Sunday, April 27, 2008

Phisix: Pummeled On Foreign Downgrades, Still In Search Of A Bottom

``The collapse of the southwest real estate bubble in the United States didn't prevent investors from over-investing in Asia. The Asian crisis didn't prevent the Nasdaq bubble from developing. [I was] surprised by how rapidly the crisis mentality vanished. People can forget the lessons of a painful experience very quickly, and that can lead to poor decisions." Robert Rubin (Sep 2004)

Oops. Just as we thought we found the first clues of a bottom, the Phisix got whacked by almost 4.7% over the week on ferocious foreign selling.

This could probably be due to the downgrades slapped by some foreign institutions to emerging markets economies rocked by the present rice crisis such as the widely followed BCA Research whom recently wrote (highlight mine)…

``higher inflation and upward pressure on interest rates, rising social tensions could force policymakers to forgo proven market mechanisms, creating distortions that have long-lasting and harmful economic implications. In turn, this can lead to higher risk premiums on asset markets. The negative shock and risk of pass-through from skyrocketing food prices will be greater in the economies with a rigid supply side and low competition. Moreover, countries where the currency has been sliding will feel the effect of rising global food prices much more acutely. Bottom line: We are positive on emerging equity markets as a whole, but are concerned about the outlook for South Africa, Argentina, Indonesia, and the Philippines because of the lack of supply side reforms over the past several years and escalating threats from food inflation.”

Coincidentally, countries negatively rerated by the BCA Research likewise suffered from a severe thrashing this week as shown in Figure 1.

Figure 1: Possible Impact from Downgrades

And the losses were quite severe: for the week, Argentina’s Merval plunged 3.89% (mid pane), Indonesia’s JKSE plummeted 4.63% (pane below center window-Dow Jones Indonesia Stock), and least affected, South Africa FTSE/JSE Top 40 dropped 1.59% (bottom pane-South Africa iShares).

This is not to pin the responsibility on a single research entity for having to recommend an “underweight”, (although they indeed command a good following among international financial institutions), the point is, the continued hysteria over the rice crisis has been generating a bad image at a time when the sentiment for risk aversion is high enough to severely affect domestic asset prices as we see today.

Yet, with government continually throwing in more subsidies at the expense of the country’s fiscal conditions (more short term placebos for long term damage-our children pays for increased tax burdens), we can’t entirely fault them for such dire outlook; this seems more of a self-inflicted predicament. Yes, we simply love to shoot ourselves in the foot.

Rice Crisis: Distinguishing Noise From Facts, Transmission of Price Signals As A Cause

As we said last week, while yes, there is indeed a global food crisis; the “rice crisis” in the Philippines seems more noise than reality.

First we don’t see snaking queues for commercial rice. Those lines in TV and elsewhere in media are with subsidized NFA rice.

Second, evidence exhibits that it is largely a policy induced crisis. Subsidies have been providing incentives for arbitrage opportunities through price spreads from which some people have responded to, thus aggravating the demand supply imbalances.

Next, you have a central bank promoting more inflationary policies by keeping interest rates at present levels while consumer prices have been surging. This deepens the incentive to “hoard” tangible goods as the purchasing power or the “store of value” of the Peso diminishes.

Moreover, we have argued that price signals have not filtered to farmers enough for them to increase income or investments, as their output have long been constricted by traders and merchants and by price controls from the government purchases. An article from the supports this premise,

From Philippine Senator Edgardo Angara, ``By the time the NFA comes in, the traders have already scooped up the entire harvest. They cannot even buy 10 percent. If you buy less than 10 percent, you're not going to influence the price movement.”

More again from the Inquirer (emphasis mine)…

``Maintaining stable prices all year round within reach of the poor and yet at the same time providing farmers with reasonable profit had been an NFA conundrum. NFA has suffered significant losses through the years as prices had been volatile and incomes of farmers have been low.

How does one maintain stable prices and reasonable profit for farmers when the market is controlled by select interest groups and by the government? The problem is essentially one of effective transmission of price signals to the farmers arising from misdirected government intervention.

When rice prices are capped and manipulated by certain interests groups aside from the lack of alternative markets (commodity spot and futures) which restricts output, financing access, hedging options and insurance coverage the result is the above “conundrum”; imbalances whose pressures have been building eventually reaches a culmination point-today’s crisis.

You don’t solve the problem of price signals with more price distorting interventions. Not even with absurd populist solutions as the so-called “genuine land reform” with poor international track record or more “distribution” centers which do nothing but increase taxpayer’s burden and resource allocation inefficiencies.

Again to quote Senator Angara (emphasis mine), ``If we let go of the NFA and give it full rein subsidizing and importing rice, then we will have a bottomless pit that will be hard to fill because it will consume so much of our taxpayers' money."

If a full subsidy to the NFA, whose institution has been reckoned as ineffectual and a source of corruption, consumes much of our taxpayers’ money, in the words of the good senator (at least we are delighted to see a politician display a good deal of common sense!), what do you think goes with land reform or more government distribution centers? You only throw the public’s money to address the symptoms and not the cause. Moreover, an unthought-of reactionary response tend to have unexpected consequences at the expense of the general public via direct or indirect taxation (higher prices) or other future crisis! In addition, you don’t get increased productivity by edict (Stalin and Mao tried it and failed miserably); it is done via the transmission effects of prices through profits.

Third, the fact that 1 million hectares of fallow agricultural properties had been reportedly leased to China is circumstantial proof that there are large scales of “unproductive” and “uncultivated” lands which simply needs to activate in order to contribute to the supply factors.

Market directed or government instituted, these idle lands will come into play as the global commodity cycle will induce more investments in response to supply demand asymmetries as reflected by market prices.

