Decoupling Recoupling Debate As A Religion

``The highest intellects, like the tops of mountains, are the first to catch and to reflect the dawn.” - Thomas Babington Macaulay (1800-1859), British Poet, historian and Whig politician

If we accept the US-OECD-Asia-Emerging Market sequencing of the global slowdown as proposed by the doomsayers, then by the chain of logic, the US should recover first as the slowdown spreads to the world.

But this is unlikely to be the case since, aside from a busted financial-real estate sector, NET exports have been a key factor to the apparent resilience of the US economy. This implies that a slowing world economy would further account for a drag to the US which is likely NOT to assume the leadership in the coming recovery.

This is where we part from the doomsayers whom have made the decoupling-recoupling debate as a religion or as some form of abstractionism similar to “If you are not with me then you are against me.” Such rigidity makes us unconvinced.

Merrill Lynch’s Richard Bernstein (HT: Craig McCarty) notes that “only 32% of the world’s equity markets are outperforming the S&P 500 so far this year (in local currency). With that performance backdrop, an appreciating dollar could attract “momentum” capital to the US.”

In such a case where then is the recoupling? With 1/3 of the equity markets outperforming the US, how can we say the world financial markets will suffer a meltdown from a deep recession unless we factor in the OECD economies as representative of the whole?

Think of it another way, if oil and food prices will remain depressed over the interim wouldn’t we be seeing some reprieve to the headline inflation pressures of non-commodity export emerging market economies from which they may be allowed room for a recovery and possibly see a reacceleration of economic growth?

Besides, if Mr. Bernstein is right and a strong dollar could push up the US markets based on momentum or M&A (which is in my view signs of rotating inflation), will not the other tightly correlated benchmarks with that of the US also reflect a similar fate?

Commodity Prices Reflect Fundamentals Aside From Monetary Factors

Another, we find it puzzling how the logic of “commodities-will-decouple-but-emerging markets-won’t” will prevail. The cornerstone of such theme is US dollar-paper money oriented.

True, we agree that the US dollar has been an important variable in shaping oil or commodities prices. But again, the world doesn’t seem to operate in simple cause and effect clauses, see figure 2.

Figure 2: CFTC.com: Oil prices Also Reflect Fundamentals

Recently soaring oil prices got the goat of some US public officials who attributed this phenomenon to “speculative” forces. Since the politicians always react on popular issues, they threatened to slap restrictions on the capital markets in order to curb so-called “speculative forces”. Thus, the US Commodity Futures Trading Commission (CFTC) came up with an investigative report to validate or debunk such suspicions.

From the CFTC report, ``The key driver of oil demand has been robust global economic growth, particularly in emerging market economies….world gross domestic product (GDP) growth (with countries weighted by oil consumption shares) has averaged close to 5 percent per year since 2004, marking the strongest performance in two decades.”

In other words, the price dynamics reflected the imbalances derived from variance in the pace of world economic growth against global oil production output more from than speculative activities. Oil production simply couldn’t keep up with global economic growth especially from emerging economies.

In the recent downturn in oil and commodity prices we see the same phenomenon at work, see figure 3 from BCA Research.

Figure 3: BCA Research: U.S. Manufacturing: Global Weakness Adds To Domestic Drag

This from BCA Research, the reputable independent research outfit (highlight mine), ``Global leading economic indicators have rolled over, implying that slower overseas growth will diminish one of the key sources of support for U.S. manufacturers. The July ISM manufacturing survey reported a drop in export orders (albeit the index is still well above its boom/bust line). A slowdown in exports is worrisome because this sector had been the primary source of growth for manufacturers in the past year, as the domestic economy is mired in recession. The only silver lining is that energy prices have finally begun to recede. Although oil prices will have to move substantially lower before having a significant economic impact, energy price relief will help to ease pressure on profit margins and lower inflation expectations. Bottom line: The overall manufacturing sector will continue to grow at a sub-par pace, and the risks will stay on the downside until the consumer retrenchment is further advanced and/or much more relief from commodity prices arrives.”

BCA’s view buttresses our position on the slowing economic world growth and the sensitivity of the US economy to the global conditions.

So as we mentioned above, the US-OECD-Asia-Emerging Market sequencing on the recent economic downshift could be the case today, but from a recovery perspective the market leadership will unlikely come from the same order.

The Acceleration Phenomenon: A Key Emerging Market Dynamic

Now take a look at this commentary from Bloomberg (highlight mine),

``In the past, when the U.S. economy weakened, the rest of the world usually followed quickly, and inflation eased as demand for oil and other commodities fell. U.S. recessions in 1990-1991 and 2001 brought global growth down by half, sending fuel prices tumbling.

``That didn't happen this time. The world expansion barely slowed last year and oil prices surged, even as the U.S. economy shrank in the fourth quarter. Only now -- two years after the U.S. housing boom went bust -- is the slowdown spreading worldwide and the price of oil showing signs of receding.”

And such outlook seems to square or match with the idea the world has been significantly less correlated with the US in the downside and possibly in the upside too.

This very important observation from Mohamed El-Erian, author of When Markets Collide: Investment Strategies for the Age of Global Economic Change and co-CEO of bond-investing giant Pimco (emphasis mine),

``In the old days, if the US economy contracted, the rest of the world would do even worse. But today, if the US contracts, the rest of the world might contract by only half. That's a fundamental change. The wealth of the emerging middle class in countries like Brazil, India and China is becoming a force in itself.”

And perhaps the economic principle that underpins such dynamic is called “The Acceleration Phenomenon”, which was developed by Aftalion a French economist as shown in Figure 4.

