that there have been instances where the length of the economic contraction overshoots the declining trend (1929, 1973 and 1981). Thus, such trend does not signify today’s performance as a foolproof indicator that if the US will enter or is undergoing a recession today, the duration will be short, shallow or will be in within the “average” or “median” context.

Another, selecting reference points as indicator for the duration could be a point of contention. Biased analysts can or will use certain reference points to prove their case.

Figure 3: The Bear Market Cycle of the Phisix, Nikkei and the Nasdaq

Figure 3 shows of the different recession instigated bear market cycles.

For instance, the Phisix (top most chart) in the aftermath of the 1997 Asian crisis fell by about 66% from peak to trough in a span of 19 months. The blue arrows point to the interim or short term bottoms which biased analyst could utilize to prove their fallacious case of short bear cycles.

Since no trend goes in a straight line we saw the Phisix rebound sharply coincident with the assumption of a new President in 1998. Eventually the rebound tapered off and the Phisix resumed its long term bear market until 2002.

A similar case can be drawn from Nikkei’s first leg down (middle chart). After 62% loss in 31 months, Japan’s Nikkei appeared to have consolidated and bottomed out. However, the grizzlies shred up the bulls which eventually compounded the losses to about 80% (from the peak) in 13 years!

The dotcom bust is the same story (lowest chart). The full bear cycle of the Nasdaq saw its index fall by 75% in 30 months or over two years, where as shown above there had been four minor bear cycles juxtaposed with 3 countercyclical bullmarket within the secular bear market cycle.

Figure 4 Northern Trust: The Business Cycle and the S & P 500

Figure 4 shows of the interplay of the Business cycle with that of the S & P 500, courtesy of Northern Trust.

While one can compute for averages or medians, data shows that they hardly fall within the exact spots. To add, bear markets cannot simply be “boxed” or sterilized into “averages” or “median” simply because the driving factors from which the imbalances accrue and unravel were unique.

Further, the assumption of the averages or median does not even consider the underlying conditions that engendered the best and the worst case scenarios which eventually gets built into the equation of “averages” or “medians”.

Such is the reason why many investors including those armed with sophisticated math models get burned simply because they give weight to experience of the recent past (rear view mirror syndrome) or interpret data to fit their biases (confirmation bias).

Little have made use of the characteristics of a “Taleb distribution”, named after the Nicolas Taleb, author of the Fooled by Randomness and the Black Swan where as defined by Martin Wolf of the Financial Times, ``At its simplest, a Taleb distribution has a high probability of a modest gain and a low probability of huge losses in any period.” Giving undue emphasis to high probability events with modest gains, while ignoring risks of huge losses from a statistical deviation is a recipe for heavy portfolio losses.

Moreover, do any of today’s economic conditions or financial markets manifests of the so called averages or medians (see Figure 5)?

Figure 5: Average? What Average? Where?

Not quite the average. Gleaned from the financial markets perspective, prices quoted or as reflected in its trends today do not reflect “typical” periods; the US dollar is on a milestone low (olive green line), 10 year US treasuries yields are knocking at a fresh multi-year lows, Energy prices (red line) are on the roof while precious metals (blue line) have just recently etched record highs even after the recent selloff.

So none of these appears to show significant correlation as with its contemporary past performance.

Figure 6: Danske Bank: BRIC versus OECD/ Exploding forex reserves

Even from the economic perspective, the outperformance of emerging markets relative to economic growth and reserves are other aspects of incomparable developments.

Figure 6 from Danske Bank shows the Leading Indicators of BRIC outperforming the OECD countries, and so with the exploding foreign exchange reserves of developing countries relative to industrial countries from

Furthermore, consider the risks arising from Derivatives, notes Martin Weiss of (emphasis mine),

``At U.S. commercial banks alone, the total notional value of the derivatives is $172.2 trillion, according to the latest report by the U.S. Comptroller of the Currency (OCC). Plus, the OCC reports that:

``In over 90% of these derivatives, there is no established exchange that helps protect either party from default.

``Just FIVE major U.S. banks control 97% of all the bank-held derivatives in the United States, a concentration of power — and risk — unsurpassed in the history of finance.

``All five of these major players would likely be severely crippled, or even bankrupted, by the default of just a few major counterparties like Bear Stearns.

``Four have more credit exposure to counterparty defaults than they have capital.