Notwithstanding, technological advances will certainly usher in the next wave of Green Revolution, an era marked by surging agricultural yields (1940-1960s) powered by product innovation.

We are not only blessed with vast amounts of agricultural lands, we are also fortunate enough to have the world’s major rice institute the International Rice Research Institute (Irri) headquartered in the Philippines. Reports say that the IRRI are in the final stages of introducing a new biotech hybrid variety (Aerobic and Submarine) which have the potentials to increase harvest yields by reducing sensitivity to drought, flooding or salinity.

Of course, there is always opposition to anything, this time the issue centers on compelling our farmers through taxpayer funds to adapt to this hybrid. If the new product has the potentials as advertised, it won’t need government’s money to get accepted and become a standard.

The point is that higher prices are forcing new investments into the industry as well as in the technology frontier which eventually translates to more supplies.

That’s why we’ve been bullish with agriculture all along. Have we not been right with this cycle?

Rice Crisis and Political Survival

Of course another dimension or ingredient to this problem is one of politics; the need by the incumbent to be seen by the public as doing something or what I call the Superman effect. People are wired to see images of heroes in action, thus the natural predisposition towards publicity stunts.

With a politically embattled administration coming off from a slew of scandals, such crisis provides the opportunities for diversionary PR stratagem, which perhaps is part of the theatrical plot, at the expense of our financial markets. What more attraction than to throw the public’s money to the “poor”! As a neighbor quipped, for “Pogi” points.

Everybody bleeds for the poor, the problem is more solutions via inflationary policies and price distorting laws or policies addressed to the “poor” increases the numbers and plight of the “poor”. People can’t seem to differentiate the trade off between today and tomorrow.

And this also why much of the world is turning into “socialism” via inflationary policies which will certainly keep the tabs of rising consumer prices until eventually either prices will be so burdensome enough to choke off demand where any government stimulus won’t work (“pushing on a string”) or provoke wars or prop more dictatorial regimes (furthers inflation) or that people would come to the realization of governments’ pretensions via the collapse of the present money standard or until a new “Paul Volker” appears.

Phisix: Still In Search For A Bottom

Nevertheless, with respect to the Phisix as we noted last week, while sentiment has produced some signs of a potential bottom, we further commented that this has to be backed or confirmed with positive technical action coupled with DURABILITY from external factors. This week’s action proved otherwise.

The intense selling produced a divergence with most international stock market benchmarks effectively decoupling from us as we turned lower.

Meanwhile, technical actions dramatically deteriorated as the Phisix fell to its major support level (again see Figure 1) where it is presently perched with the likelihood of a potential breakdown test given the intensity of the latest shakeout.

There are two likely scenarios here, one is that a successful breakdown means that a Phisix floor has yet to be established which means there could be more downside market actions.

The other is that the Phisix bounces from the present levels or from its 2,773 lows which could carve out a bullish double bottom pattern. Yet even if a double bottom does emerge it could take probably take sometime before the Phisix recovers meaningfully and exit from its declining phase reinforced by improving market action, sentiment, fundamentals and decreased sensitivity to external variables (or improvements abroad).

To be sure, we are still in a bear market until clearer signs of the bottoming phase sets in. Here is what we wrote, during the latest bounce last March in Missing Rallies or Catching A Falling Knife?

``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.”

So again have we been wrong with the cycle?

Stock Market Investing and Financial Sorcery

``We are all faced with a series of great opportunities brilliantly disguised as impossible situations."- Charles R. Swindoll, American Writer and Clergyman

To some the notion of the role of analysts or money managers is a job similar to the practice of sorcery, where we try to divine the future with tarot cards, mystical spells and arcane rituals or to its financial equivalent-with Greek ‘secret’ formulas or complex math algorithmic models or that what we say or write about should happen instantaneously or that our role is to know entirely the causalities of the marketplace, or identify market tops and bottoms, all of which should be translated to “alphas” or outperformances in our stock selection. In short, the expectations of supernatural power of clairvoyance applied to stock selection.

For me, this signifies the problem of a risk reward outlook based on cognitive biases of anchoring and the availability bias, where anchoring or focalism is a cognitive bias which describes the common human tendency to rely too heavily, or "anchor," on one trait or piece of information when making decisions ( A basic example is when one reads or gives too much weight into the recent markets activities (declines or losses) as an eternal trend, without considering the phases of market cycles. (If you think the Phisix will return to 1,000 then go ahead and sell.)

On the other hand, availability bias is a human cognitive bias that causes us to overestimate probabilities of events associated with memorable or vivid occurrences. Because memorable events are further magnified by coverage in the media, the bias is compounded on the society level (wisegeek). Example, when we read the cumulative negative gloomy headlines (from politics, rice crisis and rising prospects of a US recession) coupled with signs of declining markets then the probable tendency for impulse driven participants is to flee from the financial markets on the expectations of more bad news that would further drive down equity prices.

So a combination of “anchoring” into today’s market performances compounded by media generated fears or the “availability bias” may lead to an overestimation of risks while at the same time underestimating rewards.

Well if we apply this to the US; its markets have been plagued with a litany of dreadful news, events and developments-such as tightening lending standards, rising incidences of foreclosures and bankruptcies, falling housing prices, increasing costs of financing, retrenching consumers, diminishing trend in corporate earnings, repeated bout of seizures in the credit markets, soaring commodity prices, accelerating consumer prices-yet its major benchmarks have still been trading sideways instead of a “collapse” so far.

This has been defying the predictions of well oiled articulate arguments of bearish analysts. (Yes, admittedly my risk bias is tilted on such outlook, thus the aura of cautious investing).

But can the bears be right? Of course, but risk management depends on how one allocates his portfolio and the risk instrument used under the prevailing market cycle.