Figure 4: Gavekal: The Acceleration Phenomenon

Our favorite Mr. Louis-Vincent Gave has a better description of the Acceleration Phenomenon (highlight mine),

``In China, like in most nations, income is distributed according to a Gaussian pattern (a bell-shaped curve) with a large percentage of the population having an income close to the “average” income. Very few people have a very low income and very few have a very high income.

``If, in China, the purchasing parity adjusted average income in 1998 was US$2,000/year, then the number of people earning more than US$10,000 was have been quite small. But if, by 2003, the average income had risen to US$3,000 per person, then the number of people earning more than US$10,000 will have probably increased by a lot more than 50%.

The above chart shows a hypothetical case. If a country’s average per capita is $10,000 where the elite class (having over $15,000 per annum) comprises 2.28% of the population, an average income growth of 25% will push those in the higher echelon from 2.28% to 15.87% of the population!

The significance, again from the eloquent Mr. Gave,

`` Because we know that when it comes to the buying of certain goods and services, the historical evidence seems to suggest the existence of ‘’thresholds’’.

``For example, if the average income in a country is below US$1,000, nobody owns a television; when the income moves above US$1,000, then almost everybody buys one. For the automobile industry, the critical level seems to be US$10,000/year. For university education US$20,000, etc… Today, as China’s income distribution curve moves towards the right, a number of threshold points are passed by an increasing number of people. A quick example: from nowhere a decade ago, China now counts 210,000 US$ millionaires. The acceleration phenomenon helps explain why car sales rose 64% in 2003. China’s consumption boom has only just started.”

While indeed international channels through trade, capital flows, labor and financial linkages or even monetary pegs could combine to impact an economy, especially in today’s more globalized settings, they don’t constitute everything.

Other significant variables as political, monetary and economic framework similarly determines the internal savings and investing patterns of a country and can present itself as the defining difference to a boom or gloom. As in China’s case a slowdown may reduce the pace of the acceleration phenomenon but generally, the consumption boom derived from such dynamic can lead to a self reinforcing process.

Thus, it is possible that the prospective recovery could even come from a MIRROR progression of the proposed US-OECD-Asia-Emerging Market ranking. Likewise, monetary aspects cannot totally be distinct from economic fundamentals.

Overall, recoupling and decoupling debate should not be seen from an absolutist stand. There will be no perfect decoupling as much as there won’t be perfect recoupling.

The Pleasure of Partial Vindication, Personal Tips

``Reading is a means of thinking with another person’s mind; it forces you to stretch your own.” - Charles Scribner Jr.

It feels soooo good to be vindicated, even if it is just a partial vindication, especially coming from an onslaught of skepticism. Partial because I can be temporarily right today but risks from an adversarial outcome especially from a shock may overwhelm us again. But so far, so good.

Yes, the most difficult part from a contrarian perspective is to be unpopular. Since our insights deal with independent systemic based analysis than from outright simplification of the causality variables as espoused by almost a majority in our field, our ideas tend to be ignored. People like to be told stories that are easy to comprehend or easy to visualize or tales that attached to present prominent events or if we quote Bill Bonner of the Agora Publishing fame, ``People come to believe what they must believe when they must believe it.”

Since we don’t sell anything to anybody, my goal has always been to be as objective as possible, even if it comes at a cost of non-patronage. Sometimes in soliciting our advice, some may have probably felt offended when we dealt them the glacial realities from the functionalities of marketplace, but overtime I hope they come to realize that what we told was for their own good. Sorry it is not my role to confirm your biases.

As a student of the market we try to learn from the deeds of those whom have succeeded in the field and so attempted to assimilate the same traits tailored in accordance to one’s personality.

And as an example of such traits, we learned that independent thinking is crucial to long term investment success, so in adherence to Mr. Warren Buffett’s words of wisdom, ``You can't do well in investments unless you think independently. And the truth is, you're neither right nor wrong because people agree with you. You're right because your facts and your reasoning are right. In the end, that's all that counts. And there wasn't any question about the facts or reasoning being correct.”

Nevertheless, we don’t pretend to know everything, nor do we pretend to pinpoint the exactitudes of peaks and troughs of markets. In the years of learning, it has been a painful realization that trying to engage in market timing is almost like playing a game of vanity. Yes, at times, it comes with accompanying thrills alright; insider treats, forum whispers, support-resistance trade and gossip mongering does add up to the adrenalin. And when the tide turns in our favor we feel infallible or overconfident, never realizing that the rising tide allowed us to benefit than from what we assumed as our inherent “skills”.

But once the tide has turned against us, the pain of losses is almost always greater than the short term successes. We tend to get consumed by regrets, and worst, pass the blame on others instead of admitting and learning from our mistakes.

Besides, in contrast to the simplistic notion that financial market investments is a no-risk, no-failure model is likewise delusional. Some people think that success in the marketplace requires a magic wand. Some people think that the function of analyst is to be a soothsayer or astrologer. This is a no-no or a disconnect from reality.

Exposure in the capital markets always entail risk taking. The truth is we can’t grow trees from the sky. Maybe if you are in the government, but not in the markets. Since we can’t exactly predict tomorrow, we will have to learn how to face the hard facts and correspondingly deal with the risks with appropriate action when conditions so require.

Thus, from the understanding of the cyclicality of the markets we can use our best guessestimates on the whereabouts of the phases of the cycle. Since we lack the market sophistication tools for hedging, from here we can work with what we have by balancing our portfolio in accordance to the risk environment and to one’s risk profile. In short, we get ourselves exposed to the market in the degree where we can have a good night sleep regardless of the daily fluctuations.