``Two have over four times more credit exposure than capital.

Needless to say, derivative exposure by the US financial system to derivatives is unequaled in history. Yet, the loss estimates on the financial sector from the evolving mortgage-securities-derivatives crisis seems to be mounting: from $100 billion by Fed Chair Bernanke last July, $500 billion from Goldman Sachs now $1 to $2 trillion from Nouriel Roubini of New York University’s Stern School of Business!

Moreover, as the world’s biggest banks have absorbed $US195 billion in writedowns and losses on securities tied to subprime mortgages, Credit Suisse Group calculates that the 10 biggest US banks have the lowest capital levels in at least 17 years (!

All of these go to show how today’s circumstances have simply been unprecedented. So how does the unparalleled or extraordinary circumstances equate to “averages” or “median” as sold by analysts is beyond me.

As a caveat, this doesn’t imply that we are bearish but instead recognize the risks involved under the current circumstances are totally different from any period of time to make valid comparisons.

Dr. Marc Faber discusses the discerning insights of market sage Peter L. Bernstein, author of the magnificent book Against the Gods, the Remarkable Story of Risk (a must read for market practitioners).…

This lengthy but fitting quote from Dr. Faber…

``Peter L. Bernstein, the wise 88-year-young economist and strategist (author of five books in the last 15 years and of the excellent, but demanding, Economics & Portfolio Strategy report), explains in a piece entitled “Uncharted Territories” that “the current scene bears no resemblance to a typical economic peak or to the conditions usually preceding a slowdown in business activity. Those kinds of conditions feature excesses in the business sector, but the business sector at the present time has a relatively clean bill of health... There are no signs of the usual boom in capital spending that leads to a cyclical top and leaves an overhang of capacity. Growth of industrial capacity over the past five years has been a meager 0.8% a year. This piddling rate of expansion is a sharp contrast to the 4.2% annual growth rate in capacity during the 1990s or to the 2.7% rate from 1949 to 1969.”

``Peter further points out that there has not been an unusually strong accumulation of inventories; that there has been an absence of sharply rising interest rates, which in the past preceded recessions; and that there has been an absence of “strains in the resources of the system, such as high levels of capacity utilization and low unemployment”. (Peter Bernstein has developed a “Strain Indicator”, which indicated the problems we had in the 1970s, the over-optimism prior to the 1987 crash, and a clear peak prior to the end of the high-tech boom in 1999. However, this indicator “has been declining since mid 2006 and stands nowhere near where it has been at earlier business cycle highs”.)

``But Peter Bernstein isn’t optimistic about the economy. In asking himself the questions “what is going to happen next?” and “what is the outlook?”, he explains: “[T]hese questions are never easy, but they are more difficult than usual this time around. The experience is not only inexplicable. It provides no antecedents to guide us.”

``In referring to some of the unique features in the current scene – mentioned briefly above – Peter opines:

`` [W]e are unable to choose which among them is most important, but we believe the key problem is not in the financial sector. Rather the basic difficulty is the impact of these financial shenanigans on households. The deflation in home prices is not only unsettling to homeowners; it has in effect removed a crucial part of the consumer’s piggy bank. Home equity is no longer a source to finance consumer spending. This development is unsettling in its own right, but it is only a reminder to homeowners that their major asset is in deep trouble and is not likely to improve any time in the foreseeable future. If we are correct in placing primary emphasis on the problem faced by households, the economic malaise will not be brief, even though its depth is uncertain. The process is going to be like water torture – drip by drip over an extended period of time until all these excesses are squeezed out of the system and new and happier horizons can open up.”

``The author Dave Wilbur has said: “One of the world’s greatest problems is the impossibility of any person searching for the truth on any subject when they believe they already have it.

``Similarly, Peter Bernstein concludes his report with the observation that “there is a lesson here so obvious we hesitate to set it forth. History shows even the most knowledgeable people forget this lesson over and over again. We do not know what the future holds. Once we begin to make major and unhedged decisions on the assumption we do know what the future holds, we will have passed the inflection point on the road to disaster.” During the Battle of Britain, in the Second World War, a saying went the rounds of the Royal Air Force: “There are old pilots and there are bold pilots, but there are no old, bold pilots.” Therefore, as we move into 2008, I would rather err on the side of caution in terms of taking large onesided and leveraged positions in any asset market, individual stock, or sector. As Peter Bernstein has argued, we are indeed in uncharted waters and economic and financial history provides us with only an incomplete and outdated set of signposts to go by.”