The Difference of the Analysis of Market Cycles From Stock Selection

We had been lucky enough to have predicted the rise of the Phisix in 2002, the renascence of the Philippine Mining industry in 2003, the Peso’s reversal in 2004, the US housing bust in 2006, the rise of soft commodity prices or Agriculture commodities to even the Phisix bear market in early August (see Phisix: Undergoing A Cyclical Bear Market Within A Secular Bull Market Cycle?). Therefore much of the major cycles were firmly under our grasp.

Of course I had some blips too. For instance, I even got teased for “panicking” out of the market at the first sign of a meltdown in July when the market sharply recovered into October. Obviously from the privilege of the hindsight, October proved to be a classic Bull trap which basically validated our July-August view. Unfortunately “pressures” to participate in rallies compelled some risks positions, which have now been adversely affected by the recent declines. The good news is that some segment of cash which had been raised during the initial selling was kept as insurance against adversity and now serves as buffers for opportunities.

Yet as you can see, reading market cycles is starkly distinct from stock selection.

Remember stock market investing is a complex task. The financial marketplace is basically a collective psychology of thousands of participants whose decisions are weighed by diverse variables…in the stock market-from mere emotions, tips from friends or brokers to syndicated moves by stock market operators to calculated engagements by institutions. Thus, the attempt to read the minds of these participants is the equivalent practice of financial sorcery.

If a stock/s does not reflect the performances of any representative benchmark such does not imply that it is always blessed or condemned to either outperform/underperform forever. Remember, reading past performances into the future is never a guaranteed outcome. While history may have some guidance, they may occasionally diverge.

In addition, while the performances of stock markets here or elsewhere are driven by its own cycle, this is not a simple task because stock market cycles are underpinned further by the intricate interplay of a host of other cycles (psychological, economic, business, credit etc…).

That is why I pay heed to Mr. Edwin Lefèvre’s a.k.a. Jesse Livermore quote as my stockmarket meme (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 go up...I speak in a general sense. But the average man doesn’t wish to be told that it is a bull or bear market. What he desires is to be told specifically which particular stock to buy or sell. He wants to get something for nothing. He does not wish to work. He does not even wish to have to think. It is too much bother to have to count the money that he picks up from the ground.”

Mr. Livermore implies that performances of individual stocks depend on the whereabouts of the general stock market cycle. How true this is? Today, under this interim bear market cycle, we can name only a handful of stocks still trading at the near peak (of not less than 20% decline). So his assertions are more valid in general than otherwise.

Moreover, individual stocks are likely to perform under their own distinct functionalities given the above premise- it could be driven by mere emotions, corporate developments or fundamentals, insider activities, technical or by a consortium of stock operators or by anything else.

In other words, attempts to identify all these short term variables consistently are beyond my or anybody’s ken. It is nearly an impossible task.

All we know is that especially applied to the Philippines, whose market is way underdeveloped, when the stock market is bullish people conjure up all sorts of (mostly invalid) reasons to participate in rising stocks regardless of risks. This applies inversely to falling markets. Thus, expectations to predict which stock issue would move next, or would serve as the next “favorite”, or attempting to time markets for tops and bottoms is a futile exercise equivalent to financial sorcery.

Again from the legendary trader Jesse Livermore ``It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight. Men who can both be right and sit tight are uncommon. The market does not beat them. They beat themselves, because though they have brains they cannot sit tight."

Bottom Line: We are NOT in the practice of financial sorcery. We cannot identify the next crowd favorites. We invest out of risk reward tradeoff concerns, where present declines appear NOT to entail a reversal of the long term trend but instead reflects on the interim countercyclical trend amidst a secular bullish trend until proven wrong. Nonetheless, we are NOT impervious to mistakes or losses as risk taking is NOT about perfection or the ability to predict winners consistently but one of reducing risk and optimizing gains. We must remember that since markets operate on cycles, no trend goes in a straight line. Impatience guarantees underperformance.

Finally, the major force of ANY asset boom-bust cycles is rampant speculation driven by excessive monetary inflation and massive credit expansion. There are not enough indications of such excesses permeating into the domestic stock market or to the domestic economy. Not yet anyway. Moreover, such stimulus have not driven the stock market levels to euphoric stages or equally have not yet posed as systemic risks to the economy. Therefore, the present decline is unlikely a long term trend reversal.

Given the present environment of fear, as our favorite icon, Warren Buffett once said ``Great investment opportunities come around when excellent companies are surrounded by unusual circumstances that cause the stock to be misappraised."

Negative Real Rates Fuels Boom Bust Cycles And Enhances Inflation Dynamics

``Inflation is like sin; every government denounces it and every government practices it."- Frederick Leith-Ross (1887-1968) civil servant and international authority in Finance

Asset boom bust cycles under the paper money standard have principally been driven by monetary or credit inflation which are further stoked by unbridled speculation or investor irrationality.

This from George Soros, ``Boom-bust processes usually revolve around credit and always involve a bias or misconception. This is usually a failure to recognise a reflexive, circular connection between the willingness to lend and the value of the collateral. Ease of credit generates demand that pushes up the value of property, which in turn increases the amount of credit available.”

In short credit is the lifeblood for boom bust cycles. In a boom phase, ease of credit and increasing collateral values engenders a self reinforcing cycle buttressed by an expanded risk appetite. The opposite holds true in a bust phase, tighter credit and falling collateral values is by itself a self feeding mechanism backstopped by a shift to risk aversion.

Today, we have been witnessing the full boom bust cycle playout in the US real estate and mortgage markets. That is why the US government has been lowering its Fed controlled short term interest rates, it has also been widening the range of institutions requiring direct funding access from the Fed, and loosening up of the standards for collateral eligibility as basis for such funding, aside from changing policies needed to accommodate such facility. The aim is restore the ease of credit, restore risk taking confidence and provide a floor to declining collateral values.