Remember, we can’t get married to the market too. We will have to understand that market returns always reflect a tradeoff between risk and returns. The mainstream or my counterparts rarely touches on these aspects. That’s why horse racing sells, you are trained to look at gains and ignore losses. In other words, we learned that investment success has the golden rule-to know your risk. So before putting money in the any endeavor always know how much risk you can afford to take and position accordingly.

We will have to always keep ourselves open to the diversity in opinion or perspectives since it is one way to extract or collapse built in complacencies or biases. Since the market is a channel of exchange thus it is always about diversity-that’s how transactions get consummated. Buyers need sellers in as much as sellers need buyers. That’s the beauty of the market, satisfaction is usually attained by virtue of exchanges.

Finally, understanding the thought process is also another very important factor for us. That is why it has been an obsession for us to study the behavioral framework in terms of finance or economics. From Bernard Baruch (1870-1965), Financer, Speculator Statesman and Presidential Adviser, ``“Only as you do know yourself can your brain serve you as a sharp and efficient tool. Know your own failings, passions and prejudices so you can separate them from what you see.”

Phisix: Understanding Benchmarks; Tidal Flows and Ebbs

``I don't set trends. I just find out what they are and exploit them." - Dick Clark, American Entertainer

Recently we were asked why we chose 2,650 as our threshold benchmark for a transition to a bottom cycle than 2,600.

Figure 5: stockcharts.com: Phisix Does This Like A Recoupling?

Our reply is that trend lines can be deceptive. Look at figure 5, the green line (1) was the original downtrend line, when the Phisix made a first attempt to bottom out in May- unsuccessfully (red circle). Thus the high from that failed breakout becomes our beacon or our lamppost to suggest of the transitioning from the current phase (bottom) to the next phase (advance). That benchmark is about 2,900.

The next blue line (2) signifies the second downtrend line at 2,600, which we thought acted as a minor resistance with the most recent high at 2,650 (blue horizontal line) or a margin of 50 points as enough cushion for false breakouts.

Well the Phisix performed exceptionally well this week. Our benchmarks were significantly overrun. All downside jolts from the US markets have been met with a shrug or insouciance. However the upside was treated with even more dazzling sprints. Plainly said, the Phisix disregarded significant downside moves in the US markets but outclassed them when they moved up. Our Phisix hasn’t behaved like any of the recoupling rubric as proclaimed by the macro looking market and economic Jeremiahs. Not yet anyway.

In fact, the Phisix appeared to have acted out the script we presented last week in Phisix: Knocking At The Exit Gates of the Bear Market!...to a tee!

Moreover, the Phisix strongly outperformed the US market up 4.2% backed by strong broad market activities. Considering that the US closed significantly higher last Friday, we are likely to see a strong opening on Monday.

True, foreigners remain net sellers but they have been reduced to a significant minority (44% week on week) as local money has now dominated the upside action. If the forcible liquidation coming from abroad has diminished thus it is understandable for the locals to take on the destiny of Phisix on their own hands. It is HOME BIAS working at its finest (for the year and since October of 2007) so far.

In short, compared to May, today’s rally seem have stronger legs which should imply what we have been looking for- a transition cycle.

For the bottom phase, we expect one of the two scenarios: one a consolidation or base formation, or two, gradual ascension. If the Phisix should move abruptly higher we might see a sizeable retracement but the recent lows or the former resistance now support should hold, if we are correct about the market in a bottom cycle. And in a bottom the appropriate action would be to accumulate on issues to position for a recovery.

By the way we shouldn’t expect so much for this cycle. The Phisix is still faced with severe external risks, and could be weighed by storms from shocks. Nonetheless, a bottom suggests of a base in spite of the tempest. Anyway, our idea is that if some markets in Asia can pick up in as much as the Phisix then a potential recovery is in sight.

Some have asked me on what issues to buy.

Allow me to quote my favorite from Edwin Lefevre from the classic book Reminiscences of a Stock Operator, ``I never hesitate to tell a man that I am bullish or bearish. But I do not tell people to buy or sell any particular stock. In a bear market all stocks go down and in a bull market they go up...I speak in a general sense. But the average man doesn’t wish to be told that it is a bull or bear market. What he desires is to be told specifically which particular stock to buy or sell. He wants to get something for nothing. He does not wish to work. He does not even wish to have to think. It is too much bother to have to count the money that he picks up from the ground.”

Proof? Look at Figure 6.

Figure 6: PSE: Sectoral Indices In Synchronized Actions

According to Mr. Edwin Lefevre (a.k.a. Jesse Livermore) “In a bear market all stocks go down and in a bull market they go up...” All industry indices have performed almost in sync-bank-blue, services-gold, mining-black candle, commercial-maroon, property-red, and holding green-from bullmarket to bear market to the recent turnaround.

Of course one may argue that one industry could outperform the other. That is true. But generally speaking, they flow or ebb like a tide on the beach.

The last bear market saw almost all stocks fell beyond the 20% threshold bear market levels, except for a few which we identified in Phisix: Learning From the Lessons of Financial History.

If we are right about the Phisix’s new cycle, then the next cycle should see the same characteristics.

Wall Street Journal: Professor Johnson’s Medal Standing Prediction; Philippine Olympic Delegates of ONLY 15 Aspirants Reduces Odds For Gold!

The Wall Street Journal recently published the predictions of economist Daniel Johnson, a professor at Colorado College, on the possible totem pole rankings of medals among the participating countries in the Olympics. Professor Johnson was said to have accurately the outcomes during the past Olympic games (summer and winter) since 2000.

As for the basis of Professor Johnson’s model?

From WSJ, ``five basic pieces of data for each participating nation: GDP per capita, total population, political structure (democratic, authoritarian, military or communist), climate (the number of frost days) and home-nation bias.”

In short, economics, politics and environment were mainly used as gauges to predict outcome.

