TARP's Neil Barofsky: Far More Dangerous Today Than A Year Ago

Huffington Post interviews TARP's Neil Barofsky.

From Huffington Post: ``Neil Barofsky is the man who tracks the historic bailout known as the Troubled Asset Relief Program or TARP. Named in December, the 39-year-old special inspector general monitors a dozen separate ...

The interview ends with Mr. Barofsky's chilling message on the US financial system: ``We may be in a far more dangerous place today than we were a year ago"

Sectoral Performance In US, China And The Philippines

``[Asia is] a very different dynamic compared with the rest of the world. Most banking systems in Asia are flush with liquidity as they have a surplus of deposits over lending. So if [corporates] have in the past financed in the international bond markets, when it comes to refinancing they can turn to the local market alternatives because plenty of banks are still willing to lend”- Jason Rogers, a credit analyst at Barclays Capital Asia-Pacific corporate bonds surge

In bubble cycles, the object of a speculative bubble, after a bust, normally takes years to recover.

To cite a few, the Philippine Phisix following the 1997 Asian Crisis episode hasn’t fully recovered even 12 years after, Japan’s Nikkei 225 and its property sector remains in doldrums following the bust in 1990 (that’s 19 years!), and the technology centered dot,com bust during the new millennium in the US has left the Nasdaq miles away from its peak, 9 years ago.

The recent bubble cycle phenomenon evolved around the US real estate sector which had been funded by the financial industry. In short, these two sectors-financials and real estate accounted for as the epicenter of the bubble cycle crisis. So given the nature of bubble cycles, I originally expected the same dynamics to unfold.

The fundamental reason for this is due to the market clearing process or the process of liquidating clusters of malinvestments acquired during the bubble.

And since bubble blowing or the “boom” phase is a process underpinned by policies that is cultured by the markets over time, the liquidation or the “bust” phase likewise employs the same time consuming process but in reverse.

But I guess this dynamic doesn’t seem to be the case today or put differently, this time looks different.

Why?

Because US money managers have largely been overweighting the financial sector, see Figure 5.

Figure 5: Bespoke Invest: Institutional Sector Weightings

According to Bespoke Invest, ``money managers collectively have 18.5% of their long portfolios in the Financial sector, which is the highest weighting for any sector. Technology ranks second at 16.8%, followed by Health Care (12.9%), Energy (12%), and Industrials (10.3%).

``The second chart compares these weightings with the sector weightings of the S&P 500. As shown, institutions are overweight the Financial sector the most and underweight Consumer Staples the most.”

Obviously, the enormous backstop provided for by the US government to the US financial sector has circumvented the natural process of liquidations from fully occurring.

Hence, the intriguing outperformance led by the money managers piling into a sector under the government “umbrella” to seek profits or “economic rent”.

Yet, despite such outperformance, government intrusion to the industry will likely result to more systemic distortions.

To quote Professor Mario Rizzo in a recent paper ``These are agents whose discretionary behavior, insulated from the normal discipline of profit and loss, can significantly affect the course of economic effects. Thus, discretionary behavior on the part of monetary authorities (the Fed), fiscal policy makers (Congress or the Executive), or even in some cases private monopolists, can increase uncertainty faced by most economic agents (“small players”). They will have to pay more attention to trying to guess the perhaps idiosyncratic behavior of the big players. Economic variables will become contaminated with big-player influence. It will become more difficult to extract knowledge of fundamentals from actual market prices.”

Again, pricing signals are becoming less efficient due to government intervention (more difficult to extract knowledge of fundamentals from actual market prices) and is likely to heighten systemic risks (can increase uncertainty faced by most economic agents) arising from the asymmetric behavior of the industry participants shaped by regulators (insulated from the normal discipline of profit and loss).

In combination with the toxic assets stacked in the bank balance sheets, I would remain a skeptic over US financials.

Interesting Parallels In China And The US, Possible Opportunities

It is interesting to see how some parallels can be gleaned from the institutional interest in US stocks and in China’s recent sectoral performance.

While Financials, Materials, Consumer Cyclicals, Energy and Industrial outperformed the S & P 500, in China, Energy, Materials, Financials, Technology and Industrials constituted the top 5 during the latest run on a year to date basis, see figure 6.

Figure 6: Bespoke Invest: China’s Sectoral Performance

In other words, except for Consumer Cyclicals in the US and Technology sector in China, there seems to be some common interests from respective domestic investors-energy, materials, financials and industrials.

