Quote of the Day: Experience is a continuous exit exam

Experience is not much of a teacher; it is, rather, a continuous exit exam. For we are not very good at "learning" from events.

- You are told that experience is accumulated knowledge when it is largely a survival filter, a fitness test. Those we call "experienced" are simply those who had the traits that allowed them to survive in a given function in order to be able do it for a long time: what we call on this forum absence of fragility.

- This confusion is similar to mistaking the Lamarckian for the Darwinian. There is some direct learning (Lamarckian) in experience, but it has to coexist with a stiff selection test.

- The consequence is that "experienced" people should limit their teaching to avoidance of fragility.

- And our preferences show that we get the point (intuitively): we tend worship old people when they are successful, and despise (and neglect) them when they are ordinary. Yet both have, technically, the same "experience".

This is from my favorite iconoclast theorist, mathematician-philosopher and author Nassim Nicolas Taleb at his Facebook page

I think that this "experience is not a teacher" observation seems highly relevant to the stock market industry. 

Many (if not most) "experienced" industry participants (veterans) never really seemed to have learned from their "experience". They are often swayed by other matters, particularly social influence (status signaling) or industry interest (principal-agent problem). 

While they have "survived" the sharp vacillations of the marketplace over the years (experience), their survival "filter test" must have come or emanated from other means or source for them to disregard or become oblivious to the lessons of their previous episodes of life. In short, they lack the skin in the game.

And yes, in general, the public loves winners or the "visible" and almost completely disregards the "unseen" alternatives. That's because the survivorship bias, which aside from the innate impulse to adhere to the law of least efforts has largely been ingrained to us by media. 

Survivorship bias effuses an aura, or even a delusion of hope. Such hope feeds on the optimistic 'feel good' bias of the general public.

Unfortunately much of the optimism channeled via the survivalship bias are bereft of real circumstances. And this is why superhero themes (one or a few protagonists saving the world) have constantly been a bestseller whether in the movies or in politics. Superhero themes embodies the visible, emotive values and short term gratification.

Note: I made additions (in italics) to my original comment

Denials are Hazardous to One’s Portfolio

The Phisix bear market has caught many by surprise. And the typical reaction: massive denials.

As shown in the above diagram, denials are natural or common traits of a fledging bear market cycle.

Denials are just one of the 15 psychological defence mechanism[1] used by us…humans. Psychologist categorizes denial as a primitive defence mechanism.

In psychoanalysis denials come in three forms[2]; Simple denial (literal deny the reality), minimization (admit the fact but deny its seriousness via rationalization) and projection (admit the fact and seriousness but deny responsibility or pass the blame on someone else).

The latter can be associated with regret theory or the psychological anguish from an opportunity loss. For example in investing, the fear of regret can make investors either risk averse or motivate them to take greater risks[3]. This partly explains why people tend to double down on losing positions in order to avoid the fear of regret.

Denying responsibility and passing the blame on someone else can also be read as the heuristic called self-serving attributional bias[4]

For instance, the mainstream’s tendency to pass the blame on foreigners as culpable for the current market meltdown signifies as signs of denials and of self serving or self attributional bias.

Denials also go with the endowment effect or the status quo bias or where people tend to put more value on what they own or technically “where most people would demand a considerably higher price for a product that they own than they would be prepared to pay for it (Weber 1993).”[5]

By denying the reality of a bear market, many maintain the notion that securities they own are unlikely to be affected by the growling grizzly bears.

But what are the odds of stocks surviving a bear market?

Not good if the 2007-2008 serves as a model.

Using the US as example, here are some excellent news quotes

From a 2009 article from Bloomberg as I previously posted[6]: (bold mine)

Wal-Mart Stores Inc. is the only Standard & Poor’s 500 Index company that has rallied during the entire 22-month recession.

From another 2008 article from Bloomberg[7]: 

The worst annual decline in the Standard & Poor's 500 Index since 1931 has dragged down every industry in the benchmark gauge and 96 percent of its stocks.

All 64 of the S&P 500's so-called level-three categories, groups such as ``distributors'' and``leisure equipment'' with as few as one company, dropped in 2008. Four hundred eighty-two companies slipped as the 500-stock index slumped 46 percent, poised for its biggest yearly retreat in eight decades.

I have pointed out in the past[8] that even when the Philippine economy nearly fell into a recession in 2007-2008, and even when earnings declined modestly from record highs, the Phisix crashed 56% and hardly any liquid stock remained unscathed or unaffected by the bear market destruction.

Conventional fundamentals hardly had been a factor in stock market pricing. Yet the investing public has been remiss of the lessons of 2008, mostly due to the indoctrinations of the industry.

Looking at international markets the Phisix fell as deep as with other emerging market equities from a contagion and not from a crisis. Foreign and US stocks, the latter the source of the crisis, have also been battered[9].

The bottom line is that when the bear market tsunami strikes almost all boats sinks by the end of the cycle.

US treasuries, European and Global bonds and high quality US corporate debt defied the US bear market of 2008

Of course today isn’t 2008. But there is hardly any evidence of which stock/s will defy the bearish downpour. In Walmart’s case, 1 out of the S&P 500 companies is a rarity.