His prediction for the Beijing games?

Courtesy of Wall Street Journal

What significance from this exercise?

According to Professor Johnson as quoted by WSJ, ``what matters most isn’t comparing the take-home medal count of one nation compared to another but instead measuring it against the nation’s own expected performance, based on his metrics. “This is more of a benchmarking analysis than anything else,” he said, to gauge which nations are over- or under-performing their expected totals. Plus, the overall tally is obviously influenced by the size of each nation and how many athletes they train and send to the games. “One reason Botswana doesn’t win a lot of medals is they don’t send a lot of participants each year,” he said.” (highlight mine)

This blog has predicted that socioeconomic conditions seem ripe for the harvest of the ever elusive first Olympic dream gold medal especially in the realm of boxing as discussed in The Socionomics of the First Philippine Olympic Gold Medal-Thank You Manny Pacquiao.

Unfortunately, we learned that with only ONE boxing representative, Harry Tañamor, the odds for attaining such monumental goal vastly dims-(just learned that the others had lost in the prequalifying rounds prior to the Olympics).

Why?

Aside from economics and the sports itself, the quest for the Olympic gold is also about statistical probabilities as qualified by Professor Johnson.

In short, to INCREASE the odds of realizing such dream we need MORE qualified delegates to represent us. The more the entries, the bigger the chances.

Anyway, good luck to our athletes. We will need alot of them.

Gender Barrier Coming Down In The Olympics: A Reflection of World Socioeconomic Progress?

Evolving important social and economic global trends can be seen in the Olympics-female participation in the games have been getting broader.

From the Economist,

``AT THE beginning of the modern Olympic era in 1896, sport was a male preserve. In the first games there were no women among the 241 competitors. Women got their first shot at summer Olympic glory four years later, when tennis, golf and croquet were deemed suitable pursuits. But as it became more acceptable for women to compete in strength- and speed-based sports, the proportion of female athletes at the Olympics has risen. This year's games in Beijing has more female competitors than ever before, making up 45% of the 10,700 expected participants."

Courtesy of the Economist

Seen from the angle of Olympic delegations, participating nations sending all male teams have likewise been on a decline trend…

Courtesy of gulfinstitute.org

This has been especially evident in some Muslim countries which in the past has had strict clothing and cultural proscriptions.

The implication, according to the Gulf Institute (highlight ours),

``Removing the obstacles for women’s participation in athletic competition and sports in general creates a more inclusive and progressive society that ensures equal rights for all its citizens. It comes as no surprise that countries that do not allow women to compete internationally, whether in such events as the Olympics, FIFA, or the Asian Games, are likely to practice other violations of women’s rights and restrict women’s participation in public life in other ways. Nawal El-Moutawakel, the Moroccan Olympic champion in 400 m race, has put it best in an interview with the Swiss Academy for Development,

“Women’s participation in sport is a reflection of the position of women in society in general. The entrance of women into these sporting spaces often coincides with women's entrance and active participation in civil society and politics.” Therefore, the international community and civil society organizations must join their efforts to bring about a more open and fair social environment by ensuring that women everywhere have access to developing and expressing their athletic potential.”

In short, the lowering of gender barrier possibly reflects the potentials of higher productivity and importantly prospective signs of a more diffusive socio-economic progress.

Technology Changing The Way Games Are Played (Swimming)

Technology seems to have altered the competitive dimensions in the sport of swimming. Skills will now have to be complimented by hydrodynamic designed swimwear (fabrics with least drag) in order to gain an edge…(yes even in sports, gains can be set at the margins).

Courtesy of menstyle.com

This from the Economist,

``But technology matters even more in the swimming pool. The body suits worn by swimmers today reduce drag through the water—especially after a start and following a turn—by as much as 10% compared with suits worn at the last Olympics.

“The most popular body suit this year—the $550 Speedo LZR Racer—is credited with some 46 world records since it was introduced just six months ago. Comparable bodysuits have since been rushed out by Arena, Adidas and Mizuno in time for the Beijing games.

“Speedo gets its edge from a space-age “pulse” fabric and the way it’s welded together rather than sewn to create a smooth, streamlined shape in the water. Engineers at NASA’s Langley Research Centre in Virginia tested more than 60 different fabrics in a wind-tunnel for Speedo to find out which offered the lowest skin resistance…

“The researchers at Langley found that at the speeds simulated in the wind-tunnel, the smoothest fabrics and weaves had the lowest passive drag (the resistance generated by a swimmer kicking forward with the arms stationary out front after a diving start or turn).”

Speedo LZR Racer in Action Courtesy of the Economist

I guess this means it won’t be just about competitive “Olympic” skills this time. Nonetheless, this should also be seen as an incoming fashion trend.

Simply said, we’d probably see more of this high tech $550* swimwear gear pervade the swimming pools.

*of course, one should expect retail prices to be lower so as to gain a 'critical mass'-often the hallmark of technological innovations

Global Markets: The End Of The World? Or Overestimating Global Consequences?

``I cannot find a single convincing argument that tells me that astrologers won’t do better than economists…The problem is the arrogance of these economists, they’re making people rely on theories that have not worked, do not work, and are really dangerous.” Nassim Nicholas Taleb

If you look at today’s prevailing sentiment, especially from those within the US, the perception is that the global financial realm looks likely headed for a meltdown. This leaves investors the Hobson’s choice of running to the hills for cover or burying one’s money under the ground.

Of course, such sentiment has been bolstered by falling asset prices, which if we borrow George Soro’s “reflexivity theory” basically means irrational beliefs or convictions reinforced by market actions can help shape reality- or that market trends have the tendency of molding fundamentals than the other way around.