In other words, the US has been utilizing expansionary monetary policies, aside from fiscal policies to reduce the negative impact of a bust phase.

And this boom bust cycle has not been isolated to select asset classes as inflationary policies likewise have been affecting consumer prices around the world. Why? Because, while governments can control its printing presses, it cannot control where the money printed goes.

As Dr. Frank Shostak explains, ``increases in money supply lead to a redistribution of real wealth from later recipients, or nonrecipients of money to the earlier recipients. Obviously this shift in real wealth alters individuals' demands for goods and services and in turn alters the relative prices of goods and services. Changes in money supply set in motion new dynamics that give rise to changes in demands for goods and to changes in their relative prices.

``Now, the effect of changes in the demand and supply of money and the demand and supply of goods on prices of goods is intertwined and there is no way that one can somehow isolate these effects.”

In other words, when monetary factors are constant, a price increase in a particular good means a shift in relative prices and not absolute prices. For instance, given a typical household budget; if the price of food increases, then the additional income spent on food would cause a diversion away from spending on non-food goods or services. This should translate to a downward pressure on the prices of non-food goods or services.

But obviously since the price of almost every basic goods and services are on the rise this goes to show how the absorption of the inflation dynamics have shifted from financial assets to consumer goods on a global scale.

Figure 2 shows of the real interest rates in the US have spawned the largest boom bust cycle in the US.

Figure 2: Negative Real Rates in 2003-2006 and 2007 til present

We have spilled so much ink with negative interest rate. Negative interest rate is when changes to consumer price indices or consumer price inflation are growing faster than nominal rates.

To quote Mike Larson of, ``When real rates are negative, it's a sign that policy is easy. That can drive inflation pressures and inflation expectations higher. When real rates are positive, it means that monetary policy is restrictive. That, in turn, tends to keep a lid on inflation.”

As we previously wrote, negative real rates deal with the function of money as a store of value or the opportunity cost of holding cash. Negative real rates basically is a policy for dissavings (punishes savers as the purchasing power of a currency erodes via higher consumer prices) and encourages the public to go into debt and venture into speculative activities to preserve the store of value. It gives false signals to the marketplace, and encourages malinvestments. Thus negative real rates feeds on inflation driven asset boom bust cycles.

Figure 2 shows that in 2003 to 2006 real interest rates were kept in negative territory for about 3 years. Today, real interest rates have further plunged into a deeper negative territory since the credit crisis erupted in 2007.

Figure 3 Northern Trust: Housing and Credit Boom Fueled by Negative Real Rates

Chief Economist Paul Kasriel of Northern Trust gave a great presentation on how negative real rates have turbocharged the US housing and mortgage bubbles.

The select charts shows of the (left chart) Market value of real estate as % to after tax disposable income (circle shows of the accelerated trend of home prices during negative real rates).

This leverage build up was equally evident on US houses which had been used as an ATM substitute via a net home equity extraction (circle shows the dramatic expansion of credit during said period).

Figure 4: Northern Trust: US Current Account Deficit Exploded While Bank’s Mortgage Business Boomed

Figure 4 again courtesy of Northern Trust shows how US banks capitalized on the Mortgage boom by dramatically expanding the share of mortgage assets to total earnings (right chart) again during the same period.

Current account deficits reflected the pace of US household borrowing. Again the left chart of figure 4 demonstrates how the pace of deficits expanded rapidly as US households borrowing boomed, again under negative real rates.

The lesson that can be drawn from this is that as inflation pressures seems apparently building up around the world (China and GCC continue to amass current account surpluses) especially with the present deep negative real rates in the US.

Negative real rates are likely to fuel either a bubble in some asset classes (most likely in commodities or commodity related assets) or could be passed off or transmitted through higher consumer prices.

The Philippines is likewise under a negative real rate climate, hence, the rice crisis could be a possible manifestation of this phenomenon backed by skewed policies.

Further, as we have been saying all along, I wouldn’t exactly shut the door for a potential recovery in the Phisix, especially on commodity related issues. While it may take time, increased speculation utilizing liquid assets backed with potential stories (yes remember markets operates on biases which for stories!) should be good candidates for today’s alternative store of value.

Thursday, April 24, 2008 Economics 101: The Price of Gas

Occasionally we come across analysis or missives dealing with high gas prices to tangential issues.

However, this terrific 591 words article by Mr. Sterling T. Terrell published at the is a concise and incisive encapsulation of the dynamics of today's gas prices.

Quoting Mr. Terrell's entire article (highlight mine)

Gas prices are up and oil executives are once again testifying before Congress. Clearly, many politicians, pundits, and consumers lament the rising cost of gas. Before we join them in their chorus, let us take a step back and ask this question: Are gas prices really all that high?

A change in price can be a result of inflation, taxes, changes in supply and demand, or any combination of the three.

First, we need to take into account inflation. The result of the Federal Reserve printing too much money is a loss of purchasing power of the dollar: something that cost $1.00 in 1950 would cost about $8.78 today. As for gas prices, in 1950 the price of gas was approximately 30 cents per gallon. Adjusted for inflation, a gallon of gas today should cost right at $2.64, assuming taxes are the same.

But taxes have not stayed the same. The tax per gallon of gas in 1950 was roughly 1.5% of the price. Today, federal, state, and local taxes account for approximately 20% of gas's posted price. Taking inflation and the increase in taxes into account (assuming no change in supply or demand) the same gallon of gas that cost 30 cents in 1950 should today cost about $3.13.