Realize that for every 50% decline this would translate to a 100% upside move to recover. And for every 40% loss means 67% upside for a recovery. Finally for every 30%, 42% upside growth is required.

These numbers are not insignificant. And should there be a crisis, some stocks may even vanish: think Enron, Bear Stearns, Lehman Brothers.

Instead of having 1 live bullet and 5 empty chambers in a revolver, playing bull in a yet to mature bear market is like playing Russian Roulette in reverse: 5 live bullets and one empty chamber.

If there may be any bullish actions in place, we may consider…

temporarily the US dollar index….perhaps as hedge against naked long equity positions.

Another potential bullmarket is gold over the longer term. But Philippine mines have yet to prove that they can defy the general trend.

People disdain bad news, but denying bad news will neither extinguish its existence nor eradicate its consequences on the world.

In essence, denials signify as self-deception.

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[1] John M Grohol PSY. D. 15 Common Defense Mechanisms psychcentral.com

[2] Wikipedia.org Denial

[3] Investopedia.com Regret Theory

[4] Wikipedia.org Self-serving bias

[5] Behavioural Finance Endowment Effect

[6] See Wal-Mart: The Only Crisis Proof Stock During The 2008 Crash October 16, 2009

[7] Bloomberg.com S&P 500 Index Drop Leaves 64 Industries With Losses (Update3) November 21, 2008

[8] See Dealing With Financial Market Information February 27, 2011

[9] CNN Money 5 lessons from the crash September 10, 2009

Video: Celebrity Prank

From WorldTalkLIVE, (hat tip Zero Hedge)

On the night of July 27th, 2012, a huge prank was pulled in New York City and this is the video of what took place. Brett Cohen came up with a crazy idea to fool thousands of pedestrians walking the streets of Times Square into thinking he was a huge celebrity, and it worked! Not only did it work, it caused quite a stir. This social experiment, of sorts, makes a profound statement about how modern culture is so attracted to pop culture, without any real credibility needed.

He dressed up like a typical celebrity and was accompanied by an entourage of two professional bodyguards, two assistants, and photographers pretending to be paparazzi. While the assistants and photographers waited for Brett to exit the 49th street marquee at NBC Studios, they started a buzz that a "big star" was about to walk out, thus making it worth their while to wait and get a picture. Many asked the crew whom Brett was, and no answer was given. They were forced to either make something up, or just take a picture with him in hopes that their Facebook friends or Twitter followers might have a better idea.

As the crew walked over to Times Square, the crowds around Brett grew on each consecutive block. Very few people even questioned who he was, where he was from, or what he does. Brett took pictures with nearly 300 people before the stunt ended. The video even includes interviews with people who had just taken a picture with Brett, and puts them in an awkward position when they're asked questions such as, "Where do you know Brett from?" and "What's your favorite movie he was in?" Many of them were overwhelmingly excited over Brett's walk through Times Square, and it showed.

While the video may have been intended to amuse audiences, there is a subtle message from it: They reveal of the cognitive biases from which the most people fall for, in particular the framing effect (people tend to reach conclusions based on the 'framework within which a situation was presented), the survivorship bias (tendency for people to look at the visible, particularly the winners or the survivors) and rationalization (making excuses).

Beware of the popular, because they are most likely illusions.

Global Warming in the Perspective of Social Science

Politics has mainly been about arousing emotions. In the debate over global warming, arguments have essentially been reduced to either black and white, or either “you are for are against us” (False choice).

Never mind if previous predictions has always failed due to misdiagnosis arising from blind spot-illusory superiority cognitive biases or the overestimation of one's assumptions (knowledge problem).

Professor Steve Horwitz puts the global warming-climate change issue into perspective with 8 highly relevant questions (from thefreemanonline.org) [Italics bold original]

1. Is the planet getting warmer?

2. If it’s getting warmer, is that warming caused by humans? Obviously this is a big question because if warming is not human-caused, then it’s not clear how much we can do to reduce it. What we might do about the consequences, however, remains an open question.

3. If it’s getting warmer, by what magnitude? If the magnitude is large, then there’s one set of implications. But if it’s small, then, as we’ll see, it might not be worth responding to. This is a good example of a scientific question with large implications for policy.

Matters of Science

All these questions are presumably matters of science. In principle we ought to be able to answer them using the tools of science, even if they are complex issues that involve competing interpretations and methods. Let’s assume the planet is in fact warming and that humans are the reason.

4. What are the costs of global warming? This question is frequently asked and answered.

5. What are the benefits of global warming? This question needs to be asked as well, as global warming might bring currently arctic areas into a more temperate climate that would enable them to become sources of food. Plus, a warmer planet might decrease the demand for fossil fuels for heating homes and businesses in those formerly colder places.

6. Do the benefits outweigh the costs or do the costs outweigh the benefits? This is also not frequently asked. Obviously, if the benefits outweigh the costs, then we shouldn’t be worrying about global warming. Two other points are worth considering. First, the benefits and costs are not questions of scientific fact because how we do the accounting depends on all kinds of value-laden questions. But that doesn’t mean the cost-benefit comparison isn’t important. Second, this question might depend greatly on the answers to the scientific questions above. In other words: All questions of public policy are ones that require both facts and values to answer. One cannot go directly from science to policy without asking the kinds of questions I’ve raised here.