In the US signs of a deepening economic slowdown, tighter access to credit, rising cost of money, declining collateral prices, forcible liquidations, rising bankruptcies and foreclosures, the seeming paucity of capital, diminishing consumer spending, decreasing business spending, falling corporate profits and a continuing gridlock in the global financial system compounded by high food and energy costs have combined to impinge on the country’s socio-ecosystem.

And the inference is that trade, finance, credit and labor linkages, aside from unpredictable tide of capital flows, effects from intertwined currency regimes and consumer sentiment channels in a more intensified and interlinked world raises the risks of a contagion-a global recession or even a world depression. (The latter has been a popular topic searched at my blog. Besides, google search shows 3,020,000 links, compared to world recession of 546,000-meaning a surge of topical resource materials)

Meanwhile, emerging markets former darlings of global investors predicated on economic growth outperformance appears to have now been consumed by the conflagration of soaring food and fuel prices or mainstream’s definition of “inflation”.

So, from the chain of linkages shown above, the world “recouples”.

Add to this dimension is that since globalization has so far bolstered the faltering US economy via the underlying strength of the global economy fed by the transmission link of dollar links and currency pegs, manifested through via the export and financial assets channels; thus, a softening of the ex-US economic growth tends ricochet back to the US economy, reinforcing a vicious countercyclical trends around the world.

Shrinking US Deficits Mean Lower Liquidity and Higher Risks

Figure 1: Gavekal: Shrinking Global Liquidity via US Trade Deficit (HT: John Maudlin)

As we have pointed out previously pointed out in Global Financial Markets: US Sneezes, World Catches Cold!, the slackening of the non-petroleum trade deficits (largely indicative of slowing demand growth in the US) have been replaced by a surge in petroleum imports (oil imports now comprises almost 50% of total), which makes the overall deficit marginally lower but still significant see figure 1.

However, the recent decline in Oil and commodity prices seem indicative of two important dynamics: one global economic growth could be in decline (see Philippine Economy: World Financial Markets Allude To Diminishing Risks of Inflation) and second, diminishing trade or current account deficits have translated to reduced US dollar based liquidity circulating throughout the world financial system.

Since most of the world transactions remain anchored to the US dollar the US current account deficit functions as the world’s working capital. Hence the decline in the trade or current account deficits leads a contraction of liquidity in the global marketplace and a potential dollar squeeze that leads to a financial crisis somewhere.

Figure 2: Economagic: US Current Account, S&P 500 and US Dollar Index

Figure 2 from the Economagic shows that in the past, significant improvements in the US current account (see blue circles) have coincided with a recession, weakening equity price values and a rallying US dollar trade weighted index.

We have been seeing many of these factors in motion-recession still unofficial, faltering US equity benchmarks, global credit crunch, and consolidation of trade weighted US dollar index-as the current account balance deficits have markedly improved.

So the point is global liquidity have been greatly impacted by the ongoing deleveraging process in some of the major developed economies and the pronounced transfer of wealth from oil consumers and oil producers which can equally be seen as a transfer of wealth from the private sector to the public sector (which likewise adds to the tightening). Thus, the risk environment remains elevated for MOST of the world’s financial markets.

But When The Parasite Is Removed, The Host Will Thrive.

It can also be said that we can’t disagree with the analysis that the world risks transiting into a recession, considering that OECD economies constitute nearly 2/3 of GDP (nzherald.co.nz).

But then again, given the high levels of risk aversion and the impact from contracting liquidity, we can’t also read too much of the aggregate as representative of all the parts, lest be engaged in the fallacy of division- what must be true of a whole must also be true of its constituents, because of the following:

1. There are inherent nuances in the risks profiles of every nation due to the idiosyncratic political, economic and financial/capital markets structure or in the policy directions by respective authorities, see table 1.

Table 1 Economist: Country Risks Scores

This from the Economist (underscore mine),

``The credit crunch continues to depress ratings in the developed world. While the emerging world largely dodged the subprime bullet, it is beginning to feel the impact of the credit crunch and the slowdown in the OECD. Inflation is also having an adverse effect on emerging market risk scores. Inflationary pressures are in part due to high fuel and food costs, but also sometimes reflect overheating and capacity constraints. Central banks are generally behind the curve in tightening monetary policy and will have to raise interest rates aggressively to rein in inflation. This will create strains for companies and households which have borrowed heavily in the boom years, particularly if output growth slows.”

Whether the problem is inflation or from spillover effects from credit crunch or a combo thereof, the different configurations and policy directions determines the disparate risk profiles of each nation. So it would be ridiculous to lump the Philippines in the same category with Zimbabwe or Iraq in as much as it would be ludicrous to classify the Philippines with that of Switzerland or Finland.

Thus, the different risk profiles will result to diverse outcomes relative to economic wellbeing or financial market performance.

2. Doomsayers could be overestimating the risks associated with the chain effects from global linkages while underestimating other variables such as domestic investment and consumption patterns aside from regionalization trends or policy levers available to authorities.

Figure 3: ADB: Emerging Asian Regionalism

For instance, while it is true that Asia remains sensitive to world trade, where 67.5% of exports represent final demand OUTSIDE of the integrated Asia, regionalization has not been CONFINED to simply trading channels but to other aspects such as tourism, equity markets and bond markets (e.g. Asian Bond Market Initiative), foreign direct investments, trade policy cooperation and macroeconomic links as shown in Figure 3.