Neither have supply or demand remained constant. The world economy is growing. China and India are obvious examples. At the same time, Americans continue to love driving SUVs and trucks. As for supply, we are prohibited (whatever the reasons may be) from using many of the known oil reserves in our own country. Furthermore, due to government regulation, the last oil refinery built in the United States was completed in 1976. In addition, the Middle East is politically unstable which leads to a risk premium on the world's major source of oil. It is obvious that the demand for oil has grown while supplies have been restricted.

The average price of gas in the United States today is approximately $3.25. The question is, why are gas prices not higher than they are?

Blaming greedy oil companies on the rising price of gas is simply irresponsible. The profit margins of a few selected industries are as follows:

Murray Rothbard considered this the best text available on price theory.

The water utility industry has higher profit margins than major oil and gas firms! Why isn't every CEO with profit margins above that of the oil companies made to testify before Congress for "price gouging"? Clearly, greedy corporate profits are not the issue.

Again, while just over nine percent of the price of a gallon of gas goes to oil company profits, approximately twenty percent of the price of a gallon of gas is composed of federal, state, and local taxes.

Those who want the government to step in and do something about the high price of gas are either forgetful of recent history or too young to remember the oil crisis of 1979. During that time, restrictions on the price of gasoline led to the inability of some to find gas at all. Price ceilings always lead to shortages. The only thing worse than having to pay "too much" for gas is not being able to find gas at any price.

Let us not be swayed by politicians out for power or by reporters out to create news where none exists. Facts and economic logic should prevail rather than rhetoric.

End quote

Economist: Business Environment Index

The global business environment ranking chart as constructed by the Economist magazine based on: macroeconomic stability, infrastructure, flexible labor market, quality of the workforce and policy conduciveness for businesses.

The chart is a mix picture which includes the best places to do business to important economies and their respective ratings.

This from the Economist,

``DENMARK is the best place to conduct business over the next five years, according to the Economist Intelligence Unit's six-monthly business-environment index. Out of 82 countries Denmark scores highest in most of the ten measures used, such as macroeconomic stability, infrastructure and policy towards private enterprise. Its flexible labour market and highly educated workforce are particularly attractive to businesses. America slips four places to its lowest position since the index began in 1997 as economic and financial conditions look set to deteriorate and trade protectionism to increase. Venezuela tumbles 12 places to languish just below another socialist bastion, Cuba. Only Angola is a worse place to do business.”

Overall, the chart exhibits the degree of openness to markets and its antipode…socialism.

Monday, April 21, 2008

Has The Phisix Entered An Initial Bottoming Out Phase?

``Asset managers without long-term lock-ups (or with impatient clientele) are surely more likely to be asset gatherers—appealing to the poorer judgment of their clients who want instant returns and low volatility. Those asset managers are no different than politicians—winning votes with popular short-term promises at the expense of long-term consequences. Politicians figure the next guy will be left holding the bag and have to deal with the mess. Short-term money managers, figure their clients will.” –Josh Wolfe, Forbes Nanotech, Timeless Space & the Mismeasure of Risk

It’s been quite a while since we’ve dealt with the stock market.

Nonetheless, as seen from my little social world, it seems that the present market activities have shifted the emotional reactions by market participants from one of inquisitiveness (in search for explanations) to one of deafening silence. In just over six months amidst a stinging 25% loss from the market’s peak, enthusiasm in the marketplace has remarkably suffered from a scathful drubbing. Viewed from the market’s psychological cycle, could this account for a transition from the denial stage to submission phase so soon?

The marketplace is a dynamic environment fluidly responding to permanently changing conditions. That’s what makes it so challenging. Yet, most participants seem to believe that this endeavor assumes like a game of dice throws; with limited variables at play that renders a quantified outcome. Instead, for us, the prospects of the risk return outcomes in the financial markets could be assessed from mostly a combination of market action (sentiment, cycles and technical indicators), and importantly fundamentals.

Sentiment Measures: Accumulation By Long Investors A Positive Signal

In my previous article Phisix: “Fear Is A Foe Of The Faddist, But The Friend Of The Fundamentalist”, we elaborated on several market internal measures to gauge investor sentiment where in particular we dealt with the Daily trades, which for me, serves as the best measure for speculative activities. See figure 1.Figure 1 PSE Daily Trades: From Speculators to Long Buyers

Daily trades incorporate the daily transactions of ALL market participants, i.e. from scalpers to punters to traders to investors be it from local or foreign participants.

Here we noted that since the Phisix segued into the advance phase in 2003 and more than doubled in price value (1,000 to 2,200), daily trades has mostly drifted from somewhere between 2,500 to 5,000- where we assumed the average as somewhere around 3,000 to 4,000 a day but interspersed with intermittent anomalies.

In short, the growth in the Phisix during the 2003-2006 cycle could be construed as coming from limited punts and mostly from fundamental accumulation and thus has not been indicative of a bubble in progression.

This is important to understand because secular inflection points or major cyclical long term trend reversals almost entirely emanate from “bursting bubbles” in the world of central bank money, where asset classes are inflated by monetary policy induced credit or leverage driven speculative excesses which eventually either collapse under its own weight or from policies meant to curtail its pernicious repercussions to the real or main economy.

It was only during the last quarter of 2005 where daily trades consistently trended higher, which incidentally coincided with the firming of the Peso, from which we surmised the strength of the Peso as having possibly drawn in more participation from the locals and consequently the increased episode of speculation.

Yet as the US mortgage and credit bubble imploded and spread globally and into the Philippine Stock Exchange, the subsequent loss has, as expectedly, reduced interests of market participants (mostly punters) who were caught with losing positions or have found stock market investing as an unworthy alternative or importantly where present losses have stricken fear into the hearts of the investing public with its recent volatility and with the social bearing consequences from the recency bias-meaning the impact of the herding/bandwagon effect (“with everybody losing, why should I dabble with stocks?”).

