Research Process, Value of Time and Probabilities are Key to Outperformance

``Imitation in markets often gets a bad name, but it's important to recognize how vital imitation is in our day-to-day lives. We imitate each other all the time, primarily because other people often have better information than we do. It becomes a problem in markets when everyone starts to imitate one another, and they forget about what they're doing in the first place. It leads to excesses.”- Michael Mauboussin

Rather focusing on tangential issues, I’d like to impart to you some pointers on how to improve your portfolio returns from Michael Mauboussin, chief investment strategist at Legg Mason, an $850 billion highly acclaimed global asset management company in the US and author of the new book More Than You Know. In an interview with David Meier of Fool.com, Mr. Mauboussin cites three critical factors to concentrate on (emphasis mine)...

``The first thing, I would say, is to focus on process versus outcome. So process means understanding the research process, trying to understand specifically if expectations in the prevailing stock are too high or too low, and recognizing that even if you have a good process, periodically things will not turn out as you had hoped. [However,] a good, quality process will lead to good long-term results.

``The second thing I would say is recognize the role of time. In the very short term, it is almost impossible to discern between luck and skill, because there is just simply too much noise in the system. But over the long haul, certainly a good process will prevail. So [recognize] that it is important to be patient, and often, as you said before, to do absolutely nothing. This is not a business where more activity leads to better results. I think, in general, people perceive that. And certainly in America, there is an idea that doing more work is better. That simply does not hold for the stock market.

``The third thing is to recognize that markets are fundamentally probabilistic, and because they are probabilistic, it requires a certain psychological approach and psychological mindset. By the way, in Robert Rubin's wonderful book, In an Uncertain World, he talks a lot about the probabilistic mindset. He says many people believe they are [taking such an approach,] but very few people have the disposition or time or training to do it properly. So when you have a probabilistic mindset, you are constantly thinking about different alternatives. You are constantly taking information and updating your probabilities and outcome assessments and recognizing, again, that there are many psychological biases that can come into your doing that properly.

Of course you don’t normally obtain such judicious advice from the investing business, such as conventional brokers or some domestic financial institutions alike, as they are hardwired to think and impress upon their clients that returns from the markets entail frequent churning activities. As I’ve said before, it’s mainly because of their revenue models; in contrast to the investing profession, like Mr. Mauboussin of Legg Mason, which focuses on generating “Alphas” or above benchmark returns.

And neither would you hear from investing business community the probabilistic approach towards investing. Probability of outcome is the primer for risk management and essentially differentiates gambling from calculated risk taking ventures. By determining the odds, or the ratio of favorable outcomes to unfavorable outcomes, one could act to reduce or limit risk exposure and optimize on returns.

In my case, the investing-research process, as you probably all figured out, has been largely an amalgam of the Big Picture (particularly capital flows dynamics and monetary and cross market analysis), behavioral finance/economics (understanding the thought process to limit heuristics and mental shortcuts or biases) and a combo of sentiment and the technical picture with occasional dabbles on valuations. In short, I try to be as methodical and systematic as what Mr. Mauboussin suggests and recommend that you do as well.

Domestic Political Developments Unlikely to Drive Markets

I read from some ad hoc commentaries that the direction of the domestic financial markets for the coming week would find bearing from the Philippine president’s State Of the Nation’s Address (SONA). I find this attribution to be ludicrous. Unless of course, draconian policy changes would be endorsed to either choke or liberalize business conditions, the most one can expect from these events would simply be vainglorious political rhetoric and counter demagoguery from the political opposition.

If the previous market’s reaction to past political conditions were to be a gauge (e.g. aborted coup, heated elections, garci scandal, etc...) then the market could be expected to discount this as a nonevent. And as for these forecasters groping for any variables to associate to the market’s behavior, Robert Prechter of the Elliot Wave Theory describes them best, ``Those who regard the news as the cause of market trends would probably have better luck gambling at race tracks than relying on their ability to guess correctly the significance of outstanding news items.”

I would view developments in Lebanon as having more potential significance than local politics. The present military engagement has the open-ended possibility to escalate and diffuse as to drag the entire region into conflagration. With the world’s oil supplies, about three-fifths of the world’s proven oil reserves (see Figure 1), heavily dependent on the region, an expanded theater of war would bring the world to its knees with a supply shock. Think oil at $100 per barrel at least! That is the reason why we have to keep our eyes on the unfolding geopolitics rather than be transfixed on vapid and toxic domestic “personality based” politics.

Figure 1 Moneyandmarkets.com: Commanding Share of Middle East Oil

CBS Marketwatch Mark Hulbert: Explanations R US

The gullible investing public have been regularly inured to believe, especially by mainstream media and their coterie of analysts, that non-economic events (wars, natural calamities & etc.) have significant impacts in the activities in the financial markets. But do such events really move markets?

CBS Marketwatch Mark Hulbert in his latest article “Explanations R Us” cites a study (emphasis mine)...

``A comprehensive analysis of the impact on the market of non-economic events, which despite being nearly 20 years old remains one of the standard academic works on the subject, appeared in the Journal of Portfolio Management in 1989. It was written by economics professors David Cutler, Lawrence Summers, and James Poterba (Cutler and Summers are at Harvard; Poterba is at MIT).

``The professors designed their study to find evidence that non-economic news regularly has a big impact on stocks. They focused on all entries in the "Chronology of Important World Events" from the World Almanac for the period beginning with Pearl Harbor and ending with the 1987 Crash, and then eliminated from their list any events that the New York Times did not carry as a lead story and that the Times' Business Section did not report as having affected investors.

``The result was a list of 49 distinct events, such as Pearl Harbor, the Korean War, Kennedy's assassination, and so forth. The professors then measured the average absolute return of the S&P 500 index on these days.

``The professors came up with little evidence that non-economics events had a big effect on the stock market. On average, across all 49 events on their list, the S&P 500 moved just 1.46%, less than one percentage point more than the 0.56% that prevailed on all other days. Because of this small difference, the professors concluded that there is "a surprisingly small effect of non-economic news" on the stock market.