In addition, learning from the Asian Financial Crisis of 1997, it is noteworthy to cite the region’s attempt to undertake insurance measures such as monetary cooperation like the Chiang Mai Initiative (CMI), or a resource pooling strategy consisting of bilateral currency swap arrangements to cushion potential recurrence of external shocks. Another is the Manila framework, “a regional surveillance mechanism to monitor economic development and issues that deserve attention by the participating members.” (ADB)

Next, in the perspective of policy leverage, the humongous currency reserves of China ($1.81 trillion as of June 2008- Bloomberg) and the rest of the emerging market rubric which accounts for 76% of the $4.9 trillion global reserves in 2007 (Michael Sesit-Bloomberg) allows for much leg room for domestic investment spending or stimulus.

Investment bank Merrill Lynch estimates that Emerging Markets are expected to pour a huge amount of these reserves into infrastructure expenditures as shown in Figure 4.

Figure 4: US Global Investors: Expected Share of EM Infrastructure expenditures

According to khl.com, ``Annual infrastructure spending in emerging markets (EM) - Africa, Middle East, Latin America, Eastern Europe and Asia - is expected to jump +80% over the next three years, according to financial management and advisory company Merrill Lynch.

``The company's latest forecast said EM infrastructure spending would rise from US$ 1.25 trillion to US$ 2.25 trillion annually over the next three years, thanks to more aggressive government spending programmes, fuelled by decades of under-investment in power, transportation, and water, and higher analyst estimates.” (highlight mine).

So while the much dreaded consumer goods and services inflation wanes in the following months, we can expect EM governments to address its policy leverage by renewing its focus to build internal productive capacity.

Here in the Philippines, infrastructure expenditures are expected to climb to $50 billion from 2007-2010 (chinapost.com).

From the investor's point of view, areas where such huge investment undertaking will take place should translate to massive growth potentials and outsized prospective returns.

3. As we have repeatedly been saying, the problem of systemic overleveraging and the attendant market prompted deleveraging process has been mostly an Anglo Saxon or US-Europe affair with very little or minimal exposure in Asia or in the Emerging Market economies see figure 5.

Figure 5: IMF Global Financial Stability Report Update: Bank Writedowns and Capital Raised

Figure 5 from IMF shows that writedowns far exceed capital raising activities mainly seen in the US. From the IMF, ``However, disclosed losses have thus far exceeded capital raised and banks face difficulties in maintaining earnings due to falling credit quality, declining fee income, high funding costs, and exposures to “monoline” and mortgage insurers.” (highlight mine)

Thus, it is essential to understand the distinction among countries baggaged by cyclical or by structural variables. This also means countries affected by countercyclical factors are likely to experience shorter term pain compared to the structurally impaired markets whose recovery are likely to be protracted due to the sizable market clearing process coming out of severe malinvestments.

So we can’t buy on the notion that the world will evolve towards absolute “convergence” based on financial market performance and or in the economic outlook in as much as we can’t expect total “divergence”.

Under today’s environment, economic and financial market performances will likely be discriminatory than a holistic episode as seen during the recent past.

To quote Peter Schiff of Euro Pacific Capital (emphasis mine), ``The world is over-reacting to our problems, almost to the extent that we are under-reacting. Investors are over-estimating the global consequences of the collapse of the American consumer. I have long argued that American consumers have been functioning as global economic parasites, feeding off the productivity of the rest of the world. When the parasite is removed, the host will thrive. While those who have loaned us money will finally recognize their losses, the truth (belatedly recognized) will set them free. Once they move on, the world will enjoy enhanced growth, as it reclaims the savings, resources and consumer goods previously sent to America on credit.”

Phisix: Knocking At The Exit Gates of the Bear Market!

``A natural system has built-in redundancy. It manages and heals itself. The economic system is no exception…I argued against the idea that the economy is a "house of cards," susceptible to collapse as soon as a few cards are dislodged. We suggested that it's more like a beehive. The future of the hive does not depend on full employment for all the worker bees. In fact, an accident can put many bees out of action without compromising the hive as a whole.”-David Ranson, Economics as Metaphor, Wall Street Journal

Amidst the snowballing portrayal of gloom and doom, the Phisix once again appears to be playing our script to a tee.

Last week’s sizzling performance by the Phisix (up 2.85%) wasn’t much of the fanfare. That is, if we take into the account simply the nominal gains. Any market watcher could dismiss this rebound as simply a typical “dead cat’s bounce”.

However, unlike in the previous rallies, what deserves our attention is that the domestic benchmark appears to have reached a CRITICAL level enough to allow for a seismic shift AWAY from its present cycle.

As a reminder, like Mother Nature, financial markets always operate in cycles. This means that presently, the Phisix STILL is technically in a declining phase, otherwise known as a bear market. Segueing into the next cycle means undergoing a cycle shift to a market bottom.

Since market cycles constitute a process, a bottom can be characterized as a period of consolidation (sideways movement) and or incremental recovery. Again all these take time to unfold.

And a shift from the bottom to the next cycle means that as equilibrium has been attained where sellers have reached an optimal level or where they can’t drive down prices further (since they are equally met by buyers at a defined price level or range), investors will gradually develop confidence enough to start improving on pricing valuations.

Thus, from a bottom phase, once optimism starts to gain ground, we can expect the market to evolve into the advance or in the case of the Phisix the resumption of the secular bull market.

Since the Phisix appears to have reached the cusp of reestablishing a market bottom, the obverse side is that if it fails, this implies of the next round of declines or a series of losses to the level of testing the most recent lows.

However, considering that much of today’s rally have been VERY MUCH UNLIKE the past, this seems to present a fairly good chance for a successful breakaway!

Since our goal is to identify a market bottom going FORWARD, as discussed last week, I’ve drawn an outline of measures aimed at identifying the prospective reemergence of the cycle. Hence as previously enumerated:

1) mending MARKET INTERNALS,
2) improving TECHNICAL PICTURE,
3) reversal of FOREIGN FUND FLOWS,
4) possible SIGNS OF DIVERGENCES relative to US markets,
5) improving regional bourses performances and lastly
6), acceptable FUNDAMENTAL "story" for the investing public.