7. If the costs outweigh the benefits, what sorts of policies are appropriate? There are many too many questions here to deal with in detail, but it should be noted that disagreements over what sorts of policies would best deal with the net costs of global warming are, again, matters of both fact and value, or science and social science.

8. What are the costs of the policies designed to reduce the costs of global warming? This question is not asked nearly enough. Even if we design policies on the blackboard that seem to mitigate the effects of global warming, we have to consider, first, whether those policies are even likely to be passed by politicians as we know them, and second, whether the policies might have associated costs that outweigh their benefits with respect to global warming. So if in our attempt to reduce the effects of global warming we slow economic growth so far as to impoverish more people, or we give powers to governments that are likely to be used in ways having little to do with global warming, we have to consider those results in the total costs and benefits of using policy to combat global warming. This is a question of social science that is no less important than the scientific questions I began with.

I could add more, but this is sufficient to make my key points.

Professor Horwitz’s striking conclusions:

First, it is perfectly possible to accept the science of global warming but reject the policies most often put forward to combat it. One can think humans are causing the planet to warm but logically and humanely conclude that we should do nothing about it.

Second, people who take that position and back it up with good arguments should not be called “deniers.” They are not denying the science; they are questioning its implications. In fact, those who think they can go directly from science to policy are, as it turns out, engaged in denial – denial of the relevance of social science.

Global warming-climate change is as much about economics or social sciences than just an issue of environmental science. Don’t be misled.

Brain Damage and Better Investment Decisions

Jason Zweig in his latest article at the Wall Street Journal cites a study which suggests that people with brain damage are likely to make superior investment decisions than normal people…

With computerized traders that "hold" stocks for only a few seconds at a time and markets that can swing wildly in a matter of moments, long-term investing seems to be on the verge of extinction.

Perhaps this is inevitable. It turns out that short-term thinking is deeply embedded in the workings of the human brain. New research suggests that in order to avoid trading your accounts to death, you must counteract some of the very tendencies that make Homo sapiens the most intelligent of all species.

In a study published last month in the Journal of Neuroscience, researchers from California Institute of Technology, New York University and the University of Iowa looked at how people use past rewards to predict future payoffs.

Directly behind your forehead is a region of the brain known as the frontopolar cortex. Much larger in humans than in other primates, this area is critical to such advanced mental functions as memory, exploring new environments and making decisions about the future.

In the new study, the researchers wanted to see how the frontopolar cortex contributes to predicting rewards. So they compared people with damage to the frontopolar cortex against two control groups of healthy people and those with injuries elsewhere in the brain (but not the frontopolar cortex)….

When confronted with the unpredictable, however, the frontopolar cortex refuses to admit defeat. It draws on all your computational abilities to search for patterns in random data.

In the absence of real patterns, it will detect illusory ones. And it will prompt you to act on them.

No wonder so many investors find it hard to muster the willpower to buy and hold a handful of investments for years at a time.

But if "buy and hold is dead," as growing numbers of investors argue, it isn't clear what else is alive. In the lousy markets of the past decade, various alternatives such as "tactical asset allocation" (or market timing), mathematical risk-reduction techniques and even plain old intuition haven't worked out all that well, either.

Most of the folks who say buy and hold is dead don't talk much about their long-term returns. Instead, they stress how they have done recently, a tactic that for many potential clients has the same irresistible appeal as the last couple of pulls on a slot machine.

The solution to short-term thinking isn't to bash yourself in the forehead with a hammer, of course. But you can use your brainpower to your advantage.

Every investing decision you make should be the result of a deliberate process.

The implication that it would take brain damage to make for a better investor would seem downright preposterous (the same goes with the theory of high IQs)

Pseudo scientific studies like the above disparages the individual’s distinctive capacity to deal with the ever changing circumstances we are faced with.

While it may be true that many people have the tendency to fall for cognitive biases, in reality all of people’s actions are driven by incentives

Incentives are shaped by the dynamic admixture of many factors—including genes and the environment, peer pressure and social status, educational background, culture, religion, technology and even to social policies such as zero bound rates—in relation to changes to the environment, social relations and the economy (even if some of their actions can be read as cognitive biases or heuristics—pattern seeking behavior).

This applies to short-term thinking.

Deliberate process is more about containing the urge for the dopamine to govern one’s action, or importantly, managing emotions through emotional intelligence (EI) to attain self-discipline.

Superior investing decisions can be attained even if you have a normal brain.

Phisix: The Correction Phase Cometh

I believe that the Phisix has entered a temporary corrective phase, or a pause from the bullmarket.

I wrote last week[1]

given the recent dramatic record run up, we should expect natural profit taking process to follow. And perhaps such profit taking will take cue from weakening commodity prices (CRB) and stock markets abroad led by the S&P 500 (SPX). This is likely to be a temporary event, or another episode where steroid propped financial market clamors to be fed with more steroids of inflationism.

Perhaps the weekend elections in the Eurozone could also spice things up.

I have been pointing out from the start of the year that the bullrun of the local stock market may last until the first semester of this year[2] from which we may encounter renewed volatility.