The lesson here is not to simply to adhere to superficial clues or heuristics or mental short cuts. Sensationalism can divert you to wrong causes and lead your portfolio astray. The financial markets are more abstract, complex and multi-dimensional than commonly thought.

Dow Jones 10,700: Marking the Line in the Sand?

I've always thought that politics...geopolitics, i mean, does play a key role in shaping the direction of the markets. As I've noted in the past, once the critical benchmarks in the US equities come tumbling down, the sluicegates of liquidity maybe opened anew to forestall any incidence of a Central Banker's dreaded nightmare...'deflation'. This could be a possible legacy from Greenspan to Bernanke, otherwise known as the "Bernanke Put". Political expediencies may once again govern money policies.

I had been looking at 10,400 level, about 10% from the recent highs, as a possible threshold level, but maybe have found a clue from Stockcharts.com's Chip Anderson. According to Mr. Anderson...

"Three big down days have sent the Dow back down to the 10,700 support level. What's that you say? 10,700 is just a number? Just a number like any other? Oh really? Check out this chart:

"10,700 is a number that should make your ears perk up. If the current Mid-East problems push the Dow well below 10,700, it will mark a significant change in the market's technical picture."

Would a break of 10,700 level then be quintessential marking "the line in the sand"???

Mixed Market Signals, Unfolding Business Cycles

``Ignoring market risk will mean that, from time to time, performance will be lumpy...The fund is unlikely to outperform benchmarks consistently. Rather, the goal is to outperform on average, most of the time, and over the long run.''- Martin Whitman, manager since 1990 of the $8.3 billion Third Avenue Value Fund.

While I might have been right about rising gold prices, the correlation between non-US equity benchmarks, particularly of the emerging market ones, and rising gold prices appears to have broken down.

This week, aside from gold and oil, safehaven bets in the US dollar (as measured by its trade weighted index) and US treasuries have rebounded (as measured by Morgan Stanley US Government Securities) as shown in Figure 2.

Figure 2: Stockcharts.com: Rallying US dollar Index and Morgan Stanley Government Securities

In the currency markets, the rise in the US dollar index has resulted to a broadbased decline in Asia’s currencies. The Philippine Peso fell .08% to Php 52.39 against a US dollar from the previous Php 52.35.

The Bond markets have indicated for a slowdown in economic growth and inflation expectations with a hefty decline in US treasury benchmarks across the board. With Fed funds rate at 5.25%, Treasury yields for Notes (2, 5, 10 and 30 years) including the 3-month T-bill have all widened inversions except for the 6-months T-bills which closed basically flat. Aside from signifying a possible slowdown on a tight money backdrop, another Fed hike in August with bond yields at present levels, or a continuing rally in bond prices even at the event of a pause in August, is likely to widen the yield inversion curve growing the risks of a US led recession.

Asian bonds have mostly rallied, including the Philippines. This has likewise been indicative of a possible slowdown of the world economic growth.

Figure 3: kitcometals: Record HIGH for Nickel

While the bond markets suggest of a slowdown in either economic growth or inflation expectations, in the commodities front we are witnessing a strong resurgence following oil’s new highs. Nickel carved out a fresh record high up 15% for the week (see figure 3), followed by a strong finish by copper (+4.7%) silver (+1.1%) and gold (+5.23%). The commodity indices of the CRB-Jeffries closed 2.68% higher to bring year to date gains to about 7.6% while the energy heavy Goldman Sachs Commodity Index surged 3.78% to a NEW record high (see Figure 4)!

Figure 4: Stockcharts.com: Rallying CRB and Record High Goldman Sachs

Contrasting stories, we have here. Unlike in the May selloffs where except for the US dollar all assets had been sold off, today there are emerging dissonances. The bond markets whisper of subdued inflation, and a prospective economic growth slowdown, while the commodity markets remain beneficiaries of the residual inflationary policies. You have a yield curve inversion to reflect a tightened money environment but M2, Bank Credit and Commercial papers continue to expand. You also have rising dollar to corroborate the tightening by central banks however, a rampaging gold offsets this. I have argued to the contrary of the consensus opinion that gold’s fate (see June 19 to 23 edition, Has Gold Found its Bottom? Philippine Mining Index to Lead Phisix Anew?) has not been entirely inversely related to the US dollar. In times of uncertainty, gold and the US dollar may coexist. Not to mention that higher oil prices would translate to more US dollar requirements for oil consuming nations, thereby temporarily propping up the value of the world’s currency reserve.

What does this mixed signal imply? Have the leakages in the financial system found its way to commodities? Are the bond markets wrong? Such that commodities will continue to climb even amidst a muddle through environment and eventually bond yields follows? Or are the commodities markets bound for a belated selloff?

So far one clear indication is that the equity benchmarks have been the unambiguous losers. Global benchmarks have taken a direct hit. Wall Street benchmarks have been significantly down (Dow Jones -3.17%, S & P 500 -2.31%, and Nasdaq -4.35%) and so with most of the world’s major or emerging market benchmarks.

Figure 5: Absolute Partners: Average Returns by stage of the Business cycle

Maybe it depends on the stage of the cycles. According to Niels C. Jensen of the Absolute Partners, based on a study called ``Facts and Fantasies about Commodity Futures1”, by Gary Gorton and K. Geert Rouwenhorst back in 2004 (emphasis mine),

``We make the following observations:

1. As we already pointed out, over an entire economic cycle, stocks and commodities behave quite similarly, at least as far as the total return pattern is concerned.

2. Stocks (and bonds) do much better than commodities in late recessions and early expansions. Late recessions are, in fact, the worst environment for commodities where the average return has been negative.

3. The best environment for commodities is late expansions where the average return both in absolute and relative terms is very attractive.

4. In early recessions, where stock and bond returns really suffer, commodity returns are still quite attractive, at least in relative terms.

``All this leads to the $1 million question: Where in the cycle is the global economy today? Knowing the answer to that may explain the difference between poor and good performance in your portfolio over the next 12-18 months.”

Does the weaknesses in the stockmarkets’ worldwide compounded by the tepid rally in bonds imply that we are now entering into the early stages of a recession? We will see.