This is what I wrote then, ``This leads us to deduce that once the 3,000 level per day is met, the Phisix could mark a BOTTOMING OUT since fundamental based buyers are likely to dominate the Phisix investing space!”

Put differently, the present figures as shown in the daily trades chart reveal that the chapter of speculative froth has closed with the exogenous triggered meltdown.

Figure 2: PSE: Diminishing Peso Volume on Reduced Volatility

But this also means that the “reversion to the mean” by the daily trades suggests that in the CONTEXT OF SENTIMENT the Phisix could now be in the INITIAL PROCESS of carving out A BOTTOM.

Coupled with the STILL ELEVATED NUMBER of daily issues traded (another measure of sentiment), a meaningful decline in the Peso volume of cumulative daily transactions to the 2006 levels (see red line in figure 2) on inchoate signs of declining volatility in the face of the unblemished Phisix’s long term trend, the diminished activities of punters could be read altogether with the other developments in a positive light. So in the dimension of the market action in the PSE, we could be actually seeing signs of the Phisix “bottoming out”.

As a REMINDER, when we say potential bottoming, it either means an extended process of base building or consolidation or a slow recovery (usually a U shaped chart) because it takes awhile or more time to reestablish the confidence lost from the recent traumatic encounters.

Moreover, we shouldn’t expect a similar pace of outperformance as the previous years (not yet for the meantime anyway) or a V-shaped recovery since the risk environment abroad still manifests some indications of persistent credit tensions. Besides, any V-shaped recovery could mark another Bull Trap as discussed in “Missing Rallies or Catching A Falling Knife?”.

The important point to understand in a bottoming out process is that the downside risks are seen subsiding compared to its upside potentials, or that the odds of further market weakness seems to be declining compared to the odds of future gains, although it may take sometime to accomplish the latter. In other words, on an investment standpoint, gradual accumulation is likely to be a better option today than selling.

Further Confirmation Required

Figure 3: Global Benchmarks are Recovering

Could the Phisix go lower from here? Absolutely. But most likely it will attempt to find a base using the recent lows (2,772) as a yardstick. To go beyond it means all our bets are off.

This also implies that the Phisix needs to be further buttressed by MORE TECHNICAL ACTION to underpin such cyclical transitions, matched by DURABILITY from possible renewed pressures from EXTERNAL INFLUENCES or AN EXTERNALLY LED RECOVERY see figure 3, which is most likely the case today.

Utilizing global benchmarks, signs of “decoupling” has still not been palpable, but surprise surprise…global markets appear to be recovering even in the face of an onslaught of bad news…persistent credit crisis, more signs of US economic slowdown, declining corporate earnings in developed countries, surging consumer prices worldwide, soaring oil, food and other commodities.

Major benchmarks as the US S & P 500 (center window), the Dow Jones World Index (top most pane), emerging markets (window below center) and Asia Dow Jones ex-Japan (bottom pane) have made substantial recoveries.

Emerging markets appear to be leading the recovery front with a possible breakout attempt over the coming sessions on the back of record breaking commodity prices… yes, Crude Oil at an astounding US $117 a barrel!

We see very strong performances from key emerging bourses as Brazil and Mexico (both attempting to breakout to record highs),South Africa (at record highs) and Russia (likewise nearing record highs).

On the other hand, China’s previous sizzling performance (jumped sixfold in over 2 years) has suddenly blown cold deflating by 41% year to date and by 49% from its October pinnacle, it is my guess that China’s performance could probably mimic Saudi’s Tadawul Index which also exploded sixfold during the bubble years of 2004-2006 and eventually gave back 65% of its gains. Today the Taduwul index has been in consolidation since late 2007 and up by over 35% from the recent troughs.

Figure 4 perf charts: Phisix Underperforms!

Yet, the Phisix continues to lag major bourses as shown in figure 4 courtesy of which shows the performances of the major benchmarks along with the Philippine benchmark since the global markets broke down in October of 2007.

Emerging markets have recovered most of their losses and is down by only about 5% compared to Dow Jones world index -10%, Dow Jones Asia Pacific ex-Japan -14% and the S & P 500 -11% while the Phisix is down 19.5% hardly distant from its recent lows.

This lagging performance could be traced to the uncertainties surrounding the potential impact of the recent rice crisis to risks of social upheaval and to the risks of the deterioration of the country’s fiscal position, which I think is (one) overstated, (two) a temporary phenomenon and lastly a self-inflicted predicament as the local authorities have themselves been responsible for painting this “crisis” impression turbocharged by a sensationalist media (diversionary political ploy perhaps?).

Deeper Negative Real Rates As Potential Impetus

Finally, I read an article where the IMF recommended to Philippine monetary authorities to further cut rates amidst the present environment in the expectations that inflation pressures will taper and the US dollar will recover which should temper oil and commodity prices.

Figure 5: US Global Investors: US Money and Global Money To The Sky!

I think the IMF projection is too optimistic. One, contrary to my expectations of a stronger dollar early this year, the US dollar index has remained soft. Two, the global credit and US economic woes are likely to linger with more forthcoming “socialization” programs. This implies further pressure on the US dollar. In short, a US dollar recovery in the second half is unclear. Third, a revival of US economic growth in the second semester is also uncertain. Fourth, the pumping of money by global governments (see figure 5 by US global investors) has less been able to bridge the capital vacuum required to rebuild confidence in the US financial system. Instead, the money intermediated into the global financial system are being channeled or “finding a home” into commodities and basic goods, thus higher consumer prices or as tagged by media “inflation”.

At present rate, consumer prices are rising faster than what is expected by authorities, thus at the prevailing clip, rising consumer prices could eclipse present borrowing and lending pegs, aside from the coupon rates across the yield curve by our sovereign debt papers. Plainly put, the purchasing power of the Peso continues to erode as the prices of consumer goods soar.