In March I said[3]

the raft of credit easing measures announced last month will likely push equity market higher perhaps until the first semester or somewhere at near the end of these programs. Of course there will be sporadic shallow short term corrections amidst the current surge.

However, the next downside volatility will only serve as pretext for more injections until the market will upend such policies most likely through intensified price inflation.

The reason for pointing this out is to dispel the misimpression that I only see the market as moving in one direction—UP.

It just so happened that last week’s correction came sooner and deeper than expected.

For Every (Mini) Boom, a (Mini) Bust

And the recent re-emergence of the downside volatilities which again has likely been prompted by overbought conditions seems to have taken cue from the external environment.

Emerging markets around the world or not limited to Asia have mostly been slammed. Major Asian bourses have been battered as well.

In a relative sense, in general, Asia has endured substantially more losses than the US or Europe.

And it is ironic that crisis afflicted Portugal, Italy and Spain posted marginal gains this week. Meanwhile Greece equities collapsed, the ASE general crumbled by 11.3% this week and down 10% for the year.

Meanwhile the losses of the Phisix seem understated.

Instead of the usual rotation, or the process of alternating winners and losers, this week, the broader market breadth sharply deteriorated.

In just one week, overall positive market sentiment seemed to have been reversed. Declining issues reasserted dominance with manifest forcefulness.

The scale of last week’s dramatic recoil has almost mirrored the fierce downside move of September-October of 2011, where the Phisix lost 18% from the August peak.

Of course current conditions are different from the 2011. But the point of the above is to show the perspective from the big picture and not just to absorb the frames presented.

Technically speaking the Phisix has yet to breach the 50-day moving averages. This could be seen yet as a positive sign.

In addition, the seeming resiliency of the Phisix means that while most of the broad market losses have been concentrated on the implosion of many “miniature” bubbles seen in second and third tier issues, the heavyweights has been less affected.

Of the 13 issues with 3% and above free market capitalization float that constitutes 70.38% of the Phisix basket as of Friday’s close, 3 defied the last week’s carnage, while 5 issues fell more than the decline of the Phisix. The Phisix dropped 2.63% which reduced year to date gains to 17.93%

It is just apt to remind everyone that Newton's third law of motion[4] “To every action there is always an equal and opposite reaction" has some validity in the stock markets.

The lesson being that during occurrences of market euphoria, where powerful speculative activities or price chasing dynamics results to many high flying issues, a reversal of which would result to prices falling more swiftly and more intensely almost as they have ascended.

Prices fall faster than they rise because of the behavioral principle of loss aversion[5], where fear is a stronger motivator than the pleasure of gain.

That’s why I don’t recommend chasing prices.

Asset price inflation is followed by asset price deflation: minor boom bust cycles within major boom bust cycles.

Except for the mining issues, the previously biggest winners (Property and finance) have basically been last week’s largest losers. Because the losses of the holder sector have been limited the mother units of top performers have taken the top spot in terms of returns on a year to date basis.

The swift and dramatic reversal of the market’s sentiment haunted the high flying mining peripheries first, which then rippled across to the heavyweights, the contagion effect has visibly been seen in the breakdown of the mining index.

Commodity Prices as Stethoscope

Importantly, adverse developments at the world commodity markets may have influenced the recent crash of the local mining sector.

Yet such decline have not been limited to gold or oil but dispersed throughout the entire commodity spectrum.

And instead of earlier divergences[6] where global financial assets has seen price inflation amidst a backdrop of declining commodity prices, recently, divergences seem to have transformed into a convergence—where both commodity prices and financial securities have been evincing signs of lethargy.

This serves as further proof that assets have been highly correlated and that markets have been severely distorted or “broken”[7] where the pricing mechanism have been manipulated to reflect on the preferred pricing levels by politicians.

Thus today’s investing environment has been transformed into a grand casino operating on the principle of a “Risk On or Risk Off” environment.

From the technical viewpoint, commodity markets seem to highlight the ongoing corrosion of price trends. Both the broad commodity index the Reuters/Jefferies (CRB) and the main US oil benchmark the West Texas Intermediate Crude (WTIC) seem to be signaling a bearish head and shoulder pattern. The WTIC has already broken down while the CRB has yet to breakdown.

Though I am not a believer in patterns, the numerous momentum players can make such patterns as self-fulfilling over the short term.

That’s why this week will be crucial for the CRB, where a successful breakdown of which may be portentous to global stock markets, the Phisix as well.

We should remember that oil markets hardly exhibits “real economics” or free market based demand and supply. Oil markets, as I have repeatedly pointing out, have been highly politicized[8].

The welfare states of many of the major producers, particularly OPEC economies or even non-OPEC such as Russia[9] greatly depends lofty oil prices, perhaps about $85 and above. Even President Obama’s green energy projects have been anchored on high oil prices.

This means that if oil prices breaks below their welfare threshold for a prolonged period, then this would incite popular uprising and the eventual collapse of the current political order.

And this is why oil producing governments have been limiting private sector’s access to oil reserves[10]. Yet the capacity by these governments to bring oil to the surface has been constrained by government budget, which has been mostly spent on welfare (yes to buy off their political privileges from their constituents), and the lack of technology.