One thing I would like to repeat is that the Bernanke Put, i.e. Fed’s willingness to bail out the markets with a flood of liquidity, a possible legacy from Greenspan, remains an open option as argued in my June 5 to June 9 edition, (US Recession Watch: A Fed CUT in June or August?).

Once Wall Street’s benchmarks hit substantial or pivotal lows, you can be assured that not only will the Fed pause but Mr. Bernanke & Co. will embark on an abrupt series of rate cutting spree in fear of “destructive” deflation. The appointment of Henry Paulson formerly top honcho of Goldman Sachs as the Secretary of the US Treasury underscores this interest to protect members of the Financial community. Talk about maintaining special interest groups.

Figure 6: stockcharts.com: Phisix in a Predicament

Finally, relative to the Phisix, it was a curious episode for the Philippine benchmark to rally significantly last Thursday despite the steep losses in Wall Street, which made me think that the gold-phisix correlation could be at work. However, the failure of the mines to perk up gave me less confidence for this outlook. Friday’s 2.27% drop basically reflected the loss of the week (down 2.12%) and validated my doubts. Although, it is too early to call off the relationship: One day or week does not a trend make.

On the fundamental side, Japan’s first interest rate hike in 6 years was accompanied by placating statements of “no intention” of raising rates at consecutive meetings which implies of an orderly pace of tightening. This should reduce the probabilities of a precipitate margin based liquidations of financial assets worldwide.

Second, while my outlook remains for a dovish Fed stance in the face of a deteriorating equity market and softening economy, a continued rally in the commodity markets would most possibly filter into emerging market bourses eventually. If the business cycles study above by Mr. Gary Gorton and K. Geert Rouwenhorst replays itself then possibly commodities are still the place to be in and so with emerging market bourses.

Based on the technical perspective, the outlook remains mixed. Over the short-term especially on Monday, the Phisix may replicate the activities in Wall Street anew and do some backing and filling jobs as it had broken support see Figure 6. The gaps which it had opened would be most likely closed while at the same time trade within the 50-day moving averages (red line) and 200-day moving averages (blue line) over the interim.

I expect some tradeable opportunities in the market despite some interim pressures, simply buy and support and sell on resistances. Keep some long positions on mines and oil for insurance purposes.

Lebanon’s Proxy War may lead to $85 to $100 oil?

Last week, I mentioned that crude oil treaded at a critical juncture looking for either a correction or a breakout. With the market’s declarative stand, Oil finally resolved the impasse with a breakout to a FRESH record nominal High. Its sibling gold was equally buoyed as shown in Figure 1.

Figure 1 stockcharts.com: Record Oil, Gold Follows

While one may argue that seasonality could have also been a factor in oil’s latest upsurge in view of the summer driving season in the US, the breakout coincides with the escalating violence in Lebanon which could have further tipped the fragile scale of balance in the world oil markets.

The public appears to have seriously underestimated the ongoing military developments in the Lebanon, which could run the risks of further escalation. The warring protagonists, Israel and the Hezbollah, seems to acting as representatives for other parties involved in advancing their positions in the Middle East, particularly, the United States and Iran and possibly Syria. In short we could be witnessing an unraveling of a proxy war.

According to the astute guys at Stratfor,

``Hezbollah has two patrons: Syria and Iran. The Syrians have used Hezbollah to pursue their political and business interests in Lebanon. Iran has used Hezbollah for business and ideological reasons. Business interests were the overlapping element. In the interest of business, it became important to Hezbollah, Syria and Iran that an accommodation be reached with Israel. Israel wanted to withdraw from Lebanon in order to end the constant low-level combat and losses...”

``Hezbollah strategically was aligned with Iran. Tactically, it had to align itself with Syria, since the Syrians dominated Lebanon. That meant that when Syria wanted tension with Israel, Hezbollah provided it, and when Syria wanted things to quiet down, Hezbollah cooled it.”

Hezbollah’s possible motivations for the kidnapping and killing of Israelis soldiers which provoked the vindictive strike in Lebanon could be for Iran, 1) to expand its negotiating levers or bargaining chips on its present standoff against the United States on its nuclear program and 2) in lieu of the Al Qaeda, by realigning a global network against US interests, to possibly ‘reclaim its leadership in the Islamic radical resurgence’.

For Syria, a possibility to reassert control or possibly reabsorbing Lebanon and/or to expand its commercial exploits.

For the US, according to the Stratfor, ``an invasion of Hezbollah-held territory aligns Israel with the United States. U.S. intelligence has been extremely concerned about the growing activity of Hezbollah, and U.S. relations with Iran are not good. Lebanon is the center of gravity of Hezbollah, and the destruction of Hezbollah capabilities in Lebanon, particularly the command structure, would cripple Hezbollah operations globally in the near future. The United States would very much like to see that happen, but cannot do it itself. Moreover, an Israeli action would enrage the Islamic world, but it would also drive home the limits of Iranian power. Once again, Iran would have dropped Lebanon in the grease, and not been hurt itself. The lesson of Hezbollah would not be lost on the Iraqi Shia -- or so the Bush administration would hope...Therefore, this is one Israeli action that benefits the United States, and thus helps the immediate situation as well as long-term geopolitical alignments.”

Further, today’s warfare could be a prelude to a US/Israel led military strike on Iran utilizing the present hostilities as cover.

In short, the risks run high that the theaters of war may escalate to include major oil producers as Iran. This heightened anxiety is giving way to a premise for higher oil prices as the drumbeat of war persists. Israel is said to be calling up its reserves, while Syria and Egypt are said to be having on going talks on this matter according Stratfor. $100 per barrel soon?

Based on technical or chart data, using the most recent trough-to-peak move, Crude oil may attempt to go for $85 (!!!) before undergoing a retracement.

Politics, Flawed Policies and the Road to Hell

``But there are many others who are not bashful about using government power to do "good." They truly believe they can make the economy fair through a redistributive tax and spending system; make the people moral by regulating personal behavior and choices; and remake the world in our image using armies. They argue that the use of force to achieve good is legitimate and proper for government - always speaking of the noble goals while ignoring the inevitable failures and evils caused by coercion. Not only do they justify government force, they believe they have a moral obligation to do so.”-Congressman Ron Paul of Texas

Oil prices soared to fresh record nominal levels yet domestic media, as we have it, continues to downplay on its significance, relegating such developments to secondary headlines and opting to give prominence to domestic politics. Media, after all, is about entertainment; it is paid to get your attention rather than to inform.