Market Internals Turns Significantly Positive

First we noted that one way to gauge a market bottom would be to assess investor sentiment through market internals as shown in Figure 6.

Figure 6: PSE: Advance-Decline Spread: Broad Based Improvement!

The Advance Decline Spread is a very significant market breadth indicator. It reveals whether rallies are based mainly from BLUE CHIP issues or importantly if the rallies are being reflected over the BROAD MARKET.

Since the start of the year the Phisix has had THREE bull market insurrections. In the three rallies we saw a weakening trend of the POSITIVE advance decline ratios whereas during the declines we saw LARGER negative ratios compared to the rallies, this gap signals the general bearishness of the marketplace. Effectively, we understand now WHY the previous rallies have failed. This seems not to be the case today.

Another, since the start of the year, the bandwith of advancing issues relative to declining issues had been shrinking (channel drawn by RED lines). This means that as the Phisix have declined, the selling pressures as reflected in the BROAD Market has been diminishing. The recent massive breakout on the POSITIVE side accentuated by the spikes (green circle) to the January highs lends credence to the strength of the recent rally!

A continuing rally accompanied by broad market gains ensures this shift away from the Bear Market Phase.

Next, we also noted that a transition to a bottom needs to be accompanied by improvement in the technical picture as shown in Figure 7.

Figure 7: stockcharts.com: Technical Picture and Divergences

The recent rally has brought the Phisix to touch the 50-day moving averages (blue line) similar to the rally in May (see green circles). Perched at 2,584, we need a breach from this level and also from the 2,650 level (minor resistance) to reinforce the confidence of a market bottom.

Of course, if the Phisix advances way beyond 2,900, the likelihood is that we have progressed into the next level, which should be a delight to local punters.

Of course, the local benchmark should also go beyond the variable 200 day moving average (red line) to likewise revalidate the return of the bullmarket.

Emerging Signs of “Uncoupling”; Ambiguous Regional Synchronicity

One of the MISSING puzzles during the former rallies had been SIGNS of DIVERGENCES, another variable which we identified as a potential support in the departure to the so-called “recoupling” thesis. Yes recoupling could happen to many markets, but we don’t share the view that it is going to be a “one size fits all” phenomenon (as argued above).

From the start of the year, most the bear market rallies seen in the Phisix had been accompanied by a corresponding rally in global bourses (near congruence in the blue line trends). This has been a continuing evidence of the high correlation among global equity markets.

Surprisingly, this week’s rallies apparently deviated from the norm and had been manifested over a much awaited development for us- a divergence or “decoupling”.

When the US markets yielded to substantial selling pressure by losing over 2% on Monday, the Phisix sympathized but only lost .5%. On Thursday, as the Dow Jones Industrials lost 1.7%, the Phisix became nonchalant enough to even generate slight gains! So in 3 occasions over the past two weeks, the Phisix seems to have virtually ignored the developments in the US markets.

Thus, Figure 7 exhibits what we’ve been rambling about: the relative DIVERGENCE from the lackluster environments of the US S&P 500 (above pane), Dow Asia ex Japan (pane below main window) and Emerging Market Indices (lowest pane) as denoted by the arrows.

Another minor factor has been regional recoveries. As identified last week in Phisix Best Week of the Year; Identifying A Market Bottom, The Phisix-Peso Tango, some potential bellwether candidates of a market bottom formation (based on charts in) have been in Vietnam, Singapore, Japan and China; although like the Phisix, these needs to be further corroborated by either reestablishing a series of higher lows or as mentioned above by EXTENDED consolidation.

Foreign Flows As Sufficient Support But Not A Necessary Condition

The only factor that seems to be out of our guideline at the moment is foreign fund inflows as shown in Figure 8.

Figure 8: PSE: Foreign Flows Remains On A Negative Bias

The recent spikes in the chart accounted for special block sales, thereby had been omitted from our analysis.

While the extent of the foreign selling has starkly been reduced, since the second bout of selling reappeared last October, as shown by the wedge formation (red lines), daily activities still manifests of continued but subdued net foreign selling.

This is understandable considering that the capital raising activities via forcible liquidation is still an ongoing process of deleveraging on a global scale.

However, it seems that the chunk of the foreign selling appears to have climaxed in Asia and maybe here too. According to a report from Reuters about 80% of the new money taken into Asia last year has already been redeemed.

This means that LOCALS and NOT foreign investors have spearheaded the recent rally. This also means that while foreign money can act as a sufficient pillar in support of the Phisix, it is NOT A NECESSARY CONDITION.

The underlying question is how enduring can local participants buoy the local markets; something which we think will be promptly addressed during the succeeding sessions.

Naturally, it would be a delight to see locals could come into the picture considering the present conditions. My suspicion is that most of these have been by institutions than from retail investors.

Moreover, locals have been the very important missing link into the domestic capital market development, so any signs of participation signify as a welcome development, aside from the relative proof that domestic factors can potentially outweigh external variables.

Fundamental Excuse: Reversing the “Rising Fuel=High Inflation=Lower Stocks” Causality

Finally, as for acceptable fundamentals for public consumption, the recent weakness in global energy prices has also been reflected in the streets through the rollbacks of local fuel prices.

Therefore, for publicity purposes, the popularly accepted oversimplified causality of “rising fuel=high inflation=lower stocks” has effectively been reversed lending to an impetus for the recent rally. Of course, the same cause-and-effect argument has not been validated in most of the world’s bourses debunking claims that “oil” has been the key variable responsible for the weakness in the financial markets.