In the Philippines, the top 3 sectors have been Mining and Oil, Industrial (energy) and holding companies, whereas financials and services (telecoms) have been laggards.

Except for the financials, basically we see the same pattern playing out.

More interesting insights from Bespoke Invest, ``Sector performance in China paints an interesting picture. In typical selloffs, sectors that lead the rally see the steepest declines, while laggards in the rally tend to outperform. In this selloff, however, this trend is much less evident. The chart below shows the average performance of Chinese stocks by sector during the rally and since the peak on 8/4. While Energy led the rally and has seen the sharpest decline, in other sectors the relationship has been much less evident. For example, Utilities and Telecom Services were in the bottom four in terms of performance during the rally, but during the decline they have also been among the weakest sectors with the second and third worst performance.” (emphasis added)

Given the degree of corrections, it appears that China’s financials are on the way to outperform but could still play second fiddle to Energy.

So while I would remain a skeptic over US financials, it’s a different story for China and for Asia.

Nonetheless if we follow Dennis Gartman’s 7^th rule of his 22 trading rules, ``Sell markets that show the greatest weakness, and buy those that show the greatest strength. Metaphorically, when bearish, throw your rocks into the wettest paper sack, for they break most readily. In bull markets, we need to ride upon the strongest winds... they shall carry us higher than shall lesser ones”, then this would imply that energy, materials and financials could be the best performing sectors over the coming years and could be the most conducive place to be in to achieve ALPHA.

That’s also because China has aggressively been bidding up global resource and energy stocks, for reasons we cited in China's Strategic Resource Accumulation Continues.

Finally, this brings up a possible “window of opportunity” arbitrage for the Philippine markets. Since the local financials have severely lagged the recent rally and IF the same US-China patterns would play out sometime in the future, then positioning on financials on market weakness looks likely a feasible trade.

In addition, the underperformance of the telecom sector which has patently diverged with technology issues has piqued my interest and could be a point of discussion for another day.

Risk Reward Tradeoffs And Not Plain Vanilla Averaging Down Is What Matters.

``If a speculator is correct half of the time, he is hitting a good average. Even being right 3 or 4 times out of 10 should yield a person a fortune if he has the sense to cut his losses quickly on the ventures where he is wrong.” -Bernard Baruch (1870-1965), Financer, Speculator Statesman and Presidential Adviser

A friend recently asked me if averaging down is the best way to approach the market, given today’s environment.

My response is- it depends.

In the investing sphere there is NO straightforward answer to glory, as much as there is NO Holy Grail or FOOLPROOF mathematical Greek “quant” formula or models to success.

For us, the success of such approach will depend on the market cycle, or it could also depend on the fundamental reasons behind the deterioration of the market or security or it could reflect on the discipline of the market practitioner.

Averaging Down = Playing with Falling Knives

Remember the basic rule is that PRICES ARE ALWAYS RELATIVE. Higher prices can become more expensive in as much as lower can prices can get cheaper.

The assumption that ALL prices that goes down will automatically always turn up is very dangerous. You may end up deeply hurting yourself by playing with falling knifes.

Table 1: Returns Required To Break Even

Table 1, as previously shown at our August 2007 article Why Cutting Losses Is Better Than Depending On Hope, depicts of the amount of losses and the corresponding gains required to offset or neutralize each losses.

The bottom line is that it takes MORE EFFORTS in the form of corresponding gains to offset every equivalent amount of loss initially generated. Imagine a 25% loss requires 33% gain to offset the original position as much as it would take a bigger 100% advance to cover up a former 50% loss. The bigger the loss, the greater the gains required to recover.

Therefore the assumption of “averaging down” means piling on more losses in the expectations that you can reduce your costs in the hope that the assets you’ve invested on would eventually recover. But what if it doesn’t? What if these assets continue to fall?

In essence, the basic problem with this assumption is that you don’t know WHEN the market/security stops falling. And if we keep adding to these losses, even if it does lower your averages, it exposes you to even more losses!

Figure 4: bigcharts.com: Averaging in Nasdaq’s Dotcom Bust Is Equivalent to Catching a Falling Knife

Market Cycles, Reference Points and Framing

Look at figure 4 courtesy of bigcharts.com. It is the chart from the US major technology weighted bellwether, the Nasdaq. If you had bought the Index in 1987 (leftmost red arrow) and held on it until today you’d still be up about 5 times even after the bust. But if you had “averaged down” consistently-periodically (say once every year on every market dips-assuming optimistically- but unrealistically- that you can catch every dips) you could have either given up some of these gains because of the sharp volatility swings during the latter half of the 90s until 2003.