Because of the penchant for drama, personified by top-grossing tele-drama series, the public’s appetite for partisan politics have been constantly whetted upon by the incessant stream of internecine information. While glossing over the ramifications of rising crude prices, in the coming days, you can expect consumer prices in general to rise alongside, and the typical response by some political groups would be to advance on protest rallies using this as cover. As if the toppling of the incumbent government would be able to resolve the imbalances in the heavily politically dictated global oil economics. It never ends.

And because the voting public’s interests are mostly fickle and short-term oriented, the classic response of any democratic governments or its underlying institutions would also be that of immediate-term gratification or appeasement, mostly in adopting policies tilted towards the “appearances” of having significant bearings on “social” dimensions.

Think minimum wage. Most economists are cognizant to the fact that pricing labor costs above what the market can afford to pay have been generally baneful or deleterious to the business climate and contribute more to the unemployment figures rather than solving them, yet because of short-term political demands, such as the Catholic Bishop’s Conference of the Philippines’ (CBCP) adaptation of the ‘Marxist’ view of “priority of labor over capital”, these policies have been commonly accommodated for by policy makers.

Flawed short term policies applied over and over again engenders arrant wedges of inequalities. In short, the glaring conflict of interests between short term political gains for the stark purpose of power preservation and meaningful long-term reforms has been a stirring vacuum in most instances as history have shown are unlikely to be filled. Political players, like anywhere else or for that matter in any form of government, are likely to be subordinate and beholden to the short-term interest of their subjects or interest groups that sustain their existence.

Just ponder, how can long-term structural economic disequilibrium be resolved when political expediencies dictate the appeasement, through the “band-aid” approach, of the public’s divergent immediate term interests?

Today, most governments, be it developed economies and/or developing third world states or taxonomically “emerging market economies” have instead relied on economic growth to resolve such deeply-rooted imbalances borne out of collective policy failures in almost all aspects of governance. They are all in the hope that the present asymmetries will be offset by continuing economic growth. Yet, evidences show that such imbalances get to be accentuated, not diminished.

As testament, money and credit growth, instruments by which collective governments have control over nationally (for US- internationally), has grown tremendously over the years far surpassing the growth in real economic activities. Naturally, such tidal wave of liquidity has percolated into the private sector too. Present inflationary manifestations have been an inevitable product of these. In other words, the offshoot to these state induced interventionists inefficiencies and incompetence are the macro imbalances present in the financial and economic system in the world today. What is unsustainable simply won’t last. But as to when this imbalances would unravel is something I can’t predict. As an example, think of the entitlement programs set to implode in the coming years even among industrialized nations (US, Europe, Japan et.al.), due to the colliding impacts from a myriad cocktail of rigid labor and immigration policies, asymmetric capital flows, evolving demographic trends and scientific and technological breakthroughs (converging trends of nanotechnology and biotechnology-which may expand the average lifespan of the population). Nonetheless, such strains would eventually be evinced or transmitted to the financial markets and the global economies.

Despite the cognizance of such variability, most politicians and bureaucrats have largely turned a blind eye on these. Why? Because it requires painful UNPOPULAR structural adjustments, such as hefty cuts in welfare benefits or massive increases in taxation or extended working age requirements or a combination of, something of which they hope would simply go away.

While the gullible public would naturally be enchanted by ‘motherhood’ rhetoric premised on a corporeal “utopia”, who would elect a political actor who would subscribe to worldly pain, e.g. work-saving-investing ethics, as to attain such lofty goals?

My point is simple; voters like the average market investors are after short-term gains and would mainly espouse panaceas in whatever form in pursuit of these. Being personally responsible and observing a regimented way to uplift one’s life is smirked and disdained upon, simply because governments are there and perceived upon as an ‘easier’ channel to provide the short-circuited goals by manner of coercive unproductive redistribution. For an individual, why work or save when government “should” provide? For companies, why be efficient, if they can use laws and regulations to subvert competition, keep costs down and enhance profit margins? Yet, the supreme irony is that despite belaboring governments to live up to expectations (whatever that may mean to you or me), we hate (elude) paying taxes and abhor the perpetual corruption arising from the tentacles of bureaucracy. Still, to quote Murphy’s Law, ``Anything that can go wrong will”. Woebegone, the perpetual vicious cycles of personality based politics!

Nonetheless, statist advocates still believe that Big Brother in government knows what’s best for us. However, even the “noblest” of laws generally meant for our supposed wellbeing have turned out to be a miserable, dismal and disastrous failure. Take for example in the US, the national prohibition of alcohol beverages or the Volstead act of 1919. In an attempt to make alcohol consumption as illegal, the law, according to former US Congressman Bob Baubman (emphasis mine), ``was touted by its backers as the solution to reduce crime and corruption, solve social problems, lower the tax burden created by prisons and poorhouses, and improve health and hygiene in America.”

The net result? According to Congressman Bauman (emphasis mine), ``This ambitiously wrongheaded experiment clearly failed miserably on all counts. Alcohol became more dangerous to consume; organized crime was born; the court and prison systems were overloaded; and corruption of police and public officials was rampant.” In addition, many other repercussions emerged, such as the loss of tax revenues, unbridled smuggling and racketeering, and excess violence according to wikepedia.org. The feckless “moralistic” (ha ha ha!) law which even then US President Harding hardly observed (as a proponent of the law as Senator, he kept bootleg liquor at the White House!) was finally repealed in 1933.

In the Philippine context, as in every government diktat, quoting Honesto General of the Inquirer (emphasis mine), ``The culture that it is okay for a government corporation to lose money--it's only taxpayers' money, anyway--prevails to this day. There are now over 300 government corporations losing a total of almost P50 billion a year.”

As a saying goes, ``The road to hell is paved with good intentions.”