And when the public doubts the viability of the purchasing power of the currency, it loses its function of “store of value” which means the public may actively “hoard” goods, financial assets as stocks or tangible assets as real estate as a substitute “store of value”.

If our authorities will comply with the IMF or maintain the present interest rate fixings, then it is promoting a negative real rate environment. Such environment essentially penalizes savers and encourages speculation and hoarding. The irony here is that government sets the policy, but “arrests” people who would simply be responding to the incentives set forth by the designated regulatory climate.

On the other hand, if authorities increase rates, given the continuing plight of the US dollar, they may attract speculative capital from overseas given the window of interest rate arbitrage which may lead to increased pressures for domestic money growth and again higher “inflation”. Damned if you, damned if you don’t.

Maybe stock markets abroad have been recovering not because of improving fundamentals but rather from the second wave of tsunami of excess money flooding the global monetary system. As Fritz Machlup wrote, "... continual rise of stock prices cannot be explained by improved conditions of production or by increased voluntary savings, but only by an inflationary credit supply."

Rice Crisis: Adverse Side Effect From Hefty Political Subsidies

``Inflation is like sin; every government denounces it and every government practices it." - Frederick Leith-Ross 1887 -1968 civil servant and authority on international finance

We have cited the negative impacts of the ongoing rice crisis in How Surging World Rice And Food Prices Could Impact the Philippines and Rice Crisis: The Superman Effect And Modern Agriculture to the heightening the risks of social instability, more intrusive government policies which may hamper market mechanisms that may have a lasting side effect and harm the economy over the long run aside from impairing the balance sheets of the national government. In addition, we attributed the inefficiencies and imbalances of the industry to the lack of market signals aside from the webs of laws that has severely distorted the marketplace.

Combined, these added risks may impose a hefty risk premium to our asset class, where the hurdle rate of investments returns must significantly be greater relative to the given risk environment. And with today’s risk averse environment, high risk premiums represents an unattractive proposition for investors.

Yet, in vigil to the unfolding crisis, what we have observed was that anecdotally speaking, the problem of rice shortages is one concerning government “subsidized” National Food Authority (NFA) rice more than a general or nationwide rice shortage.

We don’t see people lining up for commercial rice because commercial rice partially reflects market prices. Whereas subsidized rice is entirely and artificially sold cheap to the “poor”, at a loss to the account of the government and charged to future taxpayer’s money in order to buy political stability. As an aside, we don’t see “riots” in the street yet (as reported by some news accounts) although we do see snaking queues for NFA rice.

The problem is that government subsidies have been compounding on the dysfunctional government controlled market for rice. The greater the price difference between commercial rice and subsidized rice, the greater the tendency to have a “crisis”, as some people have used such opportunity to “arbitrage” for profit -buy subsidized NFA rice, repackage and resell them at commercial rates, thus leading to more speculative pressure.

The following news reports depicts of the harsh realities from perverted government policies,

``The governor also directed the mayors to assess economic conditions in their areas, investigate the reported adulteration of rice through the mixing of cheaper NFA rice with commercial supply, and to submit periodic reports and recommendations to his office.” (

``Justice Secretary Raul Gonzalez personally caught at least one dealer mixing National Food Authority (NFA) and commercial rice in his home province of Iloilo over the weekend.” (

As we have written earlier, government policies create the incentives from which the people respond to, yet they get arrested from skewed regulations.

Yes, there is indeed a global rice problem. But the problem in the domestic setting is a basically an adverse side effect from hefty political subsidies.

Price Signals Work In Some Areas

Just consider; record food prices have started to impact investments decisions elsewhere in the world.

For instance, Russia plans to be a major exporter of grains within 5 years banking on the unused 20 to 25 million hectares of land for such purposes. (

Amazingly, even in Afghanistan the food crisis have borne a rare positive unintended effect, swapping heroin for wheat, this excerpt from Telegraph’s Con Coughlin (highlight mine),

``In parts of Helmand Afghan farmers are this year sowing wheat instead of poppy - not because they have suddenly been converted to the argument that producing heroin is not in the national interest.

``Market forces have been the deciding factor - with wheat prices doubling in the past year, and the street price of heroin falling, it is now more cost effective to grow wheat.”

In the US, farmers have started to opt out of the cropland conservation program which HAD KEPT THEM FROM CULTIVATION to cash in on the booming agriculture industry pls. refer to figure 6. See how government policies even in the US have contributed to the underinvestment-overinvestment cycle?

In the past, depressed food prices benefited consumers, yet the program was designed aimed at sustaining US farmers by effectively curbing supply through subsidies. Farmers were paid for not producing on their cropland!

Figure 6 New York Times: As Prices Rise, Farmers Spurn Conservation

Now that agricultural prices are skyrocketing, half of those enlisted in the conservation program have dropped out.

This from New York Times’ David Streitfeld

``Born nearly 25 years ago in an era of abundance, the Conservation Reserve Program is having a rough transition to the age of scarcity. Its 35 million acres — about 8 percent of the cropland in the country — are the big prize in this brawl…

``Such problems were never contemplated when the Conservation Reserve was conceived as part of the 1985 Farm Bill. Participants bid to put their land in the program during special sign-ups, with the government selecting the acres most at risk environmentally. Average annual payments are $51 an acre. Contracts run for at least a decade and are nearly impossible to break — not that anyone wanted to until recently…

``The program peaked late last summer, with more than 400,000 farmers receiving nearly $1.8 billion for idling 36.8 million acres. Put all that land together and it would be bigger than the state of New York.”