But if you initiated buying anywhere near the peak of the dot.com bust in 1999-2000 and averaged during the past years (assuming equal level of the amount of purchase-with periodical averaging), you are still likely to be underwater (negative) even after eight LONG years!

And worst, if you bought into some of the favorite issues (and averaged “down” them!) during the heyday of the dotcom boom like Pets.com, Webvan, Exodus communication, Egghead.com, eToys or Furniture.com (cnn.com), you would have ended up with a big fat egg as these companies went kaput or bankrupt!

Remember, reference point always matters. Again if you initiated entry at the bottom of 2003 at the time when everybody was in disgust with technology issues then you are likely to be making some money today even if you periodically applied averaged “up” over the past few years. See the change in perspective? If I use the 1987 and 2003 as my reference point, you are most likely to be up, while if I utilize 1999-2000 perspective you are most likely down.

Don’t forget we are talking of nominal returns and not real (or inflation adjusted) returns. If we apply real returns on portfolio performance then your gains would be trimmed and your losses are likely to be accentuated (pls refer to table 1).

In essence, up or down (portfolio performance) depends on the date of entry, or prominently, on the whereabouts of the market cycle.

So we have to be wary of the nature of the “framing” presented to us by financial experts. From the hindsight everything is fait accompli, but what matters is not the past but the returns from taking on risk from the future. We can only learn from the past and apply its lessons in the future.

In addition, we can easily be captivated by the returns offered without understanding the risks behind such dynamics, this signifies as a basic caveat.

Risk Analysis Is A Fundamental Concern

In the same context, earlier this year, somebody suggested buying into US Financials as they believed that the string of sharp losses translated into feasible buying opportunities. We dissented, see Has Inflationary Policies of Global Central Banks Boosted World Equity Markets?

For us the US financials represents an epitome of a market trend that is in a structural decline.

Why? Because it will simply take years for US financials to normalize by writing off losses or by attaining full recapitalization following the gargantuan yet-to-be-revealed losses on their balance sheets, which is estimated to now reach $1.6 trillion by Bridgewater Associates (New York Times), after accrued recognized losses accounted for only about $400 billion or about 25% of estimates. Such losses may even adjust to the upside as the extent of damages becomes more visible.

In addition, financials will remain under tight pressure as it is in the process of “deleveraging” in the face of a “perfect storm”- tightening credit standards, falling economic growth, declining corporate profits, higher default rates, potential spread of asset portfolio losses (prime and Alt-A loan portfolios, commercial real estate, corporate and junk bonds) and high energy or consumer goods inflation.

Now add to the burden of the financials is the surfacing of the issue where a supposed implementation of a new regulation (FAS 140) that would lead to a prospective technical insolvency stirred a panic over “Government Sponsored Enterprises” or GSEs in Fannie Mae (FNA) and Freddie Mac (FRE), which paid for record yields on the sale of 2 year notes, saw a remarkable plunge in their stock prices see figure 5 and the attendant volatility in the US markets led by the financials.

Figure 5: stock charts.com: Trouble at the GSEs

Figure 5 courtesy of stockcharts.com, shows Fannie Mae and Freddie Mac (F&F) having been caught in a panic frenzy while S&P 500 Financials Sector Index (lowest pane) and S&P Bank Index (pane below main window) have altogether been in a sharp retreat since May.

For starters, Fannie Mae and Freddie Mac are privately owned companies but receive support from the Federal Government. Because of this privilege they also assume of some public responsibilities.

F&F are accounted for as among the largest corporations in the world. They function to provide for a secondary market in home mortgages by purchasing mortgages from the lenders who originate them. They also hold some of these mortgages while others are securitized and sold to other investors in the form of securities stamped with the GSE guarantee (Jack Guttentag-mtgprofessor.com).

Figure 6: NYT: GSE’s Reach of Problems

The recent GSE’s problem is a systemic issue.

According to RGE spotlights (Hat tip: Craig McCarty) ``F&F own or guarantee some $4.5 trillion or 45% of all outstanding mortgages in U.S. Much of the $1.6 trillion agency debt is held by foreign central banks, i.e. sharp reduction in 2004-2006 of agency debt due to accounting restatements contributed to 'bond yield conundrum' as foreign central banks had to resort to existing Treasuries in order to compensate for agency debt shortfall.” (highlight mine)

Aside, (see figure 6) these companies provide the capital that banks use to write new loans. If F$F stop buying loans, banks may stop making new loans, freezing the US housing market (NYT). In addition virtually every Wall Street bank and many overseas financial institution, central banks and investors do business with F&F (NYT).