Crude Oil hits Fresh Record at $78 per barrel amidst Media's stoicism

Domestic media's predilection to cover sensational political issues rather than focusing on what truly affects our lives is simply amazing. These simply reflects on the public's gullibility to trivialism and "personality-based" politics "statist" solutions to our daily lives.

Crude oil has passed the recent high mark as early as the afternoon (Philippine time) and surged way above its resistance level, as discussed previously ($80 here we come). The absence of such news accounts is truly deafening.

Anyway, what media papers over is what we deal with. According to Bloomberg (you may click on the link for the entire article),

July 14 (Bloomberg) -- Crude oil rose above $78 a barrel in New York for the first time as escalating violence in the Middle East and disruptions in Nigeria threatened global supplies.

Hezbollah militants fired rockets from Lebanon into Israel's third-biggest city after Israeli forces bombed Beirut international airport and other targets. A Nigerian newspaper yesterday reported that rebels had attacked pipelines, later denied by the owner of the facility, Italy's Eni SpA.

``There's real disruption to supplies in Nigeria, potential disruptions in Iran, and now you've got what's happening in Israel,'' said Tobin Gorey, commodity analyst at Commonwealth Bank of Australia Ltd. in Sydney. ``Who wants to sell in this environment?''

Crude oil for August delivery rose as much as $1.70, or 2.2 percent, to $78.40 a barrel in after-hours electronic trading on the New York Mercantile Exchange. It was at $77.95 at 7:45 a.m. in Singapore, 35 percent higher than a year ago.

Phisix, Peso Driven by Fedwatch Plays; The Gallery Experience

``Globalization is defined as integration of economic activities, via markets. The driving forces are technological and policy changes--falling cost of transport and communications and greater reliance on market forces.” Martin Wolf, columnist, Financial Times

Morgan Stanley’s Stephen Jen recently wrote ``the market’s fixation on the Fed is justified, because it is the Fed’s action and posture that will dictate the global liquidity cycle and investor risk-taking attitude.” If global markets are indeed following the US Fed as a gauge on the liquidity cycle, then reckoning on the probability side, it is likely that the US Federal Reserve is at the near end or the peak of its tightening phase (for the moment).

So far, the domestic financial markets appear to buttress my view, that a pause or a cut for that matter, would restore the US dollar diversification investing theme. As I mentioned too in the past editions too, the rally in the gold market, another barometer of the anti-US dollar trade, appears to correlate with the performances of emerging markets bourses. For the week, as gold jumped 3.05% to $634.8 per oz, the US dollar denominated sovereign ROPs rallied, the Peso firmed by a hefty 1.43% to Php 52.35, while the Phisix gained a considerable 3.64%.

Figure 4: Phisix (candlestick) and the USD/PESO (blue line)

As you can see in Figure 4, the Philippine Peso has shown quite a strong association with the performance of the Phisix, such that a rising Peso positively correlates with an advancing Phisix (red arrows) and vice versa. This suggests that portfolio flows into the domestic financial markets could have at the margins contributed to the rising Peso.

While the Phisix accounted for foreign money outflows during the last four weeks, this has reversed as of last week and would probably see continued inflows if global investors persist on the Fedwatch plays. Although Monday could probably start off weak following the lead of Wall Street’s conspicuous decline last Friday, which could possibly be a buying window.

While risks factors arising from the latest selloffs are still present, I remain cautiously bullish with the Phisix, on the account of the US dollar diversification theme and a bullish outlook in gold, and would closely watch the bond and gold markets for signals on the possibility of the re-emergence of the risk reduction trade.

Finally I was at the gallery of the PSE in Makati last week, the quintessential casino hall of the stockmarket, where the ambiance was filled with all sorts of rumors/gossip based activities and the proliferation of mental shortcuts which can be heard from most of the participants, and was delighted to hear that retail investors have now learned how to follow on the gold markets with respect to the mines. For a long period (2003-2005), if you recall, I have decried on the public’s indifference to a rising gold vis-à-vis the mining sector even when the Philippines sits on one of the largest reserves in the world. As said in the past, psychological evolutions take time to form or shape, and as the gold and commodities markets resume their ascent they will further diffuse into the public’s mindset until the great upside capitulation comes (time to get out!). As always, it has been an unfolding cycle.

Post script, I continue to shun the trading floor and the gallery or stock forums due to the adverse experience in my second venture into stockmarket investing in the mid 90s. As a gullible novice then, I heeded on tips from group chatters which got me badly burned figuratively or my portfolio mauled, aggravated by margin trading, that I almost literally leapt out of the 12^th floor of the Tektite building (formerly the trading floor) out of despair and swore off the touching the markets then…until of course, I met my mentor who taught me the prudent way. How times have changed.

Record High Oil Prices and Interventionist Policies

``Since Japan's boom ended in 1990, its regulators have been using every presumed macroeconomic "tool" to get the Land of the Sinking Sun rising again. The World Bank, the International Monetary Fund, local central banks and government officials were "wisely managing" Southeast Asia's boom until it collapsed spectacularly in 1997. Prevent the bust? They expressed profound dismay that it even happened. Argentina's economy crashed despite the machinations of its own presumed "potent directors." I say "despite," but the truth is that directors, whether they are Argentina's, Japan's or America's, cannot make things better and have always made things worse.”-Robert Prechter, Elliott Wave Theory

Well, news headlines had been surprisingly silent about recent spike of crude oil prices to new record nominal levels exacerbated by brewing geopolitical tensions. I say exacerbated because, oil prices have been advancing incrementally even prior to the controversial ‘tests’ which provoked a worldwide uproar as shown by the blue arrow in Figure 1.

Figure 1: stockcharts.com: benchmark WTIC Crude oil at a trading range?

While it maybe premature to discern as to where oil prices would be headed for over the interim, Friday’s activities as portrayed by the price movements in the chart appears to suggest that oil could have hit a peak following a “double top” (red arrows). However, since the second quarter, the oil benchmark appears to be in a trading range from about a low of $68 to a high of over $75. Again, it is too early to say where oil prices are headed for but if it does successfully breakout over and above from the said channel, we could possibly see oil prices test the $80 to $85 mark. Otherwise, it could fall to the lower segment of the trading range.