The implication of the above is that these governments will probably try to restrict production, seek the war option[11] (e.g. urge the US to militarily take on Iran), inflate their economies to pay for their welfare system or influence major central banks and politicians of major economies to resort to more inflationism.

I might add that given the current political arrangement, it may not be farfetched to deduce that many, if not most US politicians from both parties, have been bankrolled by these oil producing client states.

Add to these, falling oil prices jeopardizes President’s Obama’s green projects.

Thus contemporary political institutions significantly dependent on revenues from resources (resource curse) rather than from trade would represent a vested interest group that would lobby to seek for bailouts in the form of inflation or through bank rescues.

Don’t forget one of the beneficiaries of US Federal Reserve bailout in 2009, was ironically, the Libyan government headed by then ally turned enemy Muamar Gaddafi[12]

So from this supply side perspective we understand that the policy direction of current governments will be through more inflationism. [On the demand side, money printing has enabled the welfare state to grow]

China’s Weakening Consumption Demand?

The listless state of commodity prices may be driven by two important forces;

One is consumption demand.

If the sluggishness in commodity prices has been representative of consumption demand, then the likely source for such weakness could emanate from China.

Soft economic data on export and import data for April (right window[13]) and a seeming rolling over of China’s equity markets (left window) seem to support this angle.

While many analysts read this to be an anomaly, such as ‘calendar effect’, I don’t. I would prefer to wait and watch.

I have been saying that China could be the global markets next black swan[14] whose economic slowdown has been highlighted by growing signs of the political fissures.

And that’s why I believe that the Scarborough Shoal territorial claim dispute has either been a squid tactic meant to divert the public’s attention from real economic conditions or a yeoman’s undercover sales job for the US and China’s military industrial complex[15] or both.

And given China’s Keynesian policies of permanent quasi booms, then it should be expected that a commensurably huge bust will be in the offing. Evidences of malinvestments have already been present; 64 million empty apartments, ghost cities and vacant shopping malls[16] which have been considerably financed by China’s version of the $1.7 trillion shadow financing system[17].

The question for the coming bust is a WHEN rather than an IF. And this depends on the China’s state of real savings

At present, the $64 trillion question is to what degree will China’s government’s conduct the bailout? If China still has substantial real savings then her government may be able to kick the proverbial can down the road.

As Austrian economist Dr. Frank Shostak explains[18],

For a while, the government's package can appear to be working; this is because there is still enough real savings to support both profitable and unprofitable activities. If, however, savings and capital are shrinking, nothing is going to help, and the real economy will follow up with further declines.

That’s why I am largely neutral on China’s financial markets.

In the commodity sphere, China has become the proverbial gorilla in the room as the largest, if not a significant, consumer of many commodities (see upper window)

As IMF’s Shaun K. Roache writes[19],

China is a large consumer of a broad range of primary commodities. As a percent of global production, China’s consumption during 2010 accounted for about 20 percent of nonrenewable energy resources, 23 percent of major agricultural crops, and 40 percent of base metals. These market shares have increased sharply since 2000, mainly reflecting China’s rapid economic growth. History has shown that as countries become richer, their commodity consumption rises at an increasing rate before eventually stabilizing at much higher levels.

Further, commodity prices seem to be correlated with the actions of China’s equity bellwether the Shanghai index (lower window[20]).

Yet the correlation can go both ways, either China’s or the commodity markets could lead. The Shanghai index [SSEC] may recover (perhaps boosted by a major move from Chinese authorities) and this may provide a lift to commodity prices, otherwise a continuing and deepening slowdown of China’s economy could pose as a drag to the commodity markets which will diffuse into the SSEC.

On the other hand, a major boost from a major central bank could power commodities higher, and this may help buoy China’s markets higher.

Or Indecisive Central Bankers?

Weak commodity prices may have also been symptomatic of asset liquidations, perhaps evidenced by JP Morgan’s $2 billion trading losses in credit derivatives[21].

This may be indicative that commodity prices along with financial asset prices could be factoring in less than aggressive interventions from major central banks.

And this may have been underscored by the ECB’s reluctance to intervene[22], perhaps until political impasse at several EU nations will have been resolved.

Sunday’s elections in Greece has failed to “put together a government[23]” from which contending parties, divided between pro- or anti- bailout camps, have reportedly been haggling to form a coalition to avert national elections. Such national elections have been seen as increasing the risks of a Greece exit from the EU.

Ironically, the EU officials appear to be openly talking about a Greek exit[24], perhaps to condition the public of its eventuality.

The same is true for France where the parliamentary elections in June will either solidify the dominance of the socialists[25] or may open the nexus for the extreme (fascist) right to acquire and expand power[26].

Thus until the political leadership of these nations have been established, the ECB will likely to adapt a wait and see stance.

And except for the Bank of Japan (BoJ) whom has continued to expand her balance sheet[27], the Bank of England (BoE) as well, has officially declared a halt[28] on their asset purchasing program, which I say is temporary.