Figure 7: Northern Trust: Largest Fed Cuts (in percent) since 1982!

Even monetary policies applied to the present circumstances by the US Federal Reserve has been relatively unorthodox, unconventional or most aggressive by historical measures (the use of depression era laws to rescue Bear Sterns, aside from the emergency lending policy bypass used by the Fed to accommodate lending for securities firms at a similar rate to commercial banks underscores the severity of present conditions).

This form Asha Bangalore of Northern Trust (highlight mine)…

``The Fed’s record in the August 2007 – March 2008 period will probably go down in history as the most aggressive and creative. The TAF, TSLF, and PDCF programs are its creative endeavors aimed at reducing the credit crunch and liquidity problems, while the sharp reduction in the federal funds rate is the aggressive feature of monetary policy changes in recent months. The FOMC has reduced the funds rate 300 bps between September 18, 2007 and March 2008. In nearly 26 years, such an eye popping drop in the federal funds rate in a seven-month period occurred only between August 1984 and March 1985 during Chairman Paul Volcker’s term.

``In terms of a percent change, the latest 300 bps cut in the federal funds rate is the largest (57.1% drop) since September 1982. The only period when it was close to the recent drop was a 55.5% decline in the seven months ended November 2001.”

In sum, all of these should extrapolate to a cautious, conservative and defensive stance as well as its accompanying actions aside from adopting open mindedness and flexibility than get suckered by our biases.

Remember, voyaging in unexplored territories means that we have little clue of what to expect and of the risks we are faced with. But learning from Warren Buffett simply means we cannot afford to freeze and should face up with the circumstances, ``On fears of a crash or meltdown or bad things happening in the market…Something bad will happen, but you could go back at anytime in the last 100 years and say the same can freeze yourself out indefinitely.’ Every investor must play the hand he is dealt.”

The debt crisis abroad is actually a process where non productive or speculative debt or Ponzi debt structure (Minsky model) is being destroyed. Eventually this “destructive process” will reach a culmination point where economic activity may be able sustain the level of debt in the economy, thus the storm will pass, as the contagion “forced selling” effect would have peaked-as with any normal cyclical transitions. It is not the end of the world as we know it, but part of a necessary market cleansing process. It does take time though.

We are not a stranger to this (go back to figure 3); the Phisix confronted the same phenomenon during the Asian Crisis of 1997 and agonized for 6 years. Japan’s Nikkei had a horrid 13 year of painful adjustments from such unsustainable debt levels. The Nasdaq crash took over 2 years to recover and was also a consequence of outsized leverage but restricted to the corporate sector.

All we can say with a little more definitiveness is that the continuing financial crisis will demand more actions from the authorities to the point of undertaking massive subsidies from which the latter would comply. The Financial Times says that major Central Banks are now discussing ways to absorb mortgage losses using taxpayers money to fund the losses!

The problem with this route is one of the unintended or unforeseen effects of more interventions (moral hazard, probable path to hyperinflation or global depression, extreme currency debasement, bubbles in new assets and others) from which may extend or defer the day of reckoning of the present imbalances from taking its natural path of adjustments or which may exacerbate the systemic risks to even more vastly unsustainable levels.

Yes, while cyclical divergences allow us to be more confident of the future relative to the fundamental standpoint of domestic or regional economy or markets, it would be best to heed the prudent advice of Mr. Peter Bernstein and Dr. Marc Faber who posits that we should avoid the road to disaster by eluding the presumption of knowing with absolute certainty what the future holds, based on incomplete and outdated sign post that go by.

To our understanding the domestic market is undergoing a normal countercyclical interim bear market phase as it is digesting both the pressures from the credit instigated losses abroad and the necessary adjustments from the valuations standpoint predicated from an economic downshift. But considering the cyclical aspects of the domestic economy and the local financial markets we are likely to be operating from a secular bullmarket until proven otherwise, although risks from the unexplored global conditions should dictate for more prudent actions.

Last, we should be aware of the incentives of the proponents of the both extreme scenarios, since many of them thrive on business models which require the fulfillment of their wishes or advocacies rather than the representation of objective analysis.