Conventional mainstream analysts argue that slowing economic growth would likely depress oil prices. I am, however, uncertain and unconvinced of that outcome. If history would be a guide, and by vetting at the factors buttressing the present cycle, it may even suggest the contrary, according to the maverick guru Jim Rogers in his book “Hot Commodities”, ``In the history of oil prices, supply demand imbalances trump even poor economies and technological revolutions.” He goes to mention that in the 1970s as major economies like the US, Europe and others went sour, the price of oil rose 15 times! Such that not even technological breakthroughs supported the increase in supplies then to dampen prices.

Figure 2: Chart of the day: Inflation adjusted Oil prices

A replay of history or even a semblance of would translate to over $150 bbl, based on the 1999 low of $11 bbl at 15 times. Despite the fresh nominal record high last week, current oil prices are still below the inflation adjusted highs of the late 70s as shown in Figure 2.

If one would discern from the present market activities, despite the consensus outlook of some $10 to $15 per barrel of “speculative” or “terror” premium, the recent liquidations on heightened risk aversion last May appears to validate the supposition of inelasticity of oil prices relative to economic growth. If oil prices continue to ascend despite economic doldrums this could be a possible affirmation of the Peak Oil theory, or the diminishing supply of cheap oil.

One should not forget that Oil economics has been one of the areas where government intervention has been a primary mover. In other words, the massive imbalances as a result of the contortions brought about by the collective governments attempt to control the industry, for the so-called ‘social benefits’, have been reflected in today’s market prices.

While news accounts and mainstream analysts incessantly talk about growing demand from China and other emerging countries and the geopolitical tinderboxes as key drivers of sky high oil prices, hardly anyone talks about the structural side, namely, the past and present “nationalizations” of the industry and government price subsidies (limits efficiency and restrains output and investments), the inadequate “transparency” of proven oil reserves by Oil producing states (overstated OPEC reserves that allowed for higher production rates during depressed oil prices), “windfall” taxes and the tomes of environmental regulations and other legal strictures imposed (NAMBY-Not in my backyard drilling, gasoline formulations that led to refinery shortages); all of which has contributed considerably to the shortages of investments or the underinvestment to the industry thereby restraining supplies.

Moreover, on the demand side, the inflationary policies, such as prolonged periods of easy money policies (boom in worldwide real estate industry), surging credit growth and expansionary money base (boom in global financial markets), currency pegs (e.g. China remimbi-US dollar-current account imbalances) adopted by major economies aside from the stockpiling of strategic reserves have contributed to its explosive growth.

If government’s directives have been efficient, why has there been a massive shortage of investments by both public institutions and the private companies? Why has the demand-supply imbalances remained unresolved, if not aggravated? Or simply, why have oil prices persists to remain at lofty levels? And again, who pays for such miscalculations or ineptitude? Obviously, the people/consumers/constituents who ironically had been the intended party to benefit from supposed control. Whereas in the free markets erroneous decisions lead to individual losses or bankruptcies, flawed government policies have been borne by the citizenry or constituents via increased taxations or loss of purchasing power which essentially leads to the deterioration of the standards of living.

In short, the colossal high oil prices have simply been a manifestation of failed aggregate interventionist policies, very much like the endemic structural inequalities present in the Philippine economy and not due to the inadequacies of laissez faire markets. It is not the inability of free markets to function, but rather the lack of it. We tend to see what we believe in rather than believe in what we see.

As an offshoot to these, major Oil companies have been restrained from expanding of their reserves and/or adding production outputs due to the regulatory constraints and most importantly due to the inability of the companies to ascertain on the viabilities of prospective projects as a result of the uncertainties from the actual data on existing demand and supply (remember fudged data on proven reserves).

Petro companies have instead embarked on buying up of reserves of existing companies rather than undertaking drilling or oil/gas exploration themselves; the account of Chevron-Unocal merger in August 2005, the recent $21 billion Anadarko acquisitions of Western Gas and Kerr-McGee, Devon’s Energy’s $2.2 billion purchase of Chief Holdings attest to these unfolding developments.

Figure 3: Energy Letter: Global Rig Count (April)

Yes, while there has been a surge in drilling activities worldwide mostly due to juniors explorers see Figure 3, another problem according to Elliott Gue of the Energy Letter is of declining well productivity-well flows are of lesser quantity and target wells are of smaller reserve/reservoirs.

So, government interventionist policies, diminishing reservoirs/declining well productivity and geopolitical anxieties have been significant fundamental contributors to rising oil/energy prices and continue to do so.

Investment implication: the obvious trend is to search for junior explorers who could build up sizeable reserves and become likely acquisition targets by Oil Majors.

Bullish Gold Backed by Gold/Oil Ratio

``I wish I had an answer to that because I'm tired of answering that question.” Yogi Berra, former catcher manager in Major league Baseball

One interesting if not amazing development in the marketplace during the recent markdown was crude oil’s resilience despite the attribution of some $10 to $15 of “speculative” or “terror” premium to the price of oil by conventional or mainstream analysts.

Figure 5 Stockcharts.com: Holding WTIC Crude (candle) amidst financial market turmoil.

As Figure 5 shows, the West Texas Intermediate Crude ($WTIC) benchmark meandered sideways (horizontal blue line) as rising “risk aversion” supposedly reduced or marginalized leveraged positions from the high performance markets as shown by the Dow Jones World Index (declining green arrow).

Could the present developments indicate that the resiliency in oil prices amidst the financial turmoil represents a validation of the Peak Oil theory???

Figure 6 Matthew Simmons: Rising Demand on Declining Spare Capacity

In the face of persistent robust rising demand and supply constraints, (such as dwindling rigs, aging workforces, rusting iron, aging refineries, evaporating cushion, accelerating decline curves, end of technology, low prices that dissipated the once robust industry~Matthew Simmons), as shown in Figure 6, are we then looking at higher oil prices in the immediate future considering a more hospitable inflationary landscape?