Another, F&F acts as major counterparties in the interest rate swap market which hedges on prepayment risks and maturity mismatches on the balance sheets (RGE spotlights-Hat tip: Craig McCarty). The role of GSEs has heightened the concentration risks for these markets.

As you can see the GSEs are heavily imbedded into the world financials institutions such that in the event of a failure or default they are likely to generate total cataclysm in the world markets, which is not likely to be the case since regulators will likely intervene.

But the other side of the coin is that taxpayers will likely pay a heavy price over these rescue efforts, notes the astute David Kotok of Cumberland Advisors, ``The government backing of F&F is “implied” and not explicit. A Congressional guarantee would change that. Studies of the cost of this Congressional failure suggest that the annual cost of this uncertainty created by the Congress is in the multi-hundred billions.”

And this is the probable reason why the US dollar index got slammed (down 1.07%) and gold soared by nearly 3%. And this too is the principal reason why we can’t be fundamentally bullish on the US dollar (yet), because even while global governments will act to “superficially” contain consumer goods inflation by increasing policy inflation (government spending-subsidies or doleouts or via tariffs) the extent of damage in the US financial system is so huge that would translate to constant intervention from authorities (which means more inflation).

This brings us back to WHY “averaging down” isn’t always a good option, take it from David Kotok (highlight ours), ``Common shares of F&F are another matter. We value them at near zero. In the Bear Stearns event we saw affirmation that the federal government had no sympathy for equity investors even as it preserved the rights of debt holders and counterparties. We believe the same is true for F&F. The stock market thinks so, too. That is why the equity value of F&F has been decimated. We have avoided F&F shares and have been selective in the use of broad ETFs where they are part of a large assemblage of stocks.”

If a stock is going to zero, what good is it then to average down?

In terms of fundamental risk analysis, owning the aforementioned shares simply because it is going down or for averaging purposes is a recipe for the total annihilation of one’s capital. It can also signify a “value trap” or prices have gone substantially below fundamentals as to draw in value investors into believing they are buying value but then experiences further dramatic decline in value.

In this case, averaging down becomes the terrifying equivalent of catching a falling knife.

If we are insistent to use “averaging” on a bear market as a strategy then extensive risk analysis on the company or the industry’s risk reward potentials should be utilized. Otherwise we must remember the 2 general rules of bear market investing: one bear markets tend to get oversold and remain oversold and two, bear markets decline on a ladder of hope where support levels exist to repeatedly get breached until hope vanishes.

Averaging Down Is A Market Discipline

Finally, averaging down is an approach that should reflect the investor’s market discipline. A risk strategy utilizing this methodology means consistency in its application throughout the market cycles. It means rigorously knowing your risk appetite and the constant assessment of fundamental variables.

We cannot be a fundamentalist when the market is down and transform into momentum traders when the market goes up, for this only heightens your risks engagements- as you put more risk capital as markets go down-while limiting your profit potentials when the market goes up. Thus the risk reward tradeoff is tilted to the side of risks. Besides, only brokers get rich with such market attitude.

As world’s most successful stock market investor Warren Buffett once said, ``Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it."

Phisix: Domestic Participants Panic! Bottom Ahoy?!

``Time is what matters most. Just as time is the friend of the great business and the enemy of the not-so great business, so to time, like volatility, makes friends with the long-term investor and antagonizes the short-term one.” –Josh Wolfe Timeless Space & the Mismeasure of Risk

Post Holy week of 2008, we noted of an article by a high profile domestic analyst in a business broadsheet satirically provoking local stock market participants to “panic” so as to “end” the anguish of the present bear market.

The article appeared to be a “reverse psychology”, as we wrote in In A Crisis, Be Aware Of The Danger But Recognize The Opportunity, ``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."

Instead we suggested that prudent investors ought to understand the global credit-equity cycle, which appears to be of more impact to our equity market more than simply reading too much of sentiment as a potential indicator of the direction of our market.

Let us see why…

Figure 1: stockcharts.com: World Equity Markets Have Basically Tracked US Financials

Figure 1 courtesy of stockcharts.com depicts of the Dow Jones World Index (main window), whose peak seems to resemble the local Phisix (not shown), has been winding down since the US General Financial Services (lowest pane) has broken down in July of 2007. In short, global equity markets have been heavily correlated with the performance of US financial stocks and apparently have signified as a drag.