Meanwhile, US Federal Reserve through their chairman Mr. Ben Bernanke continues to dither or give mixed signals on the prospects of more quantitative easing measures[29]. True monetary conditions in the US remains easy, as seen by the renewed pickup of growth in M2, but this could be offset by perceptions about inadequate support.

The current Operation Twist has also been slated to expire next month or on June[30].

And if history will rhyme, then the past two incidences where the Fed technically concluded market intervention programs led to sharp downside volatilities, as shown in the republished chart[31].

My hunch is that the current market pressures could most likely be exhibiting parallel symptoms of market’s apprehension over the lack of further steroids.

[As a reminder, I am vehemently against inflationism, but as an investor, we have to be realists and play by the cards we are dealt with]

Conclusion and Recommendations

The current weakness in commodity prices, which has partly been transmitted to the global stock markets, could represent a deepening China’s economic slowdown (bust has not yet been established) or the factoring in by financial markets of the withholding of the provision of more support to the financial markets, by central bankers, via direct interventions of asset purchases or even both.

And any further weakness in commodity prices will likely filter into the asset markets.

As an aside, I know much of the mainstream will say that weak commodity markets should be a positive aspect because these lowers input costs and improves profits. In reality, what they mean is that “low consumer price inflation” will justify more interventions from major central bankers.

And this has been exactly the message I have been saying, see my March note

“the next downside volatility will only serve as pretext for more injections”

The general idea is that markets have been prone to boom bust cycles or the inflation cycle[32] or volatility as a result of government and central bank policies that keeps markets dependent on “on and off” steroid boosters.

My guess is that China’s markets will be addressed politically in the same way too.

And it would seem that periods of greater market volatility and the ensuing fear will leave market participants begging for more interventions and inflationism.

For the Phisix, the current resiliency by the heavy caps has been a noteworthy auspicious development. Yet we should not discount the likelihood of a contagion from any adverse exogenous events.

My inclination is that based on the above evidences and in the understanding that NO TREND GOES IN A STRAIGHT LINE, the Phisix will likely undergo a correction or profit taking phase.

This retrenchment, perhaps 5-10% from the peak or a low of 4,800, should be seen as healthy and normal. Should this be realized then the local benchmark will likely drift rangebound.

Of course external developments will play a big role in either confirming or falsifying this.

Yet I am LESS inclined to believe that a new high for the Phisix will be reached soon. Such should be until major central bankers will have announced their renewed support for the markets or if there have been conspicuous signs that they have been operating behind the curtains.

Should I be wrong and the local (and global) markets continue to tread higher without support from major central bankers, unless this would be backed by a strong surge of lending from the banking system particularly in the US, Europe or China, then we should even be more cautious, as any rally would likely lose steam from the current environment, again, without steroids.

The outlier risk from this would even be a crash, as Dr. Marc Faber suggests[33] during the second half of the year.

So far, the fact is, that the damage seen in the market internals will have to be remedied first.

The good part is that the much of the selloff has been locally driven which unfortunately has affected many momentum participants. Yet foreign buying remains net positive in spite of the carnage and may have provided cushion to the heavyweights.

Well this chapter should serve as part of our continued learning process.

Finally in the expectation of the possibility of the non-participation of central banks until June or after, this means greater volatility ahead in both directions.

Investors may raise their cash balance during rallies and buy on every episodes of panic. And in the event that any one of the major central banks declares the next steroid (the size should matter), then our strategy shifts to buy high, sell higher.

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[1] See Bubble Signs at the PSE: Raising Capital Through Pre-selling Model, May 7, 2012

[2] See An Inflationary Boom Powered Phisix Bullmarket January 22, 2012

[3] See Global Stock Markets: Will the Recent Rise in Interest Rates Pop the Bubble? March 18, 2012

[4] Wikipedia.org Newton's third law

[5] Wikipedia.org Loss aversion

[6] See Are Falling Gold Mining Stocks Signaling Deflation? April 25, 2012

[7] See “Pump and Dump” Policies Pumps Up Miniature and Grand Bubbles Aprl 30,

[8] See Are Surging Oil Prices Symptoms of a Crack-up Boom?, February 24, 2012

[9] See The Geopolitics of Oil and Russia’s Knowledge Economy March 13, 2012

[10] See Peak Oil Represents Government Failure, February 10, 2011

[11] See Saber Rattling over Iran is only Part of the Big Oil Price Story January 25, 2012

[12] See US Federal Reserve Lent To (or Bailed Out?) Libya’s Qaddafi in 2009, April 5, 2011

[13] Danske Research China: Slowing imports & exports due to calendar effects? , May 10, 2012

[14] See Signs of China’s Snowballing Political Crisis: Six Arrested over Coup Rumors, April 1, 2011

[15] See The Scarborough Shoal Standoff Has Not Been About Oil, April 16, 2012

[16] See China’s Tiger by the Tail, April 13, 2012

[17] See China’s Bubble Cycle: Shadow Financing at $1.7 Trillion, June 28, 2011

[18] Shostak, Frank The Rescue Package Will Delay Recovery, September 29, 2008 Mises.org

[19] Roache Shaun K. China's Impact on World Commodity Markets, IMF Working Paper, May 2012