Figure 7 Dailywealth: Gold/Oil Ratio: Gold cheaper than Oil

Which brings us to the next premise: could rising oil prices inspire a more animated rally in gold considering that its historical median is about 14 barrels of oil for every once gold, when its present level trades at low of a 8? My probabilistic guess/answer: yes, it would.

Fed Dilemma: Too Much Pressure To Continue Hikes

Yes, I have raised such concern that the Fed may initiate a pause or even a succession of rate cuts on the premise of an adverse US slowdown (see June 5 to 9^th edition: US Recession Watch: A Fed CUT in June or August?) highlighted by a continued downdraft by US financial markets benchmarks.

I have also raised the contention that a Fed Pause is likely to occur due to:

One, the political season is back, with congressional elections due later this year, suffering electorates are unlikely to vote for incumbents.

Second, Bernanke’s ideological leanings have been that of the Milton Friedman “monetarist” school of thought, where the salient solution to economic or financial dislocations is to inundate the system with liquidity.

Three, an upcoming economic slowdown or “moderation” under the semantics of the Fed.

Market guru/savant and philanthropist billionaire George Soros foresees a US “hard landing” recession in 2007, AME info quotes Mr. Soros, ``Almost inevitably, they have got to overshoot because they can't stop (raising interest rates) until the economy shows signs of a slowdown. By the time it shows these signs it may be a little too late. I happen to be on the pessimistic side.” So do I.

Except for the 3-month Treasury bills at 4.98% (???), the yield curve has now fully inverted (shorter term yields higher than long term instruments) following the Fed’s 17^th rate increase and the decline of the long end of the curve. This marks a restrictive territory for the price of money raising the probabilities of the specter of a recession in the horizon. As for the anomalies in the 3-month Treasury bills, it is said that what keeps its yields from rising is the prevailing onrush to the “flight to quality” mentality.

Yet, a marked slowdown or even a recession is no guarantee of easing inflation as had been in the 70s, ``Economists are also mistaken in their belief that a weakening economy will counteract inflationary pressures. This overlooks the fact that a weakening U.S. dollar will stimulate demand abroad (emphasis mine) at the same time it restrains it here at home. So even as Americans consume less, prices will continue to rise as they are forced to compete with wealthier foreigners for scarce consumer goods.” commented Peter Schiff of Euro Pacific Capital.

In addition, there is a growing popular clamor against such succession of rate hikes. According to the Bloomberg, in a poll conducted by Bloomberg/Los Angeles Times, ``By a 65 percent to 22 percent margin, Americans oppose another rate increase by the central bank, which says such moves are necessary to counter inflation.”

Moreover, while everyone seemed to be focused on rising commodity prices, as the commonly perceived ‘causal’ factor contributing to the groundswell in consumer/producer prices, none has taken into account that rising cost of money (until it stifles demand) has inflationary tendencies too, the amusing Mogambo Guru elaborates, ``And if you think that gingerly raising interest rates will stop a rising inflation, you are wrong, wrong, wrong. Until the rates get so high that they cripple the economy, higher interest rates only produce higher prices, which is de facto inflation: As the producer of goods and services borrows money to finance the on-going business, the higher costs of that borrowing have to be figured into the higher prices of the final output of goods and services so that the business can make a profit. So in the short run, higher interest rates actually cause higher prices. And that's another compelling reason, as if you needed any more reasons, not to let inflation in prices get started by letting inflation in the money supply get started.”

Put differently, raising rates in a measured pace are not going get us anywhere, unless the governing authorities decides to reassert themselves to combat inflation in the truest sense, i.e. regardless of the consequences in the market or the economy, in the same path of the Former Fed Chief Paul Volker in the early 80s or if bond vigilantes compel the Fed to do so by preempting the Fed and sell down US treasuries. However, the magnitude of leverage present in the financial system has had far more consequential impacts relative to the previous regimes as to make it far more parlous.

Finally, immoderate liabilities accrued by the US government will be further burdened by continued rate increases, to quote Daily Reckoning’s Bill Bonner, ``The Fed may want to fight inflation, they say, but its hands are tied. The federal checkbook is overdrawn by some $500 billion this year. In addition, the U.S. Treasury has a trillion-dollar mountain of short-term debt it must refinance in the months ahead. And then, there are the voters themselves, faced with rising interest rates, falling house values and $2.7 trillion worth of adjustable rate mortgages that will be reset in the next 24 months.”

What I am simply saying is that the Fed may succumb to either political or economic or financial pressures or a combination thereof as to take a pause or even reduce its tightening stance. This should, in essence, fuel the anti-US dollar sentiment or dollar diversification theme which would lead to resurgences in the liquidity flows into high return markets as commodities and emerging markets bourses.

Figure 3 Stockcharts.com: Rebound in Phisix (candle) and CRB Index (line chart)

The recent reaction by the world financial markets practically averred of this phenomenon. Commodities as measured by the CRB index gained 3.4%, Emerging Market stocks rallied mightily, our Phisix climbed an eye-popping 4.5% on Friday to lead Asian bourses on the backdrop of a reversal of foreign outflows seen in most of the week. With Friday’s surge, the Phisix accrued a 3.11% advance over the week.

If the latest “benign Fed” elixir does continue to gain momentum, which I am inclined to think of, we would likely see an interim reversal in the decline of Philippine bonds yields and of the USD/Peso and a rally in the domestic equity market. This will reflect a regional motion, meaning a similar rally in Asian currencies, bond markets and equities.

This does not however write off my long term cyclical view that interest rates will continue to rise in the distant future, underpinned by the well entrenched inflationary variables.

Figure 4 Economagic: Looks like a 40-year trough-to-trough cycle for benchmark treasuries

Figure 4 appears to show of the benchmark US Treasury yields on a 40+ years full trough-to-trough cycle, interspersed into 20+ year trough-to-peak (red arrow), and about 20 years peak-to-trough (blue arrow). The fast shaping advance or trough-to-peak cycle seems to be at work today, despite the recent stimulatory Fed Speak and the stark recoveries across assets in the global financial market.