However, in contrast to the Dow Jones World index, which remains above its recent low, the local benchmark the Phisix has severely underperformed by successively carving out new lows despite this week’s technical rally.

Will Global Financial Markets Survive High Oil Prices?

In addition, we hear many of today’s pains pinned on oil prices. However, such causality seems specious. The same chart shows oil prices (pane below main window-$WTIC) and global equities have not been strongly associated. On the contrary, the recent rally of oil prices coincided with the rebound of global equity markets.

When oil prices pinnacled at nearly $140, global equity markets were already rolling over concomitantly alongside with the US financials. Thus, the pain from high oil prices is clearly a subordinate source of concern relative to the headwinds from the US financials.

On a positive note, $135 oil today also translates to strong demand from emerging countries, which is a peculiarity or an unprecedented characteristic given today's environment see Figure 2.

Figure 2: British Petroleum: World Oil Consumption: Signs of Decoupling?

British Petroleum notes that ``world consumption rose by about 1 million barrels in 2007, just below the 10 year average. OECD consumption declined nearly 400,000 barrels per day. China accounted fro the largest increment to consumption even though growth rate was below average. Consumption in oil exporting regions was robust.” (BP)

Essentially with oil at $135, the outperformance of emerging markets relative to advanced economies in terms of oil consumption could also be seen as another sign of "decoupling".

Yes, China surprisingly raised energy prices this week-18% diesel, 16% gasoline (NYT) and electricity prices nearly 5%-which means easing of subsidies to alleviate the growing incidences of crippling shortages arising from losses of petrol refineries, whom have been curbing production, aside from the prospects of power failure (as the Olympic season nears), as power companies have become reluctant to operate oil fired power stations for the lack of revenues to cover oil costs. Anyway, despite such increases, refined crude oil prices are still about 30% BELOW world market prices!

Of course while we may expect price increases to somewhat dampen demand for energy usage (it is expected to hurt mostly countries that don’t use subsidies), this won’t be enough to curtail overall demand as evidenced by some countries who recently undertook measures to lift subsidies as Indonesia-recently hiked oil prices last May (Reuters), saw vehicle sales 24.4% year on year but 1.8% down from April (automotive world).

Besides, the market have learned how to adjust to the recent high oil price landscape by introducing fuel efficient yet affordable motor vehicles, as shown in Figure3.

Figure 3: Economist: Where low-cost car sales are set to grow

From the Economist, ``WITH one eye on emerging markets and another on fuel restrictions more carmakers are entering the low-cost car market. Renault, which already manufactures the €7,600 ($12,000) Logan, recently announced a venture with Nissan and an Indian carmaker, Bajaj Auto, to develop a car that will compete with Tata's Nano, which goes on sale in India in October for a tiny $2,400. Sales of basic and small low-cost cars are predicted to leap by nearly 4m cars a year to 17.7m by 2012, according to Roland Berger, a consultancy. Growth is set to be highest in the emerging economies of Asia and Eastern Europe, but sales in America, home of the big gas-guzzler, will also grow by an average of 8.7% a year.”

Figure 4: Economist: Falling US Light Truck Sales

So yes, while SUVs and Hummers (figure 4) are on the decline in the US, we don’t see the same with China which has a black market for Hummers and some growing variants-Beijing Auto’s Trojan and Dongfeng Auto’s HanMa (Financial Times).

The world has survived high oil prices. And is likely to get over high oil prices provided the world can adapt to the changes brought forth in time.

In fact, as seen in above, it is not high oil prices per se that has been contributing to the angst of the financial markets and the real economy, but the rate of change of oil prices, given that oil has doubled year on year. But then again the world markets seem to be finding ways and means to adjust to a given environment.

The point is that high oil prices reflect the reality of distortive government policies on one hand, and the seismic shift in the sphere of global economic progress on the other.

Short Credit-Short Equity In The Face of Global Monetary Inflation

Next, as we further commented, the pang of the recent bear market here and abroad looks likely one which tracks the cyclical credit-equity cycle. As we earlier quoted Citibank’s Mark King’s credit-equity cycle, it looks likely that we have segued into the fourth phase, where…

``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.”

Going back to figure 1 shows that LIBOR rates have remained high signifying continuing stress in the credit markets.

The London Interbank Offered Rate (wikipedia.org) is a daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the London wholesale money market (or interbank market). To quote David Kotok of Cumberland Advisors, ``LIBOR is perhaps the most important interest rate in the world, in US dollar terms. It’s the pricing reference for probably $150 trillion. Trillion with a T. That number includes lots of derivatives.”