[20] Holmes Frank Looking to China to Fire Up its Economy, May 11, 2011

[21] Tavakoli Janet Jamie Dimon's SNAFU: JPMorgan's Other Derivatives' Losses Huffington Post, May 12, 2012

[22] Reuters India, ECB fends off pressure to take crisis action May 8, 2012

[23] Reuters.com Greek president makes last push to avert elections, May 12, 2012

[24] Thestar.com Greek euro-exit talk seeps into public as officials air doubts, May 9, 2012

[25] Bloomberg.com French Favor Socialists, Allies in June Parliamentary Elections, May 11, 2012

[26] See Will French Politics Swing from Socialism to Fascism? May 12, 2012

[27] See Bank of Japan Adds More Stimulus, April 27, 2012

[28] See Bank of England Halts QE for Now, May 10, 2012

[29] Wall Street Journal Bernanke Expresses Fiscal Concerns To Senate Democrats, May 10, 2012

[30] Federal Open Market Committee Federal Reserve issues FOMC statement, US Federal Reserve September 21, 2011

[31] See Central Bankers Whets Wall Street’s Fetish For Inflationism, March 12, 2012

[32] See Chart of the Day: The Inflation Cycle, April 5, 2012

[33] See Dr. Marc Faber Warns of 1987 Crash if No QE 3.0 May 11, 2011

“Pump and Dump” Policies Pumps Up Miniature and Grand Bubbles

A friend recently called to say that there have been numerous accounts of “miniature bubbles” in the local markets. Others claim that these have been brought about by unscrupulous people engaged in “pump and dump”.

In reality as I have been pointing out, miniature bubbles are symptoms of the ultimate bubble blower—central bank policies. Central bank policies distort people’s incentives towards money. Savings, investment and consumption patterns will have all been skewered. Where negative real rates punish savers, naturally people whose savings are being diminished through the erosion of purchasing power will seek higher yield, and thus, redeploy their savings into other activities which may include more consumption activities, speculation or high risk investments and or take up more debt to fund these activities. Even private sector Ponzi schemes has been flourishing under today’s environment[1]

In essence policies that tamper with money motivates the public to value short term over the long term.

Thus heightened price volatilities which are deemed as “pump and dump” or as “miniature bubbles” represent as symptoms rather than the cause. People will look for excuses to push up prices or speculate for the simple reason that policies have egged them to do so.

The easy money climate lures the vulnerable public to go for momentum and chase prices using any available tools (charts, corporate fundamentals or even tips[2] and rumors) to do so. And this is why pump and dumps happen.

Large price swings make some people think that stock market operators are culpable for such swing. But this would be mistaking trees for the forests. Absent easy money policies, bubbles and pump and dumps hardly has been a feature. Had there been mini bubbles or pump and dumps during the bear market of 2007-2008? No, because inflated assets were all deflating in response or as contagion to the real estate-banking crisis abroad.

Broken Markets

And as earlier pointed out[3], the US today has not been different, junk bonds or high yielding debt has been booming.

Writes the Buttonwood (Philipp Coggan) of the Economist[4]

Of course, the broader point is that investors are being pushed into these high-yielding assets because of the policy of the Fed (and most developed world central banks) of keeping interest rates close to zero. Similar reasoning drove the enthusiasm for structured products that financed the subprime boom.

Zero bound rates have prompted for yield chasing actions, here or in the US.

The mainstream finally comes to admit what I have been saying all along—that markets have been vastly distorted where one cannot use “fundamentals” in the traditional and conventional sense to evaluate investments.

The excessive price volatility in today’s markets does not match with the fluctuations of conventional metrics of financial ratios. Today’s price volatility has been incongruent with trends of corporate fundamentals. And thus as I earlier pointed out[5], anyone who believed in “fundamentals” would have sold as early as March.

Considering the huge jump in prices from the start of the year, we should be around at near the peak of 2007. So anyone who believes in this stuff ought to be shorting or selling the market. I won’t.

The left window from the chart above as I earlier posted last March has a time series that ended November of 2011. The right chart from DBS represents a more updated one albeit was updated until last March. Considering that the Phisix has now been drifting at over 5,150 which means valuations continues to climb higher away from these charts, the Phisix has become “priciest” stock market in Asia.

Yet leaning on earnings or conventional fundamental metrics, like the Heisenberg uncertainty principle, becomes a permanently moving target which is impossible to pin down, especially punctuated under today’s easy market climate.

Will I sell on the account of earnings/fundamentals? My answer is still no. Not until interest rates climb in response to consumer price inflation, or through heightened demand for credit, or questions over credit quality of government papers or the scarcity of capital becomes apparent[6]. Nominal interest rates are not a one-size-fits-all thing, and there are many measures (like real interest rates, CDS, yield curve et.al.) to gauge if the monetary environment has begun to tighten for one reason or another. This also should come in the condition that the hands of central bankers have also been shackled and would be unable to respond forcefully as they have been doing today.

For now central banks around will continue to find ways and means to push more easing measures in support of the asset markets which was highlighted by last week’s additional stimulus by the Bank of Japan (BoJ)[7]

The following excerpt from the mainstream loudly resonates on what I have been saying.