EZ Money Addicts and Pavlov’s Drooling Dogs

The global financial markets reacted impassionedly to the Fed’s recent statements following its 17^th interbank rate increase to 5.25%. The US dollar index cratered, the bond markets (sovereigns and corporate) rallied furiously as shown in Figure 2, global equity markets and commodity prices vigorously rebounded.

Figure 2 Stockcharts.com: US Dollar (left chart) and benchmark US Treasury Yields (right chart-candlestick) breaks down, while JP Morgan Emerging Debt (line chart) Rallies

Despite being noncommittal on its next moves, as reflected by their latest FOMC statement (emphasis mine) ``The extent and timing of any additional firming that may be needed to address these risks will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information'', the markets appeared to have discerned on the culmination or the near-peaking of the US ‘interest rate cycle’ following the perceived “dovish overtures” from the Fed.

``Everyone jumped on the statement's focus on moderating growth (emphasis mine). What about the shift in emphasis from the recent one-note chatter on inflation, inflation and inflation? Instead of accusing Bernanke of flip-flopping as they had in the past, analysts lapped it up, praised Bernanke for becoming his own man and congratulated him on gaining the necessary credibility to let the data take center stage” decried Bloomberg analyst Caroline Baum on the market’s U-turn.

Robert Folsom of Elliott Wave International adds his dissenting voice to the market’s seeming irrational exuberance saying that present movements signify ``defiant mockery of everything the media has said about stocks for nearly three months – namely that the Fed has been raising rates because of "inflation fears," and in turn "inflation fears" have made the stock market decline.”

True. Fundamentally speaking, as to how a “moderating” or softening economy would translate to growing/expanding earnings is something beyond me. In addition, current price valuations reflected on the financial markets have been that of “rose colored” glasses or of a “goldilocks” (not so hot or not so cold) environment, or to say at least have been priced at the high or optimistic side, a natural response to a slowdown should be a downwards re-pricing. Yet the critical question is, how rational has the markets been?

One thing I understand is that Global GDP estimates are at $54 trillion in 2005 according to theGlobalist.com, which quotes World Bank figures. Whereas the world’s aggregate capital markets have been at over $118 trillion, using Mckinsey Quarterly estimates in 2003. This suggests that the global financial markets have virtually LED the global economy (by a ratio of over 2:1) more than serving its traditional function which is to basically provide support.

Moreover, according to Bank of International Settlements (BIS) on its June quarterly review issued last June 12^th (emphasis mine), ``Combined turnover measured in notional amounts of interest rate, equity index and currency contracts increased by one quarter to $429 trillion between January and March 2006.” This implies that derivatives (or instruments used as a hedge, such as options and futures contracts, which derives their value from an underlying security, group of securities or index) bets are about 4 times the “derivative value” or the worth of the world’s capital markets and about 8 times the size of the global GDP. That is how leveraged the world is!

As to how these phenomena extrapolates on the rationality of the markets...since the world’s GDP is highly interdependent on the advances of financial markets (including the housing industry), it would need accelerated injections of money and credit to retain its present growth clip, something patterned like a grand-scale PONZI or pyramiding scheme to keep the present system afloat.

It also means that the global financial markets have to always keep growing too, regardless of what “micro fundamentals” says. The “chase for yields” and the “Current account imbalances” have been symptomatic of these burgeoning asymmetries fostered by the current monetary system, the US dollar system, matched by an equally compelling interrelation borne out of the Fractional Reserve banking system (fraction of deposits kept in reserves). Today’s liquidity flows have been multidimensional (bank and non-bank) and too complex to measure.

Once the liquidity injections reverse or the least “stalls”, the world financial markets and economies shrivels, falls or collapses like a house of cards. To quote Gavekal Research, ``Bull markets are like drug addicts whose next fix/liquidity injection provides diminishing returns. To get the same effects, the fix/liquidity injections need to always get bigger…Or serious withdrawal follows.”

I do not like to sound so macabre, or adopt the slogans of the inveterate goldbugs...yet empirical evidences point towards the escalation of these systemic risks.

For instance, recently, Emil W. Henry, Jr., Assistant Secretary for Financial Institutions of the U.S. Department of the Treasury, acknowledged about the risks posed by the mushrooming outsized Government Sponsored Enterprises (GSEs) combined mortgage investment portfolio amounting to US $1.5 trillion, where he cautions, ``While the U.S. financial markets are highly efficient and resilient, they are not infallible”.

Like all incumbent officials deliberately downplaying on its potential occurrence as “unlikely”, he admonishes that in the event that it does (emphasis mine), ``An obvious transmission mechanism is through direct losses to the commercial banking system, derivative counterparties, or other creditors. If these key financial intermediaries suffered losses related to their GSE exposures, this could lead to a broader contraction of credit availability – for example fewer loans being made or more restrictive loan terms - that could have adverse implications for overall credit availability and U.S. economic performance.”

In other words, while the endemic systemic risks have been mounting worldwide for quite sometime now, global financial markets have been inured if not hardwired into believing of the constancy of advancement, irrespective of the enormous leverage latched into the system. That’s how rational the markets are. Add leverage in order to advance the financial markets, which should translate to economic growth.

So, aside from the analogy of addicts alluded to by Gavekal Research, global investors behave like the ‘Pavlov’s drooling dogs’, (where Nobel prize awardee Russian priest turned scientist Ivan Petrovich Pavlov, 1849-1936, discovered that stimulated reflexes honed by the ringing of bells to associate for food caused dogs to drool), equally stimulated with the Bernanke-speak Fed induced monetary accommodation.

I have to confess, I am one of these investors and portfolio manager ‘addicted’ to the realm of easy money. And like Pavlov’s dogs, salivate at the stimulation provided for by loose liquidity spawned by policies authored or engineered by Bernanke & Co.

Investing on conviction has hardly been a profitable venture as experience taught me, similar to fate of goldbug zealots. While I maybe possibly a goldbug at heart, premised on the constant abuses adopted by collective governments, I have to be a pragmatic investor or trader, and by principle, a sovereign liberal individual. However, unlike the archetype ‘addicts’, adopting contingent plans over the possibility of a sigma-4 standard deviation, black swan or low probability, high impact event is a must.