While falling credit and falling equities seem to be the classic bear market which we envisage today, we are faced with an environment where rising goods and services inflation makes the classic defensive strategy (cash and bonds) as an unlikely viable option.

Why? Because the inflation phenomenon has been transformed into a global affair. To aptly quote Doug Noland, in his Credit Bubble Bulletin (emphasis mine),

``First, there is the massive flow of dollar liquidity inundating the world. Despite huge dollar devaluation, a major Credit crisis, and economic downturn, our system is on track for yet another year of $700bn plus Current Account Deficits (and this doesn’t include the massive speculative outflows to participate in the global inflation). Global economies, especially booming Asia, are awash in dollar liquidity to use to bid up the prices of oil and other strategic resources.

``Second, today’s massive dollar flows have increasingly gravitating to speculative endeavors (hedge funds, sovereign wealth funds, commodities speculation, etc.) – each year ballooning the “global pool of speculative finance” that by its very nature chases rising prices (“liquidity loves inflation”).

``Third, the confluence of the flood of global liquidity and unfettered domestic Credit systems has exerted its greatest stimulatory effect upon the highly populated countries of China, India, and Asia generally. This, then, has created a historic inflationary bias throughout the energy, food and commodities complexes.-Doug Noland Good Inflation?

Figure 5: Brad Setser: US Exports More Financial Assets

Proof? Figure 5 courtesy of the Brad Setser of the Council of Foreign Relations shows that the US exports TWICE more Financial Assets than its exports of goods and services.

To quote the meticulous Brad Setser, ``No one has argued that the main benefit of globalization is that it allows America’s bankers to sell US debt – and increasingly shares of American companies – to governments in the emerging world. But that is a fairly accurate description of current trade and financial flows.”

This is the epitome of the US dollar standard- the US sells promises to pay (sovereign debt or treasuries/agencies) in exchange for goods and services, aside from selling equity ownership in the US to foreigners (mostly emerging markets).

Thus, the ongoing wealth transfer and inflationary pass through from the US to world which has begun to boomerang back to the US.

Local Investors Gripped By Panic! Bottom Ahoy?

Well going back to the local analyst who called for the domestic participants to panic, the Philippine stock market appears to be accommodating his wishes.

Market internals suggests, despite the rally in the Phisix last week, of panic stricken activities led by local mostly retail investors.

Let us look at some of the evidences:

Figure 6: PSE: Net Foreign Trade

Figure 6 accounts for the year to date representation of net foreign trade. The chart shows that despite the most recent burst of foreign selling largely brought upon by the intense politicking amidst a drab global equity market sentiment, the intensity of foreign selling seems to have been thawing (red arrow) compared to the earlier bouts of liquidation.

In fact, for this week, foreign trade accounted for a marginal net buying of Php 152 million. But, this came amidst a negative net foreign trade breadth or the number of companies with positive foreign trade minus number of companies with negative foreign trade.

For the Phisix to bottom, foreign trade needs to revert to both a positive net Peso value and positive market breadth. We anticipate improvements on the said variables as the BSP raises interest rates in the face of high goods and services inflation, provided the politicking will abate.

However, market breadth persisted to decline despite the modest rally posted by the Phisix this week.

Figure 7: PSE data: Deteriorating Advance-Decline Spread

As can be seen in Figure 7, market breadth has turned deeply negative, but this has been smaller compared again to the earlier bouts of selling seen last January or March.

A bottoming phase would likely show lesser degree (smaller incidences of declining companies) and intensity (smaller number of declining companies during down days) of negative market breadth coupled with stability or improvement in the technical picture.

Figure 8: PSE: Collapsing Average Peso Trade Amidst Rising No. of Trades

And the kicker, as shown in Figure 8, is the surging number of trades (violet) amidst a materially diminishing Peso volume per trade (maroon).

During the earlier bouts of selling (since the second round of credit driven fears emerged in October 2007), the number of trades had been declining as the Phisix headed lower. This basically reflected a retreat of buyers.

However during the past two months we can see a reversal of this pattern, the Phisix persisted towards its downdraft but the number of trades amplified. This apparently reflects FEAR.

In addition, the latest episode of selling shows that the average Peso volume per trade has dramatically weakened. Again the lower volume plus heightened trading activity could possibly indicate fear among small accounts or retail investors!