Price Signals Don’t Work On Some

As you can see, market prices have impacted investment decisions in some parts of the world, but others have not responded to the price stimulus because agricultural inputs (as fertilizers, seeds and fuel) have likewise risen and have posed as a deterrent to increasing production.

This excerpt from MSN’s analyst Jim Jubak (underscore mine),

``There, higher costs for fuel, seed and fertilizer have led farmers to cut back on planted acreage. The promise of higher prices for crops harvested in the future doesn't work if you can't afford the materials you have to pay for now, especially when credit comes at ruinous interest rates -- if it's available at all. Farmers in these areas also don't have access to the commodities futures market, so they can't lock in today's higher prices for future grain delivery.

``That means paying today's high costs is too big a gamble for poorer farmers, who can't afford to bet that grain prices will be as high tomorrow as they are today. All this has led to situations like this one: In Pakistan, farmers will produce a smaller wheat crop this year because they've cut their use of fertilizers after a 50% price increase in the past year.”

As we have previously argued, the lack of commodity markets have prevented farmers in developing countries as the Philippines from capitalizing on today’s higher prices to fund their inputs or for capital investments, thus access to capital.

Whereas the complete dependence on the traditional networks (traders or merchants) for the sales of their products and limited access to funding has been a major obstacle to the farmers to increase output since they are subjected to market inefficiencies emanating from a wall of laws, distortive subsidies and are in bondage to special interest groups for their markets.

Technically speaking the market price signals have not filtered to these economic agents enough for them to allocate capital and resources efficiently.

Copious But Fallow Agricultural Lands

Yet, the irony is that the Philippines has been blessed with a sizeable area for agriculture, this according to the Philippine Department of Agriculture,

``The Total area devoted to agricultural crops is 13 million hectares. This is distributed among food grains, food crops and non-food crops. Food grains occupied 31% (4.01 million hectares), food crops utilized 52% (8.33 million hectares) while 17% (2.2 million hectares) were used for non-food crops.

``For food grains, the average area utilized by corn was 3.34 million while rice occupied 3.31 million hectares.

``Of the total area under food crops, coconut accounted for the biggest average harvest area of 4.25 million hectares. Sugarcane with 673 thousand hectares; Industrial crops with 591 thousand hectares; 148 thousand hectares for fruits; 270 thousand hectares for vegetables and rootcrops; 404 thousand hectares for pasture and 133 hectares for cutflower.

``According to land capability, 78.31% of the alienable and disposable land are prime agricultural areas, 6.1 million hectares are highly suitable for cultivation.

Statistics are a mirage. The assumption presented here is that these all these lands are in production, but somewhere somehow this doesn’t account for the complete picture as Philippine agriculture land is punctuated with idle lands following years of underinvestment.

In fact, last year, the Philippine government arranged to lease over ONE MILLION hectares or close to 10% of the country’s agricultural property to the China’s Jilin Fuhua Agricultural Science and Technology Development Co., Ltd. (Fuhua Co.) because of idle, uncultivated or undeveloped properties!

This from Gemma Bagayaua of GMA Newsbreak, ``Would you rather let a million hectares of agricultural land remain undeveloped due to lack of capital or lease them to a foreign company?

``This, according to a ranking official of the Department of Agriculture (DA), is the government’s main consideration when it decided to lease to China’s Jilin Fuhua Agricultural Science and Technology Development Co., Ltd. (Fuhua Co.) some one million hectares of Philippine land under vague terms. The area covers about a tenth of all Philippine agricultural land.

``The DA says that the memorandum of understanding (MOU) with the Chinese company is just an additional strategy to meet the department’s goal under the Medium Term Philippine Development Plan (MTPDP), which is to develop two million hectares of agricultural land…

``Fuhua Co. intends to plant hybrid rice, corn, and sorghum in these lands. The contract is expected to bring in about US$3.87 billion in investments.

As you can see low productivity from the lack of capital investments brought upon by market contorting policies are essentially responsible for this recent crisis.

Bottom line: the government’s predicament can be resolved by inducing more investments to the industry by eliminating these supply rigidity barriers through dramatic reforms by eliminating or reducing subsidies, by opening the industry to competition and the development of a commodity spot and futures market for increased capital access and for pricing efficiency. Yes, there will be some social costs, some people will starve with temporary high prices. But private socio-civic groups can work with government to provide for charitable donation instead of placing the burden squarely on the government.

The rice cropping cycle is a short one (3-6 months) from which fallow lands can easily be cultivated and contribute to the supply output and stabilize the present situation. Thus I think, this problem can be settled in the medium term.

Unfortunately, with the populist tendencies tilted towards more socialism, the next step by the leadership would probably be to force other croplands into rice production, thereby yes, providing short term solutions of having sufficient supplies but at the expense of the farmers (rice prices will go down and squeeze income) or for other crops which we will see prices go to the roof (think sugar, vegetables and others).

Philippine Peso and The US Dollar Burdened By Socialization

Finally, many argue that the Philippine Peso will fall as a consequence to the increased subsidies by the Philippine government. Our view is that they are only partially correct because in the analysis of the valuation of currencies requires studies on BOTH the circumstances underpinning the currencies to which are valued against. To illustrate, if the Philippine Peso is gauged against the US dollar (which is the traditional benchmark), then the factors in support of the probable value of the currencies, both the US and the Philippines, should be assessed. Remember, the currency market is a zero sum game where one wins, the other losses.

True enough, the present actions to subsidize the poor with cheap rice by the Philippine government may impair its fiscal conditions, BUT the US government is likewise undertaking a massive nationalization of its financial and banking system aside from the borrowers afflicted by the US housing bust. In other words, two countries whose currencies are valued against each other are both effectively debasing their currencies for political expediency.

One thing we can be sure with, the more government intervenes with our lives the more we are likely to see a diminished standard of living.