Besides, much of the ignored factor is that rice and food prices (which accounts as the most critical variable for the inflation issue) have also began to scale back, even as the BSP continues to warn of the threat of rising inflation. This rhetoric of the BSP, I think, aims to communicate its policy actions (yes they are likely to increase rates again) which I believe is necessary to close the inflationary stimulus from negative real rates.

Again, a combination of variables which includes declining global commodity prices, the Philippine supply side responding to the market signals aside from political pressure induced policies aimed at bolstering investment and stimulus as discussed in Philippine Economy: The Micro Impact of Inflation, Bullish on the Peso are likely to lower statistical inflation index over the next few months.

Alternatively, the investments in agriculture should enhance the development in the rural areas, which should compliment the consumer driven “multiplier” of consumption and investment from continued strong flows of remittances despite current global conditions. Another, investments in the mining and other resource oriented industries plus infrastructure development should also cushion whatever decrease from external trade and from other macro economic linkages affected by the slowdown in the global economy.

So with 4 of the 6 metrics strongly suggesting of a continuation of the present momentum-technical considerations, solid market internals or broad based buying, emerging signs of continuing divergences and fundamental excuse of “lower inflation expectations” via lower global oil prices-the likelihood is that we may see the Phisix EXIT the bear market phase sooner rather than later.

As for additional signs from regional recovery has yet been to be confirmed while a positive reversal for foreign money flows into Philippine assets could likely be a bonus.

Overall, the next sessions should determine if we should start to rejoice over the end of the bear market….or have I spoken so soon again?

The Controversy Over Oil VAT (Visceral and Astigmatic Thinking)

``No government ever wants less government — that is, less of itself." Garet Garrett (1878–1954), Insatiable Government, American journalist and author

Populism is anything panacean.

Popular political demand has it that the lifting VAT on oil prices will provide relief to consumers.

No quibble on that- yes “automatic and short term relief” that is.

But, alas the thinking STOPS here!

Look at the table provided by ADB above (shown this last week).

It shows that Filipinos spends an insignificant 2.4% of their income on energy expenditures relative to the aggregate. This means food prices does more of the damage to household spending than energy/oil. It also means households are less sensitive (more inelastic) to price changes of fuel relative to food-and so is the reason why car sales remain buoyant instead of a retreat even under surging fuel costs.

In other words, given the accuracy of estimates in the table provided by ADB, what you see in the news reflects popular dissent over higher food prices than fuel. Thus, oil prices reflect more of the political dimensions (since it’s easy to pick on oil as a culprit knowing that this is PRIMARILY an external causality).

Will the magic wand of lifting VAT ease oil prices? Yes, as argued above-temporarily.

But economic logic tells us that lower prices INCREASES demand.

This means that if oil prices in the Philippines have not reached the threshold of “demand destruction”, increased demand will OFFSET any lowering of prices from the VAT suspension.

Essentially this brings us back to square one- High oil prices but with a gaping fiscal hole! What was deemed as a solution complicates the situation even more.

Hence, what then would be the next item to blame? Will the next political demand be "Nationalization"? (Hahaha!-Philippines import almost all of its crude oil requirements which should translate to a total havoc to the national balance sheets!)

One senator suggested that VAT be replaced with a hike in luxury items (particularly car sales). The honorable senator forgets the effects of high taxes on car sales: car smuggling or legal loopholes which has resulted to the recent brouhaha over “used” car imports from economic zones (see Diesel Roll Back For PGMA’s Sona, MV Princess of the Stars Tragedy, Economic Realities of Cagayan’s Used Car Trade).

Another venerable senator suggests "efficiency" in tax collection by curbing car smuggling. Wonderful, another ideal solution- yes (we agree)! But then again this is nothing new and has been a battlecry for almost every aspiring politician. Yet, such motherhood statements or grand nostrum of lack of “efficiency” goes back to the paradox of overregulation, legal loopholes and bureaucratic leakages and corruption.

So, in effect both Senators have been discussing solutions based on a chicken and egg perspective but don’t deal with the heart of the problem!

The principle of taxation basically is the funding of government expenditures (for whatever programs) derived from revenues levied from its constituents, us the taxpayers.

Rising government expenditures without the necessary funding will compel government to borrow and or print money which results to the deterioration of the national balance sheet or the fiscal deficit.

When government competes with or “crowds out” the private sector in raising money this raises the cost of money while at the same time reducing productivity which derails investments.

Over the longer horizon, if alternative options of borrowing and printing money under degenerating deficits become unsustainable, the government will again be forced to raise taxes furthering our economic agony of rising unemployment, lack of investments, higher cost of living and depreciating currency.

Yet beyond the public’s knowledge; the demand for “reckless” spending to accommodate populist causes could entail the risks of hyperinflation! You should look at the classic hyperinflation paradigm unfolding in Zimbabwe see The Race To Currency Destruction (Hyperinflation): Want to be a billionaire?

Tersely said, short term popular elixirs will only lead to longer term pain. A cure worse than the disease.

While everyone wants to be relieved of high oil prices and the burden of taxation, what people should realize is that cuts in taxes NEEDS TO BE ACCOMPANIED BY A CORRESPONDING DECREASE IN GOVERNMENT SPENDING.

What I am trying to say is that an abolition/suspension/moratorium of VAT should come with DECREASED spending and not shifting of burdens by imposing other taxes, which lead to more inefficiencies in the economy and avenues for more corruption.

None of our political officials have proffered such option because it takes away their inherent privileges of constituent dependency or the basic premise for their existence.

That’s why populism is almost always about intuition, vacuousness and immediate pacification instead of sound policies that ensures productive economic growth by accumulating capital.