Usually, the inflection point of any cycle is marked by a shift in ownership. In a bullmarket cycle, the strong hands give way to the weak hands who pushes the market to its maturity or until the pivotal turning point. On the other hand, we should expect the same but an antipodal ownership shift in a bearmarket, where weak hands are expected to give way to the strong hands.

So for our analyst whose wishes appear to have come in full circle, perhaps this could be indicative of the nearing culmination of the bearmarket.

Has Inflationary Policies of Global Central Banks Boosted World Equity Markets?

``Economic history is a never-ending series of episodes based on falsehoods and lies. The object is to recognize the trend whose premise is false, ride the trend, then step off before the premise is discredited.”- George Soros

Activities in the financial markets can never be explained in a straightforward narrative manner.

You’d probably wonder why despite gloomy economic news in the US and in other major developed economies aside from declining corporate profits, global stock markets continue to remain elevated or are surprisingly even advancing.

Moreover, as commodities recently tanked some observers commented that the reason stocks are recovering could be due to falling inflation pressures which could likely improve corporate margins. Such argument appears unfounded.

If it is true that commodities prices have been boosted by soaring demand, then the present pace of decline should imply of contracting demand, which could be reflective of a meaningful downshift in global economic growth, see figure 5.

Figure 5: US Global Investors: Moderating Asian Exports

Asian exports are, as shown by US Global Investors, all rolling over led by a severe decline in US imports. Now the decline has been similarly seen with European imports but in a time lag. Imports of commodity producers have likewise “peaked”.

Thus, by sheer induction, equity asset prices should continue to face pressures from downside revaluation, unless the markets foresee a recovery over the near term (which is very unlikely).

In addition, if it is also true that the falling US dollar have prompted for a commodities “bubble” as argued by some then the recent US dollar rebound suggests of liquidity contraction or a monetary tightening which should also signify negatively for equities too.

Yet, stock markets continue to perform strongly even when seasonality factors such as “Sell in May and Go Away” say it shouldn’t.

Drooling Over US Financials

Meanwhile others have been drooling over at the gains accrued by the US financials following the recent bear market “reversal” marked by the buyout by JP Morgan of investment bank Bear Sterns under the facilitation of the US Federal Reserves. The impression etched by the rallying US financials is that it has bottomed or is on a path towards recovery.

We doubt such premise. To quote Mohamed El-Erian of PIMCO,

``Persistent financial dislocations have now caused the real economy to become, in itself, a source of potential disruption. During the next few months there will be a reversal in the direction of causality: the unusual adverse contamination by the financial sector of the real economy is now morphing into the more common phenomenon of recessionary forces threatening to undermine the financial system.”

This means that even if the Fed have “successfully” patched some of the liquidity dislocations in the financial markets (as evidenced by some improvements or narrowing of credit spreads) by absorbing tainted assets as eligible collateral, recessionary pressures from the real economy could add to its portfolio (consumer) loan losses which are likely to require additional capital raising exercises given the delicately compressed capital ratios, as much it is likely to its impact business operations in an environment of slowing demand, tighter lending standards and reduced investments.

Nevertheless, the disruptions (unidentified losses) in asset securitization remain an unresolved problem aside from the onus of new government regulations.

Global Central Banks Inflating Away….

So, again why are the stock markets surging?

Quoting Fritz Machlup in The Stock Market, Credit and Capital Formation ``... 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.”

In contrast to mainstream analysis, our view on the stock market has always covered “inflationary” policies conducted by monetary authorities.

It is a reason why we believe stock markets don’t always relate to the oversimplified tale of micro/macro economics or corporate earnings and may diverge from “realities”. Because central banks can always excessively inflate the system, from which to serially “blow bubbles” in terms of assets or goods as the purchasing power of a currency erodes.

We always love to cite Zimbabwe as an example. The country has been suffering from successive years of chronic hyperinflationary depression whose inflation rate is 165,000%, has 80% unemployment rate and whose currency is traded at Zimbabwe $150 million per US dollar when officially pegged currency is at Zimbabwe $ 30,000 to a US dollar or 5,000x its official rates! You can just imagine the Philippine Peso pegged at 42 to a US dollar but whose black market rate is at P 210,000 to a US dollar.

Yet in spite of the depressed earnings (no earnings to talk about) and a recessionary economy, its stock market has soared by 360% in just three weeks! See the irreverence to mainstream analysis?

We seem to have the same dynamics today in global markets. What we could be witnessing is the impact of concerted REFLATIONARY policies by global central banks. And this has could have spurred the “rotation away” from commodities and into the general equity markets spearheaded by the financials (But this “rotation” isn’t likely to be a lasting trend).