From the Financial Times[8],

Markets are broken. Accepted investment wisdom has been overturned and the basic tenets of value and diversification no longer work. The financial crisis put the market into a volatile “risk on, risk off” – or Roro – mode for which there is no cure.

For many investors, this has made stockpicking seemingly an impossible task. Markets once responded to their fundamentals. Now, disparate assets have a much greater tendency to move together, individual characteristics lost. Trusted strategies such as relative value and currency carry trades are nearly useless, overwhelmed by daily market-wide volatility.

“Assets now behave as either risky assets or safe havens, and their own fundamentals are secondary,” writes HSBC strategist Stacy Williams in a recent note. “In a world where most asset classes are synchronised, it becomes very difficult to achieve diversification. It also means that since most individual assets are dominated by a common price component, it becomes increasingly futile to invest in them based on their usual fundamentals.”

Though asset classes had been moving in closer correlation since the start of the financial crisis in 2007, the Roro trend became most apparent after the collapse of Lehman Brothers a year later. The uncertainty helped turn investing bimodal, where every price has been contaminated by systemic risk. Everything became a bet on whether we were closer to a global recovery or to deeper crisis.

So what recommendations do they offer for the public to deal with the state of “broken markets? They have three. One is to pick a position from the boom or the bust scenario, second is to chase momentum and third is to hedge positions through index futures.

I would like to emphasize on the second option, not because this is my preferred approach but because of its relevance to the conditions of the local markets, from the same article,

Another option is to seek out an investment strategy that still works. Momentum investing – in effect, buying the winners and selling the losers – is a method that HSBC analysts highlight as having been largely impervious to the risk trade. To chase a trend aims to harvest small but systematic mispricing of assets, and there is no reason to suppose these anomalies would disappear in bimodal markets, the broker argues. (In this context, the growth of high-frequency trading since the start of the crisis is unlikely to be coincidental.)

This simply means that the mainstream will largely be chasing momentum, by targeting frequency over magnitude through “harvest small but systematic mispricing of assets”. So in essence, high risk speculative activities or gambling (a.k.a “miniature bubbles” and “pump and dump”) has been recognized as the common or standardized feature of the current market place. So history will rhyme and a bust will be around the corner.

I would rather “time” the bubble cycle rather than go chasing prices. And this is why it is imperative for any serious investors to understand the bubble process or the boom bust cycle.

Stock Market is about Human Action

Finally financial markets signify a social phenomenon. There is a popular aphorism from former President John F. Kennedy, who said in the aftermath of the failed Bay of Pigs Invasion[9], which seems relevant to the financial markets,

Victory has a thousand fathers; defeat is an orphan.

Winning issues and or market tops tend to attract substantial participants as a function of easy money (get rich quick mentality), keeping up with the Joneses (bandwagon effect) or survivorship bias (focus on survivors or winners at the expense of the others) or social signaling (desire for greater social acceptance, elevated social status and or ego trips).

On the other hand market bottoms results to the opposite: depression, avoidance, isolation and animus behaviour for those caught by the crash.

Most people don’t realize that emotional intelligence or self discipline is key to surviving the market’s volatility, not math models or charts or any Holy Grail or Greek formulas. And this comes from the desire to attain self discipline than from advices of other people.

Yet self discipline is earned and acquired through knowledge and through the whetting of one’s skills based on these accrued knowledge. Alternatively, self discipline cannot be not given or inherited. And that’s why I vehemently opposed the suggestion by a popular religious personality, who had investments on a mutual fund, to get housemaids to invest in the stock market[10].

The incentive to acquire the desired knowledge and skills varies from individual to individual because they are largely driven by the degree of stakeholdings or the stakeholder’s dilemma or stakeholder’s problem[11].

Today’s information age has democratized access to information. What can be given are information relevant to attaining knowledge and skills. What can NOT be given is the knowledge that dovetails to one’s personality for the prudent management of one’s portfolio. Like entrepreneurship this involves a self-discovery process.

And most importantly, what can NOT be given are the attendant actions to fulfill the individual’s objectives.

Stock market investing is about people and their actions. That’s why this is a social phenomenon. No more, no less.

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[1] See After 5,000: What’s Next for the Phisix?, March 5, 2012

[2] See New Record Highs for the Philippine Phisix; How to Deal with Tips February 20, 2012

[3] See Self-Discipline and Understanding Market Drivers as Key to Risk Management, April 12, 2012

[4] Buttonwood Hooked on junk, April 27, 2012, The Economist

[5] See Earnings Drive Stock Prices? International Container Terminal and Ayala Land, March 6, 2012

[6] See Global Equity Market’s Inflationary Boom: Divergent Returns On Convergent Actions, February 13, 2002

[7] See Bank of Japan Adds More Stimulus, April 17, 2012

[8] Financial Times ‘Roro’ reduces trading to bets on black or red April 20, 2012

[9] Quotationspage.com Quotation Details John F. Kennedy, "A Thousand Days," by Arthur M. Schlesinger Jr [1965]., p289. Comment made by JFK in the aftermath of the failed Bay of Pigs invasion, 1961.

[10] See Should Your Housemaid Invest In The Stock Market? September 5, 2010

[11] See Knowledge Acquisition: The Importance of Information Sourcing and Quality, March 6, 2011