This from Morgan Stanley’s Joachim Fels, ``global factors have become much more important in determining national inflation rates over the past decade or so. These factors are no longer disinflationary but have turned inflationary, making it much more difficult for central banks to stick to their inflation targets, which typically date back to a time when globalization, deregulation and strong productivity growth, along with two decades of restrictive monetary policies, were still weighing down on inflation. That was then. Today, emerging market economies − through their very expansionary monetary policy stances and their hunger for food and energy − have become a source of global inflation. Also, the productivity boom has ebbed and governments are looking at re-regulating certain sectors, such as the financial industry. Last but not least, the global monetary policy stance has been very expansionary for most of this decade. All of this suggests to us that many central banks will have great difficulties meeting their inflation norms over the next several years.”

So essentially, the Fed has been injecting steroids into the financial markets, as much as other major global central have provided liquidity support to a distressed financial system, while emerging markets have long undertaken expansionary policies that has nurtured explosive demand growth in food and energy. In addition the recent spikes of food prices have further aggravated such these inflationary measures of instituting safety nets to buy off political stability.

Figure 6 US Global Investors: Asian Real Rates are Negative!

So circumstantial evidence suggest that the recent bounce in global equity markets could have been in response to the expansionary monetary policies whose real interest rates has somewhat turned negative, as shown in figure 6 courtesy of US Global Investors which accounts for the average real rates in Asia. The region holds about 70% of foreign exchange reserves. Negative real rates are likely to support more leverage driven speculative activities.

Dissent Over Subsidies, Risks of Heightened Inflation and Moral Hazards

And the efforts to subsidize the financial system has not ended in the US as the US Federal Reserves continues to expand the scope of its outreach “nationalization” programs to cover unconventional areas as student loans, credit card debts and car loans as collateral for financial institutions.

Some experts/authorities have expressed dismay over the seeming relentless use of taxpayers money to support the financial sector…this quote from Bloomberg, ``It is appalling where we are right now,'' former St. Louis Fed President William Poole, who retired in March, said in an interview. The Fed has introduced ``a backstop for the entire financial system.''

Two more quotes from the same article,

``There is no way to put the genie back in the bottle,'' Minneapolis Fed President Gary Stern said in an interview with Fox Business Network on April 18. ``What worries me most about where we wind up is that we will have an expansion of the safety net without adequate incentives to contain it.''

``It is very hard in the middle of a crisis to know where to draw lines,'' said Harvard University professor Kenneth Rogoff, a former research director at the International Monetary Fund. ``They reduced the immediate risk of a crisis, but upped the ante of raising the possibility of a bigger crisis down the road.''

The point is that policy measures undertaken by the Bernanke leadership have clearly caused some vocal dissent over the risks of increased inflationary pressures.

Snippets

The snippet of my observations:

-Inflationary activities (marked by negative real rates) by global central banks could have been responsible for bloating global equity markets.

-The recent outperformance of the financials which took away the centerstage from commodities isn’t likely to be an incipient long term trend, as continued inflationary “nationalization” programs are unlikely drivers for such reversal. Moreover, recessionary pressures in the US economy are likely to limit any progress for US financials.

-The commodity cycle works best in a negative real rate environment. This could mean that the recent decline of commodities doesn’t account for a hissing bubble but possibly of a normal corrective phase following its near parabolic ascent.

-The expectation of a reversal of the US dollar long term downtrend coming off a Fed pause is likely to be too optimistic. Since the Fed keeps expanding the reach of its bridge financing bridge facilities, this seems enough evidence that its credit system has not yet normalized and could signify as a considerable obstacle to expectations of an earlier recovery by the US economy relative to the world. In short, the US dollar’s recent rally could be an oversold technical bounce.

-While activities in the US treasuries could imply the end of the Fed rate cycle, this would likely depend on the activities in the US stock market which evidently has been proven as a mainstay barometer of Mr. Bernanke.

-Back to the Philippine Stock Exchange. Against a backdrop of recovering world markets, the Phisix seems to be the only laggard for unclear reasons. Yet, as we mentioned before, excessive negative sentiment, negative yield environment, extremely oversold levels and favorable external developments have recently aligned to suggest of a looming noteworthy tradeable bounce if not a potential bottoming process.

Figure 7: ino.com: Rice Prices Off the Record Highs

If the excuse for this slump has been predicated on the rice crisis, then as figure 7 courtesy of ino.com suggests, such “rationalization” may not hold soon.